Description

For fairly comprehensive company background and the big picture bull thesis, please refer to Coyote’s writeup from 2018 and, for industry background, PwC UK’s low cost gym report (https://www.pwc.co.uk/hospitality-leisure/assets/pwc-low-cost-gyms-report.pdf; note it was sponsored by The Gym). We will focus on our own insights around recent events and not rehash the long thesis, which we agree with and is well circulated.

After growing well in the past few years, GYM shares fell dramatically from November 2018 to March 2019 as investors noticed a price war brewing among the low cost gym operators, starting we estimate in Oct/Nov and extending through early Feb. Overcapacity leading to cut-throat pricing is the greatest risk to the bull thesis, and the holiday season pricing moves alarmed investors. While in the January trading update, management highlighted that average pricing across its gyms had only gone down ~1% from £17.50 to £17.35 as a result of the holiday promotions, what likely spooked investors was the approximately 17-23% headline price cuts in certain locations (% refers to basic DO IT plan; many price reductions were temporary 3-month intro offers). Material location-specific price cuts raised fears that some locales were already saturated with competitors, possibly a prelude to more widespread margin compression.

Following this oversupply scare, we began scraping the Gym’s pricing movements, as one of the benefits of low cost gyms is that they are transparent with pricing on their website. The data reveals a strong upswing in GYM prices through Q1 and then again into Q2. Not only did pricing rebound from November to March, it continued to strengthen from March to June, with only a miniscule number of continued price declines vs. more than half of units showing sequential price increases.

(Note for reading the table: almost all price increases and declines were the same £x bump or drop to both DO IT and LIVE IT plans at a specific gym. Sample size covered ~2/3 of sites for June vs. November and almost all sites for June vs. March. Joining fees and 3 month offers muddy the analysis somewhat, but we believe it roughly points the right way.)

The outlier Max and Min data are somewhat misleading. The greatest pricing decline was at a newly opened site, where the company is clearly optimizing membership volume. Similarly, several sites where the greatest price increases occurred were also new and clearly being tuned. Removing these new units representing  both the highs and lows of the data set changes the average only slightly.

As a short aside, while January is correctly reputed to be the largest sales month for gyms, the distribution is not as skewed as headlines would suggest. IHSRA 2016 data below illustrates sales distribution throughout the year and the relevance of pricing changes throughout the year.

Barclays has been tracking the same granular data, and has a more complete historical dataset. They published their new findings this week and upgraded the stock back to overweight based on a similar conclusion. Notably, their data highlights not only sequential growth, but YoY growth in base pricing. Their prior January analysis was late in anticipating the stock’s end of year decline, but did correctly anticipate the disappointing FY2018 trading update.

While pricing recovery is not a perfect proxy for supply-demand balance, it suggests at least that the oversupply concerns were overblown. Whether industry pricing rationality persists or not remains to be seen, but we are positive based on the data, as well as precedent in the US (Planet Fitness) and Europe (Basic Fit). Importantly, we like situations where data can readily be collected in real time and where the market appears to be slow in reacting to such information. Today, we can make an educated guess about how rational competition will stay, but we believe a better system is to track developments as they happen. Barclays highlights Leeds and Glasgow as locations where saturation could already be happening, likely based on the number of Xercise4Less and Pure Gym locations which overlap The Gym. We looked at our pricing analysis and don't see evidence that they have been disproportionately affected. However, they may be useful as the canaries, perhaps along with Liverpool.

Our view on valuation of GYM will be fluid, as sentiment and trading commentary will have a disproportionate effect beyond the short term results. Of particular difficulty for modeling the company is that pricing impacts roll in slowly as membership turns over (10.4 months average member tenure quoted). We do not have a radically different view on valuation vs. the sell side and see 300p to 370p as fair value by the end of the year. This represents 10-12x 2019 consensus ’19 EBITDA, representing 20% to 50% near-term upside. We expect positive commentary in the next trading update. From there, we believe the site maturation and site growth story will continue to unfold nicely, but we will look to our data to guide position trading.

While the term "tactical price reductions" scared the daylights out of investors, we believe that managing membership volumes does make sense for the overall strategy. The Gym remains the lowest cost option in most areas where there are Xercise4Less and Pure Gym competitors, and it is their intent to stay that way. 

One element of the volume story that we do think remains underappreciated is the potential to incrementally improve the yield per member. LIVE IT was GYM’s 2018 program introduction and now boasts 13.5% penetration from a standing start. GYM has launched two new initiatives in the middle of Q2:

1. A new membership offering called FLEX IT has been rolled out to approximately 20% of locations. It enables takers to freeze their account for up to three months at the cost of a £2 monthly premium to DO IT. Over time, this may improve the yield for the rejoiner cohort, which make up a substantial proportion (~1/3) of incoming memberships and could marginally reduce permanent attrition.

2. Approximately 1/3 of their locations have begun to offer unlimited Yanga fitness water for £4 per month. While we would have assumed low uptake on this offering, we cannot discount the experience of European peer, Basic Fit, whose equivalent sports water offering sits at an impressive high-teens+ uptake (2016 10%, 2017 17%, 2018 19%) at €4/month.

Modeling the impact of these initiatives again would be largely guesswork, but we would expect them to be incremental rather than transformative. We only mention them to highlight that there are additional levers the company can pull to stabilize or improve yield. Basic Fit, which has a similar model for continental Europe, serves as the template for GYM to improve upon upsell opportunities such as improved price segmentation, personal training, sports water, and other services. While membership growth x pricing will be the factor that makes or breaks GYM, the ancillary revenues component should not be discounted at what what we estimate to be 3-7% of Basic Fit revenues and growing.

Risks:

Competition – Pricing may weaken again if competition gets aggressive again

Execution – Continual evolution of their offering will result in some concepts not working out. The personal training initiative has not met expectations, for example

Share overhang – Founder has stepped away from business; scattering of director share sales late in 2018

Saturation – Persistent investor concerns that growth could slow, given more low cost competition in the UK. Focus on delivering smaller formats to penetrate less populous catchments may be indicative of this trend

IFRS 16 – lease accounting optically makes already optically high earnings multiples look worse

Brexit – Boris may break the UK, or he may not

Catalyst

Upcoming trading updates