Soho House: Unattractive Due To Lack Of Valuation Support

Investment thesis

Soho House (NYSE:SHCO) has survived the pandemic, but the outlook for membership growth is low given the negative macro environment. The high level of debt indicates either expensive or dilutive refinancing or risk of default in the medium term. We rate the shares as a sell.

Quick primer

Opening its first site in 1995 in London, Soho House is a hospitality brand operating a private membership platform comprising clubs, hotels, and working spaces aimed at creative industries such as media and film. It also operates services that are open to the wider public such as restaurants and e-commerce. In April 2023, there were approximately 238,000 members in total (growing 38% YoY), with around 168,700 members for the core Soho House private members club (growing 29% YoY). The fastest growing cohorts are “Generation Z” (26 years old and younger) and “Millennials” (27- to 42-year-olds). North America made up the largest market contributing 49% of FY12/2022 sales, followed by the United Kingdom at 28% (page 28).

The price of a Soho House private club membership allowing access to all 38 'houses' worldwide is approximately $4,500 per year. Soho House has a selective club membership policy.

Key financials with consensus estimates

The sell-side expects steady revenue growth for the next 3 years, although there is a decelerating profile. As the company is aiming to expand its footprint globally (Soho House Bangkok opened in February 2023), upfront investment costs mean that there is no expectation of profits, and cash burn is set to continue to FY12/2024.

Our objectives

With concerns of an oncoming recession and a 'hard landing', we want to assess Soho House's shares. Q1 FY12/2023 results showed double-digit growth in memberships, and the company continues to expand its global footprint with new locations. Private members' clubs are strictly discretionary spending, although there is a case for such spending to be used for networking and business, particularly for the arts and media industries. We want to assess the outlook for the business, and whether the shares are attractive.

Mixed signals

The business model is based on 1) increasing membership numbers, maintaining high retention and 2) diversifying the business for cross-selling opportunities, all whilst maintaining a high standard of customer experience. The company is offering something unique and desirable to the marketplace, as Q1 FY12/2023 membership numbers grew 38% YoY and membership revenues by 42% YoY. There was a waitlist of 89,000 applicants (page 29) (growing 13% YoY), although we note the rate of growth is slowing down (page 8 for annual trend) from 21% YoY in Q4 FY12/2022 and from 48% YoY in Q4 FY12/2021.

With cost inflation increasing operating costs but acknowledging the impact of the cost-of-living crisis on its customers, the company has raised pricing selectively, with existing members getting single-digit increases whilst new members face double-digit hikes. This strategy aims to reward existing loyal members, but may act as a headwind for new business.

Methods to increase new members include the 'Soho Friends' membership, a limited access service with 62,900 members for people who have visited previously as guests, at a substantially low annual subscription cost of approximately $130. However, there is limited evidence to suggest that these are leading to full membership conversions.

On a positive note, members who were 'Frozen' (suspending membership) have fallen to 2,333 in Q1 FY12/2023, and a percentage of total membership is below pre-pandemic levels.

What is a red flag to us is the slowdown in waitlist growth - the price rises certainly will not help acquire new members. Growing the network with new location openings will help, but overextending will mean rising operating costs and potentially larger losses. At this juncture, we do not see a major upturn in membership growth.

Concerns over the balance sheet

As a hospitality brand, the business aims to deliver a great customer experience. Consequently, there is more emphasis on brand value and intangibles, as opposed to tangible assets; there is $645 million in property and equipment on the balance sheet, but around twice that amount is held as operating leases.

The company listed in July 2021 partly to pay down debt. In Q1 FY12/2023 there was (excluding operating lease obligations) $734 million debt outstanding, equivalent to 52 times FY12/2022 cash flow from operating activities. The average interest rate paid on fixed-interest debt financing is 8%, highlighting that the business is seen as high risk (page 18) even before the Fed hiked rates.

With a weak balance sheet, the company faces crunch time in FY12/2027 as its debt schedule has a due principal of $591 million (page 20). The company has 3.5 years to generate that much free cash flow or to be in better financial health in order to refinance. Considering that consensus (see Key Financials table above) is expecting a further $100 million cash burn for the next two years, we believe the company will be hard-pushed to refinance. Any successful outcome will either be very expensive, or highly dilutive. In essence, bankruptcy risk is medium to high in our view.

Valuation

We believe conventional multiples do not illustrate the underlying value of the shares. The closest is EV/Sales of 1.7x (as it takes debt into account), which to us implies a business with expectations of limited growth for a membership business. As a point of reference, WeWork (WE) trades at EV/sales 5.4x, and LuxUrban (LUXH) on 2.2x. Gym operator Planet Fitness (PLNT) trades on 7.4x (although membership pricing is far cheaper).

Risks

Upside risk comes from a 'soft landing' recession, followed by an economic recovery and a strengthening appetite for consumer discretionary spending boosting membership application numbers.

The company could ask for capital such as from private equity (as per in 2012), which would increase the chances of the business surviving.

Downside risk comes from the rising risk of default, reducing the value of equity.

An economic hard landing would result in user churn as well as more membership suspension, placing pressure on cash flow, working capital, and business expansion plans.

Conclusion

Soho House has a decent brand and a relatively niche but strong following but has been a cash-burning enterprise. It has survived the pandemic and IPOed, but the current economic environment is not conducive to growing a high-end, selective membership platform business. Valuations do not point to a discounted business, and the current debt level is too high to be comfortable. We rate the shares as a sell.

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