Small Cap Value Report (Wed 30 Aug 2017) - GYM, HSS, OPTI

30th Aug '17 by Paul Scott

24 comments 13160 reads

Good morning, it's Paul here.

Apologies for the mix-up yesterday. Graham & I got our wires crossed, and both thought that the other was writing a report. Anyway, I rectified the situation with a report on 5 companies which I published last night. So yesterday's report looked at;

Interquest (LON:ITQ) - another profit warning

Findel (LON:FDL) - trading well, but I have other concerns

Image Scan Holdings (LON:IGE) - positive trading update (I hold this one personally)

IG Design (LON:IGR) - in line trading update, and decent outlook

Real Good Food (LON:RGD) - another profit warning

Here is the link for yesterday's report.

GYM (LON:GYM)

Share price: 212p (up 3.4% today)
No. shares: 128.2m
Market cap: £271.8m

Interim results - this company operates 97 low cost gyms in the UK. It reports today on the 6 month period to 30 Jun 2017.

The shares listed in Nov 2015, at 195p each. So overall, little share price progress has been made since then, once the initial flurry of excitement wore off, as you can see from the 2-year chart below;

I like the chart - a long period of bottoming out, and now what looks like the start of an up-trend. Could this be a buying opportunity? Let's have a look.

The financial highlights cover the main points, with my highlighting the most important bits;

As you can see, there's good growth. This company is basically a self-funding roll-out - i.e. the cashflows from existing sites are being used to finance the opening of new sites. I really like self-funded roll-outs as investments. The beauty is that investors can just sit back for a few years, and watch the company expand & grow more profitable. That usually leads to considerable share price appreciation.

The main risk to roll outs is that operational problems are considerable. Management has to not only manage the growth, but also keep control of a…

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Effortless Cool

30th Aug '17

The weakening in the depreciation rates at GYM is a massive red flag for me.

Gym equipment tends to get intensive use and needs to be regularly replaced to keep the membership happy and attract new members. There is a huge fixed asset base and assumptions on depreciation rates are critical to the level of profits reported. Depreciate too slowly and profits and EBITA are overstated, although it can take a few years for this to become apparent.

I view the reduction in the depreciation rates this period with great suspicion.

As an aside, I would add that the focus on EBITDA in the investor presentation bestace linked to above is entirely inappropriate, given the criticality of depreciation to this business.

Ramridge

Re. GYM (LON:GYM) What impressed me about their presentation is the fact that low cost gyms only account for around 10% of the overall UK health & fitness market. (£0.5bn out of £4.7bn in 2017).
So there is plenty of headroom to capture market share as long as their operating model remains solid and execution of current estate and expanding roll-out remains tightly controlled.

BankOfChina

Well, I'm actually looking for both investment ideas, and a new gym...so very timely article on both fronts.

Looks like a sensible little investment. On to the watchlist it goes.

(Monthly fee is £22.99 in my neck of the woods - do they have regional pricing?)

andrea34

In case anyone holding OPG, they are down around 25% due to a warning on 2018 results due to an unexpected increase in coal prices. I don't believe that this is the first time that coal prices have "unexpectedly risen"; have dumped mine :-/

rhomboid1

Interesting slide, not sure how they've missed one of their biggest competitors off the list;

https://www.lifestylefitness.co.uk/find-a-club?gclid=COHesa-N_9UCFYW37QodmQUABw

50 gyms c£18 pcm, only different in 12 monthly contract which is no biggie imho

ericb

What region are you in - China ?

Paul Scott

Hi bestace,

Excellent contribution (as always!), thanks very much.

I'll put a link to the GYM (LON:GYM) results presentation in the main article.

Regards, Paul.

bestace

The FD added some additional colour in the webcast on the change in depreciation rate.

He said that as a very young business, they were still evaluating how much life they can get out of certain assets and he cited their portals (entry systems) which they had been depreciating over 10 years, but they have now reached that point at some of their sites and found that the systems are still fit for purpose. They are therefore now depreciating those items over the life of the lease.

It's possible the changes are therefore unrelated to gym equipment, where if they are sticking to 5-year replacement cycles I don't think they could reasonably justify increasing the useful lifespan beyond that point and nor would I expect their auditors to allow that.

I had a look at a few of their competitors' accounts on Companies House and they are all indicating similar asset lives for gym equipment (typically around 6 years).

There was also an analyst question on the webcast about pricing for gym equipment and the response was that given they were rapidly increasing in size, there were economies of scale that should allow the replacement cost of gym equipment to be lower than the cost of assets that are being replaced.

Graham Ford

"Interesting slide, not sure how they've missed one of their biggest competitors off the list;"

If you look at the slide you can see that they are referencing a report by Leisure Database Company. So, it's not The Gym's data as such. I expect that Leisure Database Company either had problems obtaining the data, perhaps Lifestyle Fitness were not willing to co-operate, or it was human error to leave it off the slide.

As I mentioned, there are plenty of competitors, so it is really a case of who can execute the low-cost model most effectively. Right now, the numbers that GYM (LON:GYM) are achieving show that they are one of the best. (They've had the Paul Scott fine tooth comb treatment and were found to be sound).

As regards being locked into a 12 month contract, there are often complaints about the Ts&Cs with contract gyms in the papers and on-line. Just try googling gym membership renewal complaint. So, while being locked in a 12 monthly contract is no issue for some people there are many who have difficulty with it.

A couple of extra points on GYM (LON:GYM) . They have a very good facility whereby members can suspend their membership online, if e.g. you're ill, or away from home for a long period, and won't be able to use your usual Gym. You just pay £5 p.m. to keep your membership dormant. When I was a member, I did that, and it gives GYM a nice opportunity to tempt you back in. Plus of course I was still paying them £5 p.m. for nothing.

As regards competition, my view is that for just £14 p.m., it's going to be convenience and closeness to home that are likely to be the main factors. So if a competitor opened nearby and charged £12 p.m., would customers really give up their GYM membership to join the competitor? I doubt it personally. The price differentials are just too small at this budget level, so people are more likely to stick with the gym they are used to, and happy with.

So I remain of the view that GYM should continue to do quite well. The fears some here have expressed about depreciation policy seem overdone, in my view.

I got the feeling that GYM seem quite sensible with their accounting. Note that they didn't highlight the higher, pre-opening costs profit figure. That's just included in a table, but is not highlighted. Compare that with some other expanding retailers, who make a huge song & dance about higher profit which has adjusted out pre-opening costs.

The competition which would worry me, is free, or nearly free competition from local authority sports sites. Remember that this type of thing hurt Goals Soccer Centres (LON:GOAL) some time ago.

Regards, Paul.

nicobos

I've looked at a lot of the gym businesses over the years and whilst the mid market has been smashed (la fitness, fitness first, esporta), it is clear there's been move towards budget and premium (such as Virgin) / racket clubs (David Lloyd). The budget gym model has grown explosively and performed well over the past 5 years but I do have question marks over the long-term profitability of the sector.,.

Some questions you may want to consider before investing:

- do they mention LFL growth of the core estate? Rollout potentially masks falling member numbers / profitability of the core business. Attention is diverted to the growth in turnover which is itself a byproduct of rolling out new sites and ramp up of those sites still maturing.

- budget chains grew fast during the last recession when rents were cheap. Many leases were signed on good deals which will be subject to upward rent reviews after 5 years.

- As rent and other cost pressures (rates, wage inflation) come through to impact the business, the only lever you have to pull (assuming membership numbers are fairly stable) to maintain margin is an increase in membership fees. Ok, the fees are cheap but over 40% of those using the budget gym sector are NEW to gym-ing (I.e. Were not regular gym goers beforehand). They are going as it is Cheap! Once prices start rising and if wage inflation does not keep pace, are you so sure these members will keep going ?! It will be interesting to see how these businesses survive a recession.

- finally, there is the high member churn in the sector. Marketing budgets are increasing to keep the established sites membership numbers stable (again, impacts margin). Also, when a competitor opens in close proximity with newer equipment, you can expect to lose a third of your membership base. Due to the operational leverage within these businesses, this can have a large impact on profitability.

In summary, this model was very attractive coming out of the last recession with budget chains rolling out sites with no competition and plenty of white space to grow into. As the sector matures, I can see it suffering from the problems as the mid-market did where investors lost their shirts. It could have a fair way to run yet though..just not one to hold 'forever' imho.

Howard Marx

Great post nicobos

Viz

I agree with all that you've said, I'd add that as 'first mover advantage' (insomuch that they've already grabbed a big slice) in the budget sector, this should provide somewhat of a moat.

As Paul says, yes, it can be replicated for less, but how many people swap gyms to attend an unknown quantity for the sake of a couple of quid?

I'd like to see how many lapsed/terminated memberships were renewed and the length of those lapses (i.e. had they tried the competition and reverted back).

As an aside I was in David Lloyd last week as a guest. I was amazed at how busy it was, given it was the middle of the day on a weekday. But the prices. If you were really into fitness and had to tighten your belt, I know my host would ditch the David Lloyd membership for a GYM membership as DL is more of a 'social club'.

A lot of the budget gyms cluster in an area (near a key transport hub for example) so the location differential is not so apparent. The problem with new openings is that they work a bit like the airlines where the first 1,000 members or so can sign up for a year for half price, as they mature and reach capacity the prices do then begin to rise.

In this initial promotional period, the savings over 12 months can be substantial so that the existing gyms in the area do lose members. Combine this with shiny new equipment and it not being busy (I.e. No waiting for machines) when you need to use it, and the appeal can be quite attractive !

Then you have the 40% of newbies and churn to contend with. When there was only one gym in an area, you could pick up these members easily but say there are now 3, you have to work a lot harder to keep your membership base stable !

David Lloyd is a great business and competes mainly against independent 'racket' clubs. Whilst there was a dip in the recession, it did not fall as far as you may think as people are reluctant to give up their 'social club'. Quite often it's a place for families to spend time at weekends (kids having tennis lessons whilst parents use the gym etc); a safe and friendly environment.

It doesn't compete for the same demographic as low cost gyms and DL's members would rather give up one of their expensive family holidays per year than their annual membership.

nicobos,

Brilliant points, very well made! (re GYM (LON:GYM) ), post no.15 above.

I think you may have hit the nail on the head there.

So I won't be investing in GYM now.

Regards, Paul.

Good points, well made. I should note I have a small position in the kids isas for a longer term view.

Given the rates the ability to open new sites pretty quickly, one would hope that if they cannot retain members in the manner you describe that they can ease up on opening sites and divert cash flow together with looking at closing any sites that aren't performing as well.

I'd finally note that the DL I went to in Beckenham seemed a bit tired but that's an aside.

31st Aug '17

Plenty of food for thought there nicobos. I have no position here (yet), but here are some counterpoints as I see it:

I think too much weight can be put on LFLs by investors. Focus on LFLs by companies can lead to distorted incentives and what matters more than LFL on the top line is overall profitability. While there are tailwinds allowing the low cost sector to grow strongly, we are still some distance away from the point of saturation where sites will begin to cannibalise each other (in Germany, the low cost sector accounts for around 50% of the market compared to just 10% in the UK and in both countries the low cost players are increasing the size of the pie as well as increasing their share of it).
Although GYM don't highlight LFLs, they also highlight more than just the metrics that put the best gloss on their performance - they report on growth of members, sites and revenue so it is possible to work out a rough LFL approximation if you want.
Yes leases will be subject to rent reviews every 5 years but that is standard and is baked into the economics of each site. GYM said today that they reject 30 sites for every new site they do open, (presumably because the economics don't stack up), so they appear to have a good sense of capital allocation. £GYM are upfront about the rent reviews in their presentations. They also make the point that most of their direct competitors are privately listed and burdened with private equity debt which makes GYM a much more attractive prospect for landlords (by way of illustration PureGym last reported £327m of net debt and £69m of negative net liabilities).
If some costs do increase, I don't agree that increasing membership charges is the only lever they have; by growing they can leverage their increased scale to achieve cost savings in some areas to offset cost increases in others e.g. in the cost of gym equipment or utilities. I appreciate you were talking about a 'steady state' situation i.e. no growth, but as I said above I think we are still far enough from that point that it can be ignored for now. They can also push harder on other income streams such as the soon to be launched premium rates, charging for classes, offering fitness monitoring technology etc.
Furthermore even if margins are squeezed, two points could be made:
- firstly it does not necessarily follow that lower margins = lower profitability, on the basis that profits = volume x margin. To repeat my first point, it is overall profitability that counts and If margins are squeezed they have volume growth to compensate
- secondly, aren't low margins essentially what the low cost model is all about? if they truly aspire to be a Primark or an easyjet for the gym world, they should be aiming to have the lowest margins in the sector (but still commensurate with being able to turn a decent profit) so as to put their competitors under pressure.
In a recession I think there would be a flow of people trading down from higher cost to low cost gyms to compensate for the flow of those who are trading down from low cost to no gym at all.
On churn, yes this is higher but that is a quid pro quo for not locking customers into lengthy contracts. Churn can also work in their favour i.e. it involves people defecting from their competitors and people re-joining their gyms. 28% of GYM's new joiners self-identify as re-joiners according to the IPO prospectus (maybe they tried the competition and found it wanting?). The prospectus also makes the point that cancellations leads to 'yield maturation' as new members join at the prevailing rate which is often higher than the rate being paid by cancelling members due to price increases.

Bottom line is that I think there is a long enough runway for growth opportunities (and by extension share price appreciation) before the downside effects of maturation and competition kick in.

One final point I thought worth mentioning from today's interims is the S-curve profile of how new sites mature:

So EBITDA tops out at around £0.5m per site after 2 years. Compare that to today's actual average site EBITDA of £187k, the difference being due to the estate being so young that many sites are still early on the S-curve. That implies if they stopped opening new sites today and sat on their hands for a couple of years, their overall EBITDA would increase to around £50m, which compares to today's enterprise value of £267m.

I might be talking myself into opening a position here!

abtan

For those interested, here is the link to a prior GYM (LON:GYM) presentation, which contains a lot of useful information:

http://www.tggplc.com/media/83680/capital-markets-day-presentation-130617.pdf

For what it's worth, here are some of my own notes for GYM (LON:GYM), in which I hold a long position:

Cash generation is fantastic, with increasing economies as the chain grows.

A few top-level calcs, with figures taken from the 2 presentations mentioned in this thread:

£1.3-£1.4m to fit out a new gym (it was £1.5m a few years ago)
Mature gyms bring in £0.5m in EBITDA per year
Maintenance per new gym = £0.5m every 7 years, or £70k per gym per year
If each gym therefore makes £0.43m per year = payback period on fit-out costs is c. 3years

I may even be understating long-term profit as there is a note in the presentation I've included above that states the £0.5 EBITDA per mature site already includes maintenance costs.

Unless I've missed something these figures, alongside growing # of customers & decreasing investment in public sector sports facilities, paint a rosy picture for the Gym Group. And fingers crossed they'll be looking at other avenues for revenue growth along the way (international expansion?).
A note in the presentation link above that may interest some: Leases typically last for 15 years with fixed uplifts. Given that the first GYM opened in 2008 then, at the least, we're 6 years away from renegotiation of current leases. The company claims that business rates, etc... have had minimal impact, probably because such few employees actually work on site

My only real worry is the increasing marketing spend and how much further this might rise. Or perhaps it will fall as a % of revenues as the smaller players with smaller marketing budgets get pushed to the fringes?

EDIT:

Plus everything Bestace just said

bandal

3rd Sep '17

chilligg

4th Sep '17

Some very good contributions here on GYM, shows the quality of the Stockopedia membership. I write notes on companies that interest me as it is useful for monitoring performance and improving my returns. Given that growth shares have done very well over the last few years I thought it might be worth sharing some thoughts on valuing them using GYM as an example. Sorry if it's a bit long.

How to think about valuing growth –using GYM as an example

Investors are often faced with the type of situation where a company’s current profitability and returns are depressed by an aggressive re-investment of cash flows into growth. How should one go about assessing the potential and risks? My preferred method is to break down the opportunity into 2 parts, firstly, looking at the company as if it had no growth opportunities, and only then looking at the growth part.

Zero-Growth analysis

GYM very handily splits out maintenance capex, so we can estimate the underlying profitability. At the recent half year, free cash flow was £12.8m, (before growth spending, but including tax, financing and exceptionals, which are real employee expenses) and while we know that more sites will be opened in H2, for our purposes we can double the H1 number to get £25.6m full year. Taking average Net Assets from June 16 and June 17 of £112.8m, this gives a return of 22.7%. The underlying zero growth P.E is £264m/25.6m= 10.3x. It is clear that the underlying return on equity is high, and the no growth P.E. is low as it should be (zero growth should be priced at the inverse of the cost of capital). Let’s take a closer look at returns.

Management has indicated that new sites cost between £1.3 and £1.4m. A glance at the balance sheet shows PPE before depreciation is £155m and the number of sites at H1 is 95, giving a cost of c£1.63m per site. Maybe the trend is declining as scale and expertise reduce costs. Let’s take management’s word at £1.35m and we know the average revenue per site is £42.8m*2 / average sites (92) = £930.4k. So, the asset to revenue ratio is £1.35m/£.934= 1.44x. The implied return on investment is Return on sales divided by 1.44= £25.6m profit/£42.8*2= 29.9%/ 1.44= 20.77%.

How much should we pay for this mix of growth and return? Below I will describe a common sense approach. But, first, there is a useful model, which will help, called the Franchise Factor model, developed by Marty Liebowitz and Stanley Kogelman and I used this as a check on the numbers below. It essentially splits the P.E. ratio into a growth factor (the NPV of all future growth) and return on equity above COE. The resulting P.E. for GYM is 15.3x (7.2% growth for 10 years and 23% ROE)
The current rolling P.E. of 24x implies a growth rate of 15% for 10 years. (385 sites)

Growth analysis

We know the cost and returns expected by management, but we don’t know the size of the opportunity. We do know that low priced flexible gyms are taking market share form a stagnant total market and that share is c10%. It seems reasonable that this might reach say, 20%. It can be seen almost like a land- grab, with those best positioned to build out their estate quickest will reap the rewards. We also know that GYM is self- financing, and this is a big advantage. So, it might be reasonable to target a doubling of the estate from 95 to 190, over say, 10 years. That is slower than the current expansion rate, but seems more prudent. We can also factor in a small say, 2% inflation rate in price levels, from £14.28 to (1.02^10)= 1.21*£14.28 = £17.4 in year 10.

In this scenario, Sales in year 10 reach c£211m, and if the growth opportunity is non -existent by then, reinvestment needs will be low and the free cash flow return on revenues will be similar to the 29.9% we calculated earlier, or c£63m in profit. Put that on a low growth 12x P.E. and we get £756m market cap. If there is residual growth available, that multiple will rise a couple of points, so we might want to pin a £756m-£890m target range in year 10. The high end will give investors a 13% annualized return over 10 years or 3.3x return on capital invested.

Conclusions

I have deliberately kept the finer details of valuation models out of the discussion, because they can give the impression of precision, and this is a very imprecise exercise. Investing is all about laying out cash today, in order to reap a future return, which MORE THAN compensates for the risks. The worst case scenario for equity is always zero, but with some work and informed knowledge it is possible to find situations which offer a low probability of a permanent loss of capital and a high probability of a better than average return. Where does GYM fit within this wide spectrum? That is for each individual investor to judge. I have shown that the implied growth is 15% p.a., but I arbitrarily chose a 10 year time frame, whereas maybe 385 sites is achievable over say 15 years (a 10% growth rate). The durability of returns is just as important as the growth, because a falling ROE will impact valuation and investor returns. We have to remember that this type of product is completely discretionary and demand could disappear quickly; also while debt-free, the lease obligations are a form of long- term debt. All in all, GYM is an interesting situation. The current P.E. looks optically high, but as I have shown, even if the site expansion is only 7.2% for 10 years (half the implied growth), the potential investor returns are quite respectable

Small Cap Value Report (Wed 30 Aug 2017) - GYM, HSS, OPTI

GYM (LON:GYM)

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Paul Scott

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