Description

Michael Price coined one of our favorite metaphors for value investing: buy the “steak” cheap and get the “sizzle” for free.  We believe Life Time Fitness’s (“Life Time” or the “Company”) publicly-traded equity (“LTM”) offers just such an opportunity.  At LTM’s current market price, one can buy Life Time’s existing centers at a cheap price and get the Company’s substantial and valuable growth opportunity for free.  Thought of another way, we estimate LTM is worth at least $57 per share using conservative assumptions for growth.  It could be worth much more depending on the pace and return profile of new center expansion.  This appraisal implies that LTM is currently trading at a discount to intrinsic value of at least 40%, which provides a meaningful margin of safety to protect us against the risk of adverse developments.

GAAP Accounting Versus Economic Reality

Many within the investment community take it for granted that GAAP accounting rules accurately present the economics of a business.  While GAAP accounting standards provide a reasonable approximation of the economics of a business in most cases, there are exceptions.  These exceptional situations, where GAAP accounting obscures the true economics of a business, can sometimes result in materially mispriced securities.  We believe Life Time Fitness qualifies as one of these exceptional situations.

More specifically, we believe the depreciation expense Life Time recognizes according to GAAP accounting standards materially overstates maintenance capital expenditure requirements.  As a result, GAAP net income materially understates maintenance free cash flow, the cash flow the Company generates from its existing centers prior to investments in new centers.  Since a large portion of the investment community values Life Time primarily based on GAAP EPS, this accounting misunderstanding is contributing to the material mispricing of Life Time's publicly-traded shares.

Maintenance capital expenditures are a sensitive subject in the health club business.  There is no more certain way to send a health club into a death spiral than to starve it of capital.  A poorly maintained health club will lose members, which will quickly restrict the financial ability to reinvest in the club, which will accelerate member losses, and so on until the club is out of business.  As a result, we recognize that we bear a large burden of proof when we argue that Life Time's required maintenance capital expenditures are significantly below the rate of depreciation expense.  We believe we have a solid case.

As a starting point, the Company's stated and historical maintenance capital expenditures are well below the historical amount of depreciation expense.  Maintenance capital expenditures for a given health club are lumpy.  Generally, a relatively small amount of capital is required each year for things like new equipment with a larger amount required every five to seven years for more significant renovations.  On a straight-line basis, Life Time believes its annual center-level maintenance capital expenditure requirement is $3.50 - $3.75 per square foot with another $10 million or so for corporate-level maintenance capital expenditures.  That translates into an annual total maintenance capital expenditure requirement of $40 million to $45 million ($30 million to $35 million club-level + $10 million corporate-level) based on the Company's square footage at March 31, 2011.  In contrast, the annual run rate for depreciation and amortization (intangible asset amortization is insignificant) during the first quarter of 2011 was $95 million.  This rate of maintenance capital expenditures and the discrepancy between maintenance capital expenditures and depreciation and amortization are consistent with the Company's actual historical experience for as far back as we have data.

Exhibit 2: Historical Depreciation Versus Maintenance Capital Expenditures

Note: 2007 and 2008 maintenance capex & centralized infrastructure consists of actual reported center-level maintenance capex plus an estimated $10 million for centralized infrastructure.  Life Time included centralized infrastructure within another line item during those two years, so those two figures are not precise.

This begs the question: Why should Life Time's maintenance capital expenditure requirements be so much lower than depreciation?  We see three primary reasons.

Reason #1: Owned Real Estate

Life Time owns a significant portion of its real estate.  Depreciation expense related to real estate frequently presents an inaccurate picture of the economics of real estate ownership.  Take a walk around Manhattan, or better yet, Europe.  Buildings last much longer than their 40 year depreciable lives according to GAAP, generally appreciate in value over time, and do not require annual maintenance capital expenditures anywhere near the level depreciation according to GAAP would suggest.  This is why an investor analyzing a REIT would most likely prefer to value the REIT based on Funds From Operations (FFO), which adds real estate-related depreciation back to GAAP net income among other adjustments, rather than on GAAP net income.  According to the National Association of Real Estate Investment Trusts (NAREIT):

Exhibit 3: Simon Property Group Depreciation Versus Capital Expenditures

Simon Property's total capital expenditures were below the amount of depreciation and amortization in each of the past three years, and excluding growth-related capital expenditures, were probably 20% or less of the amount of depreciation.

As for Life Time, we estimate at least $30 million of its depreciation is related to its owned real estate.  The fact that this portion of Life Time's depreciation is not representative of maintenance capital expenditure requirements goes a long way towards reconciling the roughly $50 million difference between management's stated maintenance capital expenditure requirement and the depreciation run-rate.

Exhibit 4: Estimated Depreciation by Property & Equipment Category

Having a framework for understanding why Life Time's maintenance capital expenditure requirements could be materially below the rate of GAAP depreciation is important, but the really critical question is: Are these centers being appropriately maintained?  We believe the answer is a resounding "yes."

The most compelling pieces of evidence supporting this assertion are what the members have to say about the clubs.  To find out what Life Time's members are saying about its clubs, we went to yelp.com.  Obviously, as a growing company, Life Time has a relatively young fleet of centers, so we focused on reviews of some of the Company's oldest current format centers, those in the Detroit and Chicago markets.  These centers are generally around ten years old, so they should be through almost two full capital reinvestment cycles.

The verdict from the yelp reviews is clear.  While one can find a complaint about equipment or cleanliness here and there, the overall impression of the state of Life Time's oldest current format centers is very positive.  What struck us most was the fact that a significant number of negative reviewers actually praised the quality and condition of the given center's facilities and equipment while complaining about some other aspect of the club (e.g. pricing, parking, crowded at times, billing policies, etc.).  In most cases, these negative reviewers were clearly dissatisfied with some aspect of their experience and so had every incentive to disparage the center, yet they would commonly make a point to praise the quality of the facilities and equipment.  Here are a few examples of the positive comments negative reviewers on yelp have made about Life Time's oldest centers: 

Schaumburg, IL (Opened October 2000)

• 04/11/11 - 2/5 Stars - "... I was a member here for about a year and the facilities, equipment, and classes are all top notch. They have two of every machine for every muscle in your body, a nice pool, and great locker rooms..."
• 04/16/09 - 2/5 Stars - "...Lifetime is a BEAUTIFUL facility with all the top of the line amenities, best thing about it is that it is 24 hours. I only gave them 2 stars because of the overall experience. Yes, they have great equipment, nice facilities like the locker room, pool, hot tub...."

Troy, MI (Opened January 1999)

• 10/27/10 - 2/5 Stars - "Been a member for about 10 years, on and off. For all of my gripes, it really is one of the nicest facilities out there. More things than you could possibly want to do at gym, but you're paying for them, it's not cheap...."

Bloomingdale, IL (Opened February 2001)

• 09/15/10 - 2/5 Stars - "I just cancelled my membership to Lifetime after being a member for 4 years. The place is always clean and they have pretty much everything I could ask for for me to get a good workout in. On the other hand, the price of membership is insane...."

Importantly, Life Time's stated maintenance capital expenditure requirement is based on its long-term experience with these older clubs.  It is not the case that the Company's stated $3.50 - $3.75 per square foot center-level maintenance capital expenditure requirement is temporarily low because its center fleet as a whole is relatively young.  After reading all of the yelp.com reviews, including the negative ones, of many of Life Time's oldest centers, we are confident that the Company is appropriately maintaining its facilities.

We also discussed Life Time's maintenance capital expenditures with a variety of industry executives as part of our due diligence, and all of them felt Life Time appropriately maintains its facilities.

It is also worth noting that the only other only other publicly-traded health club operator in the U.S., Town Sports International Holdings, Inc., has a stated maintenance capital expenditure requirement that is also substantially below its rate of depreciation.

Cash Flow Well Below Potential

Life Time's existing centers are operating well below normalized membership occupancy levels, which represents a large growth opportunity as centers approach capacity.  Each additional membership has minimal variable costs associated with it so the operating leverage in Life Time's business is significant.  We do not believe this cash flow potential of existing centers is fully appreciated by the investment community.

Life Time's centers are collectively operating at less than 80% of capacity compared to the 90% to 95% normalized range that is typical for centers that have been open for at least 36 months ("mature" centers).  The Company's centers are operating below normalized occupancy levels for two reasons.  First, Life Time has 20 centers representing 23% of total square footage that have been open for fewer than 36 months ("non-mature" centers) and are still in the process of ramping up their membership levels.  This group of non-mature centers is operating at just 65.3% of capacity.  Second, Life Time's mature centers, which have historically operated within the normalized occupancy range, were negatively impacted by - and are still recovering from - the effects of the Great Recession.  These centers are currently operating at occupancy levels in the "mid to low 80%" range, according to management. 

We estimate that revenue and EBITDA will be at least 14% and 29% higher, respectively, than 2010's level when existing centers reach normalized occupancy levels.  In Exhibit 5, we layer this growth on top of 2010's results.

Exhibit 5: Life Time Fitness Existing Centers at Normalized Occupancy

These estimated normalized results are consistent with management's disclosure that mature large format centers had 37% EBITDAR margins in 2010 (including corporate overhead).  It should be emphasized that 37% EBITDAR margins were achieved at these centers last year, despite operating well below normalized occupancy.  As a result, we belive our estimates - which are for normalized occupancy - are likely conservative.  Please see Appendix A for our detailed calculations.

The next natural question is: how long will it take for Life Time's centers to reach normalized occupancy?  First, we expect non-mature centers to reach maturity within the next two years, on average, based on the three-year maturity schedule.  We think this maturity process is fairly reliable and somewhat less economically sensitive than most consumer facing growth initiatives.  Second, we expect mature centers to recover within a similar time frame due to management's success at reducing membership attrition to near pre-recession levels - which has occurred despite a generally weak macroeconomic environment and still high unemployment.  Current attrition rates are at a level that is allowing net membership gains at mature centers, thus allowing occupancy levels to rise towards capacity.  Third, management's current guidance for 2011 revenue is $980-$995 million with $1 billion as a "stretch goal."  While guidance includes some revenue from new centers, we believe our existing center normalized results are within striking distance and therefore achievable in 2012.

Business Quality

Most health clubs are not great businesses for a variety of reasons.  First, the health club business has low barriers to entry.  Opening a moderately sized health club does not require a significant amount of capital, and landlords and fitness equipment companies are generally willing to provide financing for build-out costs and equipment purchases, respectively.  Second, it is difficult to establish and maintain differentiation in the health club business.  Most health clubs offer essentially the same fitness equipment and classes, and there is little to prevent competitors from copying most innovations.  Finally, the economies of scale in the health club business are limited.  The economies of scale that accrue to many product-driven retailers, such as leverage on advertising, technology investments, procurement, distribution, and field management, either do not existing for - or deliver weaker benefits to - health club operators.

The quality of Life Time's business stands out from that of traditional health clubs as a result of Life Time's unique and difficult to replicate model.  Life Time's centers are much larger than a typical health club, offer far broader range of amenities and services, and offer an attractive value proposition considering the offering.  These points of differentiation give Life Time a distinct advantage vis-à-vis traditional health clubs in attracting certain important member segments.

The most important of these segments is the family segment, a large, desirable and under-served segment of the market.  By offering a wide range of amenities and services, Life Time is able to offer something for every member of the family, whether it is an outdoor swimming pool for the kids, child care services for a toddler, yoga classes or a massage for Mom, or free weights or the adult basketball league for Dad.  In contrast, a traditional health club that is essentially a room filled with equipment simply cannot appeal to the diverse interests and needs of an entire family.  This advantage is meaningful.  If the entire family cannot participate in an activity, it is much more difficult for any member of the family to participate in that activity for a variety of reasons (e.g. car logistics, spending an adequate amount of time together, etc.).  The importance of this advantage to Life Time's model is evident in Life Time's membership statistics.  Life Time's current model centers average 2.1 members per membership.  In other words, a very significant portion of Life Time's memberships are family memberships.  This is simply not the case at most gyms.

Life Time also has an advantage attracting other member segments, such as members who actively use the amenities Life Time offers (e.g. recreational basketball players, swimmers, rock climbers, triathletes, etc.) and members who live in the suburbs, but want a high-end health club experience.  In our view, the family segment is by far the most important segment to Life Time's model though.

However, a competitive advantage, like Life Time's strong appeal to certain large customer segments, is only really compelling if it is durable.  We believe Life Time's competitive advantage is durable, because its unique model would be difficult to replicate for two primary reasons.

First, Life Time's centers require a huge amount of capital to build.  Its current model centers require an investment of $27 million to $45 million.  In contrast, a typical health club might see a large portion of its membership base threatened if a no-frills, 3,000 sq. ft. health club opened across the street - at a cost of less than $100,000.  The barrier posed by the sheer amount of capital needed to open a Life Time-type center is further increased by the fact that financing a multi-amenity center, a decidedly single-purpose piece of real estate, is much more difficult than financing a multi-use, generic retail box.  It is also worth noting that Life Time owns its own construction subsidiary, FCA Construction, for construction management, architecture and design services and millwork fabrication related to each of its centers.  A competitor attempting to replicate Life Time's model would have to start from scratch and would likely initially incur much higher costs than Life Time does to build comparable centers.  Simply put, there are very few companies that have the financial wherewithal to build centers that could effectively compete with Life Time for its core customer segments.

Second, operating Life Time's centers requires a diverse set of skills that took Life Time almost two decades to refine and that few traditional health club operators fully possess.  Life Time's centers are not just rooms filled with equipment.  Life Time's centers are in the food service business through their LifeCafes, they are in the spa business through LifeSpa, they are in the child care business through their child center services, and they are also open 24 hours a day, seven days a week.  All of these services, the types of members they attract, local demographics, membership usage behavior, price elasticity data, and other variables make Life Time a tremendously data driven company.  Management's experience studying the data and all the different variables over a long period of time represents significant institutionalized knowledge that would be difficult to replicate.  A traditional health club operator would likely struggle to effectively operate a Life Time-like center - at least for a period of time.    This operational barrier, when combined with the large financial commitment required to open a Life Time-like center, results in an attractive moat for Life Time's business.

Industry executives with whom we spoke were not aware of any company seriously attempting to replicate Life Time's model, and primarily cited the two aforementioned factors.  One industry executive even compared Life Time's entrance into a new market - and its effect on existing health club operators - to the impact a new Home Depot might have on small, independent hardware stores.  Based on our conversations, we are confident in the durability of Life Time's market position.

In addition to the benefits from having a unique, relevant model that is difficult to replicate, Life Time does realize some benefits from its scale that further enhance its market position, including:

• Leverage on corporate overhead and technology investments
• Ability to offer access to multiple locations, some of which may have incremental amenities
• Ability to "seed" new centers with members from nearby centers operating above capacity
• Advantage in attracting talent

While Life Time is not a business so good "an idiot could run it," as Warren Buffett might say, we believe it is a much higher quality business than a traditional health club and a good business overall.

Management & Corporate Governance

Life Time has a solid management team, good corporate governance and a strong alignment of interests been insiders and minority shareholders.

Life Time is led by the Company's founder, CEO and Chairman, Bahram Akradi.  Mr. Akradi is an impressive person who epitomizes the "American Dream".  He emigrated to the U.S. from Tehran in 1978 at the age of 17 and worked to support himself and pay his way through college.  In 1982, Mr. Akradi took a job at a health club and worked his way up from cleaning the club to managing it.  He was then tapped to move to Minneapolis and open a new fitness center, which quickly proved to be a success.  Within a month of moving to Minneapolis, Mr. Akradi was made a partner in the company.  By 1985, Mr. Akradi had grown the concept to five locations with two other deals in the works, at which point the company changed its name to U.S. Swim and Fitness Clubs.  The chain was so successful that Bally Total Fitness ("Bally") ultimately acquired it.  Mr. Akradi joined Bally under a five year contract, but left Bally after three years to start his own business.  After his non-compete with respect to the Minnesota market expired in 1992, Mr. Akradi put all of his personal assets into opening up a 27,000 sq. ft. club in Brooklyn Park, MN, the first Life Time Fitness club.  Since then, Mr. Akradi has grown the Company to 92 centers, creating a company with almost $1 billion in revenue from scratch.

It is clear that Mr. Akradi is an incredibly driven person and is extremely passionate about fitness, nutrition, and his creation, Life Time Fitness.  We have heard that he works seven days a week and still teaches spin classes at Life Time Fitness clubs once or twice a week.  He is well-respected by his peers in the industry and is particularly known as being a strong, hands-on, operator.  Based on all of these factors, we have a high degree of confidence in Mr. Akradi's leadership of Life Time Fitness.

Life Time also has a good corporate governance structure.  All of the members of Life Time's Board of Directors qualify as independent directors, except for Mr. Akradi.  They all also have impressive and relevant experience and stand for election each year.  Additionally, in recent years the Company has favored using performance-based vesting restricted stock over time-based vesting incentive stock options for the long-term incentive portion of its executive compensation.  In fact, the Company has not issued any option awards since 2007.  We believe performance-based vesting restricted stock does a better job than time-based vesting incentive stock options of aligning the interests of management with those of shareholders.

Life Time's directors and executive officers are also significant shareholders themselves, collectively owning 7.7% of the Company's outstanding equity.  Mr. Akradi alone owns 2.3 million shares of Life Time Fitness worth just under $80 million.  The opportunity for Mr. Akradi to increase his personal wealth through his ownership stake by increasing the value of Life Time Fitness dwarfs his annual non-equity-based annual compensation of about $2 million.  The other top four executives of the Company each own at least $5 million in stock.  This significant insider ownership further ensures that management and the Board of Directors will run the Company in an owner-oriented manner.

Valuation

We use three approaches to value Life Time Fitness: i) comparable company multiples, ii) a sum of the parts analysis, and iii) a replacement cost analysis.

Comparable Company Multiples

Sum of the Parts

For our sum of the parts analysis, we explicitly value Life Time's business in two parts, the existing centers and the new center growth opportunity.  This separation allows us to fully appreciate the steady-state free cash flows generated by mature centers without the financial drag of non-mature centers, which underperform until their third year of operation.  This valuation summary is shown in Exhibit 1.

We believe Life Time's existing centers are worth at least $2.4 billion, based on 11x unlevered after-tax normalized maintenance free cash flow, and Life Time's new center growth opportunity is worth at least $700 million in today's dollars, based on the Company's target new center economics and our conservative assumptions about the future pace of openings and returns.  Together, the two components result in an enterprise value of at least $3.1 billion and, after adjusting for cash, debt, and non-operating assets, an equity value of at least $2.4 billion or $57 per share.  Interestingly, we believe the stock could be worth substantially more - perhaps as much as $107 per share - if the pace and return profile of new center growth is higher than our conservative "low end" assumptions.  For instance, if management were to begin opening new centers at the same pace seen during the 2006 - 2008 period, our $57 intrinsic value estimate would very likely be too conservative.

Replacement Cost Analysis

Finally, it is instructive to consider the potential replacement cost of Life Time's assets.  At December 31, 2010, the Company's gross property and equipment was just over $2 billion, which represents the historical cost of Life Time's owned assets.  In addition, Life Time has 27 leased sites and 7 ground leases, the vast majority of which are accounted for as operating leases and thus not included in that figure.(8)  We estimate the original cost of both owned and leased fixed assets was at least $2.5 billion.  However, to replicate Life Time's assets today, one would have to spend much more than that because this figure is based on the Company's historical, not current, costs.  Additionally, when we consider the replacement cost of the Company's existing membership base, employees, institutional knowledge, favorable locations, and the many years it would require to replicate, it is clear that Life Time's replacement cost - in today's dollars - is significantly higher.  In light of this analysis, we believe our $2.4 billion valuation of Life Time's existing centers, which is incorporated into our sum of the parts analysis, is conservative.

(8) We include the cost of leased assets in this replacement cost analysis, because we treat the present value of operating leases as debt in our sum of the parts analysis.

Risks

• Life Time's business is impacted by macroeconomic variables, such as consumer confidence, consumer spending, employment levels, and others. Attrition could rise from current levels and membership occupancy levels could fall if new membership gains are not sufficient to offset attrition. Members could also reduce spending on in-center services, such as personal training, spa treatments, café fare, or children's activities.
• While we believe Life Time has a strong and enduring competitive position, the company is not immune from competition. Competition could intensify.
• Life Time relies heavily on the experience and knowledge of Mr. Akradi. He would be difficult to replace, if required.

Disclosure: Long LTM

This is not a recommendation to buy or sell any security.  Please do your own work.

Appendix A

We calculate the contribution margin of an additional membership is within the 66% - 70% range, based on the following assumptions.  Margin estimates have been provided by management.

Exhibit 6: Life Time Fitness Estimated Membership Contribution Margin

We believe Life Time's 20 non-mature centers are likely to generate $69 - $86 million and $45 - $61 million of annual incremental revenue and EBITDA, respectively, once they fully mature.  See Exhibit 6.

Exhibit 7: Life Time Fitness Non-Mature Center Membership Opportunity

Life Time's mature centers have a similar opportunity to grow revenue and EBITDA as occupancy levels approach capacity.  We believe these centers will generate $62 - $119 million and $41 - $84 million of annual incremental revenue and EBITDA once they recover to normalized occupancy.  See Exhibit 7.

Exhibit 8: Life Time Fitness Mature Center Membership Occupancy

Between non-mature and mature centers, the total revenue and EBITDA opportunity represents potential growth of between $131 - $206 million and $87 - $145 million, respectively.  These figures are included in Exhibit 5.

Catalyst