Weekly Update: Basic-Fit & Discount Gym Economics

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1. Investor Dialogue: Basic Fit, The Gym Group, & Discount Gyms

2. Danaher, Beckman Coulter, & The DBS Machine

3. Wix vs Squarespace: Competing for Agencies

4. Rakuten Symphony & European 5G Buildout

5. Acast: Podcast Advertising Platforms and Growth Opportunity

Basic-Fit & Discount Gym Economics

There is something simple but powerful about the low-cost provider business model. Companies that are built with a culture of reducing costs to pass savings back to customers tend to carve out advantaged positions in many retail categories.

We’ve studied Aldi, Amazon, Costco, B&M and Dollar General, Admiral / PGR and many other low-cost providers to understand what drives the persistence in returns for discounters across categories. The discount gyms, including Basic Fit (BFIT), The Gym Group (GYM) and Planet Fitness (PLNT), also fall into this category. We also interviewed the founder of The Gym Group, the UK's second largest discount gym, last year.

Over the last 15 years, two factors have been driving the growth in discount gyms:

1. Middle-market and public gyms with expensive wet facilities are dying out as the market bifurcates between low and high-end offerings.

2. Higher fitness penetration across the developed world

These two structural drivers plus the cheap and convenient offerings of discounters has led to increasing market shares across all regions; Planet Fitness owns ~20% of the US market, UK discounters ~12%, and BFIT has a lower but growing share of European fitness. It’s also clear from studying PLNT's oldest markets that discounter penetration can reach levels beyond 20%.

What's interesting in the discount gym investment debate is not future growth but the sustainability of the returns on capital.

Discounter gyms in all corners of the world earn similar ~30% cash-on-cash returns. We hosted an IP investor dialogue to explore the sustainability of ~30% pre-tax ROIC and compare and contrast GYM and BFIT’s opportunity.

From the reported accounts, this is roughly the cost of opening a GYM and BFIT discount gym:

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GYM seems to pay similar equipment costs but higher buildout rates per square foot, which may be due to the fact BFIT runs the building process in house, whereas GYM outsources to a third-party.

GYM is the lowest cost operator in the UK and ~25% lower priced than BFIT. After 1 year, GYM also has double BFIT’s members per sqft. This could be due to the lower price point or because the UK is more densely populated than BFIT’s European towns.

At maturity, which both companies define as 24 months after opening, both companies earn ~50% EBITDA margins and pre-tax ROIC well above 30%. BFIT’s FCF per site is lower than GYM’s because BFIT is more aggressive opening sites which effectively cannibalises its existing gyms. BFIT targets 3,300 members per mature gym versus 6,000 for GYM.

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These are clearly great returns. The question is of durability.

This is what Keynes said in 1936:

there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. - John Maynard Keynes

In short, high returns on investment attract capital. This is the essence of Marathon Asset Management’s capital returns theory simplified in their chart below:

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Given the middle-market is in decline and COVID has hurt mom-and-pop gyms, the current supply-side market structure is highly favorable for well-capitalized discounters. GYM and BFIT are locking in quality locations at good rates as other retailers leave the high street.

But over time, given discounters earn 30%+ pre-tax ROIC, Marathon would suggest unless BFIT has a durable competitive advantage, new entrants will drive the incremental return to the marginal cost of opening a gym.

The bear case for BFIT seems to centre around two points:

1. There are low barriers to entry

2. The ROIIC will decline as BFIT enters more competitive markets

A single discount gym can be replicated with £1.3m of capital and a good location. The risk with high returns and low barriers to entry is that it encourages private operators who may well be happy with only 15-20% returns. Entrants could open with a similar offering at a lower price to attract new members from incumbents.

In fact, a lower price isn’t the only way entrants could pressure BFIT's incremental returns. Simply opening with new equipment or replenishing existing equipment faster could be enough. For the same price, and a similar location, it’s possible churn will spike as users switch for brand new equipment and a fresh overall gym experience.

If competitors replenish equipment faster, incumbents have to match the schedule to retain customers. BFIT and GYM currently replenish equipment on a five-year cycle, the fastest in the industry. If the replenishment cycle accelerates to every 4 years, this alone reduces the FCF / Sales by 150-200bps. This excludes other replenishment of fittings inside the gym which is typically depreciated over 20 years and is the majority of non-lease PPE. If the fittings were to be replenished every 15 instead of 20 years, this also reduces the mature FCF / S by 150-200bps.

Although it seems unlikely sub-scale competitors will replenish equipment quicker than BFIT, low barriers to entry mean there is always a new upstart with fresher equipment trying to lure your customers away.

Another risk is that BFIT’s incremental ROIC declines because it’s entering a more competitive German market:

My concern is the quality of the growth in new markets. A big chunk of the growth and, in turn, a big part of the thesis, is about the growth that they are going to see in new markets, particularly the one they recently announced, in Germany. My concern is, firstly, they don’t have the first-mover advantage, so they will come to a market that is huge but where there are already established players. Secondly, it’s a market that is highly competitive and has been led by low-cost providers, in many different industries. That, coupled with a business model that is very fragile or leveraged, in terms of their unit economics, you can probably see a very fast deterioration of additional units in the business. - In Practise Investor Dialogue

The discounter moat lies in offering the lowest price and highest convenience for a given level of quality.

Aldi and Costco more or less guarantee the lowest price on the market for a given level of product quality. Their moat lies in the fact that both companies are the largest buyers per SKU of each product in their store.

Although Amazon isn’t a discounter, Bezos committed to offering low prices and high convenience. Third-party sellers effectively compete in an auction to win the buy-box which drives lower costs to customers. More importantly, Amazon’s logistics infrastructure reduces the largest expense per parcel to ensure AMZN has the lowest total cost of shipping a parcel to customers online. This seems to be a durable advantage.

What is the moat for discount gyms?

There are a few interesting arguments from BFIT bulls:

1. Clustering / fortressing deters new entrants

2. BFIT can procure equipment at cheaper prices than competitors

3. Lower overall cost base; low FTE per gym, centralised marketing, low opex, etc.

Just like Domino’s, the discounters ‘fortress’ their gym footprint. Fortressing or ‘clustering’ units is when an operator opens a new gym close to an existing unit to split the market territory in half. Although this causes some members to join the newer gym, owning more of the territory deters new entrants.

The discounters also offer a higher-priced multi-tier membership that gives members access to all gyms. This improves the convenience to the customer and underlying margin for the discounter.

Clustering increases the durability of the operators’ positioning but at the expense of lower incremental returns, given the territory is operated by a higher cost base. Although somewhat illogical, this is historically why Dominos’ UK franchisees have been against fortressing stores; it leads to higher absolute dollar profit, but running two stores is more complex and runs at lower margins.

The unit economics above show that BFIT’s 3,300 members per mature gym is nearly half GYM’s. This leads BFIT to a 400bps lower pre-tax ROIC which could deter new entrants relative to GYM’s higher return and lower breakeven rate. If we assume a 10-year life of a gym at the reported mature gym economics, BFIT's IRR per unit is 15.8% compared to 20.9% for GYM.

BFIT’s lower return profile is arguably more attractive than GYM because it increases the durability of the company’s positioning.

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The other sustainable advantage for discount gyms is overall lower unit costs, largely driven from the 30-40% volume discounts from the large equipment manufacturers. This enables discounters to replenish equipment quicker than independent operators whilst maintaining lower prices. Bulls argue volume discounts combined with overall lower costs per gym from eliminating all wet facilities, centralising marketing, and using technology to reduce labour expense creates a durable competitive advantage for discounters.

There is no doubt discount gyms have a strong offering of low price and high convenience for anyone who wants standard facilities. It’s also clear that discounters not only grow the market but take an increasing market share from a growing pie.

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The current market structure may also prove to be a perfect setup for BFIT and GYM. COVID has cleared out any excess supply and valuations aren’t demanding.

If we only look at the FCF from the mature store base, GYM’s equity trades at ~11x our estimate of FY22 mature gym FCF and BFIT at 15x.

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BFIT and GYM are on very different trajectories: BFIT is run by its founder who owns ~13% of shares outstanding and targets 5x unit growth by 2030. GYM’s founder has retired and the company has a limited growth runway but a more mature unit base operating in a somewhat rational oligopolistic market.

GYM also has room to improve ARPU which could lead to even higher mature FCF per unit. Th e2-3 year setup for GYM is highly attractive. Over a longer duration, it could be an interesting buyout target for PLNT or BFIT or else GYM can use the FCF to buyback shares.

BFIT is more interesting to us as the company seems to be building for duration. Rene is clustering markets and sacrificing lower IRR on mature units to deter new entrants. This entrenches BFIT in its markets. However, given the CEO aims to 5x the store count by 2030, a long-term bet on BFIT relies on the disciplined allocation of FCF at adequate ROIIC.

BFIT’s 10-year IRR per mature unit is ~16% - if the units need much higher maintenance capex or lose customers quicker, this quickly declines to a rough 10% cost of capital. There isn’t too much room for error.