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How bulletproof is Brait’s crown jewel, Virgin Active?

The bull and the bear case for the gym operator….
With the hard lockdown in SA, many gym-goers invested in their own equipment and might choose not to maintain their gym memberships. Image: Suzanne Plunkett, Bloomberg

Buried in Brait’s annual results for the year to end-March, released in June, is the disclosure that Virgin Active likely lost somewhere between 20 000 and 50 000 members globally in March, as its clubs closed across its markets due to government lockdowns.

Its base dropped from 1.2 million at the end of February to 1.1 million by the end of March (both rounded). Italy was first to shut, with clubs in Singapore and South Africa only closing in the last week of the month.

For comparison, it added (net) 37 000 members in the whole of 2019, with almost half that number (17 000) coming from its largest market by members, southern Africa. At the end of 2019, this market had 728 000 adult members of a total 1.13 million worldwide.

Swift reaction

Management reacted swiftly to the lockdowns and was able to reduce cash burn by two thirds in the face of frozen memberships (no debit orders meant no revenue coming in). This was achieved through a combination of rent reductions/relief/deferrals, salary cuts, various government employee benefit schemes (such as UIF Ters in SA), tax deferrals and removal of all possible club operating costs (cleaning, consumables, TV subscriptions and so on).

In May, shareholders injected £20 million (over R400 million) at group level to “enable Virgin Active to navigate appropriately through the current exceptional circumstances”. Licensor Virgin Enterprises agreed to defer £5 million in royalties, and the group’s banking syndicate provided £25 million in new debt, with a modification to covenants to December next year.

The South African business remains in far better shape financially and did not require cash (its June lending covenant was waivered).

As clubs reopen in South Africa this week (its last market to reopen), the fundamental question facing the business, Brait and investors (as well as would-be investors) is what the gym industry will look like post Covid-19.

Has there been a structural change or is this simply a temporary blip?

The bull case

Virgin Active, rather obviously, is bullish as it believes the “large, more established and diversified operators are most likely to benefit from the industry disruption”.

It says “larger, ‘more product under one roof’ offerings will benefit at the expense of low cost, boutique, single club offerings” and that it expects a shake out of “smaller, undercapitalised operators”.

The lockdown left it with no other option but to transition to a digital-only offering, which has been moderately successful. While it leads the ‘full-service’ gym industry digitally, a number of niche players have a far stronger digital offering. In the short-term, it will augment its clubs with a digital offering (at home) which will help retain those members who are apprehensive about returning to gym.

Virgin Active says it will “emerge strongly post-Coronavirus” because of its “management team’s proven track record, diversified product/geographic offering, [and] adaptable business model built on market insight and financial discipline”. In 2016, this writer described Virgin Active as “the perfect business”, because of its annuity revenue base and strong cash conversion.

Read: Inside Brait’s crown jewel, Virgin Active

In recent years, it has shown in (especially) the South African market that a focus on optimising and increasing the utilisation or yield of its existing club portfolio would drive Ebitda (earnings before interest, tax, depreciation, and amortisation) growth. This has seen it actively managing its estate. In South Africa it closed three clubs (Pinetown, Southgate, Somerset West) and opened no new facilities in 2019.

Members are returning, albeit gradually.

In Italy, within a month, usage was at more than 50% of prior year levels (61% for the first batch of clubs that opened) and “improving”. Group exercise occupancy was at 70% within a month. In Australia, where it is a premium operator, usage was near prior year levels (96%) at its suburban clubs. At clubs in city centres, this figure was far lower (44%).

More broadly, Virgin Active says the historical health and wellness trend “is likely to remain [even more] relevant than pre-Coronavirus”, but that it will take time to return to levels of profitability achieved before the pandemic.

The bear case

But, for all the efforts and attracting members back to gym, many remain sceptical or downright fearful, rationally or not. It says in its June update that “in the period leading up to closure, sales were suppressed, and the business saw a higher number of members requesting to freeze or terminate their memberships in light of concerns over coronavirus”.

Post reopening, trends in Italy and Asia Pacific markets show that somewhere between 10% and 19% of members remain on freeze. This may not be that material for these far smaller markets (Italy has around 162 000 members, and Asia Pacific, including Australia, some 63 000), equating to roughly 40 000 members.

If 20% of members in South Africa elect to freeze their memberships, this becomes a material number.

Churn is likely to spike when the first round of debit orders in six months is processed, with a possible higher spike in membership freezes as people defer decisions on whether or not to continue with their gym memberships.

Discovery Vitality will only “top up” required annual gym visits to ensure members receive a discount until at least the end of September, after which these will be evaluated on a case by case basis.

Vitality members need to either get back to gym or ensure they achieve their Vitality goals another way (using a linked fitness device) or abandon Vitality altogether.

Add the far weaker economy in South Africa to the mix and it is questionable whether this market will remain as robust as others globally. The base, or number of members, in South Africa is far broader than in other markets and, given the effective subsidy via Vitality, structurally different.

A near 10% contraction in GDP in South Africa plus job losses far in excess of 1 million could put untold pressure on its business here.

But there is a far bigger question that will only be answered in time: To what extent have its members, especially its best members who pay full subscriptions but visit gym less often than the average, abandoned the idea of gym completely?

A real threat …

With such a hard lockdown in April, many upper middle class and wealthier members invested in (not inexpensive) indoor equipment such as treadmills and indoor cycling trainers. Popular apps such as Zwift enable ‘group’ training via these connected devices, virtually. This is a real threat to the business model of all gyms, not only Virgin. In some cases (niche spinning studios), the threat is existential.

Habits were easily formed in April and May and there are serious questions, anecdotally at least, whether these people will ever use a treadmill or Wattbike at gym ever again.

While others kitted out home gyms for weight training or functional training or yoga, given the absence of immersive virtual alternatives as well the social aspect of group training, most of these members will likely return to gym over time.

Pandemic raises longer-term questions

The global pandemic has brought into question how ‘bulletproof’ this leading gym business really is.

Recent financial metrics made it look unstoppable, and it remains the only real attraction inside listed vehicle Brait (Iceland has been sold, Premier is solid yet uninspiring and New Look remains a disaster, despite the umpteenth restructure effort).

Read: Time to break up Brait?

It is not inconceivable for Virgin Active to end 2020 with under one million members globally. Still, members are only a third of the story. Much will rely on how effectively it is able to manage yields (utilisation) and its cost base.

Brait says a more “maintainable” (in other words, realistic) Ebitda for Virgin Active in the medium term, post-Coronavirus, is £108 million a year. This is a full quarter less than the amount achieved in 2019 (£142 million).

This, together with a lower multiple, means an enterprise value 37% lower than in September 2019. Add additional debt, and the equity value has dropped by more than half.

Brait’s valuation of its 79.2% stake in Virgin Active has gone from £896.9 million at September 30 2019 to £422 million at March 30 (a weaker rand helped cushion the decline in carrying value in rands).

Any bets on what the carrying value will be once the true costs of lockdown are clear and gyms have been reopened for a few months?

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COMMENTS   16

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Brait will come back strongly. There is no doubt! And so will South Africa.

I’m not sure what is worse, your blind optimism or refusal to take facts into account…I’d suggest you look into the Dunning-Kruger effect, but guess it would be pointless as you are already proof of the cognitive bias…

He must have said it tong in cheek!!!

John is that you? It’s over buddy…

Brait and South Africa are in big trouble and there is no strong come back.

I’ve always thought this was a dodgy investment, even in the best of times! If it was such a jewel, Mr Branson would have held onto it! Just my-opinion.

One thing which I have learned from COVID-19 is to rather invest in a business which is an essential service. They are the only ones that can withstand an epidemic like this. Therefore the food producers and food retailers are a safe bet in general and within that group chose the strong ones like Shoprite.

The challenge FMCG retail face is particularly with the bottom of the pyramid (the poor) and to a degree the middle-class, who are so overburdened with debt that they have very little disposable income left (for groceries). The actions taken by government(s) during COVID caused many to loose their income streams and livelihoods. FMCG retailers and their suppliers are therefore not as resilient as you may think.

JNRB, you raise a very interesting point.

I always thought restaurants and doctors were a safe bet and I was a bit envious because these people came through the 2008 recession largely unscathed.

People have to eat and go to the doctor for medicals, right ?

Covid-19 has shown this is not the case with restaurants folding and people rather staying at home than to go to the local GP.

So, what is a safe business these days ?

I don’t know anymore 😉

An interesting point made above. We have always assumed there are bullet proof industries, like health care, education etc. We could go further and include religion and essential charitable work like WFP and various other organisations. None have been safe or saved from the socialist shut downs.

The draconian indiscriminate lockdowns have actually caused a review of this conventional wisdom.

By force/ decree and by extension we have no choice. Essential medical visits were and have been deemed by the state, non-essential. Symptoms of cancer, diabetes and heart disease – which would have been detected even 6mths ago and treated, are now forced into the keep your fingers crossed category. Like it or not, hospitals and clinics make a lot of money off treating these diseases and many others – that income stream has been cut off. Treatment has been cut off as has detection. By extension at what stage are the insurance companies going to get hammered by a wave of these out of control ailments being picked up far to late.

How many of you have children affected by cancellation of their curriculum and sports activities, by extension the critical psychological support and development aspect that this adds to their lives. All they are learning now is fear.

As for gyms – is this not a discretionary luxury spend. With disposable income plummeting in all categories, how long before this gets cut off or at least badly affected.

As lockdown extremes are seemingly lifted – we now have the so called CASE-demic being actively promoted. We have not yet seen the real economic affects of the first lockdown and world governments seem hell bent on keeping the fear elevated and looking for a 2nd lock down.

Scary times.

Went back to gym yesterday for the first time in 5 months. It was definitely not the same ‘vibe’ as before. But I found I could pretty much do everything I did before without too much trouble except for cardio which is difficult with a mask on. But as I went at a quiet time I was able to remove my mask for that particular exercise as there weren’t a lot of people around.

One new thing (Planet Fitness) is that you can’t take a towel onto the floor. This seems like a weird choice to me and I feel the solution is for the gyms to start supplying towels which you return when you leave the gym. Rinse and repeat. This will ensure that you receive a freshly laundered towel each time you attend. Seems logical to me but of course they probably won’t want to take on the expense.

I feel if gyms are going to get over this hump they need to listen to their members and welcome feedback. The problem is they are all broken down into individual clubs but decisions are made at higher levels that affect each and every club. I would strongly suggest they establish point of contact that everyone can feed back to and actually read and respond to member’s suggestions.

Considering that the capital outlay for the average piece of equipment in the gym, the treadmill, leg press or Smith Machine, for instance, is north of R40 000, then the people who occupy that piece of equipment can never pay for it. A gym makes a profit from those members who pay membership fees but never, or rarely, use the equipment. The regular hardcore members cannot pay for the equipment. They are subsidised by those who join on the special offers.

A gym’s business model, therefore, depends on those clients who pay for merchandise that they never claim. How sustainable is that in a recession?

I agree, new year, new fit me. Sign gym contact. 2 months go well, the other 22 never visit. There would never be enough space in any gym for all the paying memebers. Like the mustard companies, they make their money on what is not used.

Training with a mask on is a non-starter…that and the ridiculous one size fits all social distancing approach for gyms resulted in cancelling my VA membership…sad but have moved on…

Businesses such as virgin and discovery health will no doubt loose many members resulting in higher fees for those who are left, which will result in even fewer customers…

This plandemic and its disasterous economic effects will still take a while for everything to completely collapse

End of comments.

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