In its 32 months on the public markets, Planet Fitness Inc (NYSE:PLNT) has proven to be a bit of battleground stock. But the shorts who targeted Planet Fitness stock are in significant pain: PLNT stock has risen 118% in the past year alone.
Short covering no doubt has helped of late. The percentage of Planet Fitness stock sold short has fallen from near 15% in July to barely over 6% at the moment. But Planet Fitness posted an impressive 2017, with 14% revenue growth and solid margin expansion as well. A franchise-heavy model and plenty of room for expansion help the story as well. Between performance and the Street’s sentiment toward franchisors, PLNT stock looks like a hugely dangerous short, even after doubling.
At the same time, however, the short case still has some intriguing pillars. And PLNT’s valuation looks awfully stretched at the moment. A leveraged balance sheet has helped the stock on the way up, but could pressure the stock if the narrative here turns at all. Competition remains intense — and the history of the fitness industry is littered with fallen stars.
All told, there’s risk in taking either side of the trade when it comes to PLNT. So, after a torrid run, investors without substantial risk tolerance might be best served staying on the sidelines.
The Short Case for Planet Fitness Stock
It’s not terribly difficult to see why shorts targeted PLNT — and still might. Planet Fitness was a JOBS Act IPO, a category that has proven fertile ground for short sellers. The fitness industry traditionally has been a graveyard for investor capital. Bally’s Total Fitness went bankrupt — twice. Town Sports International Holdings, Inc. (NASDAQ:CLUB) looked headed for a similar fate two years ago; even an impressive rally still leaves the stock 50%+ below its pre-crisis levels. The well-known Curves chain has shed almost two-thirds of its North American locations after heady growth of its own.
Meanwhile, Planet Fitness was offering a different model, with $10-per-month fees and a focus on customers not necessarily that interested in exercise. CEO Chris Rondreau famously said in 2016 that Planet Fitness’s real competitors were Brinker International, Inc. (NYSE:EAT) unit Chili’s, Pizzeria Uno and movie theaters.
Rondreau’s claims aside, however, the low-cost gym model was seeing intense competition, with chains like Blast Fitness, Blink Fitness and Snap Fitness, among others, all rolling out versions of the low-cost, low-stress model.
And so the short case was relatively simple. Planet Fitness was posting exceptional growth largely through new franchises. Those franchises paid both upfront fees and paid the corporate owner to buy new equipment. That growth inevitably would slow as new locations became harder to find — most shorts dismissed the company’s target of 4,000 locations — and those upfront fees shrank. With an indebted balance sheet thanks to the IPO and a debt-funded special dividend, PLNT stock would crumble.
That case obviously hasn’t played out. But the risks cited by shorts do have some validity and should be considered, particularly given what looks like an awfully generous valuation for Planet Fitness stock at the moment.
The Problems With the Bull Case for PLNT Stock
As the old saw goes, short sellers “are sometimes right, sometimes wrong — and always early.” And the shorts, though they’ve been wrong so far, could simply be early.
After all, Planet Fitness still has a reasonable amount of debt, with the company likely to close 2018 with a net leverage ratio close to 3 times Adjusted EBITDA. There’s a significant tax receivable agreement that requires payments to the former owners; that liability isn’t included in the P&L but cost PLNT ~$11 million (over $0.10 per share) in 2017 cash flow, per the compamy’s 10-K. Planet Fitness already is at 1,518 stores, and while the company insisted on the Q4 conference call that unit economics remained positive, there is a risk of saturation at some point down the line.
The business is working at the moment. But the history of the fitness space is that businesses usually work… until they don’t. Some of the recent growth has come from steadily increasing royalty rates, which can’t last forever. New store count growth will decelerate as well, although the company expects to open roughly 500 stores in the next three years (again, according to the 10-K).
Meanwhile, valuation looks rather stretched. Based on 2018 guidance, PLNT stock trades at 34x earnings and a whopping 22x EV/EBITDA. Wall Street does love the franchise model, but even mature, established, franchisors like Yum! Brands, Inc. (NYSE:YUM), Domino’s Pizza, Inc. (NYSE:DPZ), and McDonald’s Corporation (NYSE:MCD) generally trade in the mid- to high-20s in terms of P/E ratio and mid- to high teens in terms of EV/EBITDA.
The premium to those companies could be justified by Planet Fitness’s whitespace for additional growth. But those companies have a key question of their own: at what point do franchisees start becoming disgruntled. There, too, Planet Fitness at the moment shows no sign of weakness. But higher royalty rates and less desirable locations could change that going forward.
Risk in PLNT Stock on Both Sides
I do question whether the Planet Fitness model is so unique that it can avoid the pitfalls that have snared so many companies in its industry. And I do see valuation as problematic. But shorting the company now, when performance is strong and growth is impressive, seems a dangerous move.
From the long side, though, that valuation is concerning. And this simply hasn’t been an industry suited for long-term investors. Maybe this time is different — maybe Planet Fitness truly has cracked the code. But to take that bet, I’d like to pay a lot less than 34x earnings and ~40x free cash flow.
As of this writing, Vince Martin has no positions in any securities mentioned.