Description

Planet Fitness (PLNT) is a franchisor of low-cost fitness clubs.  It provides a good service to its customers at an excellent price.  However, bolstered by insights from my friend who is CEO of a large national fitness club chain, I believe PLNT’s stock is an excellent short, for the following reasons:

1. Its valuation and business model create a highly asymmetric upside/downside balance.  Even assuming things go well for the business, the stock has 30% downside to its fair value.  If things go wrong, the stock should fall well below that point.  On the other side, the business model has little room for operational upside; even the most bullish scenario could not push revenue growth or margins high enough to justify the current stock price.

2. Things will go wrong.  Fitness clubs have near-zero barriers to entry, and competition in PLNT’s price range is already increasing.  More importantly, fitness clubs age very poorly, financially speaking; they tend to hit a wall versus competition once the equipment and club environment are several years old.  Today PLNT’s average club is young because the company has been expanding aggressively.  That average age will grow even assuming PLNT keeps opening new clubs at its current pace.  It should suffer the usual fate of fitness chains once the average age increases materially.

3. Unbeknownst to most investors (I assume), PLNT’s business model generates far more up-front revenue from a new franchise opening than those of most franchisors, currently 40% of total revenue.  Revenue growth will slow more quickly than for most franchisors even assuming PLNT’s opening pace stays steady, because the new-franchise revenue is slowing from 22% last year to 3% this year and 0% in 2017 and beyond.  More dramatically, if the opening pace slows – which it should if competition takes its toll – this 40% of revenue will decline; total revenue growth would fall off a cliff and could go negative even with positive store growth and positive same-store sales growth.

4. PLNT was a JOBS Act IPO in August 2015, and its private equity sponsor still owns the majority of the business and controls half the board seats.  This fact pattern has repeatedly resulted in a stock magically levitating while the PE sponsor unloads its shares in several secondary offerings, then declining quickly once the public share float grows and the sponsor has largely exited.

5. PLNT is the worst kind of IPO, in which the operating business remains owned by an LLC that is still substantially owned by the previous insiders, while the public shareholders hold stock in a corporation that merely owns a piece of the LLC.  This structure creates the opportunity for various types of shenanigans that siphon value away from the public shareholders and to the insiders.

My base case is that PLNT’s stock will follow the usual arc of similar retail-expansion JOBS Act IPOs and fall ~50% over the next year or two.

PLNT’S CONSUMER OFFERING AND COMPETITION

Planet Fitness has an attractive consumer offering.  PLNT pioneered and popularized the fitness club concept of a bare-bones membership that includes only cardio and strength equipment for only $10 per month nominally, $13.50 all-in.  The average American fitness club member pays $35-40 per month.  The extra money usually gets them access to a basketball court, pool, classrooms for yoga etc., sauna, steam room, hot tub, and perhaps some free classes.  However, even other bare-bones clubs have traditionally charged much more.  My home town has a cost of living that is higher than average but still low enough to support several PLNT franchises nearby.  The local mom-and-pop-run club near me offers a bare-bones membership to facilities that are far less attractive than PLNT’s and have far less total machines and free weights.  Yet it costs twice as much on the “headline” number and 2.3 times as much all-in:

For their $10/13 per month, PLNT members get a good fitness club experience, as long as they want only cardio and strength equipment.  PLNT clubs have a lot of machines with enough capacity to handle most peak periods, a bright and cheery décor, and are spacious, clean and (for the most part) new.  On top of that, PLNT’s shtick is that it is a “judgement free zone” with no “gymtimidation,” meaning that they try to make you feel comfortable there even if you are not a totally ripped/hot gym rat.  I was amused to see that they have a big warning buzzer-and-light on the wall that the staff will trigger with a button at the desk if someone using the free weights gives a stereotypical scream and drops the weights too hard.  Dropping the weights doesn’t hurt the weights, it merely creates an atmosphere they don’t want.  The staff person told me that they don’t press the button often, but they do press it.

Despite the $10/month headline price, PLNT’s ARPU is $15.64, in part due to the annual fee, in part because half of its members choose to spend $20/month rather than $10 to get the “Black Card” membership.  The black card adds reciprocal access to all PLNT locations rather than just one’s home location, unlimited guest entry, use of (high-end) massage chairs and tanning beds, half-price in-store drinks, and merchandise discounts.  The black card take-up rate has steadily risen from 38% of members in 2010 to 57% in 2015.

PLNT’s offering has sold very well.  The company has been growing its total club count by 22-25% each year for the past five years, with same-store sales growth of 8-11% each year as newer clubs build their membership rolls.  As of 1Q16, PLNT has 1,113 franchised clubs and 58 company-owned clubs, 1,171 total, with 8.3 million members (including “pre-sales” of memberships for clubs not yet opened).  Management frequently says it has “commitments” (unclear how firm) from existing franchisees to open another 1,000 clubs over the next five years and intends to keep opening clubs at the current pace of 215 per year for the foreseeable future.

The problem for PLNT is that there are no barriers to entry – literally zero apart from advertising scale.  Nothing PLNT does is particularly hard for others to do.  Indeed, compared to most businesses, running a fitness club is unusually easy to do: select and rent retail space, buy the equipment, keep everything clean and well-maintained, marketing, and membership management.  PLNT also has zero differentiation compared to legacy competitors other than price and their “judgement free” shtick, both of which are easily imitated.  PLNT’s only advantage is the scale to do more media advertising and build a brand – but most marketing expense is local and has weak scale benefits, branding is not a strong attribute for a fitness club, and your gym’s location close to home or work is its most important marketing attribute.   

Indeed, the problem for PLNT is much worse than that.  In the fitness club world, it is not only easy for a competing club to be as good as yours; it is easy for it to be better.  All it has to do is open later than your club with newer equipment and a fresher environment.  Although inertia will prevent some members from switching clubs, enough of them will switch that it is a major drag on profitability over time.  The only way to compete is to renovate the stores and buy new equipment more frequently than the theoretically useful lives would suggest.  Doing so drastically increases the store’s capital intensity and doesn’t even prevent all the customer defections.  Here is a piece of the email that my friend the fitness chain CEO sent to me:

Zero barrier to entry biz, endless competition including from people who "just think it’s fun to run a gym," hyper trend driven (though this hits the "basic" places less than the boutique studios/content concepts).  Don’t miss the 2nd half of the "near beats far, new beats old" truism of gym biz.  People like shiny new equipment.  Equipment is expensive/can't cost justify replacing it every 3 or 4 years.  So new guy opens around corner from you with SAME price (never mind deflationary/lower) and it hits you hard.   Only lever you have is drop price - but again not much of a lure to say I'm $8 vs. the guy with great equipment a block away is $10 (the bigger the price spread the bigger that is a lure).  And remember, Mr. $10/month franchisee is still paying off overpriced equip force-purchased 2-3 years ago from the mother ship. . . .  Used to be a gym "peaked" c. year 5 into 6, now much more likely year 3 into 4.

One thing that further piles on to this point - current customers will not give you "credit" for refurbishment.  IE - when we upgrade the equipment at a location (that was totally gross) they say "FINALLY I'm getting my $X per month worth."  Attempts to use that refresh to RAISE prices are always met with total hostility - they feel they'd been "carrying us" as it were.   Indeed the whole experience triggered a lot of people to go look at other neighborhood alternatives.  So if the franchisees are assuming a revenue "boost" when they do these refreshes – we never saw it.  And that being true, irrational for franchisees to spend that kind of $$ to do it.    

Planet Fitness’s own in-store staff demonstrated this dynamic to me.  During one of my prospective-customer visits, the staff person was friendly yet low-pressure, not selling hard.  Yet he still made a pitch at the end for joining his location (which opened within the last year) rather than one of the other Planet Fitness locations nearby (2-4 years old).  (I had not brought up other locations.) “I definitely like this location better than our other ones in our area.  This is the newest one, and that really makes a difference.  Compared to here, the other ones feel, you know, a little grungy.”

Increasing competition is already in sight.  At least nine other chains – Blast Fitness, Blink Fitness, Charter Fitness, Crunch, Fitness 19, Fit-4-Less, Retro Fitness, Workout Anytime, and YouFit – are all offering $10, $15, or $20/month memberships (mostly $10) with various combinations of services.  They have over 900 locations combined and are all growing fast in percentage terms.  Based on watching their new location announcements and some spotty aggregate data, I would guess they are roughly keeping pace with PLNT in new locations per year.  Crunch is the most prominent, probably because it started in Manhattan; it has “over 140” locations with a national footprint (CA, CT, DC, FL, GA, IL, KY, MA, NE, NJ, NY, OH, OR, PA, PR, TX, VA, WA, WI).  Fitness 19 also has “over 140” locations with a national footprint (CA, CO, GA, IL, KY, MD, MI, MN, NC, MH, NV, NY, OH, OK, PA, SC, TX, VA, WA).  

Most of these chains are copying PLNT’s $10 price and most other facets of its consumer offer.  Crunch has “no judgments” plastered across the top of its web site and describes itself this way:

THE CRUNCH PHILOSOPHY

There are no judgments here – No too much or not enough. No glares of disapproval. Here we keep open minds. We are nurturers. We seek only to encourage, empower and entertain. There is no one type. There is no one reason. There is no one way. What we are is a diverse community; what we have is a culture of fun; what there is, is room for everyone: all kinds of people with all kinds of goals who’ve chosen to come reach them with us.
Crunch. No Judgments.

Chains have also copied PLNT’s décor – Blink Fitness claims, “The colors we use are scientifically proven to enhance your workout and have an uplifting effect on mood” – and copied its $20 membership tier.  The tier benefits are almost identical to PLNT’s, as are some of the names (“orange card,” “lime card”):

Other chains may also have similar tiers but do not put the details on their web sites.

The combination of increased competition and aging clubs is going to become a larger and larger problem for PLNT.  PLNT’s “commitments” for 1,000 new franchise openings will become harder and harder to execute on, because the copycat competitors will increasingly beat PLNT to the next-best remaining location.  Once a competitor takes that space, the area around it is no longer a good potential PLNT location, and it may eat into the footprint for an existing PLNT club.  No matter how much advertising PLNT is doing, if Crunch (or whoever) has a club that is half as far from somebody’s home or work, that somebody is highly likely to choose the Crunch over PLNT unless they don’t know Crunch exists.

The club-aging issue makes this problem much worse, even assuming PLNT can keep opening 215 stores per year.  Below is my build-up of PLNT’s store base by vintage, working off of their reported store numbers.  The blue numbers are reported, the red numbers are guesses that are good enough for these purposes:

The average age is calculated assuming that all clubs in the 10+ bucket are 11 years old.  The average is set to rise from 4.1 years in 2015 to 4.9 years in 2018.  Remember, my subject matter expert says a fitness club now peaks financially in year 3-4.

PLNT attempts to counter this aging issue by requiring franchisors to replace their equipment every 4-6 years (at a cost of ~$600k) and refurbish their clubs every 4 years (at a cost of $100-300k).  But as my friend highlights, spending this capital does not boost membership and, indeed, does not even prevent all the potential defections to newer clubs.  Existing franchisees may start balking at spending for these upgrades as frequently as contemplated when they see they will not get a good return on that investment, even in terms of avoided membership losses.

PLNT’S BUSINESS MODEL WILL KILL ITS FINANCIAL RESULTS IF MEMBERSHIP GROWTH DISAPPOINTS

PLNT currently generates a whopping 40% of its revenue from franchisee payments for new club openings rather than from ongoing operations.  Revenue from new openings grew nicely through 2015 as the number of openings grew (96, 118, 149, 171, 209 over the last five years).  But it will now flatten out to zero as openings flatten out at 215 per year.  If franchisees ever pull back from openings, as seems likely once the realities of an aging club base start hitting, total revenue growth will go negative.

That 40% number is an estimate, but is a precise estimate.  The combination of tables and MD&A text in PLNT’s SEC filings split out six separate revenue lines, as follows.  The percentages in parentheses are the mix of total 2015 revenue:

• Franchise (22%), which is composed of:

• Royalty revenue (14%):  New franchise agreements charge a royalty of 5% of a franchisee’s monthly dues and annual fees.  PLNT charged much less in earlier franchise agreements, which are still in place.  Only 30% of current locations pay 5%, and the average royalty rate was 3.27% in 2015.  That number has been steadily rising (from 1.39% in 2010) as more new franchises are added to the base.  The best thing PLNT has going for it is the tailwind from this rising average royalty rate, which is pure profit and boosts margins.

• Franchise & other fees (5%):  Franchises pay $10,000 to open a new location; $10,000 to sign an area development agreement; fees for each online member sign-up (because PLNT runs the web site); and fees for each member billing transaction.

• Placement revenue (3%):  Franchisees are required to purchase their equipment from PLNT.  For a club opening (but not for an equipment refresh), they are also required to use and pay for PLNT’s “placement services” to deliver and install the equipment.  

• Commission income (5%):  Franchisees purchase merchandise, promotional materials, store fixtures, and signage from approved third-party vendors.  PLNT earns commissions on those purchases.

• Corporate-owned stores (30%):  Membership dues, etc., from the 58 locations that PLNT owns and operates.

• Equipment (44%):  Franchisees must buy all their equipment from PLNT.  After the initial purchase, locations tend to replace their cardio machines every 4-5 years and weight machines every 6-7 years.  Management says replacements will be 24% of 2016 equipment revenue and “high-teens / low 20s” longer term.

Pulling all these strands together, using the 2015 results, here is the breakdown of revenue generated solely by store openings, using my estimate for each line item:

THE FAMILIAR RISE-AND-FALL PATTERN OF A JOBS ACT IPO WITH A PRIVATE EQUITY SPONSOR

For short sellers, the JOBS Act has been the gift that keeps on giving, especially if the issuer has a private equity sponsor.  I’m sure there must be one, but I can’t think of a single such stock that has worked out well for the public shareholders who didn’t sell within the first year.  The pattern is clear:  The private equity sponsors find and acquire a company that is in growth mode, usually physical expansion mode.  The growth isn’t worth as much as people think, either because the profits aren’t there and will never come, or because the profits will deteriorate, or because the growth will hit a wall sooner than some people expect as the best expansion opportunities are used up.  They float a small percentage of the company in the IPO.  The growth story plus the low stock float plus, I assume, some active stock price “support” by insiders and their investment bank book runners/enablers keeps the stock levitating and even produces a nice initial run.  The company conducts three or four follow-on secondary offerings in the first 12-24 months, in which the sponsor unloads most or all of its remaining position.  Then the business stalls out and the stock crashes.  Usually the stock crash is well out of proportion to the size of the stall.  For recent examples in the location-based retail sector, see FRSH, down 64% in a year (was -70%), FRPT, down 50% in a year (was -70%), and HABT, down 59% in a year.  Sometimes the business does not even need to stall for the stock to collapse.  SHAK is -55% from its high in a year while the brand is still “hot” and the growth continues to be fine.

In PLNT’s case, after the IPO, insiders affiliated with private equity firm TSG owned 58% of the Class A (public) stock, 71% of the Class B stock, 66% of the total voting power, 45% of the operating LLC’s Holding Units, and controlled 4 of the 8 board seats.  In June PLNT completed the first of the inevitable secondary offerings, selling 10% of the total shares to the public (all from TSG) and an additional 1.5% as the green shoe to their book runners (all from TSG).  The stock was at $19.50 on a Monday just before the offering announcement, it fell to $18.25 on Tuesday, the deal went out on Wednesday at $16.50, the stock closed that day at $17.00, but on Thursday it came roaring back to $19.00.  Isn’t it amazing (cough cough) how, unlike most secondary offerings of fully-floated companies that are issuing new shares directly, these low-float secondary offerings of insider stock almost always work out so well in the short term for the company and particularly well for the book runners who supply shares to their clients and buy the green shoe for themselves?  Anyway, after that secondary, TSG still owns a majority of the total economic interest and controls half the board.  More secondary offerings will be coming in the next few quarters.

PLNT has a bonus feature for short sellers that is rare even among JOBS Act IPOs: A complicated ownership structure that provides ample opportunity for insiders to effectively steal from the public shareholders.  As a private entity, Planet Fitness was an LLC.  The entity gains significant tax advantages by maintaining the LLC and creating a new public corporation that merely owns units in the LLC.  The combined business enjoys a low nominal tax rate, but the public corporation is required by contract to cede 85% of the realized tax benefits to the insiders who own the rest of the LLC.  Here is the ownership diagram from the secondary offering’s S-1 filing.  The listed ownership numbers account for the 10% public offering but not for the 1.5% green shoe:

Coincidentally, SHAK and HABT are two of the few JOBS Act IPOs that shares this structure.  Their public companies also own LLC shares and are each required to pay 85% of the tax benefits to the insiders.  You can read here and here about the various shenanigans that can ensue, to the detriment of public shareholders.

PUTTING IT ALL TOGETHER – THE STOCK PROMOTION STORY, THE NUMBERS, AND VALUATION

As should be clear from the above, PLNT’s private owners had every incentive to grow franchises as quickly as possible and IPO the company right when the growth was peaking – growth not in the number of stores or members, but rather in the number of store openings.  Because each new store “peaks” its financials 3-4 years after opening, insiders would have a roughly two-year runway in which to sell stock in secondary offerings before hitting the wall.  And that is precisely what the insiders did.  The IPO was in August 2015.  In 2015, openings increased by 22%, from 171 to 209.  In 2016, however, openings will only increase 3%, from 209 to 215, and in 2017 and beyond they will be flat at best.  In addition, every year as the existing base increases, new clubs will make up a smaller percentage of the total.  The company will get a lower percentage lift to same store sales growth and to total revenue growth from new clubs building their membership rolls, and less lift from the higher royalty rates from new franchisees.

Thus, if everything goes well – i.e., new competition does not start degrading membership growth or margins – PLNT’s numbers are going to look like this (which is close to the sell side consensus):

• Revenue growth of 12% in 2016, 9% in 2017, and 7% in 2018

• EBIT margin expands to 28% in 2016 (due to eliminating the IPO-related expenses), 31% in 2017 (higher average royalty rate), and 33% in 2018

• Adjusted EPS of 0.65 in 2016, 0.77 in 2017, and 0.83 in 2018.  (NOTE: the company reports adjusted EPS largely to adjust for the LLC ownership structure, including the tax-related payable.  Unlike most growth companies’ non-GAAP EPS adjustments, these ones are fair.)

At $21 per share, that puts the company at 33x 2016 earnings and 27x 2017 earnings, for a company that is going to grow earnings by mid-single digits beyond that point, assuming all goes well.  The company is not under-levered; it already has $446m of net debt, one-fourth of its market cap.  Nor are its cash flow characteristics making the EPS numbers unfair.  The adjusted EPS numbers already eliminate the purchase accounting amortization, and the business’s slightly negative net working capital is not enough to move the valuation needle.  Thus using either a 10-year DCF model or valuation multiples, I see roughly 30% downside even if everything goes well, which it probably won’t.

RISKS

The best thing about this short is that the business has little headroom to outperform expectations.  I may be being unimaginative, but the only way I can think of to goose the results would be to re-accelerate store openings, and management has already been explaining in their earnings calls why doing so would be a bad idea.  (There aren’t enough good available locations to rent in any given year.)  It seems unlikely that average per-store membership rates at mature locations are going to rise beyond current levels.  The business is heavily constrained from raising prices given the relatively high and growing competition and given that PLNT’s primary selling point is its low cost.

The biggest risk is that these low-float stocks have a propensity to squeeze higher than you would think possible before they fall back to earth.  I have been watching PLNT for months because that pattern seemed likely here, especially because it had fallen from $19 around the IPO to $13-14 last winter.  Now that it is up 50% off that low to a new high of $21, the risk of a further squeeze higher seems much diminished.  The fall is likely a few quarters away, but the current valuation makes me willing to take a partial position now.  I don’t want to miss it, so I have entered an initial short position this week.

Catalyst

• Operational disappointments begin somewhere between 2-6 quarters from now as the store base ages and low-priced competition increases.

• The stock stops being propped up as more secondary offerings occur, the float increases, and the insiders and book runners have less incentive to keep the stock up.