Does This Fitness Investment Make Sense?

Life Time Fitness (LTH 0.77%) is looking to attract members back to its resort-like gyms. However, does this company revisiting public markets have the financial fortitude for your portfolio? Join Motley Fool analysts Asit Sharma and Emily Flippen as they discuss the topic in today's show. 

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This video was recorded on Nov. 9, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, November 9th, and I'm your Consumer Goods host, Emily Flippen. Today I am joined by Motley Fool Senior Analyst Asit Sharma and we're going to be talking about Life Time Fitness. It's an old company headed back to public markets after more than six years of being private. Asit, thank you so much for joining.

Asit Sharma: Emily, thank you for having me. Feels like I've waited a lifetime to talk about this company.

Emily Flippen: It is an interesting business. I grew up in Texas where there were a decent number of Life Time Fitness's, but I was surprised when I moved away for college and subsequent jobs, just how Asit sparse Life Time Fitness locations are. I'm willing to take a bet that there are a lot of people listening who maybe have no idea how a Life Time gym, which they do operate a chain of fitness centers, how a lifetime gym is different than an existing gym, whereas other listeners are probably saying, "I love Life Time, I have been a member for years." But whichever way it falls, it should be an interesting conversation.

Asit Sharma: I think I'm in the half of folks who know about Life Time Fitness. But maybe there is a third group there who understand it because there's one near them, but aren't really members. It's been years since I was a member of any gym. The last one I was a member of kick me out unceremoniously. But that's another story.

Emily Flippen: Well, I feel like I will need to hear that story one day.

Asit Sharma: The unceremoniousness is not understanding how to get fit. I unceremoniously removed myself my own subscription. I want to say, before we we leap in here, there's a Life Time Fitness Emily, in my town. I live in the northern part of Raleigh, North Carolina and it's huge, and this is a freestanding building on several acres. It's got really big pool with lots of amazing looking sites for young kids. It looks like something you could get lost inside of just from the road. Never been in it.

Emily Flippen: Honestly, for listeners who aren't familiar, you can almost imagine them like a little resort. My boyfriend actually gets up every morning at five o'clock and says he goes and drives 30 minutes out of his way to go to the Life Time Fitness center. He says he's working out, but I'm convinced he's just going to go and sit in eucalyptus steam room or otherwise just have this almost resort like experience before heading out for work. But with the resort also comes a pretty hefty price tag. One of the key differences between a Life Time Fitness center and a fitness center like Planet Fitness. But even expanding further, the LA Fitness's of the world is just how expensive that membership is. They have a wide range of offerings. Most locations have pools, day cares for children, group sessions, all included in the Membership price, but it comes at a price tag, doesn't it?

Asit Sharma: Yeah. It does. That price tag tells on the operating model of the company, if you're a potential investor. Emily, what about this story though? Life Time is not actually new to the public markets?

Emily Flippen: It's not, this is an interesting story. From January 2004 to June 2015, Life Time was actually a public company. They went private in June 2015. Interestingly enough, I extrapolate how I imagine these businesses that are taken private and I assume that they've been under-performing. But over the course of its life, over a decade as a public company, they actually returned over 240 percent versus the S&P 500s 85 percent. It was not a bad stock, although did obviously depend on when you purchased. But had a surprisingly strong history. But it did have that complicated departure to turn into a private business. Part of the reason why Life Time did go private through a leveraged buyout, was because it was experiencing a lot of pressure from new fitness alternatives to things like SoulCycle and CrossFit, as well as one of its major shareholders, which was really pressuring the business to convert into a REIT to really improve its tax bill, because Life Time Fitness owned the land, all the locations of which it was built. As you mentioned, these are giant parcels of land. It does make it a fun analysis, though, because we can go back to their filings right back in 2015, 2014 and look at how the business was before, obviously pre-pandemic, but also heading into going public again. How has the business changed over the past six or seven years?

Asit Sharma: I found it interesting that one of the reasons they went private was because of this emerging industry in fitness, which now has more connected fitness in some ways, Life Time Fitness participates in this. We'll talk about that as we go along. But this is a model that's worked for a lot of companies. I mean, I can think of Dell computer, which went private years ago to become better without having to answer to shareholders once pressure intensified in its main business lines. At that point, it was mostly a PC maker and into the server business. I think of Levi's jeans, which went private and really tightened down their business model and came public again. Just coming back to the public markets doesn't necessarily mean that a company is desperate. Often at times with the help of private equity and venture capital investors, companies become stronger. We're going to test this proposition as we go on. Now, before they went private, they operated 113 gyms across the US and Canada, showed consistent GAAP profit so book profits or profits according to generally accepted accounting principles. But Emily, they had a hard time generating any real free cash flow because at that point in time it was a very capital-intensive business. They had to maintain their existing locations and they were always building new ones. I want to return to this before we exit this half-hour because I think this is a really interesting point you've picked up on in terms of that capital-intensive business model, what it looks like today versus then?

Emily Flippen: It's a lot to unpack there, but to look at how the business is operating in 2021. Obviously some of these numbers are a little bit funky, because 2020 was certainly an abnormal year, but they have grown to more than 150 fitness centers again across the US and Canada. They care to more than 1.4 million active members. That's a total number of people that could visit their gym, within that is around 767,000 active memberships. People are actually paying the bill there. The thing that stood out to me was that this was actually less than the number of memberships they had back at the end of 2014, they had over 800,000 memberships before they went private and the same number of active members around 1.4 million. My first thought was, OK, well a lot of this is probably because of canceled memberships due to 2020. A lot of people probably fell out of their gym habits, didn't want to go during the pandemic and even now may not feel comfortable reinstating those memberships. But even going back to the numbers they reported for 2019, total memberships is only, I would say mildly better, they had about 100,000 more members than they do today at 854,000 members. This is all to say. It's not like this business has suddenly become a ton more attractive as they've built out more centers. Membership has remained steady, but not skyrocketing.

Asit Sharma: Even so that number funnily enough didn't bother me so much. This is a founder-led business, although not with the most attractive ownership characteristics, which we're going to talk about in a moment when we talk about the investment composition of shareholders. But the CEO who founded this company in 1992 and maybe a precursor a year or two before that, but his name is Bahram Akradi and I believe I pronounced that right. Yeah. I think Bahram Akradi. He's run this company for 30 years. If you can hit that equilibrium number of active memberships and have a persuasive plan to maybe grab more revenue per member, or introduce enough ancillary services if your model is a resort, which Emily, you said that about your boyfriend, but they actually use this terminology in their perspective. These are resort like gyms. You probably can optimize from there. That number doesn't scare me enough. They're going to a primarily leased model in their business. Today, 60 percent of these centers are leased as opposed to the 2015 era, when they owned most of their buildings, and they are targeting affluent areas, 70 percent of members are homeowners with median household incomes of $112,000. 

When you look at the cohorts that have joined after 2015, that number jumps to 127,000 median income. We know we mentioned how big these footprints are of the gyms. Just something to bear in mind, there is nothing that says in any kind of physical environment, you have to have one model. It's a bet the business when you stick to one model, I really like what Best Buy has done now, that's a completely different business. It's in the retail sector, but also dealing with multiple buildings owned, leased. They've been very good at experimenting with different size formats. I think of Dunkin' Donuts in the food sector. It seems to make sense to me that you would prototype different sizes of buildings, but maybe you can't deliver that resort like experienced in less than about 3,000 square feet. But that's not all that you get when you join up with Life Time, known for the gyms. But they have been, as we mentioned before, investing in digital offerings to have viable alternatives to people who want the connected fitness aspect of their lives. They have an app, it provides fitness concept, but they also offer an Apple Fitness Plus subscription if you subscribe to their gym.

Emily Flippen: I have to get your take on this initiative. Because I want to say this surprise me when I was reading through their filings, but it didn't because as I mentioned, my boyfriend is a member, so we got emails about these initiatives. I knew about these initiatives prior to reading any of the financial statements of Life Time and I'll tell you what, as just a consumer, it got me scratching my head. I genuinely cannot tell if I think this idea is terrible or revolutionary. [laughs] If this is WeWork or Amazon. But one of the things that they're looking to do, and this is on a very small scale right now, they are still heavily focused on gyms, but they're also creating what they called as fitness community by adding additional offerings inside their gym locations, all part of this giant, massive building, things like co-working spaces and apartments. They call it a lifetime work in lifetime living. They already have seven lifetime work locations operating in one lifetime living operating. I'll tell you what, as a user, as somebody who works from home with a partner who goes to Life Time, I can't help but think it would be so convenient to live in a place, go down stairs, go-to my co-working space, get some work done for The Fool, while also managing to sneak that gym in. But at the same time, I mean, this is crazy. This sounds like WeWork to me.

Asit Sharma: Those of you who are watching live can see this, but if you're listening on the podcast, you can't see me trying to stifle my laughter [laughs] cause Emily, I just didn't see it the total opposite way. Now before COVID, I think, yes, this might have been something that would have been persuasive for tons of people, and it still that's like to give some credence to what you're saying. It still is maybe an attractive idea for those of us who like to be fit to have work that often can extend into different hours. It seems really convenient and nice. But on the other hand, after COVID, it feels like the impetus that is driving many people is to travel and go out the world because now we're going to be in this hybrid environment where many of us will be at home all day continuing to work remote. Some business have changed permanently and they've gone completely remote. Some are hybrid where you're going to be going in a few days a week. I think a concept like this, in my opinion, might become less attractive because we already have that element of co-working. It's in our own homes. The idea now is one of socializations and maybe a gym like this has more social aspect than your average Planet Fitness and that's why it might seem more attractive but I'm going to just say for me, I would like to work out. I would like maybe to explore co-working spaces again, but not the two together. I don't know why, just give me the sauna [laughs] or give me the co-working space, but not both on the same.

Emily Flippen: I'm not sure if this actually changes anything. If you're looking at Life Time as an investment, I'm not sure if this would be the make-or-break factor, but I will tell you what just as a consumer, I can't wait for this business to start reporting quarterly earnings because I want to hear the updates about whether or not these value propositions are really being felt by consumers. I did do some poking around and I flew to their location, they have one operating in Florida for the living or they are in process of building it out, and it's expensive, it's premium. They are definitely going upmarket with all of their offerings. Maybe not the type of solution that everybody will use, but for the people who do feel connected to that fitness community then, men, maybe this just really appeals to them. I do have to ask though because I'm certain that lots of people are thinking this, which is, what's the narrative around fitness right now? Because we saw Peloton come out with a pretty dismal quarter last week. Guidance was pulled back. Active accounts pulled back from where they expected to be in management side of the fact that they just simply didn't project the reopening that we're experiencing right now. But at the same time, when I look at the membership numbers for Life Time, they're not nearly to where they were pre-pandemic. They've rebounded quite a bit, but they're still down year-over-year. Where are the consumers going to go over the next year? I'm not sure I have the answer to that. It's almost there's just question that I think investor should be asking themselves before buying any of these businesses but I feel like you have to be a believer in the model to get behind the stock today.

Asit Sharma: I agree, Emily. I think the fitness industry did not anticipate a consumer at the crossroads so every company that I looked at in this industry, whether they were gym-focused or connected fitness-focused, had a bet about the effect of the end of the pandemic on their business. Peloton, yes. We pulled through a lot of sales during COVID, but we think that consumers are going to continue to be active on our platform because our product's so great. There's a social aspect. For the gyms, hey, they're going to come back in droves as soon as COVID is over and we're going to see memberships spike again, but really, the typical consumer I think is at a crossroads in that we are enjoying outdoor experiences. We aren't cycling as much as we were to take the stress of COVID off of our bodies. [laughs] We've developed some good habits.

Emily Flippen: Hey, speak for yourself.

Asit Sharma: [laughs] Well, we in the royal we. Not to include you, Emily. I know you are very active on that Nautilus, and I had a side question because I'm looking at bikes. We'll do that offline [laughs] about your particular model, but I think for many people, this is something that is a decision that can be put off. Do I get back on my old track of using the Peloton all the time? Do I join up at the gym? Consumers just taking their time and this is affecting both types of business models. I am just waiting. If we see Life Time fitness with their own connected fitness app and offering classes online, I'm just waiting now for Peloton to have a Peloton branded gym just as an experiment. They'll present it that way. [laughs] Get a toe in the water because that model still has not settled and here we are COVID is still with us, although increasingly getting in the back our rearview mirror.

Emily Flippen: I really would like to see from this business. I'm so happy you mentioned that because this is a business that has an agreement with Apple Fitness. When you are a subscriber to a Life Time Fitness Gym, you get Apple Fitness for free if you're an Apple user and that's a great partnership. When you look at Planet Fitness, they have a partnership with iFit to make content for the iFit platform. I would love to see a partnership between Life Time and Peloton where the numerous classes that Life Time offers, a lot of them spin classes, use Peloton machines. They pay Peloton to have that experience and then Life Time can go to that again, very premium market, and say, look we have the most premium offerings. We have the Peloton bikes, we have the Peloton treadmills. Whatever those experiences may be, they're not there yet. That's just me speculating, but I would like to see something like that. That'd be fun.

Asit Sharma: That would be a margin accretive relationship for both companies if they did that.

Emily Flippen: Let's talk about those margins because Life Time needs a little bit of margin improvement here. You mentioned prior that when this was a public company in the past, Life Time never really generated a ton of cash. They always seemed to be a little bit cash-strapped, and Life Time says, hey, look, we're not as asset-intensive now because we're not buying the real estate, we're leasing the real estate, but cash flow is still something that's hard to come by for this business. Pre-pandemic, they did generate nearly two billion dollars in revenue, but that was only with $30 million in net income, so extremely low margin. Obviously, 2020 was a different story, but the cash-generation potential for this business just feels very strapped with how it's operating today, especially when you consider all of the capital expenditures that go into initiatives like Life Time Work and Life Time Live.

Asit Sharma: Yeah, this description that the company uses of being an asset-light business now, it's not deceptive, but it's subjective matter of opinion. I would challenge that in saying that when you build such big buildings, someone has to bear the cost of that, and the way the company is doing that is primarily through sale-leaseback transactions. They bear the cost of building these buildings and they sell them to an owner and they become the lessor. In exchange for owning that building and having to come up with the maintenance cash flow, you exchange that for operating the lease payments and that's a cash drain. Then also on the book side or the gap side of your business, you've got still a pretty big depreciation and amortization component. It's interesting, Emily. I did not see a property plant and equipment note in the prospectus, almost as if it wasn't material, although there's two-and-a-half billion bucks of net fixed assets on the balance sheet. But presumably, there is a segment of leasehold improvements that Life Time Fitness is putting on its own books in these buildings, even though they are now the lessor.

There's some depreciation going on there, and then they also have these right-of-use assets on their books. That's basically when you take an operating lease for a building over many years, oftentimes you have to put an asset on the books to represent your right to use that asset, and you're amortizing that every quarter. On the book side of things, they're going to show losses, but then on the cash flow side of things, it's not like the so-called asset-light model absolves them of having to make rental payments [laughs] month in and month out on these 30,000-square-foot buildings might churn some cash numbers last night. I don't see how they really scale that except maybe with a mechanism which you mentioned in our notes, which is that average revenue per member. I'm just reading from what you were pointing out last night between 2015 and 2019, we grew our average revenue per membership from $1,883 to $2,172. Now, that fell off during 2020, but they're saying they are seeing a strong rebound this year with $984, in average revenue per membership during six months ended June 30th of 2021. Over the long run, management said it's perspective. That look, this is how we intend to improve margins, we're going to offer more services. We're going to build more buildings in even more affluent areas, and we will have pricing power that way. But I think that's a long road and I don't really see the numbers panning out. Emily, they've got some debt on their books too, don't they?

Emily Flippen: They do and that makes the whole question of cash-generation, especially cash that would then accrete to shareholders just that much more challenging. I mentioned earlier that this was a business that was brought private through a leveraged buyout. Prior to this buyout, they still had about a billion dollars in debt. Never seem to have more have 10 or 15 million in cash but a ton of debt that increased obviously as part of this buyout strategy. Right now again, before going public, they have around $2.4 billion of long-term debt. They only raised around $700 million in their IPO. They did price the low end of their expected range, expecting to use a substantial portion of that to pay down some of their debt. But even if we take that debt down by 0.5 billion or so we're still talking about nearly $2 billion in long-term debt for this business, which is pretty lofty. Again, its and the interest on that its enter the cash that this business generates, which is already very low margin business.

Asit Sharma: The last point that I want to put on that debt picture is that the owner, CEO, Bahram Akradi, call him, he's the founder, still CEO. He has 6 percent of this company still and which is amazing to me after 30-years, multiple rounds of investment, a second go to public market he still manage to hang on to 6 percent of his shares. Good for him. But there are three private equity firms. Presumably, I should've double-check this in the prior year statements, the ones who took the company private, Leonard Green Partners, LGP, company called TPG Capital and LNK partners, who collectively own about 59 percent of the outstanding shares. They have voting control and they've got the right between them to nominate seven of the company's 13 directors on its board. Private equity firms are notorious financial buyers and financial operators. There's no real incentive or mechanism for the founder to say, look, I'm going to do whatever it takes the pay down this debt. I'm going to plan things for the very long term and execute on this vision to increase margins and cash flow. He stocked up against very financial minded people who may find it just OK to run the company with its consistent high interest expense on the books. As long as they see the stock price marginally increasing, there are a lot of opportunities for private equity owners who have a big chunk of a public company to extract value along the way, they can do that in lending company themselves to the public company so many ways. There are also some preferred share. It's basically a tranche of mezzanine equity on the books, which we don't have time to get into today. But this gives you just one example of how many ways private equity firms have to finance ongoing operations, even when 40 percent of a company or less than that actually is public. I feel very skeptical about the founders ability to do anything meaningful to even increase cash flow over the next several years.

Emily Flippen: I don't know about you, but personally, I am going to sit on the sidelines here. To sum it up, the first half of 21 is still been challenged for this business even though memberships have rebounded, revenue has rebounded a bit. They're still posting some massive losses. This is still very capital intensive as much as they want to say it's not, a very capital-intensive business that has very low margins. As a consumer, I'm intrigued by all these strategies. If I was a parent, I would certainly be taking advantage paying that extra money to get the day care while I went to the gym. All those things to me standout as great consumer experiences, but maybe don't translate into the best investment today.

Asit Sharma: Well, at the least, Emily, maybe at some point next year, we'll see you broadcasting on industry focus from inside your apartment that's located beside your co-working space, that's all housed in one of their big fitness centers. [LAUGHTER]

Emily Flippen: I may be the only person out there who think that, but to me that would be living the dream. Well, Asit, thank you so much as always for joining.

Asit Sharma: Thank you very much, Emily, this is a lot of fun.

Emily Flippen: Listeners that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say, hey, shoot us an email at [email protected] or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned. Don't buy or sell anything based solely on what you hear. Thanks, Tim Sparks, for his work behind screen today. For Asit Sharma. I'm Emily Flippen. Thanks for listening and Fool on!