Please ensure Javascript is enabled for purposes of website accessibility

Planet Fitness Investors Should Keep an Eye on This Important Revenue Generator

By Neil Patel – Jun 11, 2020 at 10:16AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

How one of the company's business segments poses additional risks.

At first glance, Planet Fitness (PLNT 1.92%) possesses many characteristics of a lucrative growth stock. Due to its attractive franchisee model, customer-focused culture, and scale advantages, earnings have increased 37% annually from 2015 through 2019.

The stock has followed this outstanding fundamental performance, soaring fourfold since its IPO less than five years ago. However, astute investors should dig beneath the surface to gain a better understanding of the overall business.

Business model

The most attractive business model is that of a capital-light compounder. Warren Buffett is quoted as saying that, "The best business is a royalty on the growth of others, requiring little capital itself." Planet Fitness' franchisee model fits the bill here.

Capital investments for new locations are the responsibility of franchisee groups, not the company. Mind you, Planet Fitness does have some company-owned stores in which it invests and manages itself, but these locations make up less than 5% of the total store count.

As part of the company's franchise agreement, store owners are required to pay a percentage of monthly dues and annual membership fees to Planet Fitness. In fiscal year 2019, the average royalty rate was 6.1%.

It's very easy to see how advantageous a growing store base is for the business, as these royalty dues are extremely high margin. Earnings before interest, taxes, depreciation, and amortization (EBITDA) margins for franchisee-owned stores were close to 70% in 2019, compared to 41% for corporate-owned locations.

Fitness equipment at a gym.

Image source: Getty Images.

Equipment sales

While store economics are appealing, I want to focus on a business segment that's less talked about. A little over one-third of sales for Planet Fitness are derived from equipment sales. Franchisees are contractually obligated to purchase equipment from the company and replace their existing equipment every five to seven years. Management boasts this as another recurring revenue stream. This makes sense, as a rising store base translates to more opportunities for initial-equipment and replacement-equipment purchases.

Equipment sales have EBITDA margins of 23%, demonstrating a noteworthy mark-up that Planet Fitness pockets. This is clearly different from the capital-light model described previously, but this business segment opens the company up to hidden risks.

Not only does Planet Fitness have significant supplier concentration with only three approved vendors, but large franchisee groups might push back and demand less stringent remodeling policies. The biggest Planet Fitness franchisee group owns 160 locations in 14 states. A large partner like this can certainly have some say in corporate policy change. With the average cost to open one location in the range of $1.4 million to $3.2 million, the less often a remodel is required, the better.

From the perspective of a Planet Fitness franchisee, if cardio and weight training machines are fully functional and safe for guests to use, they might be more than willing to hold off on a renovation. After all, the lower the capital expenditures, the greater the cash flow.

Keep this in mind

The reason why equipment sales don't get as much attention is because Planet Fitness has been so successful with the franchise model masking everything else. When all is well, less focus is given to potential sources of downfall. With any brick-and-mortar retail business, there comes a time when prospective store locations dissipate and growth matures. We haven't seen this yet with Planet Fitness, but it will come eventually.

When this happens, I believe there's a high probability that the company's strict remodel policy will face opposition, especially from those who have the most skin in the game -- the franchisees. Time will tell how much this negatively impacts sales.

Planet Fitness has made investors very happy and could continue doing just that in the near future, but I urge you to keep the lingering risk in the back of your minds.

Neil Patel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Planet Fitness. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Planet Fitness, Inc. Stock Quote
Planet Fitness, Inc.
$58.80 (1.92%) $1.11

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/28/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.