Planet Fitness: The Clock Is Ticking – Seeking Alpha

Nov, 20th 2020 9:55 am, Article Recommended by Dr. J. Smith

For my previous post on Planet Fitness (PLNT), I constructed an optimistic scenario and a pessimistic scenario. Planet Fitness recently turned in a challenging quarter which underperformed my pessimistic scenario. While the underlying business shows strength in the face of a worsening pandemic that has driven many of Planet Fitness competitors to bankruptcy, the company is quickly running out of financial runway, given their huge debt load and associated debt covenants.

In terms of member count, my pessimistic scenario forecast a modest quarter over quarter dip due to COVID-19, in line with the Q2 vs Q1 trend. Instead, member count declined -7.2%, erasing a years worth of member gains. Members per store declined even further.

Source: Created by author using data from SEC filings and forecast model.

Planet Fitness management gave a number of reasons for the decline in member count on their Q3 2020 earnings call. Specifically, CEO Chris Rondeau explained that COVID-19 was a big factor. As Q3 got underway in July, there was a surge in the virus in several states which appeared to shift consumer sentiment. In addition, he mentioned resumption of normal billing at the stores that had been closed, and marketing/sales efforts being compromised by closed stores, as drivers of the member count decline.

While the rate of member count decline has slowed, possibly due to the sales push mentioned by Rondeau on the Q3 earnings call (October saw a comparatively small 100K drop), its hard to believe well see meaningful improvement in member counts until were farther along in the fight against COVID-19, especially if Planet Fitness is again forced to close stores. Unfortunately, the pandemic appears to be getting worse, and with this may come new restrictions on gyms and restaurants. Although Pfizers new vaccine is a huge positive, it may not be available in large enough quantities to make a difference before the end of the year, and there are logistical hurdles towards mass distribution. There's a similar story with Moderna's new vaccine. While it's supposed to be 95% effective, Moderna stated they expect to have only 20M doses ready to ship to the US by the end of the year. As well, potential reluctance of Americans to take a relatively unproven vaccine may slow adoption. The problem for Planet Fitness is they may not be able to wait until 2021 for profitability to improve.

Q3 2020 Net Income came in significantly below my pessimistic scenario, due mostly to lower equipment sales and increased sales/marketing expense.

Source: Created by author using data from SEC filings and forecast model.

The pessimistic scenario was pretty close on Franchise and Corporate Owned Store revenue, as the member count underperformance was offset by fewer closed stores. However, Equipment Sales showed more weakness than the scenario expected, even though the pessimistic scenario included significant pressure from the 12-month extension on mandatory equipment purchases and 15% equipment discount. Cost of Revenue was lower as a result of lower Equipment Sales. Finally, National Advertising Fund expense came in 85% higher, due to increased spend on sales and marketing efforts to protect member count. At least that's my interpretation from Rondeau's explanations on the Q3 Earnings call. I would expect this increased expense to continue as long as COVID-19 threatens member count.

My previous post spent a lot of time highlighting the risks posed by Planet Fitness' huge debt load ($1.8B as of Sept 30 2020 as per their Q3 2020 10-Q). I see their most immediate risk coming from a potential breach of their debt service coverage ratio (OTCPK:DSCR) covenant, which would give lenders the right to initiate rapid amortization - aka immediate repayment of outstanding principal balance. Planet Fitness needs to keep this ratio (net cash flow / principal payments + interest) above 1.2. In regards to timing of the covenants, as per CFO Tom Fitzgerald on the Q3 Earnings Call:

Both are tested quarterly, they're calculated on a trailing 12-month basis, and reported roughly on a two month lag. In our most recent debt covenant reporting period of September 8, 2020, we had a 56% and a 108% cushion to the first triggering event for our debt service coverage ratio, and system wide sales covenant respectively.

From what I can tell, reporting on this metric doesn't include the current quarter's results, since it's said to lag by two months. The Sept 8 reporting period would then cover Q3 2019 to Q2 2020, even though it's reported with Q3 results. Adjusting my pessimistic scenario for the Q3 underperformance shows Planet Fitness may be in the danger zone by Q1 2021, with a DSCR of 1.12, as the Q1 2020 to Q4 2020 DSCR would apply.

Source: Created by author using data from SEC filings and forecast model.

It's unclear to me exactly how Planet Fitness calculates its DSCR (I'm using EBITDA as a proxy for net cash flow, although the official calculation seems more complex than that). It's also unclear if the 56% cushion Fitzgerald mentioned applies to the 1.75 or the more consequential 1.2 DSCR trigger. I think it's the 1.2. A 56% cushion on a 1.2 ratio implies the Sept 8 reporting period DSCR is at 1.87 (1.2 * 1.56), which is close to my calculated 1.98. Also, on the Q1 2020 Earnings Call, Fitzgerald mentioned there being a 50% cushion to the 1.75 threshold, which leads me to believe, as trailing 12 month results have significantly worsened since Q1, and the cushion wouldn't have expanded since then, the 56% cushion mentioned for Q3 refers to the 1.2. This is an important ratio and it would be helpful if management gave more detail on it. I will say the fact management refuses to issue guidance on this is not a good sign.

There are a number of positives for Planet Fitness, such as decreasing costs of commercial real estate, their promising internet play, bankruptcies of competitors, and COVID-19 vaccines on the way, but I don't see these ramping up quickly enough to save the company from a DSCR triggering event.

If that happens, rapid amortization could be initiated by lenders, and as I explained in my previous post, that would probably not be good for the stock price since it would give lenders a huge amount of power over the company and its cash flow and may force Planet Fitness to raise a large amount of capital at unfavorable terms.

While Planet Fitness shows a lot of promise as a market leader and innovator, its financial situation seems precarious. The recent run-up in the stock price shows there's money to be had trading the equity, but I don't think Planet Fitness will make sense as an investment until there's more resolution on the debt situation.

Disclosure: I am/we are short PLNT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My short position consists of put options on Planet Fitness.

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Planet Fitness: The Clock Is Ticking - Seeking Alpha