PLNT - Planet Fitness: Facing Challenges Amid Strong Performance

2023-09-14 12:07:53 ET

Summary

• Planet Fitness achieved strong sales and membership growth in 2Q23, with improved performance in EBITDA and EPS.
• However, PLNT is facing challenges due to limited retail space availability, potentially hindering store openings and impacting profitability.
• The extended timeline for opening stores and uncertainties may further hinder PLNT's expansion efforts and reaching long-term targets.

Summary

Planet Fitness (PLNT) operates in three segments which are Franchise, Corporate Owned Stores, and Equipment. The Franchise segment is responsible for overseeing the franchise business in different regions. The Corporate Owned Stores segment directly manages fitness centers. The Equipment segment's primary focus is on selling fitness equipment to franchisee owned stores.

Examining PLNT historical financial performance, over the past five years, PLNT has exhibited significant revenue growth, boasting a compound annual growth rate of approximately 10.6%. Furthermore, the EBITDA margin has consistently remained robust, hovering around 41%. However, despite these impressive historical achievements and a stellar second-quarter performance, there are looming challenges on the horizon.

Regarding the present state of PLNT’s business, even though the second quarter and historical financials showcased a strong performance, there are larger economic forces in play that are reshaping the landscape for PLNT. Two primary challenges stand out: the decreasing availability of retail space and the protracted timeline for opening new stores. These challenges are poised to persistently obstruct PLNT's revenue growth and profit margins in the foreseeable future. It's worth emphasizing that the resolution of these issues largely depends on external parties, as they relate to space availability and opening schedules. This external dependency makes it difficult for PLNT to internally address these concerns.

This post is to provide my thoughts on Planet Fitness business and stock. I am recommending a hold rating as I expect challenges to continue to mount, impacting PLNT upcoming performance.

Investment thesis

PLNT achieved robust systemwide sales of $1.147 billion in 2Q23, with an impressive 8.7% increase in same-store sales [SSS]. During the quarter, the company successfully opened 26 new stores. The overall improved performance in EBITDA and EPS was primarily attributed to positive variances in the corporate store and equipment segments, while the larger Franchise segment largely met expectations. Notably, corporate store margins reached an impressive 42.8%, surpassing initial estimates, thanks to reduced corporate store expenses. Furthermore, equipment revenues saw an uptick, primarily driven by higher replacement revenues.

Alongside the strong top-line performance, the company experienced notable membership growth, adding approximately 300,000 new members sequentially. This represents a quarter-over-quarter growth rate of approximately 2% and a year-over-year growth rate of about 12%. It's worth mentioning that around 75% of the company's second-quarter comparable sales increase was attributed to this membership growth, with the remaining portion stemming from rate increases. Additionally, it's worth noting that cancellation rates continued their downward trend for the eighth consecutive quarter.

Looking at PLNT’s past 5 years, it has experienced a consistent compound annual growth rate of approximately 10.6% in its revenue, maintaining a robust and stable EBITDA margin of around 41%. However, it's important to note that in 2021 and 2022, PLNT achieved remarkable revenue growth rates of 47% and 64%, respectively. I believe these exceptionally high growth rates can be attributed to the recovery from the COVID-19 pandemic and the gradual easing of COVID-related lockdown measures. In the longer term, I anticipate that the growth rate will revert to its historical 5-year CAGR.

However, PLNT are facing some headwinds. The retail space vacancy rates have decreased compared to the pre-COVID levels. This reduction in vacancy rates has made it somewhat challenging for franchisees to locate suitable spaces in the right locations. With lower vacancy rates, there are fewer available retail spaces for franchisees to choose from. This limitation restricts the company's ability to open new stores in prime locations, potentially forcing them into less desirable or less profitable areas. As a result, the company's expansion efforts may be hampered, leading to slower growth.

In addition, the heightened competition for the limited available spaces in high-demand areas may drive up leasing costs. Franchisees may have to pay higher rents or invest more in securing desirable locations, which can strain their financial resources. These increased costs can impact the profitability of new stores and make it more challenging for franchisees to achieve strong returns on their investments, potentially discouraging further expansion. I believe these obstacles may continue to impact PLNT’s expansion efforts.

"I would say the on the real estate availability, it's more it's just that it's not there's not as much of inventory out there to go negotiating. So it's not that they're not the right deal, it's just lack of available space to get it now." 2Q23 earnings results call

Lastly, the time frame for opening stores, starting from the site selection phase, which is often the most challenging, has approximately doubled since the pre-COVID era. It now spans between 9 and 12 months, compared to the previous 5 to 6 months. This extension includes longer durations for lease negotiations, more noticeable delays in HVAC installations, and other permitting and local municipality-related constraints. I believe these obstacles may continue to impact PLNT’s expansion efforts, potentially hindering its ability to open stores in a timely manner in the foreseeable future.

"I guess the other thing too with the municipalities, even the permanent, for example, even though COVID seems like it was quite a long time ago, the municipalities. The building inspectors, for example, they still work from home where they're just not as much, they're not around as much in getting as much as getting these permits signed and COs, typical occupancies issue. So it's just, everything just takes longer than it did pre-COVID. So now it's I'd say down on time, it's probably more like a nine to 12 month, nine month time frame, probably nine, 12 ." 2Q23 earnings results call

The company opened 26 stores in the quarter, which is weaker than I expected. In addition, the initial expectation for store openings in the fiscal years 2023 to 2025, which was capped at 600 stores, has now been adjusted to acknowledge that it might take more than 3 years to reach this target, depending on the duration of the current challenges and headwinds.

Management is striving to strike a balance between the lowered short-term outlook and the possibility of expanding beyond the previously anticipated 4,000 long-term units. Achieving this expansion, however, is a complex task, especially since the company has indicated that there is less potential site availability compared to pre-COVID-19 levels, despite the underlying market opportunity having grown.

Valuation

I believe the fair value for PLNT based on my model is $48.72. After reviewing PLNT's 2Q23 results, it's evident that the company is poised to encounter challenges ahead, primarily driven by reduced space availability and an extended timeline for store openings. These headwinds manifested in the form of PLNT opening only 26 stores this quarter. As such I model a slowing growth rate ahead and margin to gradually decline as it sees operating deleverage back to historical low-40s% region.

While the historical CAGR stands at approximately 10.6%, I anticipate that the extended timeline for store openings mentioned will exert pressure on future revenue growth as it will impact PLNT’s ability to open stores in a timely manner in the foreseeable future. This impact is likely to become more pronounced starting from FY24. Consequently, I have projected a decline in revenue growth to 2% in fiscal year 2025.

Additionally, I expect EBITDA margins to contract due to heightened competition for the limited available spaces in high-demand areas, which may drive up leasing costs. In my model, my target EBITDA margin for FY25 declines to 41%, against 47% in FY22, signaling my belief that leasing cost will be driven up.

I valued PLNT at its current forward EBTIDA multiple as I believe the market has priced in the bear case. Note that at 14x, PLNT is at -1 standard deviation from its historical range. Therefore, I recommend a "hold" rating for PLNT at this juncture, suggesting that investors maintain their current positions and carefully monitor the company's performance in the face of these upcoming challenges.

Risk

There are several factors that could pose risks to PLNT. These include the possibility of slower unit development, a slowdown in comparable sales growth or a shift to negative growth, and slower-than-expected membership growth. These scenarios could result in lower-than-anticipated EBITDA, earnings, and free cash flow.

Furthermore, be cautious about potential challenges such as cannibalization effects from the opening of new units, competition from a range of fitness providers offering low-cost, mid-cost, and high-cost services, and the availability of suitable real estate and site selection.

Conclusion

PLNT has demonstrated strong performance in its various segments, driven by robust systemwide sales and membership growth. However, the company faces several challenges that may impact its expansion efforts. Firstly, the decline in retail space vacancy rates has made it challenging for franchisees to find suitable locations for new stores. This limitation could potentially lead to slower growth and higher leasing costs in prime areas. Secondly, the extended timeline for opening stores, influenced by various factors including lease negotiations and permitting delays, may further hinder PLNT's ability to expand in a timely manner. Lastly, the company's store openings have become slower, and the outlook for reaching long-term expansion targets has been adjusted due to ongoing challenges and uncertainties.

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