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Gym Group (GYM) has been on my watchlist for well over a year, at which point it seemed a very expensive valuation for a company struggling to break even. The share price though has been slowly been falling back after this period of punching well above its weight. The company recently reported an impressive set of final results for 2016, making its maiden profit since IPO, so is it now time to take another look?
Gym Group listed on the main market in 2015 and claims to be a disruptive health and fitness group offering gym memberships nationwide at around 90 clubs. Members are not tied into contracts and its gyms are open 24/7 and thus the group offers a more flexible service to suit modern lifestyles. Memberships start from £10.99 a month and they come largely without frills, some gyms do though offer classes on top of the DIY equipment though.
Quick facts as at 17th March:
|Current Share Price||172p|
|All Time High||280p – 21st April 2016|
|52 Week Low/High||168p – 26th December 2016
280p – 21st April 2016
|Enterprise Value||£226m, includes Net Debt £6m|
|Fully Diluted Market Capitalisation||£221m, some options outstanding|
|PE/EPS||38 / 4.46p based on 2016 results|
THE MACRO STORY
Gym Group is trying to carve a position out as a disruptive low cost alternative to the traditional gyms that have dominated until now. The traditional model is to sell a yearly contract valid for a single club, big players are Fitness First, Virgin Active, David LLoyd etc. This traditional model tends to work well for middle class gym bunnies with a predictable routine and money to fund the often expensive fees (if not paid by the corporates they work for) but less so for those who don’t want to/can’t commit to a long term contract. The only alternative until recently has been the public/municipal facilities which often allow users to pay as they go. My own experience of council facilities though is like most things municipal, funding is the issue. The municipal leisure centre I visited for example had equipment which was probably last upgraded when Arnold Schwarzenegger was at his prime.
There are currently 6,400 gym/combined gym facilities in the UK of which the low cost sector represents just 7%, this being dominated by three players of which Gym Group is one. As shown in figure 1, the company represents just 1% of the total clubs in the UK, so there is a large potential market if more punters can be persuaded to be switched from the traditional to the low cost model.
It is worth noting that the total UK gym and fitness market has only been growing by around 2.5% a year though in recent years, we have reached ‘peak gym’. This is a mature market defined by fierce competition between the participants rather than a growing sector carrying participants. So like a finely sculptured Gym bunny, participants need to be lean as barriers to entry are fairly low and potential to innovate arguably limited. Competition is mainly defined by price, location and quality.
The budget sector though has a clear competitive advantage on price, you might make the comparison between EasyJet and British Airways. In the aviation industry it was eventually price that won leaving a smaller number of companies to fight for the premium sector. I’m not saying the same pattern will definitely emerge in the gym sector, but it might. The way I see it is that exercise is not fun, so i’d rather pay as little as possible for the privilege. There are still plenty of premium niche operators popping up though and class exercise is a big thing at the moment, underwater yoga is ‘a thing’ now apparently for example. We can probably conclude that budget operators won’t take all of the share in the sector, but I feel it is the time for health and fitness groups to put themselves in one camp or the other, of face the risk of being squeezed out of the market altogether.
TO THE COMPANY…HOW HAS GYM GROUP PERFORMED UNTIL NOW?
The Net profit for the company was £5.71m based on the 2016 results, which compares to a market capitalisation of £220m. This gives a PE of 38 and looks pricey at first glance. Gym group though is (hopefully) a growth stock and we must look more to the future rather than the past to find a sensible valuation. We’ll get to the future later but let’s take a quick glance at the last few years first.
It has certainly been a challenging 5 years since inception. Prior to 2016 the one off costs associated with new clubs and gaining a stock market listing has meant that whilst revenue has continued to grow, the operating margin has been poor, which is illustrated in figure 2. On top of the Pre IPO financing required was expensive which meant losses at a Net profit level were even higher. This meant that the group has to the end of 2016 total retained losses of £27.9m.
The green shoots are emerging though, the company though has just posted a 10% operating margin for its full year 2016 results, which includes depreciation. The company has even managed to chalk up its first net profit too, at £5.2m after tax. The management statement is brimming full of confidence and indicates that management have gained control over its cost base, improved contribution towards head office costs, eliminated material exceptional costs and begun to see the mature gyms in the portfolio contribute good profits.
At a PE of 38 though does justify the share price? This does look expensive at first glance, but the cashflow statement is where the excitement is, the company is really starting to make significant progress in generating cash of which the development in the last 5 years in illustrated in Figure 3. The Cashflow from Operations for 2016 was an impressive £24m, almost 5 times the net profit. The reason for this disparity between cash and profit is that Gym Group is a fairly CAPEX intensive business and much of this has been accounted for in prior years and is now hence a sunk cost. These assets are still being depreciated through the P&L which explains the large gap between cashflow generated and reported profits.
Given this disparity between cash generated and earnings lets take a look at the market capitalisation compared to Cashflow generated from operations in Figure 3, this method which I refer to as PCFO (Price:Cashflow from Operations) gives a figure of just 9, so all of a sudden this proposition starts to look like a very attractive business indeed, particularly if controlled growth levels can continue at this pace. This is a very different story to many of other companies on high PEs.
Free Cash Flow, i.e. after you subtract the cashflows from investments is also positive at around £2m. The cashflow from operations is being put to use making investments in the fit out of new gyms, of which 15-20 are expected to open in 2017, which will hopefully boost the cash generated from operations further in future years. The £2m or so free cash left over was enough though for the declaration of the maiden dividend, which will return £1.3m to shareholders through a 1p dividend (including interim). This places the company on a dividend yield of 0.58%, hardly competitive but management have indicated this will be progressive. So let’s take a look at how the company can potentially boost this return in the future?
WHAT DOES THE FUTURE HOLD FOR GYM GROUP?
Management have included guidance to analysts for 2017 which includes the opening of 15-20 new gyms with £25m of expansionary CAPEX required to achieve this. This is inline with the last three years expansion levels. I have used the analyst guidance as well as my own assumptions to project earnings and cashflow out for the next 10 years, based on being able to open 17 gyms a year. This would take the company to 276 gyms by 2027, more than double those committed to by the end of 2017. Figure 4 shows the results:
In summary, if Gym Group can keep control of costs and maintain the current growth rate then we are looking at some very attractive earnings and even more attractive cashflows, with my projections indicating £40m of Cash from Operations and £20m Earnings within 5 years, this would place the company on a very lean PE of 10 based on the current share price. You might be questioning whether the target of 17 new gyms a year is achievable, especially in a mature market. This and the other ‘derailers’ we will get on to later, after we look at how my projections value the company today…
WHAT IS A FAIR VALUE FOR GYM GROUP?
My own risked valuation is 223p per share, which gives a potential upside of 30% from the share price. I expect this target to be reached within 12 months barring any disappointing trading updates. Broker targets issued since the results are 250p-275p.
My valuation is based on a 10 year Discounted Cashflow with a Discount Rate of 10% (opportunity cost of investing elsewhere) and Terminal growth of 2.5% per annum. This gives an unrisked NPV per share of 310p. I have then applied a 30% margin of safety to take account of the riskiness of cashflows, which is subjective but feels about right for this company. For the anoraks my full workings to the valuation are here which shows in detail the assumptions used and the historic data too.
WHAT ARE THE SUCCESS FACTORS/RISKS TO THE VALUATION?
The critical factor as touched upon already is gaining and retaining market share, which is a function of the following:
a) Key Management
As always a company is only as good as its management Team. The board is chaired by Penny Hughes, former president of Coca Cola GB and Ireland, she has had a host of non-executive positions including Vodafone, RBS and Reuters. CEO is John Treharne and founder of the group and has three decades in the leisure industry. Heading up the numbers is CFO Richard Darwin, a Chartered accountant and counts two previous CFO roles at Essenden Plc which was taken out by Private Equity in 2015 and Paramount Restaurants before that.
Management have a stacks of smaller scale leisure experience and chaired by Penny with extensive major corporate experience. Management also own 5% of the company between them, helping to align shareholder interests. Final credit to management is the very clear reporting to shareholders and detailed guidance.
b) Winning and Retaining Customers
For 2016, the company reported approximately 5,000 members per gym which together with a tight control on costs generated a respectable operating margin of 10%. But what happens if customers desert? I have run the following sensitivity analysis which shows how sensitive the number of members in each club is to the overall valuation. A 20% spread increases the valuation 300% based on the opening of 17 gyms a year. The reason for this is fairly simple, much of the cost base is fixed so every member counts and contributes towards this cost base. Rather surprisingly if gym group were able to open just 5 gyms a year but achieve 5,500 members per club then the valuation is around 360p per share compared to 310p for 17 gyms a year but just 5,000 members per gym. The analysis is fairly simple but the message is also clear, quality over quantity. So return to the above concern about whether the company is able to grow at 15-20 gyms a year in the long term, my analysis suggest it isn’t essential to create value, as long as the locations it does choose are in locations with a high potential number of members and leases can be secured at a good price (more on costs laters) .
We also discussed above about the market not growing much overall, Gym group therefore needs to compete head on. Interestingly though Gym Group claim that 34% of new joiners have never used a gym before. Whilst this is obviously positive it seems to be at odds with the overall sector data, unless we believe low cost is the only driver of growth in the sector. Fundamentally though to retain and attract new customers is a function of mainly price, location and perhaps to a lesser extent service in this low cost segment, although not unimportant.
Starting with service, the group counts over 10,000 reviews in the last year at FeeFo, an online survey company. The score is currently 4.4/5. This is a very good score, unfortunately the competitors do not have a feefo score, nor are there sufficient reviews on alternative services such as Trust Pilot, so we can’t compare. Nonetheless if Gym group can sustain or improve the service level without much investment then I have no concerns in this area at present.
Moving on to price, the good news here is that Gym Group currently have the lowest headline rate of any of their major competitors. This is despite a major presence >30% within London, where rates commanded are often higher.
Pressure may increase as competition increases, but this will be an issue largely in areas where there are other low cost gyms present. There is a limit to how far customers will travel to visit a gym to save a few quid. That is not to say the gym group can set the price where it has no competition, another alternative is for consumers to switch non gym related activities or even revert back to the couch. Let’s take a doomsday scenario and look at how a drop in headline membership rates may impact the valuation…
c) Driving Revenue and Controlling Costs
I’ve ran another sensitivity which shows the effect of increasing/decreasing revenue and costs. This again is a fairly simplistic sensitivity which assumes a one off increase/decrease in cost/revenue in 2018 and inflationary increases thereafter. It is based on 5,000 members per club with 17 new clubs opened per year.
The conclusion? It is not catastrophic for a 5% increase in costs and 2.5% decrease in revenue, this would equate to a 200p unrisked NPV per share, but it certainly would mean the shares are fully valued today. On the flipside increasing revenue 2.5% and decreasing costs yield and valuation of over 400p per share. The company has increased headline rates by 3% for 2017 and it will be interesting to see how this affect membership levels and whether this will flow through overall revenue per member increase also.
The balance sheet is in good shape and I project that current plans for growth can be funded organically. There may be a need to dip in and out of borrowings through troughs and peaks, but the group currently has £30m of undrawn borrowings out of a total facility of £40m. The £10m currently owed is due for repayment in 2020 and there should be no issue with repaying or refinancing this facility when that time comes.
There should also be no need for any equity financing based on organic growth and I expect this option only to be pursued if a highly accretive acquisition presents itself or a major move into a new geographical market.
ANY OTHER CONSIDERATIONS?
The only other thing to note is the recent exit of the private equity (PE) backers with their 30.5% share. This has unnerved some, but is completely normal for PE to exit once a company becomes stable. So far we have seen disclosures to suggest that 50% of the shares disposed of has been acquired by Merill Lynch and what I understand to be High Net Worth German Investor Daniel Crasemann, with his Barralina vehicle. In total after the PE exit around 56% of the shares are with institutions with disclosable positions.
BUY – Initial Price Target – 217p, 26% upside
I like businesses that are simple and fairly easy to understand and it doesn’t get much more simple than this one. The maiden profits are a positive step and the outlook for 2017 looks positive. It remains to be seen whether this trend can continue but the risk/reward looks appealing at present. The focus should continue to be on high quality locations and working hard to maximise the number of members per club. The major risks are the low barriers to entry, a slow growing overall market and the pressures of competition that this will bring. At present Gym Group has the lowest headline rates and excellent service so has a solid footing to protect and increase market share, if and when the competition intensifies.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.