Nawar Alsaadi's  Instablog

Soko Fitness & Spa Group (SOKF.OB) offer professional fitness, beauty salon and spa services focusing on the middle to higher end customers in China. The Company provides programs, services and products that combine exercise, education and nutrition to help their members lead a healthy way of life and achieve their fitness goals; currently Soko is the largest such operator in Northeast China.

The company operate 3 fitness centers (14% of revenues),  9 spa and beauty salons (80% of revenues) and one beauty school (6%); further 4 facilities are being constructed and scheduled for completion in 2010  (two beauty salons, yoga center and fitness center).

Market share and growth potential

Soko operate principally in two cities Harbin (10 million people) and Shenyang (7 million people), the penetration rate for fitness services in this area of China is very low estimated at between 0.5% to 0.8% of the population being a member of a fitness club, SOKO has 16% market share in Harbin in fitness services and 8% market share in Shenyang; for beauty salon and spa, the company estimate a market share of 25% to 30% of the market.

SOKO attempts to differentiate itself from the competition by focusing on high quality consistent service, at the moment the market for SOKO services is price oriented, however management believes that over time the market will be more segmented with a better distinction between higher class and average operators; accordingly management has scarified some membership growth in return for higher prices and higher quality.

The market for fitness, beauty and spa services in China is growing at a brisk rate powered by a growing middle class and adoption of the western style of living, in 2008 alone revenues in the industry grew by 23.8% to RMB 320 billion, making the market the third largest market after the United States, France and the largest in Asia.

Business model

The company offers both a membership model (at the fitness centers), as well as one time to multiple times services purchase option at the beauty, spa and yoga centers, at the end of 2008, the company had 13000 fitness centers members and 19500 beauty and spa annual clients; the company also undertakes cross marketing between those services and sells health and beauty products to its clients.

Most of SOKO memberships are pre-paid and are none-refundable, whether it is a 3 months, 4 months or 1 year or more memberships, members must pre-pay the entire amount before using the facilities, this setup is somewhat discouraging to some clients, but it offers the company a significant amount of upfront cash flow and lowers the risk of none payment by the client.

The company also operate a beauty school, while the beauty school does generate additional high margin revenues, it is also used as a source of staff for SOKO various salons and spas, the top 5% of graduates are offered positions at SOKO facilities.

The company looks to develop fitness centers, beauty salons and spas is upscale urban areas to be close to its target customer, according to the company experience, it takes approximately 3 to 4 years for a new centre to mature with the fixed cost being spread over a larger membership base over time, the beauty salons and spa usually experience faster initial growth rates in comparison to the fitness centers.

Results & Valuation

SOKO has experienced very strong revenue, cash flow and net income growth in the last 3 years:

Revenues:

2006: $7.4m

2007: $13.9m

2008: $19.6m

 
Cash Flow:

2006: $2.9m

2007: $5.15m

2008: $9.4m

Net income:

2006: $3m  

2007:  $5.3m

2008:  $7m

SOKO currently appear extremely undervalued vs its historic growth rate, future expected growth rate and in relation to its peers in the industry.

Margins have trended lower as the quickly company expand its footprint, there is a lag of 3 to 4 years for the fixed costs invested in a new facility to be fully optimized over a larger membership and customer base.

P/E multiple

In terms of P/E multiple the company trades at a P/E of 6.5 which is substantially lower then the average for the industry (24.9), applying the industry metric SOKO would trade at $11.50.

P/S multiple

In terms of price to sales, the company trade at a multiple of 2.3 vs 4.3 for the industry, applying the industry metric, the company would trade at $5.6   

P/C multiple

In terms of price to cash flow, the company trade at a multiple of 4.9, vs 9 for the industry, applying the industry metric the company would trade at $5.5.

P/B

In terms of P/B multiple the company trades at a P/S of 1.9 vs 13 for the industry, applying the industry metric at $20.52.

Meanwhile the company has generated superior ROE/ROA and ROC of 35.6%, 25.2% and 34.1% over the last 12 months, which is significantly better then the industry which yielded negative returns in all those metrics over the same period.

It is worth noting however that the valuation multiples are based on its US counter parts, but since there is only a small number of comparable companies to SOKO in the public market, the comparison of SOKO vs the industry is somewhat lacking, accordingly the company valuation should be weighted more toward the company historic execution and expected growth prospects.

Investment thesis

SOKO offers excellent growth prospects at low valuation, the low valuation should shield the investor in case of operational under performance; however should the company operate as expected the stock will offer significant returns.

Both the macro picture in China as well as the micro characteristics of the company offer strong prospects for growth, the rise of the Chinese middle class, the low penetration of fitness and spa services, the market leading position of SOKO in the northeast all offer a favorable background for continued growth.

The company management (which owns 45% of the company) appears to be taking the right strategic steps to position the company as a mid to high end fitness and beauty services provider, the model has shown resiliency in the current economic slow down, while over the long term it offers the opportunity for a brand premium to be built into the stock.

The company enjoys a strong business model, with cash flow generated on pre-paid basis and plowed back into the business to generate yet further growth and further enhancing the customer experience, the company has a solid and growing membership base, thus making its future revenues relatively easy to predict, companies with a predictable cash flow usually enjoy a premium valuation in the market.

Catalysts

As an over the counter stock, the company should switch over the medium term to a major exchange (remain to be confirmed). The continued growth in interest and valuations in Chinese stocks listed in the US market will insure increased flow of funds to yet to be discovered companies such as SOKO.

I believe a target price of $6 to $9 in the next 12 to 24 months is achievable driven by higher stock market visibility, continued strong business growth and an expansion in the valuation multiples.

Nawar Alsaadi

Disclosure: the author does not hold any stock in SOKO, but is considering to purchase a position.

References:

-          Company SEC filings

-          Company website

-          Company presentation

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