Description

Town Sports International Holdings, Inc. (Nasdaq: CLUB)

Town Sports International (“TSI”, “CLUB”, or the “Company”) owns and operates 150 fitness clubs in the New York, Boston, Philadelphia, and DC markets.   CLUB is a growing, annuity based business, with pricing power, trading at a bargain price.  We believe at current levels, the stock has minimal downside and upside potential of 50-100%.  The stock is currently trading at $11/share and should easily earn $0.90 in 2008; which is we believe to be a less-than-normalized year for the Company.

The shares are off more than 50% from its spring-2007 highs of $24/share.  Largely an over-reaction to short-term pressure on the business from higher levels of attrition, lower new member growth, slight margin degradation due to higher than historical expansion (new locations create a drag on margins during their first year of operation), and general negative sentiment towards consumer related companies.  On the Q3 call, the Company lowered 2007 guidance from $0.79-$0.83 to $0.75-$0.76 for CY2007. 

We believe that normalized earnings power of this business is $1.00/share, and even higher if you exclude locations opened less than a year – as they initially negatively contribute, but will undoubtedly contribute without further capital investment.

TSI enjoys an economic moat through its leading market share in the current markets, recurring revenues, scale economies and a product that is at little risk of being extinguished through technological innovation anytime this century.   TSI also has pricing power.  They’ve consistently been able to raise rates annually without hurting membership statistics.  Further, activity from both strategic and financial players indicate that we could be in the early stages of an industry consolidation. 

Valuation

On an absolute basis, the shares are cheap.  12x, 5.3x and 9x 2008 EPS, EV/ EBITDA and EV / EV/EBIT, respectively.  After-tax ROIC is a reasonable high-teens and we believe the stock should trade at least at 18x normalized earnings or $18/share.  Should margins return to historical levels and TSI successfully executes the planned 2008 expansion, and as the market looks more towards 2009,  we believe the shares could trade at 18x 2009E EPS of $1.20.

On a relative basis, the shares are even cheaper.  Comparable companies trade at much higher multiples (over 20x EPS and 10x EBITDA) and recent M&A activity suggests that strategic and financial buyers might be willing to pay north of 10x EBITDA ($25/share).  Bruckmann, Rosser, Sherrill & Co., which first invested in CLUB in December 1996, still owns 27% of CLUB stock. 

Business Description

103 of CLUB’s 150 clubs are within a 75-mi radius of New York City.  Approximately 74% of clubs are “Fitness Only”, offering the classic cardio, weights, personal training, classes, etc.; these average 20,000sqft.  The remaining 26% of clubs are “Multi-Recreational”, offering the same things as “Fitness Only” with the addition of one of more bolt-on facilities such as swimming pools or basketball courts; these average 40,000sqft.  Clubs are split almost evenly between urban and suburban locations.  CLUB had 483,000 members as of September 2007.

The Company derives revenues from two main sources: i) monthly dues and initiation fees (80%), and ii) ancillary offerings, such as personal training (20%).  There are two types of membership, Passport and Gold.  Passport Memberships range from $49-$95 per month and offer members unlimited access to all clubs; constitutes 42% of members.  Gold Memberships range from $39-$81 per month and offer members unlimited access to 1 club and limited access to the others; constitutes 58% of members. 

Clustering and Expansion Strategy

The Company’s stated clustering strategy offers a number of potential benefits.  By operating in 4 major metro regions, CLUB markets convenience (locations near home and work), increases its brand recognition, leverages its SG&A dollars, and uses its knowledge of local real estate to expand rationally.  CLUB has the #1 position in both NYC and Boston, #2 in DC, and #3 in Philadelphia.  According to management, there is the potential for 350 clubs within these markets – more than double the current number.  Clubs normally become EBITDA positive after 9-12 months of opening.  By Year 3, a new club will generate $3mm in revenue and have a 25% EBITDA margin—including corporate G&A. Thus, in periods of expansion such as now, overall margins are temporarily depressed. 

Favorable Long-Term Trends Support Growth

According to the IHRSA, a fitness industry association, health club members aged 55+ comprised 20% of total members in 2005, up from 9% in 1990.  Over the same period, total health club members increased from 20.6 million to 41.2 million.  As more Baby Boomers enter retirement, there is a case for continued growth at health clubs aided by this group. 

Additionally, the obesity problem in the US continues to grab headlines and is the focus of an increasing number of public health initiatives.  Several bills have been introduction to offers various incentives to both employers and individuals.  For example, (i) WHIP as proposed allows employers a tax deduction for fees fitness facility.  This bill apparently enjoys bipartisan support and has been referred to a Senate committee, and (ii) PHIT, as proposed, amends the tax code to treat up to $1,000 of amounts paid annually for exercise equipment and physical exercise programs as tax-deductible medical expenses.

Management also believes there is a growth opportunity within their “Corporate” program.  Currently, only 20% of members are affiliated with a corporate plan; as employers promote healthier behavior to mitigate direct and indirect healthcare costs, this presents an opportunity for CLUB to gain members.

Summary

In summary, we believe that this is an opportunity to invest in a growing business that has large amount of recurring revenue, pricing power and reasonable returns on capital, and a large economic moat at a bargain price.  Further upside potential exists given that the relative valuation of publicly traded comps and recent M&A transactions.   This risks and bad news have largely been priced in to this name and the risk/reward offers an interesting opportunity. 

Catalyst