We believe Town Sports International (Ticker: CLUB) represents a compelling investment opportunity with 50%+ upside in the coming 12 months. The story is as follows:

 

-         Town Sports holds a unique position in a reasonably high quality business

o       Very hard to replicate assets

o       Unlevered club-level IRRs average about 20%, Year 5 cash returns on original investment are about 35%

-         The stock is cheap on a number of measures:

o       EV/EBITDA                                 4.8x 2008 and 4.4x 2009

o       P/E:                                               10.8x 2008 and 9.7x 2009

o       Free Cash Flow to Equity:             22% in 2008 and 26% in 2009

o       EV to Replacement Value:             ~0.8x

-         Beyond just valuation, there are reasons to believe the stock can trade meaningfully higher as this story evolves

o       CLUB has under-appreciated tailwinds to revenues and earnings due to significant investment in previous periods.  Recent club openings are just starting to contribute to EBITDA

o       Management guidance may be conservative and contemplates weakening membership in the back half of the year

o       Two large owners hold 47% of the stock - at some point we suspect they will seek liquidity.  There are at 3-5 strategic players who would likely be interested in this set of assets

-         Healthy capital structure

o       Debt is termed out until 2014

o       No covenant issues

o       Growth is self-financing from operating cash flow

-         Management is solid and the new COO brings innovative ideas to the company

 

-         As far as we can tell there is really one primary concern that gives investors pause.  That is, the worry that weakness in the economy and layoffs in the New York Metro area will result in meaningful membership attrition

-         Secondarily, some analysts have raised concern over competition

 

We think we can substantiate the merits of this investment thesis and provide evidence that the risks are not substantial.

 

Town Sports International Holdings owns and operates fitness clubs under brand names such as New York Sports Clubs, Boston Sports Clubs, Philadelphia Sports Clubs, Washington Sports Clubs, Etc.  In total the Company has 161 clubs of which 111 are in the New York Metro area.  The company expects 168 locations by year end 2008.

 

 

 

 

Over a period of twelve years CLUB has grown from 30 clubs to 161 today.  About two thirds of this growth has been organic through de novo openings.  During this period the company generated EBITDA growth in every year but one.  The company has generated ~20% unlevered IRRs on their clubs and realizes very profitable mature location economics.

 

On the most basic level, successful health clubs need to have the right location and the appropriate price point / level of offering to attract members.  No doubt The Sports Club/LA and Equinox have higher end offerings and higher price points.  But, this certainly does not mean they have higher returns on capital.  In fact, Town Sports model of 25k square foot clubs and average price per month of ~$70 may be a better model than much larger clubs that charge closer to $125+ per month.  CLUB’s 500,000+ members suggest that the company has a good product at the right price for a certain segment of the population. 

 

The Company’s locations would be very hard to duplicate.  Current and previous management spent years waiting for leases to become available in areas they wanted to grow.  Then, they built out each facility (cost of about $4.0mm on average) and grew membership over time.  Clubs require time to become profitable - it takes about six months to be EBITDA positive and 4 years for payback on investment.  It takes time, money, and skill to profitably grow this business. 

 

As well, a standalone club is not as profitable a model as a number of clubs in the same area of the same brand/offering.  Geographic clustering plays a role as marketing dollars are more effective in areas where a company has multiple clubs. Town Sports has been particularly effective in this regard given their concentration in a few metro areas.  Members also like having multiple clubs in a city – one near work and one near home.  We contend that it would require a long period of time for anyone to replicate CLUB’s assets in the NYC, Boston, Philly, and DC areas.

 

By our estimation all of the above facts suggest a relatively high quality business and hard to replicate assets. 

 

 

 

Shares Outstanding                   26.4mm

Share Price                               $9.00

Market Cap                             $238mm

 

Net Debt                                  $304mm

 

Enterprise Value                       $542mm

 

 

 

2008                            2009

EBITDA (Street Est. in $mm)                           $113                            $124

 

EPS (Street Est.)                                              $0.83                           $0.93

 

FCF to Equity (Calculated in $mm)                   $52                              $60

 

Note:  So readers can replicate our math for Free Cash Flow to Equity we provide the following example of our calculation for 2008:  EBITDA of $113mm minus D&A of $51mm = EBIT of $62.1mm.  Minus Interest Expense of $26mm = Earning Before Tax of $36.1mm.  At a tax rate of 41% we have Earnings After Tax of $21.3mm.  Add back D&A of $51mm and subtract Maintenance Capex of $20mm and we arrive at $52mm of Free Cash Flow to Equity.  We could have also included a working capital component but have not for simplicity.  But, it is worth noting that CLUB is a negative working capital business due to sign-up fees and customer monthly pre-payments and thus CLUB throws off cash while growing.  Maintenance Capex of $20mm is based on an estimate from management.  This seems within reason to us – it equates to $120k per club per year (based on 168 projected year-end 2008 clubs).  In reality, clubs would more likely be on a 5-year cycle for major refurbishments so it would be $600k every five years for each club.  Other club managers have told us this is well within reason for clubs of ~25k square feet.

 

By very rough math, it costs about $4.0mm on average to build out a club today.  Thus it would cost about $675mm to replicate the set of assets that CLUB will have at year end 2008.  That means that equity investors today can buy these assets at about 80 cents on the dollar of replacement value. (Note: 100 cents on the dollar = $14.00 stock price) 

 

To our eye, all of the above valuation metrics suggest a stock that is pretty cheap for a growing business with good returns on capital.  Also, as we’ll discuss in a moment, we think CLUB has significant earnings power that is yet unappreciated by some investors. 

 

 

 

Growth from Maturing Stores:  As of the end of Q1 on a TTM basis CLUB had $146.8mm of pre-corporate EBITDA.  This EBITDA consisted of:

 

 

Once the newer clubs mature and start generating EBITDA consistent with the rest of the portfolio, instead of a loss of $2.8mm, they should contribute $25.3mm or so.  That would bring pre-corporate EBITDA to ~$175mm.  Subtract out Corporate G&A of $35mm to $40mm and you arrive at $135 to $140mm of EBITDA once locations already opened have matured.   Simply the maturing of locations already built (Capex already invested) will bring the company to meaningfully higher EBITDA than they have today.  

 

Conservative Guidance:  Management has guided to 2008 revenues of $510 to $520mm and EPS of $0.80 to $0.84.  Unlike what we’ve seen with other public companies, management guidance is not predicated on some ‘back half recovery’.  Rather, in this case management guidance is built on the assumption of deterioration in the back half and higher attrition.  The Company has not yet seen an up tick in attrition but has built one in for conservatism.  Thus, if attrition stays at current levels and does not worsen in the back half of 2008, then revenues and earnings will outperform current guidance.  (Attrition concerns discussed later in greater depth)

 

Shareholder Base Could be Cause for a Sale of the Company:  CLUB shares are 47% held by two firms.  Farallon owns 20.2% and private equity firm Bruckman, Rosser, Sherrill & Co. owns 26.2% and has been in the investment since 1996.   We think that at some point at least Bruckman, Rosser and potentially both investors will seek liquidity.  We think there would be a number of potential strategic buyers including:

 

-         24 Hour Fitness with 425 clubs in the U.S.  Has a geographic focus on Central, and Western U.S. with some NY clubs

-         Fitness First with 500 clubs in Europe, Asia, and Australia (2mm members)

-         Virgin Active with 170 clubs worldwide (900k members)

 

CLUB has about $36mm in corporate expenses.  We think roughly $10mm if this expense could be eliminated in a strategic deal.  Add this amount to our mature store analysis EBITDA and you get close to $150mm in potential EBITDA.  If a strategic buyer had to pay 5.0x that amount it would equate to a $17.20 stock from $9.00 today.  A 6.0x multiple would be $22.50.  It is hard to say what the right multiple would be but deals since 2004 in the space have been 7.0x to 10.0x on stated EBITDA (not pro-forma). 

 

Note:  Lifetime Fitness (Ticker: LTM) trades at 9.5x TTM EBITDA and 8.0x forward EBITDA.  But, LTM owns some of their real estate so an investor would have to adjust for that fact when comparing the two.

 

 

 

CLUB debt consists of:

-         $183mm of Term Loan Facility on which they were paying about 4.7% as of March 31^st, 2008

-         $127mm of Senior Notes at 11% interest.  These are currently PIK and will move to cash pay in February 2009

 

If necessary CLUB can borrow another $75mm under the Term Loan Facility.  We do not expect this will be needed though since the investment in clubs in 2008 will be financed from operating cash flow.  We do not expect year-end debt levels to be appreciably different than they are today (unless CLUB moves aggressively on their $25mm buyback).

 

The Leverage Covenant in the Term Loan Facility of ‘Total Debt to EBITDA’ is 4.25x.  This is substantially higher than the TTM Multiple of 2.8x and the credit metric will only improve as EBITDA climbs in coming periods.

 

 

 

Turnover among senior management beginning in October 2007 created some anxiety among investors.  The company’s CEO at that time, Robert Giardina, resigned abruptly due to health reasons.  In January CLUB’s COO Randall Stephens resigned. Lastly, CLUB’s long-time CFO, Richard Pyle, announced his decision to retire in January.  While no one would want this much turnover in a supposedly healthy company, these moves do not indicate changes to be overly concerned about.

 

We confirmed Giardina’s resignation for health reasons with an independent consultant and take comfort in his remaining on the board of directors.  Giardina was not replaced by a newcomer but by an 18-year veteran, Alex Alimanestianu, who had been President and Chief Development Officer.  The COO was not getting the job done and was replaced by an executive from Starbucks who was in charge of 1,100 Northeast locations. Based on our checkings, the CFO Richard Pyle had planned to retire earlier but postponed his decision due to Mr. Giardina’s resignation.  Mr. Pyle, too, was replaced by a company veteran, Dan Gallager, who was most recently SVP-Finance.

 

Since the new CEO and CFO have been with CLUB for some time we believe the transition to new leadership has been smooth.  We have found them to be solid managers/leaders capable of executing on the growth plan.  In addition, the new COO appears to have the exact right pedigree to focus on improving the “customer experience” at the clubs, which should help drive retention.

 

 

 

Town Sports locations experienced about 3.1% monthly attrition in Q1 suggesting the average club membership lasts about 27 months.  This attrition is the natural result of people moving, having kids, changing their habits, etc, etc.  Of course the job of local managers is to constantly backfill with new members.  Luckily for all those people who give up their membership there are typically a whole group of people who are looking to sign up for a new gym – new college grads, people moving into a new geography, those with health resolutions, etc, etc.  The ranks of those people giving up their membership versus those joining a club typically offset themselves. 

 

The concern of course is that this time could be different.  The biggest fear is that given the economy in general, and more specifically the job losses in finance in the New York area, people will start to cancel their gym memberships.  Loosing members is clearly tough on clubs since they are largely fixed costs enterprises and thus each member’s fees are close to 100% contribution margin. 

 

We offer the following thoughts on this.  First, thus far job losses in 2008 in NYC have not been that bad.  Trailing three month unemployment in NYC is 4.9% versus 4.7% last year.  This remains a pretty healthy employment environment.  In 2002-2003 NYC unemployment averaged between 7.5% and 9.0%.  This was a period in which CLUB continued to operate very profitably.  Some gym managers have suggested that people out of a job tend to go to the gym a lot more and therefore (at least for awhile) are even less likely to give up their membership.  For all these reasons, we don’t think the simple thesis that jobs are weak in NYC should be enough to scare investors away.

 

In summary, we are mindful of NYC employment levels but do not think recent layoffs currently portend major problems for CLUB.  The company has operated in much more difficult environments in the past and done just fine.  And, they have guided revenues and earnings based on a weaker environment so it sounds like they have been sufficiently conservative. 

 

Finally, some analysts have raised concerns over competition.  Surely an onslaught of irrational competition would be a negative but we don’t see evidence of that.  The health club business has always been competitive in NYC (and Boston / DC / Philly).  Competitors have come and gone – but, to be successful in the business requires the right locations/leases with the best value propositions for prospective members in the area.

 

24 Hour Fitness (controlled by private equity firm Forstmann Little) has a single location in NYC in the Flatiron District and LA Fitness has three locations in the suburbs of NYC.  That is really the extent of new competition from national health club chains.  We really do not believe this is much cause for concern.  Rather, it is validation of the attractiveness of the New York market.  In addition, we think that as large competitors look at a buy versus build decision, CLUB is a natural acquisition candidate.  Why spend many years to build a network of clubs in Town Sports’ key cities while at the same time potentially overbuilding these markets?  An acquisition of CLUB would keep the markets a lot healthier and would require meaningfully less time.

 

We think Town Sport represents a pretty high quality business.  Their returns on capital are consistently solid and CLUB owns a set of assets that would be very difficult to replicate.  This is a business that investors should want to own when they can invest at the right price.  Right now investors can own these assets rather cheaply on measures of EV/EBITDA, EPS, Free Cash Flow to Equity, and multiples of replacement value.  The time seems right to us.  

 

Investors should take comfort that Capex already spent and clubs already opened create a natural earnings tailwind for coming periods.  The valuation of CLUB gets really cheap if we value the enterprise on a ‘mature location basis’.

 

Ultimately with think CLUB makes sense as an acquisition for another large player and we think the shareholder base would support such a move.  In the meantime, CLUB has a nice growth plan which is self-financed from operating cash flow and a healthy balance sheet.  Management is solid and has some interesting new initiatives at hand. 

 

Finally, we think concerns over the New York market and potential competition are somewhat overblown.  Management has already built conservatism into their guidance and the current valuation more than discounts the risks in the market.

 

 

We think fair value is anywhere from $14 to $18 per share.  This is based on a range of metrics including 1.0x replacement value, a 12.5% yield on 2009 FCF, and/or a conservative 5.5x multiple on forward EBITDA.