Description

Opportunity:

Xponential Fitness was the victim of a short report which caused the share price to decline 37% on June 27, 2023. XPOF’s short interest was ~700,000 shares prior to September 2022 when short interest began to rise steadily before reaching 4.73M shares on June 15, 2023 shortly before the short report. Shares short as of June 30, 2023 are still elevated at 4.46m. This short report contained arguments that fell into two buckets: personal allegations and business assertions. The personal attacks against CEO, Anthony Geisler, may have caused some investors to exit XPOF until the dust settles because the fundamental business arguments are easily debunked (with some work and a clear understanding of this business) and should not have caused a nearly 40% decline.

After talking with other funds, investors seem to fall into two camps following the short report: investors either care more about the personal attacks or fundamental business analysis. We deeply care about management’s character in all our investments, and we were able to get comfortable after doing additional work on the personal attacks. Many of these charges turn into a “he said, she said” subjective analysis. The best that we can do is present our objective arguments for why the short report made unlikely or unfair conclusions. We feel highly confident that the short report’s fundamental business assertions are wrong and easily debunked.

Our primary research should help fellow investors come to the same conclusion as us, and potentially cause the 4m share short interest to migrate towards 1m shares as recent volatility results in shares migrating into steadier hands and longer-term focused funds.

This short report created an excellent opportunity for investors to acquire a great business at a significant discount. XPOF was trading for 19x 2023 EBITDA prior to the short report, and it’s currently trading for 12.7x 2023 EBITDA despite a broad franchise concept comp group trading for 21.5x 2023 EBITDA. XPOF notably is growing square footage and SSS faster than any other franchise stock in our comp group; we believe XPOF deserves a multiple at least in-line with the comp group. XPOF is worth $35.50 on 2023 EBITDA, and $40 on 2024 EBITDA for 79% and 102% upside, respectively. We continuously underwrite two years out because predictive power drastically decreases beyond two years.

VIC member Bentley883 posted a recommendation of XPOF on November 7, 2022. We will not waste readers’ time by providing a detailed overview of the business because we think Bentley’s article was sufficient.

Note Regarding Short Report

Shortly before submitting our report to VIC, we noticed that the short author’s terms and conditions disallow us from distributing any excerpts, links, or reproductions of his work except to reference his website. We had previously planned to include quotes of his work to represent his arguments most accurately; however, we have reframed our analysis to take the most conservative stance to avoid violating the short author’s terms and conditions. I think our response deducts from the quality of our report, but I didn’t feel like it was worth a potential legal battle.

Short Report Personal Attacks

The recent short article made several personal attacks against CEO Anthony Geisler and one shot at CFO John Meloun that we feel made unfair and potentially misleading assertions. The primary personal allegations against Geisler include the following:

1. Geisler was the CEO of Interactive Solutions which was an alleged pump and dump, and Geisler tried to run a cashier’s check scheme to have investors mail money directly to Geisler.
2. Former LA Boxing franchisees and colleagues had a low opinion of Geisler.
3. Geisler displayed a gun and threatened to kill a court appointed process server.
4. Geisler condones a culture of sexual harassment.

Imagine you are an XPOF shareholder, and these allegations are made 30 minutes before the market opens. I think a lot of people sold first and asked questions later. That’s understandable because these allegations were serious and potentially thesis changing. We will address each charge individually.

Personal Allegation #1 – Interactive Solutions was an alleged pump and dump and Geisler tried to run a cashier’s check scheme for his benefit.

Information regarding INSC was very hard to find considering that EDGAR doesn’t keep digital filings prior to 2001, INSC was pink sheet listed, and Interactive Solutions is such a generic name. Let’s review facts that can be independently discovered about Interactive Solutions Corp and Brinton Group.

• Interactive Solutions Corp was incorporated and went public through a reverse merger on February 14, 2000.
• Interactive Solutions had a relatively impressive Board of Directors.
  • Ed Tracy, then Chairman of Interactive Solutions, had previously been President and CEO of the Trump Organization. He had also been Chairman, President, and CEO of Capital Gaming International. Tracy has subsequently been President, COO, and eventually CEO of Sands China (a subsidiary of Las Vegas Sands). Tracy was named as one of “The Best-Performing CEOs in the World” in 2014 by Harvard Business Review. Currently, Tracy is the CEO of Hard Rock Asia.
  • Merle Berman represented District 2 in the Nevada Assembly.
  • Anthony Cabot is a highly accomplished Gaming Lawyer.
  • Ed Fishman co-founded Players International, which was previously known as Players Club.
• The Brinton Group was a firm based in Thailand that promoted stocks. Some of the purported stock sales were rumored to be deceptive and even include sales of fraudulent stock certificates.
• The American FBI, Australian police, and Thai police collaborated to raid Brinton Group. Brinton Group was known as a “boiler room” which was accused of luring dozens of Australians, New Zealanders, Americans, and others to invest in stocks in the US and Canada. I have seen loss estimates ranging from $100m to $300m.
• 84 or 85 employees of Brinton Group were arrested and initially charged with fraud for allegedly selling non-existent stocks, but prosecutors dropped the fraud charges.
• 7 Brinton Group employees (including Paul Mary Hickey, John Martin Kealy, and Ronan Jospeh Murray) were sentenced to prison and fined for conducting a securities business without a license.
• Geisler was never charged by the FBI or SEC for any wrongdoing in relation to Brinton Group.
• Interactive Solutions was never charged by the FBI or SEC for any wrongdoing in relation to Brinton Group.

I believe the following to be the nature of Interactive Solutions’ relationship with Brinton Group. Brinton Group invested in Interactive Solutions Corp either before or at the time of the reverse merger. After that, Brinton Group acted as a rogue shareholder that conducted illicit activities potentially including selling fake shareholder certificates for Brinton Group and its employees’ sole gain. Let’s say that I was a shareholder of company ABC, and I began to conduct a pump and dump independently of company ABC’s knowledge, would the management of company ABC be slandered as management of a pump and dump? I think that answer is obviously “no” if management had no knowledge or involvement in the shareholder’s scheme. Bill Hwang at Archegos manipulated Viacom's share price through total return swaps, which resulted in a $20bn blow up in early 2021. Bill Hwang’s actions caused VIAC’s stock price to increase 150% in 3 months after which VIAC issued primary shares at a very attractive price. Hwang effectively pulled off the pump, but VIAC’s share issuance removed his ability to dump shares at higher prices. No one would blame VIAC’s management for Bill Hwang’s actions. In the same way, I don’t think it is reasonable to blame INSC for the actions of its shareholders.

The SEC has charged shareholders with pump and dumps in the past. If Geisler or Interactive Solutions Corp or Chairman Ed Tracy were involved in a pump and dump, why was there never an FBI or SEC charge? Why have Ed Tracy and Geisler been able to be CEOs and board members of other public companies if they were guilty of a pump and dump? Clearly, the FBI was aware of the case and had detailed information into the situation with Brinton Group because the FBI collaborated with Thai and Australian law enforcement on the initial raid. I would argue that Geisler, Interactive Solutions, and Ed Tracy were deemed to be innocent of any purported manipulation.

An emotionally compelling part of the short seller’s allegation against Geisler and Interactive Solutions is a video interview with a 23-year-old Geisler with a caption that says, “Geisler is Holding an EMPTY BOX”. A full transcript of the documentary can be found here.

First, I’ll briefly address the “empty box” comment. Interactive Solutions was building a game that allowed users to play casino games on their computer at home. Geisler is holding a box representing the graphics of the game at its expected completion later that year. The game (titled Vegas Fever Winner Take All) was developed and commercialized in 2001. Importantly, Vegas Fever was published by Encore Software, which was a Fortune 500 company at the time. Further, the Venetian reached an agreement with Interactive Solutions to market Venetian branded games in Vegas Fever, and Venetian planned to sell the game on The Venetian’s Grand Canal Shoppes and Venetian.com. The point is that the game was eventually commercialized and had real partners. This wasn’t vaporware.

Second, I think Geisler appeared combative in the interview, and he declined to comment on Brinton Group. I don’t know the pretenses under which Geisler thought the interview was being scheduled, but it was clear that he seemed to be excited to talk about Interactive Solutions at the beginning of the interview, and he didn’t seem prepared to discuss Brinton Group. I would imagine that it’s likely that the FBI or SEC could have sought help from Geisler and Interactive Solutions regarding the Brinton Group investigation, but I couldn’t find any information supporting that claim. Geisler may have been heavily restricted in what he could say about Brinton Group at the time. As I thought through this situation, I found myself thinking about how I would have reacted as a young 20s-year-old CEO of a public company that was potentially blindsided by an investigative journalist. I don’t think I would have reacted perfectly either. Ultimately, I take solace in the fact that neither Geisler nor Interactive Solutions were charged by any regulatory agency regarding Briton Group’s actions.

Cashier’s check scheme

The short author’s assertion that Geisler tried to run a cashier’s check scheme to convince shareholders to mail money to him directly is wildly preposterous and, frankly, embarrassing.

First, what is a cashier’s check scheme? A cashier’s check scam occurs when someone provides a genuine looking cashier’s check (which is fraudulent) and asks for some good or service in return. The scammer in a cashier’s check scheme is forging and distributing fraudulent checks. ISC was asking for a cashier’s check from shareholders to be paid to Liberty Transfer Co as the transfer agent which would issue and distribute a shareholder certificate. ISC could not be running a cashier’s check scheme since it was not issuing fraudulent checks. Further, ISC asked that checks be distributed to Liberty Transfer Co, which was not a subsidiary of Interactive Solutions, and so it would not be a beneficial party to that $100 payment. Finally, even if that pattern was wrong (which it isn’t), and ISC reached out to 100 shareholders, then that would be a $10k payment to a transfer agent (which I would argue is de minimis). Anyone willing to think through this situation will clearly see the short seller is reaching for arguments to bring Anthony Geisler’s character into question. Either the short seller 1) mistakenly understood what a cashier’s check scheme is, or 2) intentionally made a false statement about ISC and Geisler to disparage Geisler’s character and drive shareholders to sell XPOF for the short seller’s profit. Please see a picture of the supposed cashier's check scheme for your independent review. 

Question for the reader to consider: should you believe the conclusions of a short seller that either a) does not understand what a cashier’s check scheme is, or b) would make intentionally misleading conclusions to scare you into selling XPOF shares?

Personal Allegation #2 – Former LA Boxing franchisees and colleagues had a low opinion of Geisler

I find this section to be particularly interesting because the short seller only sourced quotes from two anonymous people, Former Colleague (H) and Former Franchisee (K). The quotes were entirely vague, void of evidence, and full of hearsay. The short report presented two pieces of actual evidence for shareholders to consider: a lawsuit between Sean McCully and Geisler/LA Boxing Franchise Corporation and a lawsuit between Chris Poland and Geisler/LA Boxing Franchise Corporation.

Sean McCully sued Geisler, Shaun Grove, and LA Boxing Franchise Corporation, and UFC Gym Franchise after the sale of LABFC to UFC. Sean McCully owned LA Boxing Costa Mesa, which was one LA Boxing store. His LinkedIn title of “Founder” of LA Boxing Franchise Corporation seems highly subjective.

McCully was potentially the Founder of LA Boxing in Costa Mesa, but he did not found the franchise company. LA Boxing was founded by McCully and Wade Halverson in 1992, and McCully bought LA Boxing back from Halverson in 1998. Let’s give McCully credit and say that he created the LA Boxing concept. Geisler joined LA Boxing in or around 2002. LA Boxing Franchise Corporation (“LABFC”) was founded on March 29, 2004 by Anthony Geisler (Founder, CEO, President, and Secretary of LAFBC).

I suspect that McCully could be Former LA Boxing Franchisee (K) referenced in the short report. McCully agreed to sell his ownership in LABFC to Geisler in 2007 for $2.5m which was subsequently mutually agreed to be adjusted in 2009 following the Great Financial Crisis. McCully ultimately agreed to sell his ownership in LABFC in early 2012 prior to UFC acquiring LAFBC in January 2013. McCully’s contention is that Geisler knew of the sale to UFC in early 2012 when Geisler/LA Boxing agreed to buy the rest of McCully’s ownership in LAFBC. McCully’s complaint was settled out of court. Ultimately, McCully agreed to change the terms of the deal he struck with LAFBC in 2009, and he further agreed to a sale in early 2012 before LA Boxing was sold to UFC 1 year later. The McCully lawsuit was settled out of court.

The second piece of evidence offered to short report readers involved Chris Poland. It is very possible that Chris Poland was Former LA Boxing Colleague of Geisler (H) in the short report. Essentially, Chris Poland made $1k/month in salary + a 1% commission on gross revenue of every franchisee nationally from February 2004 to 2007. Poland won a lawsuit against LAFBC because Geisler allegedly promised Poland equity when “the company got off the ground”. Poland was terminated on August 1, 2007 for “threats to co-workers and alleged violation of company policy charging personal expenses to LA Boxing.” A California jury ruled that Geisler did make a “promise” to give Poland equity and/or a free franchise in LAFBC, and that Geisler did not have the intention to fulfill that promise. The jury awarded Poland $75k plus interest and legal fees. However, that same jury ruled against Poland (and in support of LAFBC and Geisler) in his claims of i) Wrongful Termination, ii) Failure to Pay Overtime Wages, iii) Breach of Oral Contract, and iv) Malice, Oppression or Fraud. From my perspective, this looked like a typical California wrongful termination case that often gets settled. LA Boxing Franchise Corporation must have had compelling evidence to convince the jury that the other 4 charges were invalid, and LAFBC was probably somewhat surprised by this verdict considering that it went all the way to judgement.

I do not find the short seller’s evidence or assertions against Geisler during his time at LAFBC to be damaging to Geisler’s character. Neither lawsuit had any impact on my perception of Geisler’s ability to effectively lead Xponential Fitness.

Personal Allegation #3 – Geisler displayed a gun and threatened to kill a court appointed process server.

This argument was effective at using clever turn of phrase to evoke a feeling that Geisler could be unstable. Let’s review the facts of the situation before we draw any conclusions.

• Michael Danley was a process server for 25 years, and he attempted to serve documents to Anthony Geisler on November 4 or November 5, 2011.
• Mr. Danley was attempting to serve Geisler papers for not paying his full rent and without giving proper notice that he was leaving 5144 Scholarship, Irvine, CA. Importantly, Mr. Danley was serving the wrong person through seemingly no fault of his own.
• Mr. Danley went to go serve Mr. Geisler at 7:30-7:45pm, and he needed help from a guard to get into the gated community to get to Mr. Geisler’s house.
• Mr. Danley saw that Mr. Geisler’s garage was open and the lights were on, but the lights at the front door were off.
• Movers were moving Mr. Geisler into his home, and Mr. Danley asked them to get Mr. Geisler for him.
• It is disputed whether Mr. Danley stood inside or just outside of Mr. Geisler’s garage.
• Mr. Geisler entered his garage with a gun and told Mr. Danley to exit his property.

I tried to put myself in this situation. It is nearly 8pm, and sunset was 4:51pm that day, so it is dark outside. Some man comes and stands inside (or inches outside) of my garage, and my wife and kids are inside. I have hired movers to help me move into my new house. Movers walk into my house and tell me that a man is waiting for me in my garage. If I’m going into my garage at all to confront this stranger, I am uncomfortable and highly aware of my family’s safety. I am probably bringing my gun with me to protect me in case this man either standing in the dark just outside of my garage or inside my garage intends to cause me or my family harm. I would not let this man get within 21 feet of me (personal safety knowledge) in case he was lying to me about being a process server and intended to cause me or my family physical harm. I would be as vocal about the threat that I’m feeling from him to protect him and myself from bodily damage. Mr. Danley’s own account of the interaction reflects a lot of those intentions by Mr. Geisler.

Consider the actual counts that Geisler was charged with by police. 1) Drawing/exhibiting firearms, and 2) assault w/ deadly weapon other than firearm. Both charges were dismissed by the court.

The first charge of 417(a)(2)(B) is brandishing a firearm in a non-public place. Brandishing means to draw or exhibit a weapon in a threatening manner or use a weapon other than in lawful self-defense. California allows the for the use of deadly force in self-defense to stop an imminent danger of serious injury or if an intruder breaks into your home. California also allows for the exercise of self-defense if you are defending yourself, other people, and your property. Importantly, this charge was dismissed. I would assume that either i) there was insufficient evidence, ii) Geisler was able to prove self-defense to stop an imminent danger, or iii) Geisler was able to prove self-defense because the intruder broke into his home by standing in his garage or by passing through gates on his residence.

The second charge of 245(a)(1) is assault with a deadly weapon or instrument other than a firearm. In this case, I’m unclear what assault occurred. This charge does not require actual physical assault, but it does require the use of an inanimate object to attempt assault (i.e., swinging a knife) and cannot be objects of the human body (i.e., hands or feet) per People v Aguilar 1997. I read the entire complaint filed by Mr. Danley almost exactly 2 years after the incident, and Mr. Danley never references any inanimate object other than Mr. Geisler’s gun, but Geisler was clearly charged with the use of a non-firearm object. This charge was also dismissed, and I assume that this charge was dismissed because there was not a non-firearm object used to attempt an assault.

Mr. Danley’s complaint was dismissed due to lack of persecution, which means Danley stopped pursuing the complaint. A layman can read through the complaint and see that this is not well formed. For example, Mr. Danley’s complaint says “Defendant (Geisler) then lied to police and told the office handing the report that he took the gun with him because he found the fact that there was an unknown man in his garage unsettling.” For Mr. Danley or his counsel to make the claim that Geisler lied, Danley must have explicit knowledge of Geisler’s feelings (i.e., being unsettled) or perfect knowledge of the information movers told Geisler (which is impossible since it occurred inside Geisler’s residence).

I can understand Mr. Danley being uncomfortable in this situation. I would be uncomfortable if I was on someone’s property, and he forcefully told me to get off his property while brandishing a gun. I think this was an unfortunate situation that I hope Mr. Danley has been able to avoid by serving people during daylight hours and/or at residential front doors.

Personal Allegation #4 – Geisler condones a culture of sexual harassment.

To me, this was perhaps the lowest blow of all. The short seller clearly dug very deep to find information from more than 20 years ago when investigating INSC. He references multiple anonymous sources that apparently all refused to be named in this short report. Were there ever a complaint filed or lawsuit, I think the short seller would have found it. Alleging someone is a sexual harasser or a racist are two of the most disturbing empty claims to make because the accused can do nothing but say “nuh uh, no I’m not.” This label can linger, and I tend to believe that people are viewed as guilty and never really proven innocent. So, were I to make this charge of someone, I would heavily weigh the quality of my evidence.

Once again, the short seller uses quotes from Former Business Colleague of Geisler (H) and Former Business Colleague of Geisler (K) from the LA Boxing section. If the short seller is referencing the same people, then the short seller asserts that these people said something like “I would not pee on Geisler if he was on fire” among other sentiments. We clearly see that there was a deeply personal, vengeful type of dislike from these gentlemen. The short seller was diligent to find court cases involving Geisler and provided evidence to support his other claims. In this instance, there were zero lawsuits or primary evidence other than anonymous former colleagues.

The short seller found one complaint of sexual harassment between two employees at Xponential. Geisler was not mentioned in the complaint. I find it troubling that the short seller alleges that Geisler permits a culture of sexual harassment by referencing one employee’s actions toward another employee. After reading the complaint, I see that Xponential tasked three senior people to be involved in the investigation into plaintiff’s claims of sexual harassment. Ultimately, I think Xponential showed appropriate levels of commitment to evaluate plaintiff’s claims, and plaintiff settled her claim in March 2023.

80% of Xponential’s Board of Directors are women, people of color, or identify as LGBTQ+. Xponential corporate had approximately 400 employees on December 31, 2022. 70% of employees are female, and I don’t think Xponential would have been able to retain a predominantly female employee base were there a prevailing culture of condoned sexual harassment that the short seller asserts.

Ancillary (and singular) charge of CFO John Meloun – Mr. Meloun was a Director of Finance at University of Phoenix immediately before an FTC investigation resulted in a $191 million settlement.

Meloun was Director of Financial Planning and Analysis at University of Phoenix from January 2010 to March 2015, and the FTC opened an investigation into “deceptive advertising” in TV commercials run between 2012 to 2014 which ultimately resulted in the $191 million settlement the short seller referenced. Is the short seller arguing that a Director of Financial Planning and Analysis was responsible for creative content? I fail to see the relevance of this connection. The short seller is grasping at straws in targeting CFO Meloun’s experience as a Director of Financial Planning at University of Phoenix.

Personal Attacks Conclusion

We took the short seller’s personal attacks against Geisler very seriously. In fact, we initially thought that Geisler might vacate his position as CEO because the personal claims initially seemed very damning to us. We think other investors probably had similar thoughts, and XPOF probably lost some number of shareholders because of these claims. After conducting additional primary work into CEO Geisler and CFO Meloun’s backgrounds, we gained even greater conviction that XPOF was an attractive investment opportunity, and we bought stock. We think other investors will buy XPOF shares back once they have a clearer understanding of the personal attacks against Geisler.

Short Report Fundamental Business Arguments

Business Argument #1 – Unit Economics

The short author’s fundamental arguments generally focus on unit economics, but the author uses some unreasonable estimates (particularly in labor, equipment lease and interest costs, and merchandise/product cost) that have resulted in wildly inaccurate conclusions for franchisee profitability. For instance, the short author estimates that the average AKT franchisee loses $402,940/year per store. If you were a franchisee in AKT losing $400,000/year, wouldn’t you just close your doors? We will provide detailed evidence for why the short seller’s assumptions are wrong and unreasonable.

The recent short report goes so far to claim that 80% of XPOF’s 10 brands are losing money and more than half of XPOF studios never make a positive financial return. Franchise concepts are required by the FTC (16 CFR Parts 436 and 437) to provide a disclosure document that contains very specific information about investing in a franchise concept. These documents are titled Franchise Disclosure Documents (“FDDs”) and are publicly available in several states. Upon studying these FDDs, the short author makes the claim that 80% of XPOF’s brands are losing money monthly. The most recent short report presents unit economics of each brand in a table that can be found in the short report available at this link.

We summarize our estimates for the profitability of each concept in the following table. Our table organizes the concepts from largest to smallest by number of units open. We do not include Rumble Traditional, Rumble Boutique, or BFT in our analysis. XPOF does not sell Rumble Traditional units. XPOF sells the Rumble boutique-unit franchises. Additionally, we do not think that 12 Rumble units is a large enough sample size to draw from, but we are confident that Rumble franchisees are performing well considering the 12 units in this year’s FDD are doing $1 million AUVs. For similar reasons, we do not think it is appropriate to extrapolate results from BFT’s two units in its FDD.

For ease of comparison, we also show the following table which shows the difference between our estimates and the short report’s estimates. To summarize, we have slightly higher AUVs, royalties, and marketing spend, but significantly lower labor costs, product costs, and interest costs. All in, we see significantly more profit per unit.

It is important to note that many of the short seller’s estimates are generally accurate. The short author is generally in the right ballpark on the royalty rate, the marketing fee, the average square footage, the occupancy costs, the technology fee, and the insurance costs. However, the short author makes some assumptions that are inaccurate which have both small and large implications on profitability.

Smaller errors include:

• The royalty rate on Club Pilates is 8% on new units, not all units. This change occurred in the 2023 FDD, so there are 764 Club Pilates studios open at 7% and all Club Pilates units sold under FDD’s prior to 2023 that haven’t yet opened are still at 7%.
• The occupancy costs generally run $50/sq. ft. inclusive of base rent, NNN, utilities, and Wi-Fi. This table reflects $50/sq. ft. for every concept except AKT, which this short report author strangely has as $120/sq. ft.
• Lastly, there is a cost in the FDD that this particular short report left out of their chart. In addition to contributions to the marketing fund (2% of revenue), Franchisees are required to make monthly investments in local marketing of $1,500.

So, what did the author of the table above get completely wrong? In order of materiality, the short author is way off on labor, equipment lease costs and interest costs, and “product costs.”

Labor

First, it is important to note that labor costs are not in FDDs. To make these assumptions, the author uses current store economics from their conversations with anonymous franchisees. On average, the labor costs in this report are ~2.0x what we believe to be reality. Adding nearly $10,000/month to the bottom line of each of those concepts makes a massive difference.

There are two components to labor in small box fitness: an instructor and a front-desk manager. Instructors are paid by class. Newer instructors make less, more seasoned instructors make more, but on average the instructor cost is ~$40/hour. This can easily be found by talking to franchisees of small-box fitness concepts or by looking at Glassdoor salaries or job postings. Second, the front-desk manager makes roughly $15/hour and is there ~12 hours/day ($5,400/month). Using AUVs or by simply going on franchise location websites, it is very easy to calculate the average number of classes per day over the course of a week by brand. Once we know the average number of classes, we can calculate the number of instructor hours in each month. This is how we reached our labor assumptions.

There are two exceptions to this model. Pure Barre is a unique brand with a unique franchisee. On average, the PB franchisee teaches the class. Because the instructor is the franchisee, the instructor cost is eliminated, and the franchisee pockets the profit. Second, Stretch Lab’s model is more 1x1 vs 1-to-many. Members book a flexologist to stretch for either 25 or 50 minutes. In the same hour, there can be more than one “class” because there is more than one instructor depending on demand at that time. We tracked the total number of timeslots available relative to the total number of hours a Stretch Lab is open to estimate the number of flexologists required/hour. We are currently using 1.5 flexologists/hour. All in, this makes the instructor cost at Stretch Lab ~$20,000/month.

More accurate labor cost assumptions resulted in an average of $8,624 less labor cost than the short author asserted. This is very material when considering that he calculated that the average brand is losing ~$7,000/month. More accurate labor cost assumptions would have resulted in two (Pure Barre and Yoga Six) of the purported unprofitable brands becoming profitable.

Equipment Lease Cost

This error in calculating the equipment lease and interest costs is more complicated to take apart. Item 7 of the FDD clearly lays out the costs of an initial investment. It is important to note that Item 7 includes lease expenses (usually 3 months), and, for some brands (PB, Stretch Lab, and Stride), Item 7 includes the initial investment required for Furniture, Fixtures, and Equipment (FFE). To make the math simple, the easiest way to calculate all-in interest and lease costs is to assume that the franchisee purchases the equipment and FFE package and takes out a larger loan. To make the calculation apples to apples, the lease costs that are included in the net investment should be removed. This short report ends up double counting the lease costs because they are either, in part, included in the initial investment or the FFE package is included in the initial investment.

We estimate that the short report’s table overstates the all-in interest and lease costs by about $3,000 per brand per month (inclusive of the fact that we use a higher interest rate). More accurately modeling labor and equipment lease cost would have resulted in three of the purported unprofitable brands becoming profitable.

Product Costs

This information is simply not in the FDD. We are not sure where the short report author got this information. However, we can make a very reasonable estimate for merchant costs and merchandise COGS. Merchant costs run about 3.35% of revenue; XPOF as franchisor keeps 1%. For merchandise, we generally know that the average studio does $12,500 of merchandise sales per year (merchandise revenue divided by average open studios). On average, that’s a little over $1,000/month. It varies by brand as some concepts are more “merchandisable.”

We estimate that the short report’s table overstates “product costs” by ~$1,000 per brand per month. The short report author underrepresents monthly income by an average of approximately $12,000 through inaccurate modeling of labor cost, equipment lease cost, and product/merchandise cost. This materially changes his conclusions about franchisee profitability because five of the eight brands that he alleges are loss making would have become profitable if he appropriately modeled these three costs.

Unit Economics Summary

Club Pilates is crushing it. Stretch Lab, Yoga Six, and Pure Barre are doing very well. Cycle Bar has been slow to recover from the pandemic. Row House, AKT, and Stride are struggling. We don’t think this is news to any shareholder paying attention. These unit economics also correspond with the overall unit counts and strength of franchise license sales by brand. The struggling brands (Row House, AKT, and Stride) together make up less than 6% of total units and less than 2% of total revenue. From January 1, 2022 to March 30, 2023, RowHouse, AKT, and Stride have opened a total of 13 units versus 444 opens at the other brands. Clearly, the better performing brands are rightly getting more attention and acceptance from franchisees. We will be interested to see how Xponential moves forward with the three brands that are not doing as well as the modality leaders in its portfolio.

Additionally, no one knows the economics better than the franchisees. From analyzing the list of current franchisees in each of the FDDs, we calculated the percentage of franchisees that owned multiple units. Generally, it directionally corresponds to the profitability metrics we highlighted above. It also makes sense that Pure Barre would have fewer multi-unit operators considering that the franchisee typically functions as an owner/operator.

Finally, if the recent short report’s claims were true, we have several questions we would like to pose:

• Why do many franchisees own multiple units? Certainly they are in the best position to evaluate if opening more than one store is a good financial decision.
• Why aren’t transfer rates higher? Transfer rates are the rate at which franchisees sell (or transfer) their franchise right to another owner. Healthy franchise systems generally see 10% or lower transfer rates.
• Why hasn’t XPOF bought back more franchises? Xponential has historically bought back underperforming stores from franchisees that are looking to exit their commitment.

We clearly do not agree with the recent short report’s claims that 80% of XPOF’s brands are losing money, and more than half of XPOF studios never make a positive financial return.

Business Argument #2 – XPOF is hiding “Permanent” Closures

The recent short report spent a significant amount of time arguing that XPOF was hiding permanently closed units and that these closures put XPOF in default on its debt covenants. We agree that some of the stores that the short seller highlighted are not open, and we are not certain that all these stores will reopen. However, we will show that the claim that management is hiding permanent closures is somewhat misleading.

First, we want to point out that XPOF is not in default on its debt covenants. The short seller referenced the wrong indenture (retired) in the short report and said that XPOF would be in default on its debt if stores were permanently closed. The current facility has debt covenants that require that the company get prior written consent if in fact management does decide to terminate and permanently close more than 25 franchised locations during any fiscal year or 50 franchised locations in aggregate. This can easily be found in their indenture. If we were the lenders, we would be more than happy to sign off on the company closing their “transition studios” as we estimate it is roughly a ~$10 million headwind to adjusted EBITDA. As equity holders, we hope that Xponential abandons its strategy of buying underperforming studios back and allows poorly operated studios and studios in bad locations to close rather than staffing a traveling corporate unit operations team, assuming the monthly burn of unprofitable units, and trying to turn around a bad unit.

The recent short report included a list of 35 locations the author viewed as permanently closed. The FDDs, site websites, and social media pages for the brands tell different stories. Many of these so called permanently closed studios are listed as transition studios that are temporarily closed and have a reopening date or are promised to be coming soon or reopening soon. Upon further diligence only two weeks removed from the short report, we also found that one studio has presumably reopened because it is conducting classes today. Others have publicly stated that they are moving their unit. We think the assertion that these are all permanently closed is wrong and misleading. Of the 35 units that the recent report categorized as permanently closed, we have already found documentation that 13 are not permanently closed. We have included documentation of our findings in Appendix A.

We would not be surprised if many of these units are owned by XPOF, and we would not be surprised if many reopened soon. Additionally, if the studios seem unmendable, we would support the company in permanently closing units. We do not know of a single franchise concept that has never closed a unit. In our view, the current company owned studios are roughly a $10 million drag on adjusted EBITDA. Were XPOF to refranchise the successful ones and close the underperforming units, we believe XPOF’s EBITDA would increase by $10 million. That’s an additional ~$4/share to common shareholders if XPOF gets a comp average multiple. Shareholders should want this too, and it would put to bed this argument around store closures. XPOF store closures could lead shorts to say, “we were right!”, and we would have to agree. But at the same time, if half of the 87 company owned stores were closed tomorrow, I would argue that 40 closures over the course of the company’s history on a base of 2,411 studios would be an impeccable track record.

XPOF has frequently explained that it has “transition studios.” First, as with every franchise concept, some franchisees don’t follow the franchise playbook and fail, others simply have a bad location. Additionally, some franchisees relocate their franchise when their rent is up for renewal, perhaps they found a better location, or cheaper rent, or the landlord has a different use for the box. Lastly, life happens. Xponential had 2,411 stores operating in North America as of March 31, 2023 and approximately 1,300 unique franchisees as of December 31, 2022; that is a pretty large system. Franchisees pass away, get divorced, an owner/operator moves, or have other life events that necessitate a change. We believe that there will always be studios in transition. Franchisees have the right to sell or transfer their franchise, and Xponential has historically bought back units from franchisees in some cases. Over the last nine quarters, Xponential bought back 124 franchises and refranchised 77 units. This represented an annualized repurchase of 3% of the system over the last nine quarters, which we view as immaterial. Importantly, XPOF has shown an ability to turn these units around and refranchise them (77 units refranchised over the last 9 quarters). As we previously stated, we would be in favor of Xponential not buying back unprofitable units in the future because that would unlock significant EBITDA and FCF.

Business Argument #3 – Franchisees Selling Their Units

The recent short report made a big deal about franchise resales. Even if the short report’s data is true, it’s not outside of normal transfer rates for other franchise concepts. The short report claims that in the first 5 months of 2023 alone, he or she tracked 126 XPOF franchises that are available for resale. We found the short seller’s evidence is difficult to audit. However, for the sake of argument, let’s assume this is true. First, we do not know who is listing the franchise, is it XPOF or a current franchisee? If XPOF is listing the franchise, investors should be in favor of reselling franchises at attractive prices to the buyer. Why? XPOF buys struggling units back from franchisees for $1. If XPOF resells units for anything over $1, it is pure profit, and XPOF collects any royalty stream going forward. Franchisees may also list the unit for a variety of reasons we have discussed (underperformance, life circumstances, etc.). However, if the recent short report author really tracked 126 XPOF franchises for sale in the first 5 months of 2023 and 100% of those franchises sold (seems highly unlikely), it would result in an annualized 300 transfers or a 11% transfer rate in North America. Again, we think we are being wildly conservative with the above assumption that all listed units sold. That said, let’s compare this to XPOF’s historical transfer rate and the transfer rate of other franchise concepts. XPOF had 228 transfers in 2022 (9.8% transfer rate). Planet Fitness (PLNT) had a 9.8% transfer rate in 2022. European Wax (EWCZ), a franchise concept with mostly financial buyers as franchisees, had a 9.7% transfer rate in 2022. The Joint Chiropractic (JYNT) had a 6.4% transfer rate in 2022. Wingstop (WING) had a 7% transfer rate in 2022. Domino’s Pizza (DPZ) had a 6.9% transfer rate in 2022. McDonald’s (MCD) had a 9.2% transfer rate in 2022. Here again, I think that the short report author is highlighting a point that is standard in the franchise industry.

We found the following XPOF Franchises listed for sale on July 13, 2023 on the same website cited by the short seller.

• Club Pilates: 0
• Pure Barre: 0
• Cycle Bar: (1) – $500K in Connecticut
• Yoga Six: 0
• Row House: 0
• Stretch Lab: (1) - $219K in California
• AKT: Brand not on site
• Stride: (1) – $60K in North Carolina

Business Argument #4 – “Kickbacks”

The short report author made an argument targeting an industry standard and then gave it an ugly name. Let’s talk about what the short author calls kickbacks.

First, the short report author uses a false characterization of the definition of kickback in his or her report. A kickback is a specific term. A kickback “refers to misappropriation of funds that enriches a person of power or influence who uses the power or influence to make a different individual, organization, or company, richer.” The case law sited in the definition above refers to when an agent “corruptly solicits or demands for the benefit of any person, or accepts or agrees to accept, anything of value from any person, intending to be influenced or rewarded in connection with any business, transaction, or series of transactions of such organization.” These are quid pro quo financial arrangements. Generally, a kick back incorporates deception, bribery, and an attempt at inducement.

Perhaps the most prolific examples of kickbacks occur in the healthcare industry where there is significant legislation outlining and preventing kickbacks, including the Anti-Kickback Statute and Stark Law. Some examples (healthcare specific) include paying for referrals, paying doctors to prescribe a medication, paying physicians, or giving volume-based discounts, etc. There are many differences between that and what happens in a franchise.

First and foremost, no franchisee is being defrauded or harmed by XPOF. In the examples above, the doctor is prescribing a product or service a patient might not need because the doctor is induced to do so. The patient does not know about the doctor’s financial relationship. When a franchisee buys a franchise, he or she is buying a “business in a box.” The franchisor supplies most of what is needed to run that business for a price including the instruction manual or play book for that business. The franchisee is required to buy all materials from the preferred vendors. The franchisor is compensated for that and receives fees for services performed. Franchisees are not buying equipment from vendors while XPOF sits to the side and collects a rebate. It is true that the vendor does sometimes ship the product directly to the franchisee; it is also true that XPOF frequently buys and holds inventory from the vendor. XPOF buys in bulk months in advance of openings, takes inventory risk, and XPOF does this so that it can capture a larger discount relative to a franchisee purchasing for one unit. This is what we saw in the quarters leading into Q2’22 when XPOF’s inventory increased significantly. XPOF was stocking up on equipment packages to prepare for a ramp in unit openings. XPOF buys, holds, sets up, and installs equipment.

Additionally, and most critically, XPOF does not hide this financial relationship from the franchisee; Item 8 of every FDD discloses that XPOF has a right to require the franchisee to purchase any items or services necessary to operate the studio from a supplier it approves including Xponential Fitness. Additionally, XPOF provides the franchisee with a list of approved suppliers; XPOF describes that it may derive revenue from the purchase; and XPOF discloses the amount of revenue it received from required purchases in the prior fiscal year. This is not a kickback. Again, Item 8 clearly discloses this information for every franchise concept. The short seller has chosen to pick on an industry (franchisors) and not XPOF specifically in this argument.

Business Argument #5 – Overcharging Franchisees

The short report asserts that XPOF overcharges franchisees for everything. The short sellers point out that XPOF sells franchisees exercise bikes for 58% more than the cost of a Peloton. First, we calculate that XPOF makes a 32% gross margin on its equipment and merchandise sales, which is by no means usurious.

XPOF provides investors with equipment revenue and merchandise revenue, which together comprise product revenue. Additionally, XPOF discloses cost of product revenue, which consists of “cost of equipment and merchandise and related freight charges.” We simply take the difference to calculate gross profit dollars and gross profit margins for product sales. We assume that merchandise revenue is slightly higher margin that equipment revenue. Therefore, we think equipment gross margins are probably more like 30% or slightly less. Again, XPOF is making a 32% margin on equipment and merchandise sales, why does the short report author think this is egregious?   

Moreover, Peloton bikes are residential bikes, not commercial bikes used numerous times a day. Peloton disclosed in 2022 that the average monthly workouts per connected fitness subscription was 16.4 workouts/month. In PTON’s Q3’23 shareholder letter, Peloton disclosed that 57% of all workouts were non cycling related and 38% of workouts have no hardware at all. Let’s assume the average Peloton is used 7 times/month (16.4 * (1-57%)). By our estimate, the average Cycle Bar is running 120 classes/month. A commercial bike should probably be more expensive because it handles a drastically different workload and, therefore, needs to be more durable. Moreover, XPOF procures, holds, and installs the equipment for the franchisee, these services are worthy of a margin. We think XPOF’s 32% equipment margin is perfectly reasonable. For reference, European Wax charges franchises approximately 2x its cost on wax that franchises must buy through European Wax and/or its preferred vendors. I would argue that EWCZ’s 100% mark up on body wax is arguably more painful to franchisees.

Business Argument #6 – Billing Practices

The short report attempts to paint the picture that XPOF franchisees are fraudulently billing members. XPOF units average ~276 members/studio. The fact that shorts can find complaints from a handful of members is unsurprising. Instead of going through reviews for all 2,411 open XPOF franchises, we used the Better Business Bureau to tabulate the number of complaints in the last twelve months and the number of complaints in the last three years for a reasonable sample size (targeting 10% of open units).

We acknowledge that not everyone complains to the Better Business Bureau in the event of a problem. We also acknowledge XPOF franchisees are imperfect human beings who employ other imperfect human beings who communicate with an average of 276 other imperfect human beings monthly. There will be conflict, and we hope that XPOF can work with franchisees to implement best practices and ensure continuity of service across all studios. We further hope that XPOF emphasizes follow-up with members who feel they have been wronged. That said, if XPOF members churn at 6-7% annually, the average franchise has had close to 325 members over the last three years. To average only 1 BBB complaint in the last three years seems like good performance and not indicative of a system wide or pervasive gym theft scheme.

Business Argument #7 – Improper Reporting

Lastly, the short report author argued that XPOF presents its financials in two misleading ways. The short author alleges that XPOF excludes underperforming stores from its same store sales and AUV calculations. We do not think that XPOF is doing anything misleading. In fact, Xponential reports AUVs and SSS in-line with industry standards. I wonder if we’ll be seeing this short seller target all concepts that report SSS? Xponential’s AUV calculations are based on units that have been open for more than 6 months, and XPOF’s SSS calculations only reflect units that have been open for more than 13 months and thus have revenue to compare against in the prior year period. Xponential has disclosed the same consistent methodology to investors since the IPO. Moreover, the company has been clear that even if you include the units that have been temporarily closed in the AUV calculation the result is immaterial. For Q1 2023, recalculating Xponential’s systemwide AUV to include excluded studios would result in a 0.9% change to the AUV figure ($542,000 vs. $538,000).

Finally, the short author claims less than 40% of XPOF’s revenue is one-time and non-recurring. The belief that only royalty and marketing fees are recurring is silly and factually wrong. This truly is not a point of contention. Equipment sales and franchise license sales are both paid up front; we agree that those are not recurring transactions. From a GAAP perspective, investors could argue that franchise license fees (aka franchise territory fees) are recurring because the license is amortized over the life of the license (10 years), but we have not taken that stance out of conservatism (and neither has the company). Royalty fees and marketing fees, monthly technology fees, training fees, merchandise fees, credit card rebates, video on demand subscription revenue (XPLUS), XPASS revenue, and even revenue from the company owned units are all recurring in nature. We calculate that 75% of XPOF’s revenue is recurring based on our 2023 revenue estimates.

Business Argument Conclusion

Investors should be comforted that unit economics are generally strong, especially among the brands that are growing studios (which represent 98% of revenue). Ultimately, the health of any franchise business is reliant on the health of the franchisee. We take comfort in the following facts. Many of XPOF’s franchisees own more than one unit. XPOF has commitments from franchisees to open 1,968 more units in North America and 1,063 units internationally at March 31, 2023. AUVs have continually increased since the depth of COVID, and disclosed AUVs were $542,000 (which is an all-time high) at March 31, 2023. Healthy business returns at Xponential’s largest brands and driving significant FCF for XPOF shareholders. We think XPOF could generate approximately $225 million of Free Cash Flow (approximately 25% of its market cap) between Q1’23 and the end of 2025.

Valuation

We’ll briefly touch on valuation. We comp Xponential to other franchise businesses. XPOF has the highest growth algorithm (unit growth + SSS growth) in our comp group of franchise concepts that derive the majority of revenue from franchisees. Therefore, we believe that XPOF warrants a premium multiple; however, we are underwriting XPOF with a multiple in-line with comps out of conservatism (PLNT, EWCZ, JYNT, WING, DPZ, QSR, YUM, PZZA, MCD). This group trades at 21.5x 2023 EBITDA and 19.1x ’24 EBITDA. Ascribing those multiples to XPOF implies a $35.50 PT (78% upside) on 2023 EBITDA and a $40.00 PT (101% upside) on 2024 EBITDA. Our underwriting does not include any additional cash generated or the potential benefit from turning off XPOF’s strategy of acquiring underperforming stores. Moreover, we account for the preferred by assuming it is taken out at $21.60 using additional debt. We think XPOF is an exceptional investment opportunity, and we are excited about the opportunity to buy XPOF here.

Key risks to our thesis include lack of continued customer adoption, a painful recession which could cause customers to trade down to a less expensive workout option, inability to sell new franchise licenses, general deterioration in unit economics, and an inability of franchisees to open new units.

Appendix A: Franchise Units listed as “Permanently Closed” that don’t seem to be “Permanently Closed”

1. AKT 9232 Wiles Road – Listed as Coming Soon

2. AKT 801 S. University Dr – Listed as Coming Soon

3. AKT 10635 Sheldon Road – Potential Move; AKT 2023 FDD lists as 10617 Sheldon Road (Page 211)
4. AKT 620 Riverside Shops Way – Listed as Coming Soon

5. CycleBar 5600 N 7^th St – The Cycle Bar FDD lists 3 open Phoenix locations, all of which are taking classes according to the CycleBar website. The FDD also includes a fourth Phoenix location that has been transferred several years in a row. We suspect that is this unit.
6. CycleBar 3535 NW 83 Avenue – Taking Classes
7. Cycle Bar 2222 Weston Road - Reacquired by XPOF – CycleBar 2023 FDD, Page 227
8. PureBarre 23410 Civic Center Way – Relocating

9. PureBarre 319 East Ontario St – Temporarily Closed, Reopening on 8/31/23

10. PureBarre 1380 Duckwood Dr – Reopening Soon

11. PureBarre 187 Columbia Turnpike – Temporarily Closed, Reopening Soon

12. PureBarre 19825 Belmont Chase Dr – Temporarily Closed, Reopening Soon

13. Row House 437 S. Highway 101 – Moved, Row House Del Mar

Disclaimer

Our firm currently holds a long position in this security which can currently be considered a long-term holding. Our research is completely independent and based on public information, our proprietary research, and our analysis of that information. While Author has tried to present facts it believes are accurate, Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in XPOF. Reader agrees to hold harmless and hereby waives any causes of action against Author related to the note above. As with all investments, caveat emptor.

Reader agrees that content in this report is not owned by Reader, and you therefore agree not to distribute this report or any excerpts from it other than by providing the following link: valueinvestorclub.com. You agree to abide by the terms outlined valueinvestorclub.com.

Catalyst

Short squeeze

Inaugural Shareholder Day on September 6, 2023 - nobody holds their first shareholder day to tell you why they suck. 

Investors gaining comfort with short report allegations

Preferred equity conversion and potential debt offering to repurchase shares