Good afternoon. My name is Jesse, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Planet Fitness Third Quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question, please press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. With that, I'll turn the call over to Brendon Frey from ICR.
Thank you for joining us today to discuss Planet Fitness' third quarter 2017 earnings results. On today's call are Chris Rondeau, Chief Executive Officer, and Dorvin Lively, President and Chief Financial Officer. A copy of today's press release is available on the investor relations section of planetfitness.com. I would like to remind you that certain statements we will make in this presentation are forward-looking statements. These forward-looking statements reflect Planet Fitness' judgment and analysis only as of today, actual results may differ materially from current expectations based on a number of factors affecting Planet Fitness' business. Accordingly, you should not place undue reliance on these forward-looking statements.
For a more thorough discussion of the risks and uncertainties associated with the forward-looking statements to be made in this conference call and webcast, we refer you to the disclaimer regarding forward-looking statements that is included in our third quarter 2017 earnings release, which was furnished to the SEC today on Form 8-K, as well as our filings with the SEC referenced in that disclaimer. We do not undertake any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. In addition, the company may refer to certain adjusted non-GAAP metrics on this call. Explanation of these metrics can be found in the earnings release filed earlier today. With that, I'll turn the call over to Chris Rondeau, Chief Executive Officer of Planet Fitness. Chris?
Thank you, Brendon, thank you everyone for joining us for our third quarter earnings call. Building off our strong performance in the first half of the year, the business continues to perform very well. Same-store sales were positive for the 43rd consecutive quarter, increasing 9.3% on top of a 10% comp gain in the third quarter last year. Total revenue was up 12.1%, revenues in each of the three segments were up in the quarter, with franchise, our highest margin segment, increasing 30.6%, 31 new Planet Fitness stores opened during the period, bringing system-wide total stores to 1,432. As discussed on previous calls, over the past year, we've been conducting price elasticity testing in several markets throughout the U.S. and Canada to evaluate the impact of increasing our Black Card monthly dues.
We are proud to have held our Black Card pricing flat at $19.99 for the past 15 years, while at the same time increasing its value to our members significantly. The value of our reciprocity benefit alone has increased dramatically as we've grown our store base from 20 stores when the Black Card was first introduced to more than 1,400 stores today across the U.S. Our members truly appreciate this perk, and in 2016, 50% of Black Card members across the country used a club other than their home club at least once. Since first rolling out the Black Card membership, we have built designated Black Card Spa areas in our stores, added Total Body Enhancement, massage chairs, and HydroMassage beds. These numerous benefits, combined with the ability to bring a friend for free, continue to make the Planet Fitness Black Card a great value for consumers.
We are pleased to report that the price elasticity test results were overwhelmingly positive, naturally increasing the average blended rate of new joins. As a result, and with close collaboration with franchisee leadership, we decided to allow all stores system-wide to roll out the new $21.99 Black Card price beginning September 1st and required all stores to implement the new pricing as of October 1st, which is perfect timing ahead of our busy season. We remain as committed as ever to providing our members with access to low-cost, high-quality fitness and are confident that this rate adjustment will allow us to continue to strengthen our member experience and provide increased value to our franchisees and shareholders.
While franchisee growth continues to be the pillar of our store expansion strategy, we are on schedule to open four new corporate stores by the end of the year, including one each in Wilmington, Delaware, in Berlin, Vermont, and two stores in Erie, Pennsylvania. All these stores started pre-sale in the third quarter and are off to a solid start. As we had said at the time of the IPO, our plan is to open a handful of corporate stores per year in new and existing markets, where we have the ability to capitalize on advertising dollars or test varying population densities and alternative build-outs. For example, our Berlin, Vermont, corporate store is approximately 15,000 square feet versus our typical 20,000 square foot store. Berlin has a population of only 40,000 people within a 20-minute drive time, roughly half the average of our typical location.
With that in mind, we are extremely pleased with the number of new member sign-ups during our pre-sale thus far and encouraged by the demand for the brand in smaller markets. We have a long runway for growth ahead of us with a potential footprint of 4,000 stores in the U.S. over time. While the vast majority of our pipeline is domestic stores, our franchisees continue to open new stores in Canada, and the demand for our first location in Panama remains strong with the official grand opening scheduled to open in the coming weeks. Speaking of our stores, Hurricane Maria had an impact on our stores in Puerto Rico as the entire island was affected by the largest storm to hit the region in nearly 100 years.
Of our 11 stores in the market, we have reopened two, and nine are temporarily closed with damage ranging from water to structural issues. Our franchisee is committed to the market and is working on a plan to reopen stores and service the community as soon as possible. Thankfully, our stores in Texas, Florida, Georgia, and South Carolina in the path of Hurricane Harvey and Hurricane Irma were not significantly damaged and remain open and operating as usual. Having said that, Planet Fitness store employees in various regions, particularly in Puerto Rico, were personally impacted, and I was truly inspired by the generosity of our franchisees and vendors who came together to raise approximately $300,000 to provide financial assistance to help with housing, transportation, clothing, and other essential items for employees and their families.
With these funds, we formalized the Planet Fitness Disaster Relief Fund, which is a nonprofit organization that will serve as a mechanism to provide relief to club staff moving forward. Coming together to support one another in times of need is what sets our franchise system apart from the rest. I am excited to share that we have enhanced our leadership team to include two new positions. Craig Miller, Chief Digital and Information Officer, joined Planet Fitness with more than 20 years of experience in major consumer brands like Sonic Drive-In, Movie Gallery, Hollywood Video, PepsiCo, and Bank of America. Rob Sopkin also joined us as Chief Development Officer.
Rob brings nearly two decades of national and regional real estate experience, spending the majority of his career working at Starbucks, most recently leading U.S. store development and overseeing the integration of Starbucks's store development with licensed stores in Canada and internationally. Cammie Dunaway recently joined our board of directors, bringing more than 25 years of experience leading the marketing and general management of global brands like Yahoo, Nintendo, Frito-Lay , and KidZania. It was another terrific quarter, highlighted by robust system-wide sales growth and earnings that exceeded expectations. We are anticipating a strong finish to the year, which is incorporated into our increased outlook for 2017. We just celebrated our 25 years in business, I believe we are just beginning to scratch the surface of Planet Fitness's full potential.
I am confident that we are well-positioned to capitalize on the many opportunities that lie ahead and deliver increased shareholder value over the long term. I'll now turn the call over to Dorvin.
Thanks, Chris, and good afternoon, everyone. I'll begin by reviewing the details of our third quarter results and then discuss our full year 2017 outlook. For the third quarter of 2017, total revenue increased 12.1% to $97.5 million from $87 million in the prior year period. Total system-wide same-store sales increased 9.3%. From a segment perspective, franchisee same-store sales increased 9.6%, and our corporate store same-store sales increased 5.1%. Over 90% of our Q3 comp increase was driven by member growth. At the same time, our Black Card membership penetration was 60%, up 130 basis points over Q3 last year. As Chris mentioned, following the successful test of the $21.99 pricing on the Black Card in approximately 100 stores, we made the decision to roll the price increase out system-wide on October 1.
The impact on October results from the price increase was positive. We expect Q4 comps to benefit from both volume and rate growth, and this has been factored into our upwardly revised guidance. Our franchisee segment revenue was $35.6 million, an increase of 30.6% from $27.2 million in the prior period. Let me break down the drivers of our fastest-growing revenue segment. Royalty revenue was $22 million, which consists of royalties on monthly membership dues and annual membership fees. This compares to royalty revenue of $15.1 million in the same quarter of last year, an increase of 46.2%. This year-over-year increase had three drivers. First, we opened 196 new franchise stores since the third quarter of last year. Second, as I mentioned, our franchisee-owned same-store sales increased by 9.6%. Third, a higher overall average royalty rate.
For the third quarter, the average royalty rate was 4.33%, up from 4.01% in the same period last year, driven by more stores at more current royalty rates. Next, our franchise and other fees were $7 million, compared to $5.8 million in the same quarter a year ago, an increase of 20.7%. These fees are received from processing dues through our point-of-sale system, fees from online new member sign-ups, as well as fees paid to us in association with franchise and transfer fees and area development agreement fees. This increase was primarily driven by additional stores, an increase in same-store sales, and higher franchise and transfer fees as compared to the prior year period. Also within franchise segment revenue is our placement revenue, which was $2.4 million compared to $2.2 million last year.
Finally, our commission income, which is made up of commission from third-party vendors, arrangements, and equipment commissions for international new store openings, was $4.1 million, compared to $4.2 million in the prior period. Our corporate-owned store segment revenue increased 7.1% to $28.6 million from $26.7 million in the prior period. The $1.9 million increase was driven by the increase in corporate-owned same-store sales of 5.1% and increased annual fee revenue. Turning to our equipment segment, revenue increased slightly to $33.4 million from $33.1 million. The increase was driven by higher replacement equipment sales to existing franchisee-owned stores, partially offset by lower new store equipment placements versus a year ago period, as a number of new store openings originally planned for Q3 this year shifted into Q4. Year-to-date, our replacement equipment revenue represented 48% of total equipment revenue.
Our cost of revenue, which primarily relates to direct cost of equipment sales to new and existing franchise-owned stores, amounted to $25.8 million, compared to $25.9 million a year ago. Store operations expense, which is associated with our corporate-owned stores, was $15.6 million, compared to $15.2 million a year ago. SG&A for the quarter was $14.1 million compared to $12.2 million a year ago. Both periods include non-recurring expenses related to secondary offerings. Excluding these non-recurring expenses, total SG&A increased by $2.9 million, or 25.6%. This increased expense was primarily to support our growing operations and infrastructure, including higher payroll and related costs, as well as cost of being a public company. Our operating income, inclusive of the aforementioned non-recurring expenses, increased 29.8% to $34 million for the quarter compared to operating income of $26.2 million in the prior year period.
On an adjusted basis, taking into account the non-recurring expenses I just mentioned, our adjusted operating margin was 35.8% this quarter versus 32% in the prior year quarter, an increase of 380 basis points. This was primarily due to revenue growth and higher margins as we have continued to leverage our cost infrastructure. Our earnings before taxes, inclusive of the aforementioned non-recurring expenses, increased 29.4% to $25.4 million for the quarter, compared to earnings before taxes of $19.7 million in the prior year period. As a result of our fourth quarter 2016 amended credit facility and increased term loan borrowings, we incurred approximately $2.6 million in higher interest expense in the third quarter of 2017 compared to the prior year period. Our GAAP effective income tax rate for the third quarter was 25.7% compared to 24.4% in the prior year period.
As we have stated before, because of the income attributable to the non-controlling interest, which isn't taxed at the Planet Fitness Inc. level, an appropriate adjusted income tax rate would be approximately 39.5% if all earnings were taxed at the Planet Fitness Inc. level. On a GAAP basis for the third quarter of 2017, our net income attributable to Planet Fitness Inc. was $15.3 million, or $0.18 per diluted share, compared to $3.4 million or $0.08 per diluted share in the prior period. Net income was $18.9 million, compared to $14.9 million in the prior period. On an adjusted basis, net income was $18.7 million, or $0.19 per diluted share, an increase of 17.9% compared with $15.9 million or $0.16 per diluted share in the prior year period.
Keep in mind that Q3 included higher interest expense of $2.6 million as a result of the prior year Q4 refinancing. Adjusted net income has been adjusted to exclude non-recurring expenses and reflect a normalized federal income tax rate of 39.5%. We have provided a reconciliation of adjusted net income to GAAP net income in today's earnings release. Adjusted EBITDA, which is defined as net income before interest taxes, depreciation, and amortization, adjusted for the impact of certain non-cash and other items that are not considered in the evaluation of ongoing operating performance, increased 22.4% to $43.4 million from $35.4 million in the prior year period. A reconciliation of adjusted EBITDA to GAAP net income can also be found in today's earnings release.
By segment, our franchise segment EBITDA increased 31.2% to $29.9 million, driven by higher royalties received from additional franchisee-owned stores not included in the same-store sales base, an increase in franchise-owned same-store sales of 9.6%, more stores at higher royalty rates, as well as higher commissions and other fees, including higher franchise and transfer fees. Our franchise segment adjusted EBITDA margins were 85.1% compared to 85.5% in the prior period. Corporate-owned store segment EBITDA increased 14.2% to $12 million, driven primarily by a 5.1% increase in corporate same-store sales and higher annual fees. Our corporate store segment adjusted EBITDA margins increased by approximately 400 basis points to 44.3%. Our equipment segment EBITDA increased 7.4% to $7.7 million, driven by higher margins. Equipment segment adjusted EBITDA margins increased 110 basis points to 22.7%. Turning to the balance sheet.
As of September 30, 2017, we had cash and cash equivalents of $93.3 million, compared with cash and cash equivalents of $40.4 million as of December 31, 2016. Borrowing capacity under our revolving credit facility stood at $75 million as of September 30, 2017, while total bank debt, excluding deferred financing costs, was $711.3 million, consisting solely of our senior term loan. In summary, we had a really good quarter, highlighted by strong system-wide same-store sales growth and EPS that was ahead of projections. Based on our year-to-date results, combined with the expected benefit to fourth quarter system-wide same-store sales from the higher Black Card pricing, we are raising our guidance.
We now expect revenue for the year ended December 31, 2017, to be between $425 million-$430 million, up from our previous guidance of $409 million-$415 million, and adjusted net income to range from $79 million-$81 million, up from our previous guidance of $75 million-$77 million. This translates into adjusted EPS between $0.80-$0.82, compared with our previous guidance of $0.76-$0.78. Adjusted EBITDA is now expected to increase between 20%-22% to a range of $180 million-$183 million for the year. We now expect system-wide same-store sales to increase between 9.5%-10%, up from our previous guidance of 8%-9%. We still anticipate selling and placing equipment into approximately 190 to 200 new stores. Based on the current store opening schedule, we believe we'll be towards the high end of that range.
As Chris mentioned, we are on track to open four corporate stores in the fourth quarter. The equipment related to these corporate stores is not in our placement guidance, as we don't recognize equipment revenue on corporate store equipment placements. Finally, we expect the average royalty rate for 2017 to be approximately 4.2% compared to 3.7% in 2016. The 50 basis points increase is higher than the 30 to 40 basis points we previously guided to based on the number of franchisees that have opted to amend their existing franchise agreements and increase their existing royalty rate by 1.59% and eliminate the commissions they pay on certain operational purchases.
It is important to note that the increased royalty revenue that we'll receive due to the +1.59% royalty rate change is being offset by the corresponding decline in commission income, as we will no longer receive commission on purchases by these stores. Therefore, we do not expect an impact on our bottom-line results from the acceleration in the royalty rate increase. As of the end of Q3, approximately 400 stores have amended their franchise agreements to +1.59%, and we expect additional amendments in Q4. I'll now turn the call back to the operator for questions.
At this time, I would like to remind everyone, in order to ask a question, please press star 1 on your telephone keypad. We will pause just a moment to compile the Q&A roster. Your first question comes from Jonathan Komp with Baird. Your line is open.
Hi, thank you. Chris, I want to start off, obviously, the third quarter, you did not have any benefits from the pricing actions yet, the comps still accelerated quarter-over-quarter despite a tougher comparison, cycling double-digits last year. I'm just curious, as you look at the business, if anything stands out in terms of drivers of that momentum and how you see that playing out going forward?
I think it's still, as I've talked in the past, I can't underestimate the impact of this, I call it the marketing machine once in an interview that, with each new join and each new club that opens, the fact that 9% gets put into marketing is what is driving the member growth as well as some rate growth. Mostly, the member growth is what's driving these comps. I think we just continually see the benefits of that. Also coupled with, as we mentioned, some small benefits of our POS system that's gotten just more refined in how it processes. Majority of it is that marketing machine that continues to drive.
I think site selection actually, because we still approve every site, as we've said in the past, we just get better at what we do with each individual location we open, so we get better real estate and better site selection that drives better comps as well.
Great. When you look to the full-year outlook for unit openings, I think the commentary you just gave implies pretty strong Q4 openings, I'm just curious what you're seeing from franchisee demand there, maybe both domestically but also internationally. I'd be curious if you had any insights, Panama, how that's faring so far with the first opening and any other color there.
Panama is planned to open in a couple of weeks here. Pre-sale there has been very strong. That's a franchisee actually from the States that's down there. The clubs here, with these comps, the franchisees continue to be bullish on the business and continue to parlay their earnings back in to open more stores. I think that's what, again, why we keep doing that 200 stores over a year.
I'd just add to Jon is that, obviously, in a development cycle, it's a long period of time, as you know. Depending on when you take over a box, if it's a plain vanilla box, you might be able to get it open in three months or so. If it's more complicated or certainly a ground up, which we're doing a few more ground ups now, that could take up to a year and a half or so. Today, our franchisees are out there. They're working on Q2, Q3 of next year, Q4 of site selections, providing those potential sites into the company. We obviously have already reviewed sites for Q1 of next year. As Chris said, the franchisee base continues to be very excited about the brand and continuing to build out.
There's a lot of action going on right now for the last two months of the year, which gets us up to that 190 to 200 that I mentioned in my comments.
Okay, thank you. I'll pass it on.
Thanks, John.
Thanks, John.
Your next question comes from Randal Konik with Jefferies. Your line is open.
Yeah, thanks a lot. I guess a question for Chris. Not to digress, but when you think about another space, like the tech space, where you see Netflix or Amazon, they get bigger. As they get bigger, they keep getting bigger still, and they build this flywheel of momentum, they call it, right?
Yeah.
Your business kind of feels like it's approaching the same or it has approached the same type of flywheel momentum. You partially touched on it with the marketing, how it just keeps feeding upon itself. When you see this kind of build, and we're seeing accelerating comps, we're seeing stores do very well. You touched on the Burlington example. Do you think about, as you gain more market share and you're pushing out these competitors, that you think about changing or moving to a higher target level of density potential in the markets you want to serve? Like for example, New Hampshire is X%, but it's lower in California, for example.
I'm just trying to get a sense of how you think about this flywheel of momentum in the business, whether it be the marketing dollars received from a new member or the success factor of entering a small market like Burlington with a smaller box. How do you think about this as you see it in the tech space today?
It's a great question. I think what we've seen, I think the more clubs we have in a market, it's like the more the tide rises, the more ships rise. I think it's what we're seeing. If you told me we'd have 17 stores in New Hampshire 10 years ago, I'd say you're crazy. Now we're in New Hampshire with 17 stores and one out of every two Health Club members is a member. We have almost 10% of the population's a member in New Hampshire. We realistically can probably open another one or two stores, I think, in New Hampshire. We're still not there. I think, like you said, the more stores we open, the more we can open. Brand awareness is up. The marketing penetration's up. It just goes on and on.
Reciprocity becomes a bigger play. The PF Black Card becomes bigger. It moves many different levers. To the Burlington thing, Vermont, if you think about that, the 20-minute drive, as I mentioned, has only 40,000 people. The town of Burlington itself has only got 2,800 people, believe it or not. It's a neighboring town to Montpelier, which only has 7,000. It's very rural, and that store is in pre-sale and is already over-indexing the average. You're the only club around for miles. To them, it's like Disney World's coming to town, and we've got more hype and more media, free press. It's like the landlord is, "National tenant's coming in and filling my space." It gets everybody excited. That's not even in that 4,000 number that we say our potential is.
It's still a test, and we've got about 20 of these with our franchisees that we're working through. This could open up the doors for a whole another level of opportunity for us. I think I've said in the past, in some ways, we're in uncharted waters. This industry had never really seen. Bally's got to 500 or 600 stores and crumbled. Gold's got to there and now is down to like 600 or 400 in the U.S. 24 Hour Fitness in L.A. have been in that 500, 600 number for many years. We blew through that in 2012, and then here we are now with 1,400. I think it's just we've got the right model, the right business, and the right marketing plan that continues to just drive comps and drive growth.
Maybe it would be helpful because something we always have gotten from the market is the question mark around that 4,000 number. I guess what would be helpful is any kind of thought process on what was considered in that 4,000 number, because you kind of made a mention that the 4,000 doesn't even include something like that you're seeing succeed in this smaller type box. I'm just curious on how you thought about that initially and what a smaller box could provide going forward.
Sure, Randy. We use a company called Buxton, as you know, and we've been using them now for the last, oh, five years or so. We were really kind of a dream client for them, because if you think about us versus a QSR, where you know who's walking in the door, maybe, if there's a loyalty program. We know where every member lives. Therefore, when we were able to give them, back in that day, probably 500 or 600 stores, we could give them a very broad cross-section of America, from urban to rural to east to west, different ethnicities, et cetera. What they were able to do then was to plot those members in and around call it 500-plus stores to see what kind of market penetration we were getting in that day and time on a store-by-store basis.
Based upon those demographics, based upon those store sizes in terms of member counts, we were able then to plot out the rest of the U.S. What I would say today is that there's clearly markets where we over-indexed in terms of a higher market penetration. As you mentioned, Chris was talking about a while ago, where in New Hampshire, we have 10% of the population. In the Northeast, we're about 4.5%-5% of the population. You get out west, it's barely 1.5% or so in terms of market penetration. There's very distinct markets in some of these different regions of the country where we already have 8%, 10%, 12% market penetration in a market.
The way we look at it then is now we can plot the 1,400 stores, we can see where our market penetration is doing very well. Maybe we have a lot more stores there. We've been there longer. We go to other markets, like in L.A., which we haven't been in L.A. for a long time now, as we put more and more stores, we see then those stores continue to perform. To Chris's point earlier, which we believe is driven by the benefits of the Black Card, the value proposition that you get from a $10 membership or the $21.99, the reciprocity, et cetera. We still feel very confident in our ability to hit that 4,000 number.
That's very helpful. My last question is this, the beauty of your model is the simplicity of it. Not to bring up Amazon again, maybe I think, wish I was Jeff Bezos, but they kind of morphed their business into adding AWS, for example. I guess back to Chris, in thinking about Amazon started with this, and a type of business moved into AWS. Do you think about, given that obviously the huge opportunity to grow more and more stores, the margins are high, et cetera, were there any types of things you think about strategically from a tangential perspective, business-wise, that you may want to explore, given the strength of the brand and the industry, et cetera?
I think you're right. Stores, there's definitely a lot of growth there. As far as I think with 10 million members and growing, there's definitely some leverage that we can take advantage of there. I think with some of this technology stuff we're working on, which we'll probably talk about here with the cardio and so on, is what we'll gain from that from a knowledge standpoint, what we learn from what our members are doing and using standpoint. Now we can actually see what their likes and dislikes are. How do we do advertising at that point? What should our partners be? What buttons are they clicking on? Are they clicking on MapMyRun? Are they clicking on Spotify? It all goes on and on and on. The industry never had the opportunity to capture data like that.
All we could ever tell is somebody actually walked through the door. We had no idea what they were doing. I think that will open the opportunities with Craig, our new CDIO, he's guns ablazing all over this, that I think where we see our clubs today and what we're going to gain from a data standpoint and how we can increase the members' experience and better the members' experience, where we are in three years from today or two years from today will be light years ahead from today.
Your next question comes from Dave King with Roth Capital. Your line is open.
Thanks. Good afternoon, guys.
Hi, how you doing?
I guess maybe first sticking with Randy's line of thinking on the flywheel a bit, maybe switching gears also. Have you guys looked at all at the lifetime value of your average customer, how that compares to your acquisition costs? Is there anything you can share about how those metrics have trended over time? As you're touching on that, maybe you can talk about the trending cancellations and churn. Thanks.
Sure, Dave. One of the things that we have the benefit of is the insight with all these members, particularly at a lot of our older stores. The older stores are going to have a longer tenure of members. We talk about attrition, as you guys know, we talk about it in terms of looking at members that have been a member of Planet Fitness over 12 months and what happens after that. That cancellation rate is 1.5%-2.5% or so a month. I think that a lot of the things that we see happening in our clubs today, particularly in markets where we get more market penetration, we look at tenure, we look at the different sections, the different types of our members. 49% of our members are millennials. How do they react?
As Chris talked about earlier, using technology in the future is going to be huge because we want to be able to cater to what they want and what are the things that they want when they come into the club. Are they going to act differently than members did four or five years ago? With some of the technology that we are working on with our equipment partners that we'll be able to roll out, we'll be able to offer them more than they have today. We believe that that will provide some stickiness as well.
Some of the other things we're doing is just in the technology areas around our mobile app, to be able to really enhance that app and to be able, particularly as one example, to have data on what members do and what their accomplishments, to be able to give that back to them as they walk out the front door. Give them a high five so that it encourages them to come back the next time. Those are the kinds of things that we're working on or that we have kind of on the radar to be able to continue to provide that stickiness factor.
Okay. Maybe along those lines on that last piece, where are you in terms of beginning to evaluate or test some of that enhanced equipment? Is that something we could see in the near term? I think in the past, you guys have talked about, or I guess there was a potential to maybe see that drive maybe some equipment installs. How far out is that opportunity?
Sure, Dave. This is Chris. We installed the first club in September in N.J. Between now and January, we have another 14 clubs going in, and it will be five of each of the three manufacturers that will be part of the RFP. As we've talked about, our contract with Life Fitness ends at the end of June. We'll be starting our RFP process, and it's with Matrix, Precor, the three big ones, Matrix, Precor, and Life. All three of those manufacturers will be in with that cardio by January, and we'll start to trend to see how the equipment's used. Now we can actually see how it's used, which is really interesting. As we mentioned, the way that it's working is the Black Card memberships will have a heightened experience. Hopefully that will drive higher Black Card sales in time.
Time will tell, and it's one of those things because it is technology, and the beauty of this cardio is it can be updated overnight through the Wi-Fi. It's not like you bought a treadmill and it's five years old, and you can't get an upgrade. You can do it on the fly. They'll actually compete like 2.0, 3.0 as we learn from what customers are doing, making it better. That's the process of learning as we roll this out and learn from the usability of it. I think it can be pretty interesting what it can do for us in the future.
Okay. That's good color. I guess just one more on the guidance, Dorvin. How much of the increase was related to the Black Card pricing growth? I guess what sort of adoption of the $21.99 does that assume? I think you may have said the number of the stores that are in that, I guess what sort of adoption at those stores, and should we be holding that 60% penetration constant? What's the grandfathering rules? Any color there would be helpful.
Sure. Existing members, they retain their membership. Before we raised the price, our Black Card was $19.99. Those Black Card members continue to pay $19.99. All new Black Card members pay the $21.99. That's how the membership works. As I mentioned in my remarks earlier, with respect to our upward guidance on comps, we think that the $21.99 price impact for Q4 will be in the neighborhood of 70, 75 basis points. That's embedded into the way we put forth our guidance. With respect to the Black Card percentage, we're at 60% at the end of Q3. During our pilot, we saw small to negligible decrease in Black Card percentage. We don't expect that to be huge or to be very similar to the pilot. We'll see now as we go full with all the clubs here in Q4.
That's how we factored it into our Q4 comps, or full year comps rather.
Yeah. Thanks for taking the questions, and good luck with the rest of the year.
Thank you.
Your next question comes from John Heinbockel with Guggenheim. Your line is open.
Based on your sense of your franchisees uptake, right of the swap, right, between the royalty rate and commission income, could the royalty rate be well above 5% next year or no?
Yeah. John, we're not going to talk about guidance for next year yet. We'll do that when we release our year-end results. I would say that obviously the clubs that have amended, you'll see a higher royalty rate.
Right.
We don't know yet how many of all of those will adopt by the end of the year so that we get a full year impact of that next year. Again, as I mentioned, it's all set by commissions. We expect a lot of them will. Keep in mind, John, as you know, we still have a number of stores out there that are significantly under the 5%. When you add the 1.59, you may still not be at 5%.
Okay. When you look at how much you're spending on marketing, how close are we to or do we ever get to a point where you can relax the local spending requirement, maybe as an offset to that is raising the royalty rate further. Is that something that could be done and is that something that could be done sooner rather than later or no?
Yeah, I'd say probably later rather than sooner. I think there's still so much more we need to penetrate these markets and really what is the true capacity of the clubs as far as is it 7,000 members or is it 9,000 members? I don't think we really know till we get there. I think it's when we realize we're not selling any more member growth and we're not keep spending more dollars that we realize that we're maybe at that tipping point, which I think is quite a ways off before that happens. As far as the royalty rate question, I think there's probably more can we raise it? I think it's if we continue to drive comps in a few years, we keep driving comps well, the clubs make more money and they're more profitable, I think then we can probably share in that down the road.
I think for now, we're probably in a good spot. I think, the fact that the franchisees keep putting the money in to build more stores, they're not just taking it home, they're putting it to work for us, we kind of win on the other end anyway.
Lastly, you think about this RFP versus prior ones, and in the commentary on technology, do we see a quantum leap in what's available out there? If there is a significant leap forward, would you see or could you see franchisees replacing equipment before they're required to, or they would still probably wait until that's up?
I believe if we can prove that it enhances customer experience and even more so increases Black Card percentage, that will be the true tailwind that will get people to get excited about doing it early. If we can start getting that to happen, that's a no-brainer really.
Okay. Thank you.
Thanks, John.
Thanks, John.
Your next question comes from John Ivankoe with JPMorgan. Your line is open.
Thank you. A couple of questions, if I may. Firstly, in terms of the grandfathering in of the change in the Black Card fee, is that you grandfathered in until the end of their term? Is it multiple years? What exactly do you mean by grandfathering, and when do you expect all Black Card members to be on $21.99?
Yeah. There'll be a point even in three, four, five, 10 years that not everybody will be at $21.99 because they are, John, truly grandfathered in. Whereas as long as they don't cancel their membership, they don't lose that rate. If they cancel and come back, then you lose it, which time will tell. I think to that point I just mentioned is that we could see some benefit of some stickiness from them realizing that if they cancel this membership, even if they're not using it for a few months, that you don't ever get this rate back. We could get some help from that down the road and that end of it, too.
Yeah. It's definitely an opportunity to communicate, for sure. I think most people-
Yeah
wouldn't assume that forever means forever. Okay, now, I certainly haven't sensed that the franchise community was struggling for profitability. In fact, just the opposite. Yet, this is a nice shot in the arm for profitability at the franchise level. Is there anything that they're giving in order to get this? Whether it is, to the previous question, more marketing dollars or equipment or higher store growth? In other words, also referencing a previous question, what do they put back in the flywheel to basically give back some of the benefit that they're receiving?
Yeah. I think it goes back to the extra $2, the extra said 9% marketing between LAF and NAF. I think between the marketing funds, that does drive more marketing they're putting back in. I think, as I mentioned to John Heinbockel, I think the fact that they keep putting more money back into the building more stores and hopefully with this extra shot in the arm, and you're right, the clubs are already really profitable. Now it's even more so that they continue to open more stores and keep them excited about the brand. As long as they're excited, and as I mentioned in the past, I feel like I have two sets of customers. One is our franchisees and one of our members, and if we can keep our franchisees super happy, they'll keep our members even happier.
I think we keep them excited for the brand and continue to grow.
That's great, Chris. It certainly seems that there's a lot of things that are lining up right now for a meaningful step up, whether it's in 2018, 2019, or 2020 in terms of that 200 new clubs a year. What are you currently thinking about in the pipeline, and is this kind of what we've been waiting for in order for the penetration of the brand to expand even faster than it already has?
Yeah. I'll go over and add to it, but I think they're excited, and I think retail, as we continue to see on TV, it's every day there's another group of chain of stores closing, stores are downsizing, and we're right in the perfect wheelhouse for them. All the reason landlords want us and with the model, the comps the way they are and with this new $21.99 and what that's going to do for stores, the system's excited. There's no way else to put it besides that. People are ready to rock and roll.
Yeah, I'd add to John that we're very excited to have Rob Sopkin on board as well. Obviously, he comes from big brand, lots of locations, understanding retail, understanding what drives retail, and one of the things that we have ahead of us here is over the next four or five years, we're going to have a lot of locations that are going to come up for lease renewals. If you go back five, six, seven years ago, we were competing for main and main with a lot of the names that are maybe not even in business anymore, but we weren't always getting main and main.
We've had examples just here in the last 12, 18 months where a franchisee, their lease came up, they relocated, in a couple cases in the same shopping center, but they went from an elbow to an out parcel, et cetera, or an end cap, and significant increase in revenue by just getting better visibility, being in a better site. One of our mantras from our real estate perspective is not only to find a couple hundred stores a year of brand-new sites, but we've got to continue to upgrade, if you will, some of the locations of our existing stores. I think that's another opportunity for us in some of these markets to be better front and center and to be able to drive more members per store by better real estate locations.
I promise, last one. Relocation's typically slow development. Ground-up's typically slow development. It seems like, on the other hand, you have a lot of opportunity to accelerate development. Obviously, this is a really important question, and I understand if you don't want to guide specifically, but as we think about the next couple of years, should we expect net adds similar to 2017, or do you think we can start to take you up to some extent?
No, I'm going to defer back to the same kind of guidance I've given in the past. We did this at the IPO, as you'll remember. We said we thought we could do 200 stores a year. We thought that made sense. You've probably heard us use the term, we call it thoughtful growth. We still reject sites today, John. In our real estate committee, there'll be sites proposed by either our franchisees or their broker network that comes into our headquarters here because we approve every real estate location, and we still reject some. We'll do it for a number of reasons, but some is wait till the better site comes along, given the momentum we think we have in real estate world.
I think as of now, and we'll give guidance next year, early in the year for full year 2018, but I still think kind of that 200 stores a year or so is a good number to think about.
Thank you so much.
Thanks, John.
Thanks, John.
Your next question comes from James Hardiman with Wedbush Securities. Your line is open.
Hi, good afternoon. Thanks for taking my call. A quick clarification. You talked a little bit about some of the new technology pilots, I guess we could call it, with Matrix, Precor, and Life. You kind of talked about that hand-in-hand with the notion that you're looking to re-up your equipment contract come June. The new technology, is that what's going to largely drive how you think about your supplier agreement as we look to June, or are those sort of two separate events?
June's happening regardless, but the pilot program with the technology is probably going to be the biggest part of the deciding factor. Price is important, but functionality is probably more so. If the customer experience is better and you can get more Black Card sales from it, that's most important. If you can do that, then you might get some retention and stickiness and then drive higher Black Card percentages. I think that's going to be more the deciding factor. That's why the pilot's truly important to, once again, be able to capture the data where we'll know what members are doing and what they're experiencing. How do we tee up more of what they like and get rid of what they don't like and update the content real-time.
Then give Black Card members more experience, a better experience, so that the White Card members, instead of having a typical treadmill experience, opt up to upgrade. We actually have it designed, believe it or not, that you can literally upgrade your membership on the piece of cardio. You can be on the treadmill, see the person next to you running through the Grand Canyon, you say, "I want to do that. I don't want to just run on a track." You press upgrade, and you're running on the Grand Canyon, and you're upgraded to the new Black Card membership. It's a truly dynamic technology stuff that we're working on. It's going to be really cool for us, for the program, for the business.
Wow, that's really helpful. Then, you've talked in the past about sort of the algorithm, how we should think about same-store sales contributions from clubs of various ages. Clearly, some if not all of your clubs are outperforming those expectations. Should we think that some of the stores that are 1 to 2 years old are ramping more quickly, or is it more that your mature stores are continuing to bring in more and more members and maybe the ceiling on member potential for a given club is just greater than it was in the past?
I think it's probably a bit more of the more mature clubs, as opposed to a brand-new store kind of ramping at a much faster rate than it did 2 or 3 years ago. We believe, and Chris and I have talked about this a lot over the last couple of years or so, that the franchisees' willingness to invest in re-equipping their clubs, having fresh, new equipment in, some of the remodels and renovations are taking place, building nice Black Card Spa areas. Those are the kinds of things that we believe are contributing to the fact that more and more of our mature stores are probably outperforming kind of the guidance metrics that I've talked about in the past. I've said older stores, call it 4 years, 5 years or older, are probably very low single-digit comps, 1%-3% or so.
We've seen certainly, let's just say this year, we've seen those stores performing a bit better than that. I think it's a combination, a lot of it, but I think it literally has to do with the marketing dollars, more of it, more penetration in existing markets, more value of the Black Card, hence the Black Card continues to increase, albeit slightly, but continues to increase, and then a better member experience that's driving more members per store. I think that, in essence, is what's driving the model.
I think the only other thing I'd add, James, is that we've talked about that where 90% of our openings every year are by the existing franchisees. One franchise group might have 20 stores in a market, so they have great brand-new shiny stores, and they have their original legacy stores that they see how great the new ones go and how the new finishes, the new equipment looks. Even though we can require, they're doing it on their own. They want their portfolio of stores. It's not a one-two, two-tier system. They want their portfolio of stores to all look the same. They're really into keeping their clubs looking fresh.
Really helpful. Then last one from me, sort of a state-of-the-industry question. Obviously, your focus has been on doing what you do well. I think you've had so much success that there's almost always a response or an attempted response by some of your competitors. I think the way you've laid out the industry is that specialty clubs are doing well. You guys are consolidating the value segment, and the traditional clubs are getting squeezed. I guess, two questions here. Are you seeing a response from other players in the value segment gain traction whatsoever? How would you characterize that? Do you think the traditional clubs are ever going to figure this out? What's their response going to be? Do you think they'll ever turn it around?
I don't think anything's really changed since the last couple of calls. I think there's been somewhat of more of, I'd say, a slower slowdown in the low-cost growth compared to how it was like two, three years ago, when every single person you talked to was opening up a $10 club. I think the beauty of it is the ones that open $10 clubs, they're opening a $10 a month Gold's Gym or LA Fitness type style club, so they're not really going after our culture and our judgment-free zone and our first-time gym user type atmosphere. I think if anything, they're probably making the LA Fitnesses and 24 Hour Fitnesses world's tough because they're offering Group X and spinning classes and everything else at $15 or $25 a month, like a Crunch or something.
I haven't seen anything really change other than what's been happening.
How about on the traditional side? You don't see any meaningful change to those guys?
Yeah, like the L.A. Fitnesses and the 24 Hours and so on. I haven't seen. They've probably, if anything, slowed growth as well, in the recent probably 18, 24 months compared to three, four years ago.
Great. Thanks, guys.
Thank you.
Your next question comes from Oliver Chen with Cowen and Company. Your line is open.
Hi, Chris and Dorvin. Thanks. I was curious about your thoughts around partnerships on the longer term, as you think about partnerships across healthcare or food or technology companies in health and wellness, and what might make sense for your business as you think about alliances, as we see so much happening across different aspects of this. Chris, the digital technology, maybe you could contextualize, it's been really helpful, what might be more actionable within your business model and what might be more just nice to know about, but not really practical in terms of how you balance what's appropriate for your brand, and you maintain the right level of focus, which is aligned with the core competency of what you do best. Thanks.
Yeah. I think with groups that partner with, I think while the technology might be interesting with what users are doing on the cardio and what kind of results or distances they're going and who's who, to be able to now have that data to show to insurance companies might be a partnership. Right now, we've been reimbursing our insurance companies, name UnitedHealthcare, Blue Cross Blue Shield goes down the list, but all we can ever tell them is if the person walks through the door, we have no idea what they did. It'll be interesting what this data captures. Do we have more opportunity to sell it or tell the story to either insurance companies or big corporations of what their subscribers or employees are doing and gaining benefits? That might be some sort of partnership.
With 10 million members, as I say, I think there's ways maybe to leverage the brand. I don't know whether it's weight loss apps or some other type of connection that we can even have or maybe a Black Card Plus that gives them an opportunity to learn nutrition or something like that as a partnership. I think that's probably the partnership stuff. I don't think Dorvin has anything that he can add to that. As far as the technology piece, how we can conceptualize that, I think when you think about technology and you think about wearables and fitness apps, I think what's interesting is they all track, and wearables track everything. Nothing really recommends what you do next. Very few people can capture this data and know what to do with it.
I think it's going to be, especially for our members, 43%, as I've said in the past, are first-time gym users. They just need to be told what to do. They don't even know where to start, let alone what the data's telling them to do. I think to be able to capture the data, create algorithms to then serve up, "Your next workout should be this," and help them start their fitness journey and bring them through the fitness journey for years if we can. We've never really had the opportunity to do that before, unless you had one personal trainer for every member you had, and have it for free because they're not going to pay for it. I think as you get down the road of how you learn, we don't know what people really like on cardio. Do they just press start?
Do they like to hill climb? Do they like just watch TV and that's it? What programs do they like to watch? The Black Card members will be able to walk through the Grand Canyon or walk through Paris, walk through the Charles River in Boston. If that's what they like, let's give them more experiences like that so it keeps them engaged. It keeps them curious about their next workout. Otherwise, every day you come to the gym, it's the exact same thing, day in, day out. It gets boring, right? How can we enhance that experience and get them curious about wanting to walk into the gym the next day?
It sounds like you're hitting on all cylinders, really, across the awareness and the numbers you're seeing. What would you say, candidly, are things you're more concerned about or just things you're monitoring or uncontrollable factors as we just assess risk and reward? Obviously, we're in a very good period with the numbers we're seeing. Thanks.
Dorvin, you can add to that. I think real estate's in perfect timing for us. That's good. I don't see interest rates going too crazy that slow growth down, and right now with our franchisees, because 90% of the growth is by the existing franchisees, and they got a portfolio of 20, 30 stores. A lot of them are just paying cash for the equipment build-out. It's not like that would really necessarily be a big slowdown either for us. The big thing is to stay disciplined and keep executing, and look at what opportunities we have to understanding our customers better. I think the data we capture today and will be capturing in the future. We didn't even really have data to really look at with the team we have here at the office today.
We never really had this depth five years ago or three years ago. I think every decision we've made in the last, probably, 24 months has been so data-driven, and I think the results are, as we've seen, the results are showing it. We'll be able to look through the business through a much more refined lens and make much sharper decisions, which is really driving this machine.
Just lastly, a modeling question. Dorvin, on the equipment line, what are the longer-term parameters from which we should model that? Do you expect it to stay within a similar margin range? Are there any things we should know looking ahead on a multi-year basis? Will it be lumpy, or will it be pretty smooth?
I think obviously, as you know, our current contract expires next June, our margins will be clearly flat between now and then from a margin perspective. I think we've guided or given data that we expect this year our replacement equipment as a percentage of total equipment to kind of be in the 30%-37% range. That's higher than last year. I think we were 28, 29 last year or thereabouts. More and more stores over the next two or three years will be coming up for their replacement cycle. If we keep our new flat, you're going to continue to see that replacement, I think, increase as a percentage. It just by nature tends to be lumpy, given that, one, we don't want stores replacing equipment and call it November, December, January, February, March kind of time period. Albeit some do.
It tends to be fairly lumpy. More than half usually is in Q2 and Q3, more of a down time period in terms of the usage in the club, etc. I guess as I sat back and think about maybe a little bit longer term, I still say, as I said, I think it was to John Ivankoe earlier, a couple of 100 stores a year, I think makes sense from a new openings perspective. I think replacement will probably grow a bit, as I mentioned a minute ago. The big unknown, which Chris talked about a little bit earlier, would be as we negotiate under RFP for the next contract, it'll all be about what technology is included in the equipment that we end up with, which brand we end up with, and is that still come with a price reduction?
Is it offset by technology? Etc. We're nowhere close to having that conversation yet, I think that'll be the factor that ultimately determines what that margin rate is on a go-forward basis.
Okay. That's super helpful. Thanks. Really excited about the digital innovation and congrats on a great quarter.
Great. Thanks, Oliver.
Your next question comes from George Kelly with Imperial Capital. Your line is open.
Hi, guys. A couple of questions for you. Just to start, one more on the machine technology enhancements. You mentioned different settings, walking through the Grand Canyon in different cities. Are there any other major enhancements that you're excited about that could boost Black Card penetration? What else is exciting?
There's a lot of different things on there. There's going to be, you access your own Spotify account, your own Netflix account. It remembers you, so the next time you swipe to get in, it remembers all your logins for you, so you don't have to re-log in every time you want to watch it. You can finish up the show that you watched last night at home and watch it on the treadmill, finish it up. The beauty of it, though, is, George, we learn from that, right? If you like Spotify, well, maybe put Pandora, maybe put the iHeartRadio. You just kind of can follow people of what they're doing. It might get to the point where you're actually learning people where each person's experience is independently different from each other.
I think as we get smarter on what people are doing, it's going to evolve the product, which is going to be really interesting, as opposed to just having a treadmill that sits there and does the same thing for 5 years.
Sure. Makes sense. Second question on pricing. When you were doing the test about the new Black Card pricing, what gave you comfort that you could make that mandatory across the club base? What'd you see?
Sure. Yeah. Reciprocity is by far the number one biggest used perk, if you will, of the Black Card. 50% of our Black Card members in 2016 took advantage of that perk and used the clubs at least once, other clubs than their home club. 20% of every Black Card workout last year was not at their home club, was at a different club. As we started with Black Card, we had 20 stores. Now we got over 1,400, so that perk is a well-utilized perk and is tons of value for $2. For $2, you've got access to 1,380 more stores, so it's a great perk. Guest privileges is a huge perk, where you can bring a guest for free. Inside our stores, we used to just have a couple of tanning beds in the corner and that was about it.
Now we have, we call it Black Card Spa, which is a little bit like the private Delta room in the airport. There's a little lounge area. We have our tanning, the massage beds, the massage chairs. You have a TV to wait for your session. It's a little bit of an exclusive feel when you get in there. The value has just increased greatly from when we came up with the $19.99 price. The $21.99 for $2 is such a great value. It's still a no-brainer compared to the 10. It's actually a better value than the 10, I think.
Okay. When you were doing the test, though, it sounds like there weren't any kind of major changes. Did you see any kind of difference in Black Card adoption?
Yeah, with the clubs, we did the test in almost 100 stores, it was like zero. Some clubs had none. All the way up to maybe 2%, 3% max.
Okay. That's an easy choice. Thank you.
Yeah.
You're welcome.
Thank you.
Your last question comes from Amanda Adami with Macquarie. Your line is open.
Hi. Thank you for taking the question. Most of mine have been answered. I just wanted to make sure that I understood in terms of the shift from the new store openings that were scheduled in Q3 that shifted into Q4. I wanted to know if any of the scheduled openings in 2017 have been pushed into 2018, and if so, if any of these were an impact of the hurricanes.
No stores impacted by the hurricane in terms of our openings. We guided, if you go back to our last quarter, we guided to 190 to 200, so we're still at 190 to 200. Small shift and just timing of a handful, small two or three clubs that could have shifted from Q3 into Q4. As I've said before on the calls, that you get down to the last couple of weeks of trying to open a club and you run into, or you can run into a number of issues to get your certificate of occupancy to get moved in. It can literally be the inspector's out of town for a couple of days to, they come in and make you do additional work to get a store open. We're not concerned with anything that moved out of Q3 into Q4. We're still very comfortable.
As I said, we expect to be at the high end of that range of 190 to 200.
Okay, great. Thank you so much.
Thank you.
This concludes today's Q&A session. I would like to turn the call back to Chris Rondeau.
Thank you. I'm excited. Thanks for joining us. I'm excited to be able to show such a great Q3 and look forward to wrapping up Q4 here, and speaking to you all early part of next year. As you can see, the momentum we've gathered, we're definitely capturing from this marketing and the opening of new stores and each new member fueling this flywheel, if you will. I think you can see with the horsepower that this company is capturing from this market penetration as well as brand awareness. It's exciting to see that the business is where it is, and I think look forward to the future for sure. Thanks for joining us, and have a great night.
This concludes today's conference call.