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Planet Fitness' Unit Economics Show Signs of a Bright Future

By Neil Patel - Aug 23, 2020 at 7:24AM

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It might be time to add this low-cost gym operator to your portfolio.

As one of the leading franchisors and operators of fitness centers in the United States, Planet Fitness (PLNT 0.86%) had quite the run of success up until the coronavirus pandemic forced the stock to drop 25% year to date. The company's sales in Q2 2020 (ended June 30) were down 77.9% from the prior-year period as a result of temporary store closures due to the coronavirus.

Planet Fitness' franchise business model is attractive to investors as long as the unit economics of individual locations generate favorable cash-on-cash returns. While its gyms begin to reopen across the country, I believe the company can get back to producing those pre-coronavirus returns and still provide a solid runway for growth.

Intangible assets

Not only does the company benefit from economies of scale as it relates to marketing spend, equipment purchases, and real estate acquisition, Planet Fitness also makes money by selling its intellectual property to franchisees. This business model exemplifies that of a capital-light compounder, where franchisees put up capital for the business to grow.

piles of cash going from smallest to largest

Image source: Getty Images.

This is very important since lower reinvestment requirements translate to greater free cash flow, which ultimately means a higher valuation. "The best business is a royalty on the growth of others, requiring little capital itself," Warren Buffett once said when describing Microsoft in the 1990s.

As of June 30, 95% of locations were franchised. The company had over 1,000 new locations under ADAs (area development agreements) with franchisee groups, which were extended out 12 months due to the onset of the pandemic. This means that the proportion of franchised locations is trending even higher, which will be a boon for the company.

Unit economics

In order to continue appealing to franchisees, Planet Fitness locations must provide impressive returns. Based on results from 2019, unlevered (not debt-financed) cash-on-cash returns for franchised stores in the second year of operations averaged 25%, which was in line with corporate-owned stores. If we assume the typical franchisee puts down 30% cash and finances the rest of the purchase price with debt, then that means the return on equity is considerably higher than the 25% unlevered return previously mentioned.

This is supported by the fact that 90% of new stores opened in 2019 were by existing franchisees, which is a clear sign that the model is working for all parties involved. With its most expensive membership, the PF Black Card, priced at $22.99 per month compared with the industry median of $71 per month, it's obvious that there is some untapped pricing power as well.

Furthermore, management still believes in the long-term potential of the business in the U.S. "While the near-term operating environment is likely to remain volatile and negatively affect our near-term revenue and profitability, I'm confident in the long run, once the pandemic is behind us, that Planet Fitness will be able to significantly widen our competitive moat," CEO Chris Rondeau said on the most recent earnings call.

Compounding machine?

Planet Fitness' franchise model has the makings of a true capital-light compounder investment. This is probably the most ideal opportunity for a stock market investor since the business will require little reinvestment to grow, making franchisee groups foot the bill for growth instead.

Investors looking to purchase shares should wait until there is more clarity surrounding the pandemic and when things will return to any level of normalcy. Keep Planet Fitness on your watch list and be ready to load up when the time is right.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Neil Patel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft and Planet Fitness and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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