Description

The Gym Group (LSE: GYM) is the second-largest low-cost gym chain in the UK, with about 230 gyms - behind the leader, Pure Gym, with about 330 gyms, and considerably larger than the third player. We believe it provides a very assymetric way to bet on the normalization of low cost gym economics in Europe, helped by the pessimism currently overshadowing the UK market and lack of understanding by the general investing public of gym dynamics (namely new gym ramp ups and the impact of Covid on gym demand/supply and resulting paybacks) - a thesis that is similar to the BFIT story, but with less reliance on future growth and backed purely by the earnings power of the current estate.

As an introduction, the low-cost gym sector is a growing market, having increased the number of members by 21% per year in the UK during 2015-2019 (vs 1% per year for other gyms). Currently, 15% of the UK population is a gym member, with room for growth compared to the prevailing rate in the USA (20%), Nordic countries (21-22%), and the Netherlands (17%).

Additionally, the low-cost segment has been gaining share against the mid-market, due to a better-suited offer to current fitness trends (e.g., many users don't require a pool and sauna, which are among the most significant cost drivers of a “full-service” gym). In the UK, this segment currently represents 27-45% of the market (depending on the study), again with room for growth compared to the 70-80% seen in the USA and 50-60% in the Nordic countries and the Netherlands. Notably, many low-cost gym chains were founded during the 2008-10 crisis, and we expect a potential new recession to further accelerate the "trade-down" trend from mid-market to low-cost. Multiple European operators showed strong growth during the purchasing power slump experienced in 2011-15 based on our experience. In the UK, part of the market is also occupied by "public" gyms (i.e., supported by local municipalities), which several industry insiders indicated might close due to declining budgets for this purpose, given the challenging macroeconomic conditions in the country.

In line with most of the leading players in the sector globally, The Gym Group had attractive unit economics pre-Covid, achieving a 3-year payback (at the EBITDA level, i.e., ROIC of ~30%) on new gym openings, despite being priced ~10-20% lower than Pure Gym.

The Gym Group's shares were initially punished by pandemic restrictions and more recently by rising electricity costs and the slow return to face-to-face work in gyms near urban centers. However, we believe the market is significantly underestimating The Gym Group's potential for normalized earnings. Since 2019, the company has opened about 50 gyms, but its enterprise value at the current share price is ~30% below 2019. Most gyms have a typical two-year ramp-up period , as validated with experts and in line with e.g. BFIT, and adjusting for this, we believe GYM is valued at about 3-4x its normalized EBITDA (vs private sector multiples of c. 7-8x EBITDA). Furthermore, in a scenario where the company stops opening new gyms, this EBITDA should convert at least 50% into cash flow given negative working capital and moderate maintenance capex (~70k GBP per gym per year).

We believe this earnings normalization will come in the next 3 to 5 years and, as a result, the market will revalue the company to reflect its currently "hidden" profitability. Taking this into account, in a scenario where the EBITDA per mature gym returns to close to 2019 levels and the gyms opened over the past two years reach maturity, we would be talking about 0.43m GBP of EBITDA (after rent) per gym times ~240 gyms (assuming 10 net opens), or ~100m EBITDA. Netting 20m in central costs gets us to 80m EBITDA (3x current EV). An exit at 6x, coupled with cash generation until then, would be enough for a ~30% IRR.

Moreover, at the current price, GYM trades below the replacement cost of its gyms - i.e., it costs less to "acquire" these gyms by buying GYM shares than building them anew. Even after accounting for economic depreciation due to aging gyms and equipment, the company trades very close to the resulting value, despite historically generating returns above 20% on invested capital. We believe this fact, along with the company's moderate leverage (<2x EBITDA 23E pre-IFRS 16) and the pessimism embedded in the share price, creates a significant level of downside protection. In fact, even in a very pessimistic scenario where the EBITDA per gym remains at current levels (in spite of maturation of the gym estate and normalizing energy costs) it would be difficult to lose money given we are paying 7x that depressed EBITDA level already.

To gain confidence in these projections, we spoke with over 10 people close to the business, including several employees from Pure Gym, JD Gyms, and former Gym Group employees – in addition to, of course, the company's management team. We concluded that Pure Gym is quite similar to The Gym Group, with no apparent material difference in competitiveness between the two largest market players. The Gym Group's gyms are of good quality and, in fact, based on our analysis of Google reviews, are better rated by users compared to Pure Gym.

We also know from our other gym investments that leading industry players continue to experience ~3-year paybacks on new gym openings (i.e., ROIC of ~30%), so the business's economics haven't been structurally affected by the pandemic. As for the current differential in EBITDA per mature gym of The Gym Group compared to 2019 (GBP ~260k vs ~440k), about GBP 40k is explained by high energy costs (the company fixed at peak prices in 2022, and the contract only expires in 2024), and the remainder mainly by gyms located in urban centers still recovering member volume, as there's significant operational leverage in the business (gross margin of >90%). GYM plans to release the first-half results in September, after the new CEO, Will Orr, formally assumes his role in the company. Having spoken with several contacts close to the sector in the UK, we believe the previous CEO left the company mainly due to a vision difference for the business, as the board was looking for a more ambitious profile. We received strong references from Will Orr regarding his work at previous subscription-based businesses. Furthermore, we believe Pure Gym's strong results reported for 1Q23 indicate that gyms in urban centers seem to be recovering, a good sign for what we can expect from The Gym Group's 1H23 results.

Catalyst

Earnings normalization driven by gym ramp ups and declining energy costs