MARKET COMMENT
A Very Healthy Sector

By David Kuo (TMFDragon)
March 24, 2004

Did you know that one in twelve Britons, some five million people, now belong to a health club? 

About a third of health club members say they go a fitness centre to lose weight, whilst another one-third saunter down to their health club to relieve stress. Amusingly, more than one in ten health club members admit to joining a gym for social reasons!

With more people planning to climb onto the treadmill of well-being, the health club sector is set to grow once again. And where there is growth, there are reasons for canny investors to sit up and take note.

Lots of people who work out belong to one of the branded chains dotted around the country. These include Cannons, Esporta, Fitness Exchange and Fitness First. Other well-known health club operators are David Lloyd Leisure, Holmes Place and Dragons, which belongs to AIM-listed Crown Sports (LSE: CSP).

According to recent reports, the branded operators are keen to capitalise on current demand that is sweeping the Nation. These branded operators are expected to expand their number of outlets by almost 12% this year.

Branded health clubs grew at a cracking pace between 2000 and 2003, when their total number of outlets increased from 440 to 660 - a rise of 50% in just three years. It was that rapid expansion that destabilised the sector. Consequently, many of the then-listed health club operators fell out of favour with stock market investors, and into the hands of venture capitalists.

Duke Street Capital bought Esporta and Fitness First was acquired by Cinven. Royal Bank of Scotland (LSE: RBS) took control of Cannons Health Club and N M Rothschild snapped up Holmes Place. Topnotch, the gym that "dares to be different", sold eight of its clubs to chief executive Matthew Harris after going into administration.

Today, only a handful of pure-play health clubs are listed on the stock market, of which the biggest is LA Fitness (LSE: LFS). Today, the company reported a 34% rise in interim pre-tax profits to £3.7m on sales that grew 27% to £38m. More importantly, membership numbers rose 36% to 197,000 in the twelve months to 31 January.

LA Fitness is expected to post a pre-tax profit of £8.8m for the full year, rising to £10.2m in 2005. At 185p, its shares value the company at 12 times 2005 profits, which looks modest for a growing business. The company's net debt, which stands at £48m, is a little worrying though, given that its market value is only £76m. That said interest payments are generously covered by operating profits, and strong cash flow allowed the company to pay down its loans by over £3m last year.

Whitbread (LSE: WTB) is another play on the health club sector, and perhaps a safer one for wary investors. The company owns David Lloyd Leisure, which operates 80 leisure clubs right across Britain. In February, Whitbread, which also owns Marriott, Beefeater and Travel Inn, said like-for-like sales at David Lloyd, grew 5.8% in the first 50 weeks of its financial year.

Last year, David Lloyd delivered an operating profit £43m, representing 15% of group operating profits. Whitbread shares currently stand at 702p, valuing the company at 11 times forward earnings. The prospective yield is a hearty 3.4%.

Health clubs were once seen as the darlings of the stock market, and investors were in many ways hoodwinked into believing that any operator, regardless of their suitability, could survive in the highly competitive gym market. However, the harsh reality is that only clubs with adequate size and scale have a long-term future.