Description

CLUB has been written up on VIC a few times in the past but 3 recent events justify taking a new look.

1. Stock has come down 15% since the day before the company released its Q4 earnings. Q4 and Q1 guidance were underwhelming. I believe some of the issues are temporary and I believe we are close to stabilization in terms of number of members.
2. The company made 2 acquisitions during the last month. In particular, they bought FitCorp Clubs in Boston. While I am usually skeptical of acquisitions, I think this deal is smart. I think this could be a template for other value-enhancing acquisitions.
3. A small recent insider purchase.

Let’s first focus on the valuation and some of the key metrics.

The company generated EBITDA of $99.8 million in 2012 and cash flow from operations of $60.1 million. They spent $22.5 million in capex generating free cash flow of $37.6 million. Market cap is 220 million so last year’s free cash flow yield was 17%.

To give a historical sense of the cash flow generative nature of this business, cumulative cash flow from operations during the last 3 years (2010-2011-2012) was $186 million, while cumulative capex was $75.4 million for a cumulative free cash flow of $110 million or half of the company current market cap.

Obviously, it’s the future that matters. For 2013, I assume EBITDA of $95 million (I think this is conservative – the CFO gave me the impression that they expect 2013 EBITDA to be higher). I modeled capex at $40 million (company is guiding $37 to $42 million), interest of $22 million, and tax of around $600K (they have NOLs). I also assume $2 million for working capital increase per my discussion with the CFO. This results in free cash flow (“fcf”) of $31 million or a free cash flow yield of 14%. Note that this is after a significant amount of growth capex. If the company was not pursuing growth, capex would be only $25 million (or less) and 2013 fcf would be 48 (no increase in working capital either). So the free cash flow maintenance yield is around 22%! In other words, the entire market cap could be paid in 4.5 years. This is unusual (even for a levered company).

I am not modeling 2014 precisely, but it’s important to note that 7 clubs that were recently purchased or in construction and are EBITDA negative in 2013 will start contributing in 2014. Also, according to the CFO, starting between the second half of 2014 and early 2015, the company will have used its NOL and will start being a taxpayer. Net-net, I think free cash flow in 2014 remains the same as in 2013 assuming a similar capex level.

The recent acquisitions: 

Based on my discussion with the CFO, CLUB is paying around $5 million for FitCorp (5 gyms and 4 managed facilities). The big picture here is that FitCorp was CLUB’s largest competitor in Boston so CLUB is taking out its main competitor. CLUB may close 2 of the locations that are very close to CLUB locations, so they think they can move many members from one gym to another but only keep one location, making the surviving unit a lot more profitable. They will certainly keep the Prudential location and the Boston Racquet Club. The CFO is very enthusiastic about this acquisition: he made the comment that the Prudential location alone justified the acquisition price. FitCorp was not making money. CLUB believes that once overhead is removed and they integrate these clubs, these gyms will become very profitable. They have done that in the past and seem to know what they are doing in term of integration.

This acquisition also opens a new line of business: managed facilities. FitCorp has 4 locations in Boston. To give a better sense of the opportunity, it is important to note that FitCorp used to have 20 managed facilities in Boston but sold them over time to finance the growth of the business. With this acquisition, CLUB is getting the CEO of FitCorp,  who was running this managed facility business and CLUB will push in this area. The CFO also thinks there are great synergies between the managed facility business and CLUB network of gyms.  For example, CLUB can offer Goldman Sachs to manage its facility and give a deal to family members if they join CLUB. The leader in the managed facility business is Plus One with around 100 locations (http://plusonehealthmanagement.com/). I think there is an opportunity over the next few years to add a nice new income stream from the managed-facility business.  It would be a high margin and low capital intensive stream of cash flows that would be worth a higher multiple. It should also help with the membership of the gyms.

Included in the $11.5 million capex growth number (low end of the guidance) for 2013 is also $1.5 million for clubs that will only open in 2014, $2.5 million for a new club in Brooklyn, and some renovation money for the recently purchased location on New York City’s Upper West Side (West End Sports Club).

Hidden real estate value

Also, it’s important to note that the company owns an interesting location on the Upper East Side of New York City. They actually have a tenant there as well as one CLUB location. From the 10K: “We own our 151 East 86th Street, New York location, which houses a fitness club and a retail tenant that generated approximately $2.0 million of rental income for us for the year ended December 31, 2012.” I understand that over the years there has been some activity from developers trying to assemble enough land to build a large residential tower and that location is part of the puzzle. I don’t know where things stand and I don’t expect anything in the short term, but a real estate friend thought it could be worth $50 million. When asked why they don’t sell this, the CFO answered that they make a lot of money from the club and the tenant. That’s obviously not a great answer. I don’t value this real estate in my analysis, but it’s nice to know that it’s there. The CFO indicated that he would love to sell the location and make sure that they run the gym in the new building that gets developed there. One caveat is that the tax basis is very low so there would be tax leakage, which is one of the other reasons the CFO mentioned to explain why they are not selling the location.

The Q4 earnings release

The earnings were underwhelming because of a decrease of 12,000 members during the quarter and lower than expected guidance for Q1. The company believes that half of the 12,000 lost members in Q4 had to do with Sandy. I can’t check the number, but it does make sense that Sandy would have had an impact. Regarding Q1, the company expects less than half the net number gain that was achieved in Q1 last year (which was a gain of 10,000 members). The company is pointing to a soft economy as a reason for that. The company is starting the year with 510K members compared to last year’s 523K members and the Q1 increase is less than half of last year’s increase. So while last year CLUB started Q2 with 533K members, this year Q2 may only start with 515K members. Also, over the last 3 quarters, CLUB has lost 23K members. The fear of further decline is obviously one the reasons the stock is cheap. I expect that we are actually close to stabilization barring another 2009-like financial crisis. I say that because the average number of members for 2009, 2011, and 2012 was 509K, 511K, and 523K, respectively, with a similar number of clubs (around 160 gyms). So right now, CLUB starts the year with 510, which is in line with 2009, 2010, and lower than 2012. In 2010, the average number of members was 493K. So if we have another severe recession, the number will certainly go down but barring that, I think we are in the right zone.

CLUB expects the average member revenue to go up in 2013, but it won’t be enough to offset the loss in average number of members so comparable revenue will be down in 2013 compared to 2012.

Valuation

I look at valuation a few different ways:

1. This company could easily give a $1 annual dividend (around $24 million) and use the rest to grow the business. What dividend yield would the market use? 5%, 6%, maybe 7%. That gets you to a stock price between $14 and $20 per share. Practically, the company is restricted in its ability to pay a dividend because of a restriction basket as part of the debt covenant. This could be removed at some point. Therefore, this dividend valuation is more a theoretical exercise because practically they can’t start a dividend right now.
2. Based on other retail M&A deals, I believe a PE firm could pay a multiple of at least 6x EBITDA for this business. If the company were sold at the end of the year using $100 million EBITDA for 2014 and taking into account the $31 million in cash generated in 2013, the stock price would be around $15 per share.
3. At $15 per share, the market cap would be $360 million and the free cash flow maintenance yield would be around 12% which seems adequate.
4. I think it would be very tough to recreate this asset and if any other fitness company ever wants to enter these markets, it would be a lot easier and cheaper to buy CLUB.
5. Life Time Fitness is trading at 6.8x and 6.1x 2013 and 2014 EBITDA consensus respectively versus CLUB at 5.1 and 4.9x.

This doesn’t take into account the real estate value of their owned location or the value of the managed-facility business that they are going to grow.

In conclusion, as I look 1 to 2 years out, I don’t think it is unreasonable to see the stock at $15 resulting in a 63% upside.

Risk

CLUB is a levered (operationally and financially) play on NY/Boston/DC consumers, and that’s the biggest risk in my mind. The reason I can sleep at night while still owning CLUB is that when I look at 2009 (CLUB lost 24K members that year starting from a base of 510 members – average number of members was 509K) and 2010 (CLUB started the year with 486K customers – average number of members of 493K), the company still generated $76 million of cash flow from operations in 2009 and $51.2 million in 2010. EBITDA did go from $106.8 million in 2008 to $73.9 million in 2010 before bouncing back up. So as evidenced by the EBITDA decline, there is significant leverage. Yet the company would still generate a lot of cash flow, especially because the company would likely curb capex growth plans.

Board and management

I think management is running the business well, is good at managing costs, and is trying to increase personal training and classes (UXF for example), which makes sense. I was disappointed that the CEO sold a large number of shares a year ago or so and the CFO tends to sell shares on a regular basis.

I believe the board is shareholder friendly and I trust that with Bruce Bruckman, a smart PE guy, on the board and a large shareholder, the company is not going to do something stupid. While I believe that a quarterly dividend would have made a lot more sense than the $3 special dividend in terms of changing the market perception of the company (they would have had to refinance the debt to allow for that), the board was proactive in returning cash to shareholders and I give them credit for that. Another board member just bought 1,800 shares. While it is not very big, it is better than nothing and further confirms in my mind that this board is well aligned with the shareholders.

I wouldn’t be surprised to see the company buy back some of its shares at this valuation.

Shareholder base

Farallon Capital owns 17% of the company and has been a shareholder since at least 2006 when CLUB was taken public (and may have been involved when the company was under private ownership as well). I would expect that at some point they will want liquidity. Bruce Bruckmann from Bruckmann, Rosser, Sherril is a director of the company (his fund took CLUB private in 2004 and public again in 2006) and owns 4.8% of the company personally. It would be very difficult or impossible for him to sell his stake, so he will also at some point want liquidity. Whether it’s because of him or Farallon, I expect that at some point the company will be sold to provide liquidity for the large holders.

Catalyst

Time – 14% free cash flow yield in 2013 and growth in number of clubs

Stock buyback

Sale of the company

Catalyst

Time – 14% free cash flow yield in 2013 and growth in number of clubs

Stock buyback

Sale of the company