The Next 5 Years For Planet Fitness

| About: Planet Fitness (PLNT)
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Planet Fitness has some big opportunities that we can predict over the next five years.

The bear theses doesn't hold up very well.

However, despite the market opportunity, the stock doesn't seem to be a buy.

As I continue my quest to find 15 stocks for my Double Five Portfolio, I intend to keep going through companies that are on my watch list. Recently, a new company landed on my watchlist, and as I unpacked the story I knew I had to cover this stock next.

The company is Planet Fitness (NYSE:PLNT). Considering this gym brand operates in 48 states, it's likely you're already familiar with the name. Likewise, I've known about the company for about a decade. My first memory of the company comes from seeing a hilarious TV ad with a muscular man rejoicing over tying his shoes using the "bunny ear" technique. But knowing about a company, and knowing the business behind the company are different things.

Planet Fitness the public company

To fully understand this business, let's begin with a recap of its life as a public company. Planet Fitness went public on August 6th 2015, pricing at $16/share. Right before the IPO, the company announced it had opened its 1,000th location.

Full year results for 2014 included revenue of $280 million, 6.1 million members, and 33 consecutive quarters of same store sales growth.

At the end of 2016 revenue came in at $378 million -- up 35% in two years. There were 8.9 million members -- up 46% during that same time. And same store sales had grown for 40 consecutive quarters. Despite this growth in these important metrics, and despite some earning beats, at the end of 2016 the stock price was only up 25% from IPO.

What's holding the company back?

This question can be answered with a one word: dilution. A quick glance at the company's S-1 showed that this was a known problem with this stock from the very beginning. (See page 56)

"Investors participating in this offering will incur immediate and substantial dilution."

Before the IPO, Planet Fitness had received capital from private investors. As is the case typically in these situations, the IPO is not so much for to benefit the company as much as it's for these private investors to be able to "cash out".

This has been the case with Planet Fitness. Despite only claiming 35 million shares at IPO, the company had a total of 98 million shares (!) when including the shares held by these insiders. Since coming public, these insiders have been cashing in with a dividend and cashing out by selling shares in secondary offerings.

  • June 28th, 2016. The company had a secondary offering where insiders sold an additional 11.5 million shares.
  • September 28th, 2016. The company had a secondary offering where insiders sold an additional 8 million shares.
  • November 10th, 2016. The company (still primarily controlled by insiders) sacrificed its balance sheet to pay a special dividend of $2.78 per share.
  • November 22nd, 2016. The company had a secondary offering where insiders sold an additional 15 million shares.
  • March 8th, 2017. The company announced a secondary offering where insiders intended to sell an additional 15 million shares.
  • May 4th, 2017. The company announced a secondary offering where insiders intended to sell an additional 16 million shares.

Add it all up and that's dilution to the tune of around 66 million shares and a special dividend that cost $271 million. Very insider friendly. Not exactly shareholder friendly for the rest of us.

But the important part of this story for investors is that the share dilution should now be over. According to the most recent secondary offering press release, these insiders no longer hold any shares of Planet Fitness.

Planet Fitness's opportunity in the next five years

Planet Fitness's business can be neatly divided into three parts:

  1. Franchise revenue
  2. Corporate owned revenue
  3. Equipment sales revenue

The company operated 1,313 stores at the end of 2016. 95% of these locations were franchised, the rest naturally being corporate owned. Over the next five years, Planet Fitness is projecting 1,000 new locations. What would it mean for the company should it actually hit this projection?

  • Franchise projections

For the sake of this analysis, I'm going to assume that all of these new locations are going to be franchised locations. This is based on the fact that Planet Fitness didn't open any corporate owned locations in 2016.

Let's take the full year franchise segment revenue and divide by the total number of franchised locations at the year's end. Let's also do that for each of the last three years and average that out. Here's what that looks like:

Year Full Year Franchise Segment Revenue Franchised Locations Year-End Average per franchised location
2014 $71.8 million 863 $83,198
2015 $88.1 million 1,066 $82,645
2016 $116.5 million 1,255 $92,828

The average revenue that each franchised location generated was just over $86,000 for Planet Fitness. Modelling revenue this way obviously has its flaws, since locations opened in the fourth quarter of a year obviously generated less revenue than a location opened in the first quarter of that same year. So this number is naturally low. But this crude model gives us something to work from for analysis purposes.

The company now has over 1,300 franchised locations when including 1Q 2017 results, and is expecting to open 1,000 more locations from there. That equates to 2,300 franchised locations that we are projecting towards.

Using our crude model of $86,000 per franchised location and adding in 1,000 new locations, by the end of 2021 the franchise revenue segment could be generating $198 million. That would be up 70% from full year 2016.

  • Corporate owned projections

Since most (if not all) of Planet Fitness's expansion is going to be via franchised locations, I'm not projecting any increase for corporate owned location revenue. However, given the company's 41 consecutive quarters of same store sales growth, I'm also not projecting a decrease. Keeping it a round number, that would be $105 million in revenue.

  • Equipment projections

This is where this story gets interesting and tricky for Planet Fitness. If you're like me, you had no idea that this segment was the largest source of revenue for the company. All franchisees must buy their equipment from Planet Fitness. In addition to signing a ten year brand agreement, franchisees also agree to update all the equipment every four to seven years.

Both the franchise and corporate owned revenue segments have higher margins than the equipment segment. But the equipment segment will gain momentum over time with the rapidly increasing store count.

According to the first quarter call, 30% of equipment sales in 2016 was from equipment renewal. This concrete number really helps us be able to project what future revenue in this segment might look like.

For full year 2016, equipment revenue came in at $157 million. Given the 30% statistic we can calculate that $47 million of this revenue was from renewals. The other $110 million was from new stores. Since there were 195 new locations opened in 2016, we can calculate that each new location bought $564,000 of equipment.

We know from management that 500 new locations are slated to open over the next three years, with an additional 500 opening four to five years from now. If you split those openings evenly, then there are 250 new locations slated to open in 2021 which would generate $141 million in new equipment sales just for that year.

Projecting equipment renewals is the tricky part. First, we don't know how many locations updated equipment in 2016, nor do we know how much of the equipment got updated. There's a flexible window for stores to update equipment.

But here's what we can project. We do know how many locations have been opened, will be opened, and the earliest and the latest these can update their equipment.

Year Locations Opened Earliest Equipment Renewal Latest Equipment Renewal
2014 169 2018 2021
2015 206 2019 2022
2016 196 2020 2023
2017 166* 2021 2024
2018 167* 2022 2025
2019 167* 2023 2026
2020 250* 2024 2027
2021 250* 2025 2028

*Estimates based on forecast. Actual yearly breakdown will vary

Based on these figures, it's not implausible to see equipment renewals making up 50% of equipment revenue in the near future. For example, in the year 2021 there will be 737 locations up for equipment renewal. Stores opened in 2014 could theoretically push equipment renewals back all the way to 2021. And stores opened this year could theoretically renew at the first chance. Without a doubt, all 737 locations won't renew in the same year. But it's not unreasonable for just a third of those locations to choose to replace their equipment in 2021. A third would be right around 250 locations renewing equipment -- the same number of new location openings.

Should that scenario play out, Planet Fitness would generate another $141 million just in equipment renewals, bringing the grand total for the equipment segment over $282 million.

Add up the three business segments from Planet Fitness and the company could report full-year 2021 revenue of $585 million. This may also be conservative as it doesn't account for the possibility of any same store sales increases along the way.

The big bears

I've read several recurring bear theses regarding Planet Fitness that I feel deserve to be addressed.

  • Management's 4,000 location goal is too big.

I've read several people state that Planet Fitness simply does not have the runway for 4,000 locations domestically. In one article, the author pasted a United States map of existing Planet Fitness locations and asked (dared?) their readers to find space on the map for the more than 2,500 locations yet to be.

While it may have convinced some, don't confuse a quick glance at a map to be on the same objective level as true market research. Not only has Planet Fitness done market research, but an independent third party has as well. Both agree 4,000 domestic locations is possible. A two second glance at a 4 inch by 2.5 inch map is just not on the same level of objectivity.

For the sake of argument, let's say that the real data, studies, and math was far from the actual market potential for Planet Fitness. Let's say the research was off by 25%. That would be pretty far off but yet would still give the company 3,000 domestic locations. In fact, the research could be off by as much as 40% and the company would still be able to open 1,000 new locations before hitting a wall domestically.

And that's just the thing. The 4,000 location runway is just for the United States. That doesn't include Canada or Latin America -- which are both massive and largely untapped markets.

Therefore it seems Planet Fitness does have a lot of growth left in front of it.

  • Upgrading equipment is too expensive for franchises.

We've already seen how equipment sales for a new location are over $560,000. Since all the equipment has to be replaced, in theory equipment renewals would cost the same as what it cost initially. Equipment has to be replaced every four to seven years. That means each location needs to be putting away between $80,000 and $140,000 every year to be able to pay this expense.

Is that a reasonable number? Consider that when it comes to corporate owned locations, each location generates around $1.8 million in revenue annually. The EBITDA margin for these locations was around 39% -- $702,000 EBITDA. In its annual report, Planet Fitness claims that it has done surveys of franchisees and has found the numbers are roughly the same. Given this data, it seems that the franchisees will be able to afford equipment renewals.

Further adding to the argument that Planet Fitness franchisees can indeed afford to update their equipment is the fact that a full 93% of them operate at least three locations. What's more, over 90% of the new locations opened in 2016 were opened by existing franchisees. If the equipment renewal burden was too unreasonable, who would better know than the franchisees themselves? They would already be aware that the cost was too much and it doesn't seem likely that they would dig themselves further into a hole by opening more locations. The more likely reason that so many franchisees are opening new locations is because the economics are attractive, despite the need to constantly be renewing the equipment.

Therefore it seems that the franchisees in fact can meet their equipment renewal obligations.

  • The debt can't be serviced in five years.

It is quite a shame that Planet Fitness did major damage to its balance sheet with a one-time dividend that required the company to take on $271 million in additional debt. When adding up every contractual obligation, Planet Fitness has over $1.4 billion currently outstanding.

The bare minimum contractual obligation for 2017 is $96 million. For 2018 - 2019, the average annual obligation will drop to $71 million. However, much of the debt matures in 2021. Just paying the minimum over the next few years will leave a substantial amount of debt that the company won't be able to pay by then.

But then again, what public company pays off this level of debt in just five years anyway? Paying the minimum requirement and refinancing the debt when appropriate is quite normal -- if not expected. I have no doubt that the company will refinance when the time comes.

Remember, that a big reason the company is in this position in the first place is that early insiders were lining their own pockets. Now that they are out of the picture, perhaps Planet Fitness can start heading towards steadier financial ground. After all, that's the advantage of a mostly franchised model. Costs are light and recurring revenue streams are strong.

The real question for now is can Planet Fitness pay its very real required obligations over the next several years? For full year 2016 the company reported revenue of $378 million and EBITDA of $150 million -- a margin of 40%. Assuming revenue increases this year, the EBITDA margin could shrink considerably in 2017, and the company would still meet its $96 million in obligations with ease.

Therefore Planet Fitness is highly leveraged, but it seems that it can meet its financial obligations going forward.

Projecting the future price per share

Projecting price per share for Planet Fitness has to assume that the share dilution deluge is finally over. But that's not necessarily a given considering this company's history. An investment in Planet Fitness would have to be comfortable with this unknown.

To predict the future share price, we need to start with the revenue I've modeled for 2021 -- $585 million.

We've already seen that the EBITDA margin was 40% this past year. But it's safe to assume that this margin will actually drop slightly going forward as the less profitable equipment segment plays a larger part of the revenue mix going forward.

To try and break down segment level EBITDA margins for 2016, we can take two things as facts from management. First, practically all costs associated with "cost of revenue" relates to the equipment segment. Second, corporate owned location EBITDA was 39%.

Take the corporate owned segment revenue of $105 million and multiply by the 39% margin. That gives us $40.8 million.

Take the equipment segment revenue of $157 million, and consider the cost of that revenue was $122 million. That gives us a margin of 22% and EBITDA of $34.7 million.

Between these two segments we've accounted for $75.5 million of the total $150 million. That leaves $74.5 million EBITDA from the franchise segment. Considering revenue from the franchise segment was $116 million, the EBITDA margin is around 64%.

So here's what Planet Fitness EBITDA could look like for full year 2021.

Segment Revenue Margin EBITDA
Franchise $198 million 64% $126.7 million
Corporate $105 million 39% $41 million
Equipment $282 million 22% $62 million
Total: $585 million $229 million

Again, last year's EBITDA was $150 million. Considering the share price was $20.10 at the end of 2016, and remembering that the share count is currently around 98 million shares, then the market has been valuing this company around 13.1 times EBITDA.

Let's take our projected 2021 EBITDA. Assuming the market values Planet Fitness at 13.1 times EBITDA moving forward, then the price per share in 2021 would be $30.60. That's a 34% increase from today's price of $22.81.

My faithful readers know that I'm looking for stocks that double in a five year time frame. For that to happen with Planet Fitness, not only would my projections have to play out, the market would also have to value the company at 19.5 times my projected 2021 EBITDA. That's a scenario I find highly unlikely.

Despite liking a lot about Planet Fitness's future opportunities, I won't be adding Planet Fitness to my portfolio. While I don't see the company as a short opportunity, I also don't recommend buying shares. However, I would reconsider if shares fell below $15.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.