2023-09-13 12:29:38 ET
Summary
- Xponential Fitness is a leading player in the growing boutique fitness industry, with a diversified portfolio of brands.
- The company has a competitive advantage with its diversified portfolio, market-leading position, and relationship with franchisees.
- Xponential has opportunities for growth through partnerships, cross-selling, and increasing the number of operating studios, but faces risks such as competition, unfavorable economic conditions, and high levels of debt.
Introduction
The boutique fitness industry is growing rapidly, and Xponential Fitness ( XPOF ) is one of the leading players in this market. The company has a diversified portfolio of brands, including Club Pilates, Pure Barre, and CycleBar. These brands offer a variety of workouts that appeal to a wide range of customers. Moreover, the company has shown resilient growth in a highly competitive industry due to its competitive advantage over smaller companies. However, the tougher competition, the inability to maintain positive operating margins, and the high levels of debt offset the opportunities. In my opinion, the stock is a hold, and in this thesis, I will examine the positive and negative aspects of the company.
Competitive Strengths
A diversified portfolio of boutique studios
Xponential Fitness has a total of 10 brands of boutique studios, each one in a different fitness niche, which gives them a considerable advantage over single-brand studios because the firm has access to a larger market and can offer cross-selling as members can pay a monthly subscription and go to different types of studios. However, even with a broader offer than single-brand studios, I believe this competitive advantage has faded as fitness marketplaces now offer a comprehensive list of different studios in their apps, so a user only has to buy some coupons to trade them for classes in any boutique studio in their zone.
Market leading position
The brands Club Pilates, Pure Barre, and Cycle Bar were approximately eight, four, and four times larger than their next largest competitors, respectively, according to the last 10K Report. Moreover, the three former brands and Stretchlab, Row House, and YogaSix were listed among the Entrepreneur’s 2023 Franchise 500 ranking. The latter three brands weren’t on the list in 2022, and two of the former three scaled positions in 2023; thus, I expect these brands to continue to grow as franchisees will choose them over others as they offer higher returns and are already in the customers’ minds.
Relationship with Franchisees
Continuing with the latter idea, Xponential Fitness is deeply compromised to potentiate the return of its franchisees through Xponential Playbook, a proven operational model that helps franchisees achieve cash-on-cash returns of approximately 40% after the second year of operations. However, I think the high returns are partially due to the extraordinary increase in discretionary consumption, as US citizens saved a lot of money during the pandemic. Thus, I think it’s probable that the return falls as a product of stiff competition and a more conscious consumer.
Cross-Selling: XPASS
The introduction of XPASS in 2021 was a milestone in the strategy plan of Xponential because it inserted the company into a new market and gave a solid advantage to all franchisees. Now, Xponential competes with ClassPass or any other marketplace of fitness classes. Also, those franchisees with low utilization could join XPASS and increase their members as the latter can choose among a broader selection of classes.
As the president of XPASS, Dan Ali stated: “If we lose the customer to a studio, we’re extremely happy.” Taking his words, I think XPASS is a way to help franchisees catch new members, who probably will be exceptionally loyal as they enjoy social benefits, too.
Nevertheless, XPASS is a premium service that includes XPLUS in most of its plans; this differentiates XPASS from other marketplaces and lets it be more expensive than other plans without losing clients. However, marketplaces have a broader selection of gyms and boutiques than XPASS.
Partnerships
Xponential Fitness has partnered with Apple, Lululemon, and Princess Cruise to bring its brands to more customers and increase the enthusiasm among members. I think partnerships will drive more customers as other studios cannot make them, reducing their exposure to more customers (lower customer acquisition rate). Likewise, I believe this will be less significant as the market consolidates around a few players that will be able to make great partnerships as Xponential can do now.
Lastly, one crucial partnership is Gympass, which opens the doors to a new market of 15,000 corporate customers and over 2 million paid customers with access to Xponential brands.
Asset-light business model and economies of scale
On one hand, as a franchisor, the company tends to have small capital expenditures and predictable and recurring revenue streams. Consequently, the free cash flow can be maximized as few resources need to be invested, and the management can make better estimates of future cash flows and, hence, make better decisions.
On the other hand, as the number of franchisees increases together with their Average Unit Volumes, Xponential receives higher royalty revenue while it doesn’t have to expand its SG&A expenses, so the operating margin soars. Nevertheless, the company hasn’t achieved constant positive operating margins. I remain optimistic it will achieve them, but the lack of safe and sound financial performance aggregates higher risk.
Competitive Landscape
The health and fitness industry is highly competitive, with many players and substitutes, such as weight loss pills, diet apps, gyms, workout apps, or meal replacements. The intense competition makes it difficult to raise prices and forces franchisees to offer the best service possible at the lowest price. In this sense, I think Xponential has to worry about its quality more than any other company, as its offering is considered premium owing to the expensive cost of XPASS relative to its peers.
In general, boutique studios have an advantageous position relative to regular gyms because boutiques can offer:
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Forming a community and friendships among the members creates incentives to keep going to the gym (lower attrition rate).
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A more personal experience as trainers only focus on a limited number of people.
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More specified workouts that tailor to members’ needs and objectives.
However, an essential disadvantage of boutiques is that they are more costly than typical gyms, as they have to spread the cost of classes (space, equipment, and trainer salary) over a limited number of members. Moreover, a specific disadvantage of XPASS is that it’s only worth it in regions with a high density of franchises.
I think the industry growth (10.6%) will decrease the level of competition for a while as the revenue cake is larger, and there is little need for taking market share from other competitors to grow. Nonetheless, as the growth begins to stagger, the rivalry will increase, and many players will be forced to leave. In this scenario, I firmly believe Xponential will survive as its brands are better positioned among franchisees and customers than single-brand players that have to compete in highly competitive markets established by marketplaces such as Gympass and ClassPass. So, Xponential will have better financial resources than others to help franchisees by promoting its brands and gaining market share through acquisitions, directly improving XPASS's value.
As an example of the growth and the level of fragmentation of the boutique studios industry, we have the following graph showing the number of businesses:
Ibisworld
Yet, I don’t think Xponential has a wide moat as of 2023, but it has the strengths to survive in the long run in an industry that I believe will become more competitive. Boutique studios are easy to replicate, and online marketplaces allow customers to access different classes in different boutique studios. Franchisees benefit from purchasing discounts as Xponential uses its scale to acquire services and merchandise at a lower price. But despite that, when the industry consolidates around a few players, Xponential Studios will lose that purchasing advantage as many players will enjoy purchasing discounts.
Nonetheless, I believe Xponential has a narrow moat as some of its brands are the market leaders by a significant difference, and it can spread marketing efforts over more brands, decreasing customer acquisition costs. In addition, as the attrition rate is minimal, a new customer will have a high-value expected life. This is explained by the social benefits boutique studios offer to customers, as they make friendships and are more motivated to keep attending classes.
Opportunities
Historically, the number of operating studios has grown at a CAGR of 21% (acquisition adjusted) since 2018. Likewise, System-wide sales have grown from $560 million in 2019 to $1,033 million in 2022, principally due to the increase in the opening of studios and AUV, which grew from $449 thousand to $494 in 2022.
Moreover, a key indicator of future growth is the number of licenses sold, as they represent future operating studios. However, we must know that many of those licenses will not become opened studios. In fact, according to its last 10K report, Xponential Fitness has had to terminate 634 licenses sold, representing approximately 24% of the operating studios globally in 2022.
Comparing the total operating studios with licenses sold, we can gauge a ratio that measures the percentage of active studios relative to licenses sold. If this ratio increases, future growth may slow as more licenses have already been constructed. In 2021, the ratio fell to 48.1%, but since then, it’s been increasing to almost 50%, meaning that the company, in the best scenario, can double the number of operating studios. Nevertheless, the number of licenses sold is a gross number, so it doesn’t account for license terminations.
Author's Elaboration with data from 10K Reports
Even if the ratio has increased, I think the growth prospects remain strong, as its increase is insignificant compared to the fall in consumer confidence and the rise in interest costs during the last two years. In my opinion, the strong and resilient growth of the boutique studios industry, Xponential’s high-income customers, and the fact that wellness is becoming a top priority for people are the key elements that explain the resilient growth prospects.
Moreover, Xponential expects to increase the number of operating studios by 500 annually in the coming three years, giving a CAGR of 14.94%. I believe this growth will be easily achievable as the industry as a whole is expected to grow around 10.6% to 12.6% (globally), and Xponential has a track of outperforming the industry, the competitive advantages to do it in the following years and enough licenses sold. Likewise, the management aims for a 40-45% EBITDA margin and an annual 20-25% EBITDA growth. Additionally, the management will focus on increasing the AUV through more partnerships and XPASS, lowering consumer acquisition costs. Lastly, strategic acquisitions can raise the growth rate even more; however, a not-so-healthy balance sheet could deter management from conducting significant acquisitions.
Risks
Interest Rates
On average, a new franchisee invests $350,000 in building their studio; thus, franchisees generally need financing through debt to construct and operate their studios. With higher interest rates and less credit availability, I expect the number of licenses sold will decrease temporarily, decreasing the number of new studios and revenue growth.
Stiff Competition
As I said before, Xponential is in an advantageous position relative to single-brand studios, as it can lower customer acquisition costs through partnerships and shared marketing strategies across its brands. It also can reduce the price of equipment, merchandise, and services as its purchase volume is large. However, I expect the market will start to consolidate in the future, and those competitive advantages will fade slowly. However, brand recognition may play a vital role in the coming years.
Unfavorable Economic Condition
Rising living costs and low consumer confidence may lead customers to more affordable fitness activities such as standard gyms or home workouts. As there is a slowdown in the industry, I think the pricing competition will increase as studios won’t only compete among them but also with other more affordable fitness activities. Nonetheless, the minor attrition (due to social benefits) rates in studios may be a factor that mildly offsets pricing competition.
Debt
Xponential Fitness has a net debt of $257 million, of which over 90% must be paid in 2025. Given the last year's FCF (FCO-CAPEX), it would take six years to repay all the debt. So, the company will have to roll over the debt in uncertain conditions in the future. It may have to refinance with worsened credit conditions due to lower revenue growth, less credit availability, and worsened profitability.
Brand Reputation
Xponential relies on franchisees to bring the best fitness experience to all its clients. Still, rigorous control is nearly impossible in every studio, so there is a risk of adverse publicity, which may affect the revenue of other studios and, finally, Xponential revenue.
Valuation
In this case, I assumed an annual revenue growth of 18% until 2026 and 17.5% and 17% for 2027 and 2028. Likewise, I expect the EBIT margin to expand by 1% yearly, as the SG&A as a percentage of sales decreases constantly, which is aligned with the guidance of increasing EBITDA by 20-25% annually.
As the company does not have a constant track of sound financial performance and the competition is tough in the industry, I’ll decide to use 17% as the discount rate for future cash flows.
Please note that to calculate the NPV per share, both common share classes, A and B, were considered equivalent.
Author's Elaboration
Conclusions
Given the results of the DCF model, the shares of Xponential Fitness are fairly valued (it's a Hold). However, the model is slightly more optimistic than the guidance for the next three operating years; in fact, revenue in 2025 is higher than the expected revenue of $405 million, and the EBITDA (non-adjusted) will increase at a CAGR of 21.75% while the guidance points out a growth between 20-25%. Nevertheless, analysts are expecting operating margins of around 21-26%, but I consider them highly optimistic, especially when the EPS estimates have failed by significant surprises.
Lastly, I want to emphasize that the current share price, in my opinion, reflects all the opportunities and risks. However, even if the model, in my opinion, is optimistic, the analysts are even more optimistic. Still, I’ll wait to see if the company can achieve constant and growing operating margins before projecting it will achieve >20% operating margins.
For further details see:
Xponential Fitness: Fairly Valued Given Optimistic Expectations