Realizing Gains and Thoughts on the Gym Industry

by JT McGee

utility
Not too long ago I told you I invested in a gym run by a friend. As of this week, I’ve effectively sold out.

A group of well-financed individuals wanted in, and I couldn’t help but see the opportunity to realize a gain and move on. The terms were frankly too good to pass up.

With the deal closed, I have:

  • Locked in a gain – I’ll lock in a decent gain on my investment in the gym.
  • Created an option – In addition to realizing a cash return, I’ll also retain a 10% stake going forward, which has an unknown value. (My model is extremely sensitive, due to the inherent operating leverage in the business.)

My reasons for exiting were as follows:

  • The gym is getting a capital infusion that, in my view, funds increased capex and opex in excess of existing demand, which will result in diminishing returns. I see it as unnecessary. But I am willing to concede that my desire to avoid “cosmetic” investments may have been a big blindspot in my thinking — time will tell.
  • The new biz plan will increase operating leverage, which is — again, completely my opinion — unnecessary given already attractive economics with low operating/financial leverage. (In general, I’m of the view that great returns don’t need to be turned into legendary returns if it induces blow-up risk. Too many people are willing to risk turning 25% CAGRs into zeros by getting greedy.)
  • The new investors are independently wealthy due to another venture, and seemingly less interested in economic returns on capital than I am. Furthermore, I believe they may have a bias toward reinvestment, which, in light of a decision to increase capex/opex ahead of demand, worries me. (Fear the landman in every industry.)
  • There will be other opportunities to deploy capital when unemployment is significantly higher than 4.8%, and the cycle is closer to a bottom than a top. This isn’t a macro call, but if you think available investment opportunities are better in 2016 than they were in…say, 2011, please tell me where you’re sourcing ideas!

In short, this exit allows me to:

  1. Realize a cash return.
  2. Hold an option for potential upside in the event this becomes a home run, with no additional committed capital from my personal balance sheet.
  3. Be location independent once again — Charlotte, NC is calling me.

On the industry

In all, I tend to think service-oriented group fitness facilities are excellent investments as they:

  • Generate more revenue per member.
  • Displace capex with opex, which is beneficial in bad economic environments.
  • By my observation and belief, result in lower customer acquisition cost in dollars and cents, and as a percentage of revenue, due to an emphasis on partners/groups.
  • Win customers at the margin with friendly terms (no contracts!) afforded by higher revenue per member.

There are only five figures that matter for the gym industry:

  • CAC – Cost of customer acquisition.
  • Churn – Percentage of members who quit in any given month.
  • Cost per attendance – The best gym members pay, but never show up. (Surely some gyms measure capex/opex divided by attendance over x periods?)
  • Revenue per member – Obvious.
  • Asset turnover – $1 in annual revenue against $10 of equipment is awful, for example.

In the future, I think the gym industry will:

  • Become more corporate, with fewer mom and pops.
  • Develop black-and-white lines by pricing tiers. (Planet Fitness at the bottom, 24/7 in the mid-tier, and independent group studios and barbell clubs at the high end.)
  • Provide lumpy, cyclical returns due to inherent competition, and limited entry/exit barriers.
  • Eventually become part of the health insurance complex, resulting in outsized profits for a chosen few.
  • Remain a playground for roll-ups. With unlevered FCF yields >20%, small time operators can easily run serious PE-style roll-ups in local markets.

On private companies

In my view, private companies:

  • Are way more attractive as investments than public companies.
  • Should be valued with the understanding that, in my cases, you’re buying a job. (Assign a multiple only on profits in excess of your reasonable salaried income across a cycle.)
  • Trade at ridiculous discounts, especially to public company multiples today, even after considering liquidity, cyclicality, etc.
  • Are way more likely to generate FU money.
  • Do not fully appreciate the importance of incentive compensation for employees in the way that public companies do.

Would I invest in another private company? Yes — send me a term sheet!

In all seriousness, I’m willing to invest in probably any type of private company provided that it is relatively simple to understand and there are public comps by which I can get some sense of potential inefficiencies. (I’ve seen enough filings to know that a 50% food cost or 40% labor cost for a restaurant is garbage, for example.)

But, that said, I think my bias is that private companies are most attractive to public companies when there are inefficiencies. I don’t want a top-quartile private company; I want a bottom-quartile private company that needs some TLC. The power to effect change is invaluable for any investor in any company.But, again, that’s just, like, my opinion, man.

I’m semi-tempted to start browsing Biz Buy Sell with more tenacity. Would it be wrong to get a boilerplate document to spam for company financials? Good way to solve an insatiable curiosity…maybe?

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