|Shares Out. (in M):||28||P/E||0||0|
|Market Cap (in $M):||54||P/FCF||0||0|
|Net Debt (in $M):||180||EBIT||0||0|
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Are you interested in going long a statistically cheap gym company that is simultaneously well and badly managed? Hold your nose and follow me.
Town Sports International has been written up on VIC four times. The last write-up was in 2013 and a lot has happened since. The company has had its ups and downs over the years and these gyrations continue; recently they've gone through another 'down' and the stock suffered a huge fall. I’m not here to tell you the gym business has fantastic economics or that this company is wonderful. Rather, I’m recommending CLUB because (1) this time it's cheaper than the other times it was written up (2) your interests are very aligned with new management (3) the stock experiences wild swings due to all the operating/financial leverage and the next swing should be upward. I believe the equity is an easily double if management reacts correctly to recent weakness, but after that, if history is any guide, at some point you'll probably want to get the hell out.
Given all the previous write-ups, I will summarize the company's business succintly and continue with a timeline of recent events.
- CLUB is one of the largest fitness club owners in the United States, collectively serving approximately 651,000 members. 190 fitness clubs, mostly in the northeast, with some more in Floriad, Puerto Rico and Switzerland. Breakdown: 104 New York Sports Clubs; 32 Boston Sports Clubs; 10 Washington Sports Clubs; 5 Philadelphia Sports Clubs; then there's 16 Lucille Roberts and 11 Total Woman; the rest are single-digit location brands, and mostly higher end like LIV fitness.
- 68% of the company's clubs are fitness-only (~18k sq.ft), 32% are multi-recreational (~40k sq.ft) which includes dance, cycling, strength conditioning, boxing, yoga, pilates, swimming, spa, racket sports, basketball. 76.9% of revenue is from membership dues, the rest: personal training and various other services not included in the plans.
- Sector economics: total gym memberships in the U.S. is over 60 million (growth of 33% over the past decade) and around 40,000 clubs. The number of members ramps up during a gym's first year. There's a peak over the next couple of years and then a gradual slow decline as people stop going. Maintenance cap-ex grows larger at around that time too – this either hits profits or causes the gym to keep the same profit level by sacrificing something else. Often, the quality of the experience declines, people stop going, etc'. The challenge is to manage through these difficulties the right way. There's probably a very delicate balance that can be struck between all these variables but it really depends on the equity owner's competence, incentives, desires, flexibility in capital allocation & budgeting, and attention to detail.
- CLUB's Competitive position: the fitness industry is currently going through a period of intense competition due to (i) the trend toward 'studios' and (ii) many new 'regular' gyms that offer lower pricing and a low level of service. CLUB believes many of the latter group will not earn their cost of capital and is branding itself as mid-range player with somewhat higher prices and better/differentiated services. Also, a minority of its gyms are high-end concepts that have somewhat of a moat like the recently acquired TMPL which is still there but rebranded as New York Sports Club. Their strategy is to have clusters of clubs to serve densely populated metropolitan regions, both in urban and suburban areas, because clustering yields the following competitive advantages: (i) brand recognition of the network within the area (ii) ability to provide the activities of the multi-recreational locations to all members without offering them at every location (iii) convenience of multiple locations (iv) scale (v) cumulative knowledge in specific local real estate markets. (vi) in the urban areas, difficulty for competition to find comparably attractive locations.
Let's do a quick tour of where the stock has been since the first VIC write-up. During the bear market the stock declined 90%. The company's performance had suffered due to higher attrition, low new member growth and slight margin degradation but the move down was strong perhaps due to the combination of the company's leverage + macro fears at the time. Eventually it bottomed at $2-3 and lingered there two years. In 2010 a comeback began and CLUB rallied eventually hitting $14 in 2013 on expectations the company can keep doing close to $100M in EBITDA.
And then another downturn began, caused in good part by the 2 types of competition mentioned above (severe price discounting + studios/boutique gyms). During 2014 the stock went back to $6, and during the same year two activist investors began accumulating shares: HG Vora and PW Partners (PW = Patrick Walsh). Management didn't want to let go and, feeling the pressure to deliver something, lowered the price of their memberships (must have learned that trick from Elon Musk..). In fact they even gave a name to this strategy. They literally called it the "HVLP model" (High Value Low Price). The activists didn't exactly like this strategy and eventually they obtained a majority of board seats, kicked out the CEO and made Patrick Walsh Executive Chairman while the board started searching for a permanent replacement.
The first things Walsh did was re-hike prices, hire new executives, place a moratorium on new club openings and reduce the company’s cost structure by about $30M annually. CLUB later changed the menu to provide fitness a-la-carte according to the different classes etc', and added new activities, among which was the “shop in shop” concept: a branded fitness program that operates at CLUB facilities (first example was Cyc Fitness, a modern indoor cycling program).
Walsh seems down-to-earth and definitely sounds reassuring. His annual letter to shareholders have included the following bits: "ultimate long term goal which is to increase and maximize the per share value", "capital allocation will be a critical determinant of our future success", "differentiate ourselves from the competition", "we believe that our flexibility on capital allocation creates a material competitive advantage for the Company", "achieve a low cost structure while maintaining and enhancing sales", " our philosophy is to pay for performance" and finally: "we do not host quarterly conference calls nor do we provide guidance. We will disseminate relevant information through press releases, 10Qs, 10Ksand proxy statements. Management believes it is difficult to provide anything meaningful that has long-term significance every quarter. In addition, we do not want to encourage short-term trading of our Company’s stock."
From mid-2015 to q1 2016 the company retired $100M of debt at 40c on the dollar. The stock bottomed at about $1 near the end of 2015. In 2016 Walsh's position as CEO was made permanent and they also consolidated the COO and CEO roles into one. Many clubs were given makeovers, the company launched an app and a new brand identity was created with a warmer, friendlier, modern feel. Check this out to get an better idea: https://wearekettle.com/case-studies/nysc. Overall in 2016 revenues declined but the company was more profitable (EBITDA of $40.9M) and the stock recovered.
That recovery continued into 2017/2018. CLUB's SSS turned positive, the company's credit rating was upgraded and the stock peaked in mid-2018 at around $15. These two years were also very busy in terms of capital allocation. The company made some very interesting acquisitions that are worth checking out one-by-one:
- CLUB purchased the shuttered David Barton Gym and reopened it under the NYSC brand. When Walsh met David Barton at his new gym, TMPL ("Temple"), he acquired that too. TMPL has a unique nightclub-like concept: https://www.youtube.com/watch?v=Jk987p9x0rE
- Then they bought LIV in Puerto Rico. This is probably the most high-end gym in the portfolio, definitely not vulnerable to price wars: https://livfitnessclub.com/
- Then they bought 2 chains that are women-only. Lucille Roberts https://www.lucilleroberts.com/our-difference and Total Woman which has a strong spa component in its business as well https://www.totalwomanspa.com/
2018-2019: Negative Realities Surface and Hit The Stock
Behind the improved cash flows lied something ugly. Cutting off too many expenses at a gym is risky and CLUB is yet another example of what happens when you do that. Starting in Q3 2018, the stock changed direction sharply as SSS growth slowed. 2018 was the first year since the turnaround with a decrease in same-store member count. In 2019 the weakness has continued and they say they're working on improving performance. There are also pressures on occupancy and labor costs, namely from mandated minimum wage increases.
The situation is pretty tough. Looking at online reviews, across many locations and brands, not only are there many complaints about maintenance and service but also stories about people finding it difficult to cancel, being charged after cancellation and being charged randomly. In addition, at some of the recently acquired chains, there are many reviewers who say things changed for the worse post-acquisition. Online ratings are quite low.
In retrospect CLUB was a great short in mid-2018. But now that the market has slammed the stock all the way back down to $1, there is a potential opportunity to go long if this can be even mildly turned around. After all, management is eating its own cooking here and at some point they'll have to wake up and do something. The question is in what direction do you turn something like this around? Do you try to go back to a better level of service, a mid-level brand? Or do you now stay where you are with mold and broken machines and lower your prices to become the low-end economical choice? I think both are conceivable because gym memberships turn over fast enough to allow for a brand to evolve (though online ratings change slowly because they're an average that include all past reviews).
Either way, yes it's an ugly situation but CLUB still has positive FCF and is statistically cheap. In H1 2019 EBITDA was $45M annualized. Cap-ex at 5% of top line = $23M, which gives us cash EBIT of $22M. At around 5x EV/EBITDA and 10x EV/EBIT the stock could easily double or triple on any kind of improvement or a durable rotation from growth to value (the stock rose sharply during this week's rotation).
So I think it's a Buy at $1.92 but one has to keep an eye on the operational issues. If it does rise, it may turn into a Sell at a different price.
- Operational risks are the #1 issue.
- Financial leverage is not as bad as before but it remains a potential issue.
- Growth through acquisitions is always risky but I think they bought good businesses so far.
- Stabilization of membership growth and/or SSS
- Stabilization of margins
- Macro rotation from growth to value
- Sale of certain clubs/chains or entire business – I don't see that occurring but we're still in a low-return environment today
- Share repurchases, though I don't think it's time yet
- Issuing a dividend at some point to attract a different group of investors
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