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Bear Thesis
If one is looking to invest money in the stock market in a high risk free interest environment, my belief is that this has to be on the highest quality businesses. It does not matter if the business screams itself as growth or value. And if it’s growth, it should not be growth masquerading under unprofitable business models, questionable practices or massive piles of debt. When I look at Planet Fitness (NYSE:PLNT), the red flags I see tells me that their growth is not as attractive as it seems and in my analysis I will elaborate on how this would not be a good investment for an investor.
Quick Summary
Planet Fitness is a discount gym franchise popular in the United States. The gym became popular for its low prices and “judgment-free zone” philosophy. Based on the membership level they also provide certain differentiation in their product offerings. The company relies heavily on franchising for its expansion and had close to about 2300 stores distributed in different parts of world including Canada, Mexico and Australia.
Growth at a cost
The company has been putting up impressive growth numbers year after year. From 2017, it has been growing its number of stores at a compounded annual growth rate of 10%. Its membership levels have also been growing at a similar rate and currently it boasts more than 15 million members. Until COVID, it had shown more than 50 consecutive quarters of system wide same store sales growth. The company also shows profitability. So where are the cracks in this growth story?
Planet Fitness is on bad growth treadmill and this is very evident when you see how its growth is funded. In pursuit of expansion and growth the company is getting increasingly deeper into debt.
Why is there a downside to growing a company through excessive debt? It can be a risky venture, as it increases the financial leverage of the company and makes it more vulnerable to economic downturns and other negative events. Gym spending is a discretionary expense and can be one of the first expenses to be cut down on in an economic downturn. When a larger portion of the company’s assets is financed through borrowed money, the company must continue making interest and principal payments on its debt irrespective of its financial performance. At some point the company will reach the end of its line with its debt use and when that occurs it can restrict the company’s ability to make investments or take advantage of new opportunities since a significant amount of its cash flow must be devoted to paying down its debt. In a worst case scenario where its profits are not sufficient to cover its interest payments, the company may be forced to default on its debt and potentially face bankruptcy.
Negative Shareholders Equity
Simply put this means that the company owes more than what it has. As of their last report their total liabilities stood at $3B, with long term debt alone being close to $2B. When this is compared to their Total Assets of $2.8B, it gives us a negative shareholders equity. My theory is that they started laying the groundwork for their aggressive expansion from 2016 and from then on its quite evident on how they chose to achieve this. The problem spiraled in 2019 and it looks like the situation only slightly improved in 2022.
How well is their debt covered by their cash flows?
For a company focused on its growth, it is good news that Planet Fitness has not only positive net income but also positive operating cash flows. In situations with negative equity, cash flows can be make or break for the company. But we need to see how well their OCF covers their high debt. At close to 10%, it indicates that the company is in a vulnerable position and any decrease in their cashflows would make for a very difficult situation.
As an extension we can even look into how well the company is able to manage the interest payments on its debt (Interest Coverage Ratio). At less than 2.5, it is often viewed as a red flag and signals solvency troubles to the company under even minor impact to its earnings.
Altman Z-Score
This is another way to view solvency chances of a company. The score is calculated using a combination of profitability, leverage and revenues. Data sourced from Y-Charts shows that the score is at 1.2. A score less than 1.8 spells trouble for a company.
Questionable practices
There are practices in Planet Fitness that is unique to the company and can at best be described as slippery. The company is notorious for its in person or postal mail only cancellation policies. I had a been a member of Planet Fitness almost 6 years ago and due to unforeseen circumstances I had to leave the country but I could not get my membership cancelled remotely (as I had left the country, I eventually had to close all my bank accounts which took care of this issue). In all fairness, if I had gone over the membership agreement with a fine tooth comb, I could have prevented this scenario. However, most businesses are accommodating of exceptional circumstances but not Planet Fitness. I had almost forgotten this incident and was reminded of this recently when I was notified of a recent short report that was published by The Bear Cave. In the short report there is mention of hundreds of incidents where customers have attempted to cancel memberships but were unsuccessful. From the article:
Through numerous Freedom of Information Act requests, The Bear Cave has uncovered hundreds of consumer complaints concerning overbilling, fraudulent transactions, excessive fees, and uncancellable memberships. The complaints allege a pattern of misconduct including 1) customers sending multiple cancellation letters that are ignored, 2) cancellation attempts in person that are ignored 3) billing being resumed post-cancelation 4) spurious fees, and 5) Planet Fitness preventing customers from canceling because they owe a back balance, among many other complaints.
This practice in theory may bring in more revenues and draw out customer retention. When the cost of membership is low but the hassle of cancellation is so painful, people may not want to address it unless it is really affecting them. When left unchecked, this may cause consumers to develop a negative perception of the company, which could lead to a decline in new membership acquisitions and a loss of business from dissatisfied customers.
Another practice I personally found very amusing was their Free Pizza Days. It seems to be a counterintuitive approach to promoting healthy habits, as giving away pizza after a workout seems to be at odds with the idea of maintaining a healthy diet. It’s like visiting a doctor and getting a complimentary pack of smokes or going to the dentist for a cavity treatment and being offered complimentary donuts. It’s a nice gesture, but it seems to undermine the overall goal of promoting healthy habits.
Inflated Valuation and Downside Risks
Planet Fitness trades at 95 times its earnings, eight times its sales and 30 times its cash flows. All of this suggests that its valuation is extremely high and would make its current stock price unsustainable. Because its liabilities are higher than its assets, its book value (P/B ratio) is non-existent. For its forward multiples to get reasonable, its earnings and sales have to grow organically at above the industry average. Any extra spend on S&M would bring down its margins which would again affect its earnings. It does not look like a reasonable proposition for the company to turn to debt either. To strengthen its balance sheet, it could look at a stock offering but this would dilute existing shareholders. It does not look like there is an easy way out from here.
| Price/Earnings | Industry Avg. | Implied Downside | Price/Sales | Industry Avg. | Implied Downside |
| 95.19 | 18.42 | >50% | 8.7 | 1.45 | >50% |
Source: Author
My levered DCF analysis does not show anything better either. Projecting a bump of 40% in revenues for 2022, 30% in 2023 and 20% till 2026 with OCF margins at 30% for every year up to 2026 is an extremely optimistic approach to look at things. Plugging this number along with our Weighted Average cost of Capital at 8.1, gives us sum of present value of levered free cash flow at close to 950 million. Using a long term growth rate of 2%, we get equity value per share at $38. Note that even at very optimistic levels, we end up with an intrinsic value that is at least 50% below the current share price.
Levered DCF Analysis (Author Calculations – Company data)
Action
When I look at the many fitness chains that have gone public, I see hardly any that provided meaningful returns to investors. In fact this industry seems to be a graveyard for investors. At $7B market cap, the downside risks to Planet fitness seem far higher than any upside gain and it looks like the odds are stacked against this company (both internal and external factors may work against the success of the company). In light of this I will be taking a small short position against the company.
Please note that there are significant risks to shorting a stock and if a position moves against you, it can potentially wipe out your portfolio. To mitigate this you can consider setting up a stop loss on your position and set it at a level you are comfortable covering your loss. Another method that can be used is buying an OTM option call. Depending on option liquidity and how this is set up, even when your short position moves against you, your call option will indirectly counter this move. All of this will require active management so the easier route would be to take a position using OTM puts with long expiry. I will also be taking a small position through puts that are designed to give me a significant upside in case there is sharp swing/reset in its valuation. In a scenario where I have to get out of my short position, my puts will still be in place and therefore be able to maintain my short position on the stock.
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