|Shares Out. (in M):||128||P/E||40||0|
|Market Cap (in $M):||413||P/FCF||-||0|
|Net Debt (in $M):||52||EBIT||16||0|
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The GYM Group is a UK-based founder-led low-cost gym operator. Selling for 11x true earnings the market is not giving enough credit to a disruptive business with terrific unit economics and long runway for profitable growth by reinvesting at 25%+ ROIC.
The crucial points of the thesis are
- The UK gym sector is steadily growing both in sites and members
- Low-cost operators are consistently taking share from mid and premium players
- Low-cost segment itself is consolidating with 5 strong players representing more than ¾ of sites
- Attractive site economics and resilience to the cycle as members trade-down during recessions
- Long room to grow its current 128 estate by 15-20 new annual openings for 6 years+
- Capable and aligned management with the founder John Treharne at the helm
- Screens poorly as it looks optically expensive by almost any metric – i.e. 40x PE, 29x EV/EBIT
- Accounting earnings obscure true earnings power because of (1) the relative immaturity of more than 40% of the sites, (2) depreciation overstates actual maintenance capex needs (3) exceptional items related to an acquisition and a change in the operating model of the gyms
Sustained growth in the UK health and fitness sectors
Despite the British Heart Foundation estimates that less than two-thirds of the UK population currently achieves the minimum recommended of 150 minutes per week of moderate physical activity the UK health and fitness clubs have been growing by 4% and 6% CAGR since 2013 in membership and number of sites respectively, reaching now 9.7m members and more than 6,700 locations. Interestingly the 15% penetration rate in the UK still lags European peers like Norway, Sweden and the Netherlands all having more mature markets with penetration rates of 20%, 17% and 16% respectively. Given population growth in the UK sits below 1% per annum it is safe to assume rising awareness of the causality between lack of physical activity and increased risk of obesity, diabetes, cancer and cardiovascular diseases on top of less obvious conditions as depression and dementia.
Low-cost segment is taking share
The sector is characterised by two distinct segments – the private clubs operated by commercial enterprise and the public clubs funded by local authorities. As general budgetary constraints have motivated local authorities to cut the recreational spending by 1/5th over the last five years it is not surprising to see the number of public clubs shrinking for the period – 2,724 in 2012 for 2,709 now and a peak of 2,762 in 2015. Public sites now represent ~40% of the 6,728 of clubs in operation. The remaining 60% of the growing private segment spreads between traditional mid and premium operators, either under independent or multi-club format, which account for 3,504 sites and 52% share, and low-cost players – those charging <£25 a month on average – comprising 515 sites and 8% share.
As the typical low-cost gym has >3x the members of the typical non-low-cost peer, the growth in members and share (23% for low cost) are even more obvious from that angle.
As most first timers choose the most affordable option to get into the space and gyms are the kind of discretionary choice where some members steadily pay their monthly subscription fee but rarely show up, low-cost operators are unsurprisingly devouring the growing pie.
You can see the massive gap of member growth for traditional and low-cost operators. And when it comes to the number of gyms in operation the story is the same. There were 5,852 private and public gyms in the UK in 2011. Just 58 of those were low-cost players. At the end 2017 there were 6,312 gyms and 515 of those were low cost, so low-cost share has moved from 1 to 8% in the period. I think these are great metrics that show a structural trend of low-cost actors taking share from both public gyms and mid-premium tier private ones.
Which are the dynamics and value proposition of low-cost that make it to perform so well? First and foremost, price, price and price! Let’s admit it. Gym membership is based on a lie. A lie to ourselves but a lie anyhow. How many of you “commit” every Christmas to get fit for the new year, give up smoking or be more involved in philanthropic or societal causes? Me too.
How many of the new members the GYM gets who have never stepped into a gym before (1/3rd of the total) are self-deluders who sign up to soon stop showing up for a while and try again later even while still paying for membership? I guesstimate some. Ongoing self-delusion only works if sufficiently cheap. On top of it many existing gym customers trade down for similar reasons, too little usage of pricey alternatives. The current uncertain UK economic climate reinforces the trend.
The typical <£25 monthly fee for low-costers is excellent value for money when compared to the >£30 that most public clubs charge for subpar offerings, not to say the £60-100 of the mid and premium players. To be able to charge such prices and remain profitable most low-cost gyms differ in fundamental ways with their pricier counterparts. One, they avoid cost-bloated non-mainstream services such as pools, spa, saunas, cafe-bars and squash courts. Two, they lever IT to reduce personnel and equipment costs. GYM sites have automatic entrance with a personal code and no reception desk, with 94% of new members signing up online and the rest through on-site machines. Technology also allows to track equipment usage to optimize new investments.
This no-frills low-cost base model allows for 24/7 opening and no fixed term contracts as opposed to upper options with limited opening hours and annual lock-in terms. The fact is that as its membership conversion process is way less frictional (low prices + no lock-in) and it appeals to a much larger customer base (24/7 is appealing for night shifters), low-cost gyms are a mainstream service that rapidly gains scale when compared to the traditional options. To put numbers in context a GYM site can take around 6,000 members when matures after 2 years and around half of those members already signed up during the three-month timeframe for pre-opening conditioning. 3,000 clients before opening your business!! Compare it with the one-thousand or even less members of a typical fully scaled premium site.
Low-cost segment is consolidating itself
The low-cost family is therefore the one calling the shots, but not all siblings are equal. A quick look at the graph below reveals that the largest operators are growing sites while the smaller players are retreating. More than 3 of every 4 gyms are operated under a Top-5 brand. The rest of the market is fragmented and ranges from subscale operators to the casual mom-and-pop.
I believe the low-cost segment is prone to remain under consolidation with GYM as the undisputable leader within the segment. Moreover, the consolidation process is accelerating, as GYM accounted for 2/3rds of new low-cost openings in 2017 – that figure includes the acquisition of 18 sites from Lifestyle.
The main cause behind the consolidation trend is scale, which drives a superior value proposition and better pricing. Some facts.
- GYM spends ~£10m on central costs every year, which represent 11% of GYM current revenues. Central costs are mostly fixed. Apply such a level of overheads or even half of it in £ terms to gym chains 1/10th of GYM size as Fitness4Less or 24/7 Fitness. Are they truly profitable? Or should they better sell themselves or discontinue operations? In addition to this static analysis, GYM is scaling while the others are downsizing.
- On last year GYM spent £2m in improvements to its ERP platform and an additional million in initiatives to improve customer experience. For GYM those initiatives mean an investment of 3% of current revenues. For weaker competitors that level of investment is a no-go.
- Site density is critical to provide members with gyms conveniently located near home and work. GYM offers multiple gym membership options in exchange for a higher monthly fee. Smaller comps cannot offer that capillarity. I do not have 2017 data, but in 2015 ~11% of GYM members had signed up for access to more than one gyms vs. just 3% in 2012. The percentage grows over time as GYM opens more locations in each catchment area.
- GYM size confers the company significant leverage over its equipment suppliers and landlords, who see the company as the brand of choice in terms of sustainability and creditworthiness. This preferred status to secure locations confers GYM an enduring competitive advantage, especially in an environment that is likely to see rent in premium areas and other inputs like wages and equipment bear significant pressures as time goes by.
But this Pure Gym guys are larger, right?
The 192 sites Pure Gym operates seem like a good reason for leading economies of scale and rent terms. Leaving aside the industry does not generally operates under price-aggression mode – in a similar fashion to food retailers Aldi and Lidl – then leaving room for two or even three eventual winners, the 192 figure is misleading and does not tell the whole story.
Notably not all Pure Gym sites are low cost. In 2015 Pure Gym bought LA Fitness, a 43-site mid-market operator. Pure Gym planned to convert this mid-market gyms into low-cost units. Having this dual-to-be-one offering (or even if it remained as a dual offering) presents serious challenges to my understanding. Converting a mid-market premise into a low-cost one is a difficult and risky task. Think about the operating difficulties and cost overruns that might arise when the place to be transformed includes pools, spas and other non-mainstream services.
Incidentally, Pure Gym paid £60-80m (the exact number was not disclosed) for the 43 LA Fitness sites. That is £1.4m per gym best case and £1.9 at the worst. I remain very sceptical that the acquisition constitutes a good capital allocation decision as (1) the sites have to be transformed with all the implications I described, (2) the sites were likely to be unprofitable (the seller being a bank consortium bodes well for a story of bankruptcy) and (3) the transaction looks absurdly expensive when compared with the Lifestyle’s one that GYM completed - more on this later.
I also think that GYM’s approach is truly long-term and Pure Gym’s is not, as PE owns Pure Gym as opposed to the founder-led operation at GYM - with the support of long-term oriented funds that own most of the equity, my two cents of contribution here. On last year Leonard Green Group paid £600m or 10x EBITDA for Pure Gym. I think it is unnecessary to remember how incentives in inflated LBO transactions work in terms of exit and investment schedules. The fact that Pure Gym has announced an international expansion plan is unsurprising to me, and I think it is ill-conceived especially given the large room for growth that the UK market still offers.
Finally, gyms are the type of business where relative scale is as important as absolute one if not more. Clustering promotes multi-site membership and fosters brand loyalty. As a public founder-led company with an unrivalled covenant strength the landlords have GYM as their first choice. It follows that GYM is well positioned to offer advantageous pricing and more convenient locations. As the largest market I pick London as an indicator but apply the same logic to other areas.
Attractive Site economics
The typical GYM site averages 16,000 sqf (ranges from 10,000 to 20,000) and takes £1.35 initial capital outlay. It takes 2-years to mature and around 5-7 months to breakeven amid high-preopening costs. When a site is identified GYM takes 3 months before opening. Leases generally have initial terms of 15 years, with upwards-only inflation-linked rent adjustments every five years. The two graphs below explain the maturity profile and schedule.
A mention of depreciation and capex. Maintenance cycle for fitness equipment is five years for cardio and seven years for strength equipment. The typical schedule for a site looks like this.
For the total current 128 sites the ongoing capex needs are thus ~£10m, in stark contrast with the more than £14m of depreciation in GYM 2017 financials. Depreciation overstates actual capex needs because amongst other reasons there are gym areas made of everlasting concrete and other materials that are included in the depreciable base. This depreciation-higher-than capex means that accounting earnings understate GYM true economic earnings.
Year 0 Initial Fit-Out cost……£1.35
Revenue………………… £0.87m (5,000 members x 14.5 average monthly revenue x 12 months)
Gross Profit……………… £0.86m (£0.01m COGS are vending & direct debit processing costs)
Fixed Property costs… £0.28m (£0.18m Rent + £0.1m Rates, Service & Landlord Insurance)
Other Opex……………….£0.16m (Utilities, Cleaning, Repairs and Maintenance and Admin costs)
Pre-opening costs……. £0.14m
Maintenance Capex… £0.08m
Operating profit………. £0.08m (after capex deduction rather than depreciation deduction)
Revenue……………………£0.96m (5,400 members x 14.8 average monthly revenue x 12 months)
Gross Profit…………….. £0.95m
Fixed Property Costs… £0.28m
Other opex………………. £0.16m
Maintenance Capex… £0.08m
Operating profit ……… £0.32m
Year 3 onwards
Revenue……………………£1m (5,600 members x 14.9 average monthly revenue x 12 months)
Gross Profit…………….. £0.99m
Fixed Property Costs… £0.28m
Other opex………………. £0.16m
Maintenance Capex…. £0.08m
Operating profit………. £0.36m
The thesis is as simple as it gets. GYM is already cheap on a non-growth basis. Accounting earnings do not represent true earnings as (1) 54 of the 128 sites are still immature, (2) depreciation overstates maintenance capex , & (3) there are non-recurring accounting items that are truly non-recurring (Beware of extrapolating this case of non-recurrence, I skip any responsibility on this!).
Additionally, the company has guided for 15-20 annual openings going forward. To be honest GYM has delivered so far. Over-delivered to be more precise. The company has guided for a 1,000-site low-cost TAM and I think the number is consistent with other sources such as “UK Gym Market Review” report by Colliers or Deloitte’s 2017 “European Health & Fitness Market Report”. The strong pipeline adds significant value.
A quick check in the name of conservatism. Assuming an "only" 900-site TAM, how long will it take to get there? There have been 61, 62, 131 and 65 new openings p.a. from 2014 to 2017. That is an average of 80 and no-year below 60. Given the rapid de-fragmentation process in the market I find no reason to think that the figures will not look as rosy looking forward. The natural way of things to play out is that the UK will have 900 or even more low-cost gyms in 6 years in a conservative scenario and 5 in a base (and more likely) one.
Therefore, assuming the most conservative case of 385 openings till 2023 and given GYM’s current 25% share, how does the company guidance of 15 to 20 openings fit? Well, 15 openings per year in 6 years makes for 90 accumulated openings. 90 openings out of 385 means 23% of new openings, which is less than GYM’s current 25% share. Does it make sense? I think not given how well GYM is positioned to capture share. Remember that GYM already comprised 66% of new openings on last year. I find the 20 per year hurdle (120 accumulated for a 31% share on new openings) much more reasonable but even in the low-end as I think GYM share will point higher.
On a steady state basis and after 2-year ramp-up adjustment GYM is selling for 11x earnings or 9.4x EV/EBIT. This non-growth valuation is very conservative as I assume (1) all openings are completed at year-end (then delaying maturity) when the reality is that they happen unevenly across the year and (2) the 18 Lifestyle sites are new gyms rather than a functioning and profitable operation and ignore they have more capacity and better rent terms vs. the average site. I have also excluded for comparison purposes £1.7m of exceptional items in 2017 that are truly one-offs – mostly related to Lifestyle acquisition and integration costs. Fortunately, GYM screens poorly with 2017 price-to-accounting earnings sitting at 40x.
Despite indicative of cheapness by itself, steady-state valuation misses the big picture however. GYM has a fantastic opportunity to reinvest at high ROICs by opening new sites. The £0.36m cash EBIT a mature site makes for £1.35m of capital deployed translates into a wonderful ~27% ROIC. The company indeed guides for 32% mature ROIC on an EBITDA basis (£0.44m EBITDA for £1.35m of capital) and has delivered. I get to the following projections when growth is included into the equation.
- 20 openings every year except 19 for 2018
- All new openings happen at year end. Therefore, projections are lagged numbers with an impact on valuation as they affect the time value of money
- 10% discount rate and 12x FCF multiple to calculate terminal value (now FCF multiple is <11x)
With these projections and assumptions, I get to £452m EV and £415m intrinsic value (£3.2 per share) for GYM equity after deducting £37m net debt. This numbers are ~40% above current market levels.
Management, Culture & Incentives
A former professional squash player who even played internationally for England, John Treharne founded the company in 2007. Squash and tennis clubs were popular in the UK during the 1980s and early 1990s but ironically Mr. Treharne quickly understood the health and fitness industry was evolving to a low-cost gym model at the expense somehow of costly squash and tennis clubs that few people were willing to pay for. The 2000s saw a spectacular rise of the gym industry and particularly the low-cost branch. GYM first got funding support from PE and eventually went public in 2015. PE former owner has fully cashed out, yet the company has never stopped to follow the vision of its founder.
Treharne currently owns ~3.5% of shares outstanding and insiders (Treharne, the CFO and Board members combinedly) own ~5%. Sure, I would have preferred a higher insider ownership, but the world is not perfect. As a mitigating factor his ~£10m ownership is about 40x his fixed compensation for each 2017 and 2018, £245,000 and £255,000 respectively.
The long-term incentive side of Treharne’s compensation is linked to EPS and TSR. I am not a huge fan of these metrics either. EPS can be inflated via non-value accretive site expansion funded through cheap debt. And TSR is an uncontrolled market-thermometer rather than a true measure of corporate performance. The KPIs for annual bonus, EBITDA and site openings, are not ideal either. A mitigating factor is that there are internal hurdle rates ROIC-related for new openings. The only compensation-linked measure I truly like is NPS (linked to annual bonus), not because I think NPS is particularly a good proxy for customer satisfaction, but because it shows the company has customer orientation.
I believe Treharne is truly aligned with long-term shareholders though. He is the rare case of founder that stays after 10 years of foundation and after an IPO. In the current corporate world this C-level endurance is more of the exception rather than the rule. He does not plan to retire any soon.
In close relation to the vision of its founder the company culture makes me confident. Treharne does not see GYM as a gym operator, but as an industry disruptor that does it by offering the best value for money to customers. He thinks that the company is more like a low-cost airline like Easyjet and less like other gyms. The culture is customer-centric and the company gives responsibility to site managers to decide what is good for specific customers following general corporate guidelines.
Most of the internally generated funds are invested in new sites if they meet the 32% EBITDA-based ROIC hurdle. The company also shares a small dividend (the dividend policy is 10 to 20% pay-out ratio) as some shareholders demand. I would certainly prefer that all proceeds be reinvested at those rates of return.
Interestingly the company opportunistically acquires gyms from other chains. I leave aside smaller acquisitions in the past and last year’s acquisition of one site from Fitness First to focus on the largest transaction insofar. 18-sites from Lifestyle for £20.5m. That is £1.14m per site. Sounds like a sensible acquisition or not? Let’s compare it with the typical opening.
- Lifestyle cost per gym is £1.14m outlay + £470K conversion costs to GYM brand = £1.61m.
- Organic cost per gym is £1.35m outlay + £110K pre-opening costs= £1.46m
Lifestyle sites are £150,000 (10%) more expensive. I do not feel that it GYM is overpaying as:
- Lifestyle sites are already open, so they have less business risk as opposed to a new opening
- Lifestyle gyms are profitable from day zero, as opposed to the 3-month pre-opening period and the attached pre-opening costs that translate into some months to break even
- Lifestyle sites are generally 20-30% larger than the average GYM site so they can attract more members
- GYM has secured advantageous rent terms for the Lifestyle locations. A very rough approximation is the following. As the typical GYM site size is 16,000 sqf and the rent is ~£180,000 p.a., that is ~£11 per sqf p.a. I asked the company and double checked with a landlord and Lifestyle typical rent now is £9 per sqf p.a. To put it in another way, Lifestyle sites are significantly larger but pay similar rent in £ terms as the typical GYM site.
Additionally, the conversion process to GYM-like sites is working ahead of schedule. As a data point, just by making most of Lifestyle sites 24/7 (most of them had limited opening hours) membership in those sites has grown by 15% in just a month.
Finally, compare the Lifestyle acquisition with the LA Fitness acquisition previously described in this paper. Even in the most favourable assumption for Pure GYM (the one that estimates it paid the low-end £1.4 per LA gym and not £1.9), the sites need full conversion and are unprofitable...
- GYM starts to make capital allocation mistakes on new openings resulting in lower incremental returns on capital
- GYM screws it by overpaying for an acquisition, or by acquiring gyms in the wrong locations or with technical difficulties for conversion
- Alphabet, Facebook or whatever FANG launches a VR platform with an amazing gym app that captures members from physical gyms
- Players in the industry start a price war in a desperate attempt to take members and share
- Authorities start to actively promote other options and quite a few members begin to strongly consider open-air zero-cost alternatives like running
- New-site roll-out
- Any LBO-lover willing to pay a high multiple out there?
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