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

Q1 2014 Earnings Conference Call

April 29, 2014 4:30 pm ET

Executives

Bob Giardina - CEO

Dan Gallagher - President, COO & CFO

Analysts

George Kelly - Craig-Hallum

Jared Madlin - Piper Jaffray

Kurt Frederick - Wedbush Securities

Operator

Greetings and welcome to the Town Sports International Holdings Incorporated First Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Dan Gallagher, President and Chief Financial Officer. Thank you, you may begin.

Dan Gallagher

Thank you for joining us today. This is the Town Sports International Holdings earnings conference call discussing results for the first quarter of 2014. I'm Dan Gallagher, President, Chief Operating Officer and Chief Financial Officer of the company.

I caution listeners that any remarks we make in this conference call relating to matters that are not historical facts constitute forward-looking statements which are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which are outside of our control, which may cause actual results to be materially different from any forecasts we have made. These risks and uncertainties are described in our reports filed with the SEC including those discussed in the Risk Factors, MD&A, and other sections of our annual report on Form 10-K for the fiscal year ended December 31, 2013 filed with the SEC on March 14, 2014.

We have issued a press release discussing our results for the quarter, which has been filed with the SEC under Form 8-K. We disclaim any duty to update or revise such forward-looking statements whether as a result of future events or otherwise.

In addition, for those of you who do not have access to this release and filing, we’ve also made them available at our website www.mysportsclubs.com. This conference call is also being webcast and may be accessed via the Investor Relations section of our website. Also a replay and transcript of the call will be made available on our website following the call.

I’ll now turn this call over to Bob Giardina, the Chief Executive Officer of Town Sports International, for a discussion on the operations of the company. And then I will give further detailed financial discussion later on in the call. Bob?

Bob Giardina

Thanks, Dan. Good afternoon and thanks for joining us for our first quarter call. When we spoke with you a couple of months ago on our 2013 fourth quarter call, I laid out our strategy to position Town Sports for changes taking place in fitness industry, changes that create some near-term challenges in part of our business, but also significant long-term opportunities.

Our first quarter results reflect these near-term challenges with continued pressure on new membership and specifically guest traffic. The softness in membership sales were more announced in the month of January and February when we experienced extreme cold weather, more than usual snow days in our markets. The top line dynamics accompanied by higher than planned expenses was notably on our utilities during the unusually cold winter months weighed on our bottom line.

Looking at a few of the highlights of the quarter, as was the case all the last year, our attrition rate in the first quarter was relatively stable versus the prior year and actually slightly better than our expectation. Personal training revenue increased 2.9% on fewer members. These are two areas that we see ourselves to have able to control and where I believe the team is doing a nice job.

The issues that negatively impact of the first quarter were in-bound membership traffic and sales volumes, which we were seeing in January and discussed on our fourth quarter call. Our conversion remains the same and is solid but our guest traffic has been impacted by the competitive environment which I will discuss in a moment. Also, ancillary revenue line did not mirror expectation. While we are confident we will see improvements at these lines, we were behind plan in Q1.

We know that, like most consumer companies, weather had an impact on our membership traffic in the quarter including the most important membership joining month of January. This unusual weather also impacted our ancillary revenue lines and had a dramatic effect on our utility cost in the quarter. This netted out to revenue that fell short of our forecast by about $1 million driven by declines in membership revenue and other ancillary revenue such as Sports Club for Kids and small group training. These very areas have also drove 4.7% topical club revenue decline in the quarter. But we have also acknowledged that increased competition is drawing potential customer traffic away and this is having an impact on the membership at our clubs.

In the last two years alone, more than 125 fitness clubs have opened in our market. In addition, the trend towards boutique studios is accelerating even faster. In Manhattan alone, over the last 12 months boutiques have grown from approximately 300 units to 520 units. That equates to approximately 350 new locations that consumers can try. As I've mentioned in the past, this is good news for the industry as consumers have more options and are increasingly willing to spend more on the fitness regimen. It creates short-term challenges, but I believe our team, our 40 years of experience, our real estate portfolios, and our capital structure allow us to compete well in the changing environment.

We know that health and fitness is a cultural shift, not just a trend, and it is here to stay. So as the weak clubs shake out and we make strategic adjustments, we believe that we are in good position to enjoy long-term success.

Now looking at growth, we have already discussed our plans to open give traditional fitness clubs in 2014 as we continue to find opportunities to solidify our strong position in our core urban market as well as plans for at least BFX Studio clubs; our new multipurpose luxury studio concept. We have begun the presale process at our Greenpoint New York Sports Club location, which is expected to open for workouts on June 1, and thus far we have exceeded our presale expectations. While we will be continue to be very selective with traditional fitness club openings in the future, Greenpoint is a great example of the demand that is out there and how good locations can have tremendous success today.

Our first BFX Studio on 6th Avenue in Chelsea area, Manhattan is targeted for opening in June as well. We also have signed a lease for a second BFX Studio downtown near Wall Street and are targeting a Q4 2014 opening.

Our plan is to ramp up the number of BFX openings in the future to capitalize on a shift towards studio workouts and we believe we will have the best concept in the market.

In addition, over the course of the next quarter, we plan to review our club portfolio and will likely target approximately 5% of lower performing clubs for closure. This will enable us to consolidate a portion of these members into our existing clubs while reducing our club operating expenses such as occupancy and payroll process.

We are also working on additional strategies to compete directly with the low cost competition entering our market and actually target some of these customers ourselves. We will also be more specific on our next call.

So in summary, conversions of the new low cost competition, rapid growth of studios, weather, elevated expenses and cost associated with the opening of new club this year added up to first quarter results that were below our expectation. However, the longer-term combination of an increase consumer focuses on fitness and health and our initiative to capture our share this growing market keeps us excited, motivated, and optimistic that where we will be in a couple of years.

We will carefully find optimizing our existing base of clubs with select new clubs opening in A locations as well as a roll out of our BFX Studios. As the industry undergoes these significant changes, we are not standing still. We are working through our line of offering with evolving preferences of consumers and we will simultaneously keenly focus on maximizing profitability and cash flow generation. As I've said, we are fortunate to be well-capitalized player with tremendous brand recognition, a strong real estate portfolio and experienced and capable leadership team. We will continue to aggressively pursue our strategic initiatives in order to position for the growth that we see ahead.

And before I hand it over to Dan for his last call in the CFO role, I'm sure you saw that on Friday we have announced the appointment of Carolyn Spatafora as our new Chief Financial Officer effective May 12, 2014. We are very excited to welcome Carolyn to our team. We believe that Caroline brings the right talent and experience to the world of Chief Financial Officer and the company would benefit from her previous oversight and leadership experience.

With that, I'd like to turn it over to Dan.

Dan Gallagher

Thanks Bob. I will go through the income statement and highlights for the quarter and then discuss our outlook for the second quarter of 2014.

In the first quarter, our consolidated revenue was $115.9 million, a decrease of 2.7% in the first quarter of 2013. Our total net number count in Q1 2014 decreased by 1,000 members to 496,000 members. The number of restricted memberships totaled 41,000 as of March 31, 2014.

Monthly attrition for the first quarter averaged 8.5%, slightly better than our expectation and flat with Q1 last year. We expect average monthly attrition for the second quarter of 2014 to approximate 3.4%, a slight increase from 3.3% in the second quarter of 2013. We saw a very modest improvement in average monthly recurring EFT dues of members charged in Q1 2014 at $60.12 versus $59.84 in Q1 2013. Also, we saw our average joining fees improved slightly to $56.19 per member from $55.32 in the same period a year ago.

Total ancillary club revenue was down 4% to $22.6 million from $23.6 million a year ago due to declines in our other ancillary revenue programs such as small group training and Sports Club for Kids while personal training revenues increased 2.9%. Overall, we were disappointed with our ancillary revenue results which were in part impacted by weather experience in the quarter.

Revenue at clubs opened over 12 months decreased by 4.7% for the quarter. Comparable club revenue was affected by a decrease in membership of 2.7%, a decrease in ancillary club revenue, joining fees, and fees and other revenue of 1.7% and a price decrease of 0.3%. The slight drop in the price component this quarter was in large part due to decrease in the net amounts collected on paid in full corporate memberships.

We ended Q1 with 496,000 members or approximately 3.1% fewer members than we had at the end of Q1 2013.

Turning to expenses, total operating expenses increased 9.6% to $118 million in the first quarter of 2014. As Bob said, we saw a significantly higher than planned utility expenses in Q1 driven by the unusually cold winter weather in the Northeast which had an impact on our utility usage, but to a greater extent of spike in utility rates.

Overall, utility costs in the first quarter were approximately $1.9 million higher than the same period last year. While utility rates appear to be coming doing from the levels of experience in Q1, they are still currently at levels that are elevated from that of the prior year.

G&A expenses totaled $8.3 million in its first quarter, an increase of $1.5 million versus the prior year. Increases in the computer software maintenance were expected, but other areas such as Zeta and telephone cost and auditing and fax consulting came in higher than expectations. We expect G&A cost to come back into line in approximate $7.3 million in Q2 2014.

Operating income, excluding goodwill and asset impairment charges, for the first quarter was $1.7 million compared with operation income of $11.5 million in the first quarter of 2013. Excluding these same items, net loss for the quarter was approximately $1.4 million or $0.06 per share compared to that income of $4.2 million or $0.18 per share in the first quarter of 2013. Adjusted EBITDA was $14.1 million compared to $24.2 million in Q1 2013.

Cash flow from operating activities for the first quarter of 2014 was $14.4 million as compared to 21.8 million in the first quarter of 2013.

Total outstanding debt as of March 31, 2014 was $324.2 million and our cash position of $76.2 million for a net debt level of $248 million compared to net debt of $251.4 million as of December 31, 2013.

As previously announced, in December 2013, we entered into an agreement to sell our 86th Street club location for $82 million. Earlier this month, the expected closing of this transaction was moved to mid July and purchaser increased the amount of the non-refundable deposit from $5 million to $10 million.

Capital expenditures totaled $7.2 million in the first quarter of 2014 compared with $5.1 million in the first quarter of 2013. When including the $500,000 acquisition of the West End club in the prior year. The increase was driven by investments in planned grand club openings including our Greenpoint, Brooklyn, club as well as construction at our new BFX Studio.

For the full year 2014, we continue to expect total capital expenditures to be between $45 million and $50 million, which include $20 million to $22 million related to potential 2014 and 2015 club and BFX Studio opening.

Now turning to our outlook, based on the current business environment, recent performance and current trends in the marketplace, and subject to the risks and uncertainties inherent in forward-looking statements, our outlook for the second quarter of 2014 includes the following:

Revenue for Q2 2014 is expected to be between $116 million and $117 million compared with $120.1 million for Q2 2013. As percentages of revenue, we expect Q2 2014 payroll and related expenses to be approximate 38.3% and club operating expenses to approximate 41.3%. We expect general and administrative expenses to approximate $7.3 million, depreciation and amortization to approximate $12.1 million and net interest expense to approximate $4.8 million. We expect net earnings to be breakeven in Q2 2014 and we estimate that EBITDA will approximate $17 million in Q2 2014.

Given our result experienced in the current quarter, we have adjusted our full year forecast and expect our full year adjusted EBITDA to be close to 30% lower than full year 2013.

That concludes our preparatory marks. We'd now like to turn the call over to any questions anyone may have.

Question-and-Answer Session

(Operator Instructions). Our first question comes from George Kelly, Craig-Hallum. Please proceed with your question.

George Kelly - Craig-Hallum

Hi, guys, couple of questions for you. First, could you talk a little more about the stores closures that you mentioned? I think you said 5%, you're thinking about 5% of the total stores that you closed, I'm just wondering if you can give any more detail sort of the financial metrics that you look to when you're assessing that, and if there is any comment kind of geographic, whether they're urban or suburban or in any specific markets that you're targeting?

Bob Giardina

Yes, George, we're going to look at the entire portfolio and really try to look at optimizing our real estate. We are going to focus obviously on underperforming clubs. And I would say primarily they're suburban, suburban fitness only products where we believe we can consolidate those locations and absorb some of those members into other locations. so we're actually looking at the process right now. I think this is all driven by the fact of the number of clubs we've seen open up in the suburbs which are mainly low cost clubs and the new studios that we've seen in terms of the acceleration over the last year.

George Kelly - Craig-Hallum

And then, Dan, the building still any issue, anything you can talk to a little bit more detail just about the process, and its taken a little bit longer to close and can you (inaudible)?

Dan Gallagher

I don't really have a lot of color on that, George, other than its very complicated transaction in the sense that its not just our building really a building next door to us that they're also purchasing or dealing with at the same time. so there's a multitude of things that they're dealing with and I don't really have very good details on it other than they're very confident that this deal will happen. But they have got their non-refundable deposit to something that I would consider fairly significant now at $10 million. So if for some reason it didn't happen we would receive $10 million as the deal is put together now for that very reason. And based on the dialog with them we do think the deal is actually going to happen sometime before July 14 of this year, so the $82 million sale we're fully expecting to happen.

George Kelly - Craig-Hallum

Okay. And then last one just on you commented that the lead flow was tough in January and February. I'm just wondering if you could comment on what it look like since may be in March and how it's trending recently, if any improvement?

Dan Gallagher

It's still quiet. It's quieter than it was the last year. We're doing a lot of things to drive guest traffic, so we have some promotions out there to drive more guest traffic in the doors. But it's -- you are seeing similar trend as we have in the past.

Bob Giardina

And I think January is when we have the most issues with the weather, happened to be our most significant month of the year. And I think (inaudible) went down little more than…

Dan Gallagher

January and February.

Bob Giardina

Yeah. I think they were down little more than what we might be seeing in March. Think that helps a little bit.

Operator

Our next question comes from Sean Naughton with Piper Jaffray. Please proceed with your question.

Jared Madlin - Piper Jaffray

Hi guys. It's actually Jared Madlin here on for Sean. Thanks for taking the questions. I guess just first of all, with the five new sites of traditional club that are going in this year, I guess, what gives you confidence in those sites and the location there? Are they more urban focused? Obviously, you have Brooklyn but beyond that that those sites are one that can work?

Dan Gallagher

Yeah. They happen to be all urban locations. They are in sites that we worked on like our Avenue A site. We probably worked on it for 10 years. Greenpoint is under pre-sales right now and we are -- it's having an extraordinary response in terms of market. So we were very selective with those locations. And I think moving forward, we're even going to be more selective in terms of how we look at those markets. How other competition can come in, what competition is there. So I think moving forward, we will look at it little bit more with concerning eye. But as we said Greenpoint is up to a terrific start and there is certainly no negative surprises with that club with the way it's launching right now.

Jared Madlin - Piper Jaffray

Okay. And in terms of those, the sites in the suburbs that are potential for closure I guess, in the past have there been any other clubs you have closed in similar locations or with similar demographics and what type of membership, any metrics around member retainment that you could offer?

Dan Gallagher

In the last couple of years we have closed a suburban club in Virginia. But we really have not -- if it comes to the end of their lease and if they are not performing real closing. In this particular case will be little more proactive in terms of optimizing our real state in consolidating membership. So we are going to look at the best way to evaluate and move those members.

Bob Giardina

Right. And in 2009, I think we closed a handful of clubs, so we have pretty good statistics on member retention. It very much varies by how close the club is to the network versus how far away is the network of club is, and that part we are going to review over the next three months.

Jared Madlin - Piper Jaffray

Okay. And then just with BFX kind of approaching here, I guess from a marketing perspective what are you doing to spread the word? And then two, obviously there has been a large number of people entering this market in Manhattan alone. So what gives you confidence that the market isn't already saturated enough and anything you can offer there?

Dan Gallagher

Sure. Surprisingly enough, when I give the number of studios going from 300 to 520 that's Manhattan alone. So it has exploded. I would every single one of them has either one offering and there's probably a handful that may have two offerings. We have a complete boutique. So you're going to be able to come in there and do any type of group exercise program, you're going to be spending and you're going to be able to do a fitness program with a personal trainer. So we have a lot of confidence that we will be able to have serve the complete boutique where people can get their entire regimen at any age at all levels at that facility.

As I've said in the past, we're building the program on trainers and instructors. We're not building it on facility although the facility is going to be I would have to say that at a cost of about $2.2 million to $2.4 million it's probably is going to be one of the nicest boutiques in the country but I believe that what makes this unique is the instructors and teachers and most of them are going to be bringing their own following.

So in terms of being able to market it a lot of them already have a following that to be able to bring to the facility. We also have demographics and guests information based on our 40 years in Manhattan. So we have a lot of demographic studies we can actually pull from to be able to use information to drive people in through the door. So we feel very confident in terms of where the boutiques and what we're offering and what we're able to do. And that's why we're looking at accelerating that plan.

Jared Madlin - Piper Jaffray

Okay. and then just lastly here on the data and phone cost in the G&A there, I think you mentioned last quarter, correct me if I am wrong, that those costs should actually turn here at the end of this quarter into a benefit kind of looking at $500,000 annually. Is that still true? Are there some more incremental cost coming associated with that?

Bob Giardina

I do expect those cost to actually be more inline in Q2 -- I mean, Q3 and Q4 as well as Q2. so those costs will start to come more in line and help us get our G&A line item back into line offsetting it with the software products, the most are licensing that we're incurring. So long story short, we do expect to have net savings on a go forward basis including the phone and data. It just took a little longer than what we were expecting, the transition took longer we were expecting but it does have a fairly quick pay back at the end of the day. And the product and service that we're getting, the amount of bandwidth that we're getting is actually favorable to us. So I think the transition was longer it take but I think it was expected but (inaudible) will be there.

Operator

Our next question comes from Kurt Frederick with Wedbush Securities. Please proceed with your question.

Kurt Frederick - Wedbush Securities

Yes, thanks for taking the call. Just a question on timing of the club closures as well as the new clubs that are opening up as you're going to go through this I guess Q2 and do the evaluation and what's the timing of when they're going to be actually closing?

Dan Gallagher

Okay, we'll be able to answer more specifics on the next call. What we're going to do is we're going to look at, as I mentioned, the other performing clubs in the portfolio and we're going to look at the obligations and the movement of the members and, more importantly, employees and try to do it in a way that it's least destructive for everyone. So I think we're going to try to get that 5% all done by the end of the year but its going to be probably staggered between June and December.

Bob Giardina

Absolutely. I would say we're apparently targeting 5% and our target is expecting that they would close before the end of this year. What exact month is definitely part of the process we're working on.

Kurt Frederick - Wedbush Securities

Okay. How about the new clubs that are opening?

Dan Gallagher

Okay. The BFX Studio is opening in June. Greenpoint, Brooklyn, is opening on June 1 also, its in presales right now. And the other clubs that are opening are all in Q4.

Kurt Frederick - Wedbush Securities

Okay. And then last year going into the summary, I guess there was staffing issues with the Sports Club for Kids that led to a softer year. How is that shaping up this year?

Dan Gallagher

So we have some of the leadership under the Sports Club for Kids and we did have some vacancies in our director positions last year, which is part of the giving rise to the shortfall in Sports Club for Kids revenue we had last year. So as we enter into Q2 we should have an easier comp because kids in last year we were down a bit. I think Q2, Q3 and Q4 we were down versus the prior year. Q1 was not necessarily the case. So I think we're going to have an easier comp going forward and that's why our expectations are that we should at least hit those numbers if not better, but based on our premium being in place now for three quarters.

Operator

Our next question is from George Kelly with Craig-Hallum. Please proceed with your question.

George Kelly - Craig-Hallum

Hi, just one follow-up on the full year guidance. You mentioned down in 30% in EBITDA. Wondering what that assumes for the club closures, if --

Dan Gallagher

Nothing actually. That does not include anything about that because we don't have anything in front of us or in that regard. So I would consider those one off. To the extent we have charges related to that and we would isolate those and do our best to disclose them but I just certainly don't have the ingredients to give that now because we barely started the process other than identify that we certainly have an opportunity here.

Operator

At this time, I would like to turn the call back over to Mr. Gallagher for closing comments.

Dan Gallagher

Okay. Well thank you for joining today in the call and we look forward to reporting on our second quarter at the end of July.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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