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Many 'hot' areas of the leisure sector have fallen victim to overexpansion over the years and we see potential for the low-cost fitness model to be next
February 23, 2017

The Gym Group (GYM) came to market in late 2015 with a flurry of excitement about its disruptive business model and potential for long-term growth. However, with analysts scaling back 2019 earnings forecasts, concerns raised about the level of return on capital employed (ROCE) and noteworthy competition, we don't think it is worth paying up for the group's undeniable growth potential. Based on the current rating of 27 times 2017 earnings predictions, there could be some serious downside from any future disappointment.

IC TIP: Sell at 194p
Tip style
Sell
Risk rating
High
Timescale
Short Term
Bull points
  • Disruptive model
  • High-growth subsector
Bear points
  • Cannibalisation risk
  • Falling 2019 EPS forecasts
  • Profits very sensitive to sales
  • Forecast low return on capital employed

The Gym Group is the second-biggest player in the UK's fast-growing low-cost gym subsector, which has been winning customers from mid-market operators, which are generally scaling back. The low-cost model has also been attracting less affluent gym newbies tempted by the low membership costs and flexible month-by-month contracts. Like other rival low-cost upstarts, Gym Group is taking advantage of technological innovations to allow around-the-clock access to its gyms and provide self-service facilities that allow units to be run with a skeleton staff.

 

 

This type of gym has proved very popular, growing in six years from a near standing start to an estimated 15 per cent of the market. The experience in countries with more mature low-cost gym subsectors, such as Germany, suggests there should be plenty of room for further growth. Gym Group, which is run by an experienced management team, hopes to take full advantage of this potential by opening 15 to 20 gyms a year, which compares with 80 open units midway through last year.

However, we believe it is questionable whether these growth prospects are worth paying up for, especially given the propensity for companies in 'hot' parts of the leisure sector to disappoint due to overexpansion. Indeed, it was only a little over 10 years ago, between 2004 and 2006, that investors witnessed a rush of IPOs by mid-market gym operators that ultimately had to scale back expansion plans amid intense competition and overstretched balance sheets.

We feel some perturbing signs have already emerged from Gym Group, with Factset consensus EPS forecasts for 2019 falling back from around 13p at the time of the company's float to 9.5p today. What's more, broker N+1 Singer cites anecdotal evidence of rents starting to be bid up due to a lack of appropriate properties, and potential cannibalisation in areas such as Leeds where the number of low-cost gyms has doubled from four to eight since 2014.

While the broker is at the gloomier end of the range of forecasts, it expects return on capital employed (ROCE) for the current year of an uninspiring 9.5 per cent, dropping to 8.5 per cent by 2019. This suggests the company could be creating little real value beyond its cost of capital; not the type of growth many investors would want to pay 27 times earnings for. Any disappointment could be particularly painful given the sensitivity of profits to changes in sales - N+1 Singer believes a 1 per cent revenue change means a 6 per cent move in profit. That said, this profit sensitivity - or operational gearing in City speak - could also be an advantage if things do go well.

Yet while the balance sheet looks healthy with just £2.5m of net debt at the half-year point and a £40m financing facility available, the company's rent commitments should not be ignored - Sharepad puts a near £80m value on this - especially as changes to accounting rules mean these debt-like liabilities will need to be reported on the balance sheet from the start of 2019.

However, proponents of the stock would argue that the company still has the potential to easily double in size. And the group could boost returns and surprise on the upside as the many immature units in its estate fill to capacity and management starts to concentrate on getting more money from members through "yield management".

GYM GROUP (GYM)
ORD PRICE:194pMARKET VALUE:£249m
TOUCH:190-198p12-MONTHHIGH:280pLOW: 155p
FWD DIVIDEND YIELD:0.6%FWD PE RATIO:27
NET ASSET VALUE:87pNET DEBT:2%

Year to 31 DecTurnover (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201560.05.33.10.0
2016*73.69.05.50.8
2017*90.212.07.21.1
% change+23+33+31+38

Normal market size: 3,000

Matched bargain trading

Beta: 0.27

*N+1 Singer forecasts, adjusted PTP and EPS figures