By Quan Hoang
The Avid Hog (now Singular Diligence) wrote about Life Time Fitness (LTM) and Town Sports International (CLUB) in November 2013 and February 2014, respectively. Life Time Fitness is being bought out for $72.10 a share in cash. Town Sports is exploring strategic alternatives, including a sale. So, it's now a good time to review our theses on these companies.
I think that Life Time Fitness and Town Sports have competitive advantages in their own markets. Life Time Fitness is a category killer in suburban areas, while Town Sports has a location-based moat in cities like New York City and Boston.
Circle of convenience is an important concept in understanding these companies. Circle of convenience is the area within which customers are willing to go for a service. In cities like Manhattan, walking distance is important. In suburbs, driving distance is important.
Town Sports Has a Location Based Moat in Cities
About two thirds of Town Sports locations are in areas that are truly urban. These urban clubs include 60 clubs in New York City, 10 in Washington D.C., 7 in Boston, 3 in Philadelphia, 2 in Basel (Switzerland), and 1 in Zurich (Switzerland). Because of difficult traffic, each urban club draws customers from a market defined by a small radius. In Manhattan, Town Sports normally gets customers within 2 or 3 blocks.
Also, urban customers like having access to multiple clubs. For example, 38% of all visits to Town Sports clubs are from members visiting locations that aren't their home gym. In each key market, Town Sports built a cluster with locations that are conveniently situated near both a member's home and office.
A competitor must build a cluster of similar scale to compete with Town Sports in a city. Suitable sites in cities are scarce and leases are expensive. So, I think Town Sports' moat is wide in places like New York City or Boston.
Life Time Fitness Is an Unstoppable Category Killer
Life Time Fitness' moat is different. Life Time Fitness has 113 big clubs in suburban areas. In suburbs, people travel by car. Circle of convenience is much wider. 25% of Life Time Fitness members are further than 5 miles away from its locations. Life Time Fitness' moat doesn't come from location-based convenience, but from economies of scale on the customer experience side.
Life Time Fitness operates very big clubs. The current model of a Life Time Fitness club is 114,000 square feet. For comparison, a basic club with no amenities ranges from 2,000 to 15,000 square feet. Town Sports' suburban clubs with amenities like swimming pool or basketball courts average 40,000 square feet.
Big clubs don't result in economies of scale on the cost side. Life Time Fitness can't sell more memberships per square foot by building a bigger club. However, they can offer 114,000 square feet of amenities to each member. Life Time Fitness offers a lot of programs. These programs include yoga, swimming, running, racquet ball, squash, tennis, pilates, martial arts, and basketball. The average Life Time Fitness member uses 5.5 programs. Big clubs have economies of scale on the customer experience side. That allows Life Time Fitness to differentiate and charge a premium for its service.
As a result, each Life Time Fitness club has a local moat. It's usually surrounded by several small clubs. Small clubs draw customers within a one or two mile radius. Barrier to entry is low and there's a lot of churn and replacement. So, Life Time Fitness gets the biggest share of the profit pool in each local area.
It's difficult to copy Life Time Fitness. Each club is a mega project. Investment in each project is about $30 million to $50 million. Life Time Fitness designs its own clubs. It has a dedicated subsidiary that just focuses on drawing up the plans for each new club. The operation of each club is complicated. Each club has 300 certified employees and offers 20 programs. The capital and complexity involved is beyond what most fitness companies are used to doing.
So, Life Time Fitness is an unstoppable category killer.
Overleverage Can Kill a Fitness Club Operator
These two companies are also different in durability.
The biggest risk in this business is overleverage. This industry is littered with bankruptcies. Bankruptcy is often the result of using debt and leases to quickly expand. When financial obligations are excessive, chains may need to use all of their cash flow to pay rent and interest. They have little money left for maintenance cap-ex and end up with outdated locations. That results in a vicious circle as uninviting locations start losing customers.
Town Sports has always had low fixed charge coverage. Since 2002, Town Sports' EBITDAR/(Rent + Interest) has been about 1.5. That's because rent expenses are high in cities. Town Sports usually spends 18% of sales in rent expenses. In recent years, rent expenses have crept up to 24% of sales.
Town Sports survived the Great Recession. However, low fixed charge coverage is always a big concern for Town Sports in the face of adversity.
On the contrary, Life Time Fitness has very low leverage. At the time we analyzed, the company owned 67 of its sites. And 55 of those clubs have no mortgage. EBITDAR/(Rent + Interest) was about 6. The appraisal value of its real estate is well over $2 billion. Life Time Fitness can always borrow against its real estate if necessary. It has much greater financial flexibility than Town Sports.
The only concern for Life Time Fitness is the CEO. Bahram Akradi has done a great job at building the company. However, he was too aggressive in using debt with his own personal portfolio. In 2008, he had to sell a lot of Life Time Fitness shares at a bad price to meet a margin call. That's a sign of an appetite to maximize return regardless of the risks involved. Life Time Fitness has always been much more financially conservative than its peers. But there's a risk that Bahram Akradi is too aggressive and will overextend the company.
Boutique-type Studios Threaten Town Sports
Change is another concern in examining durability of the business. There are often fads in health and fitness. However, I think Town Sports and Life Time Fitness can simply offer new programs in their locations. Town Sports' CEO Bob Giardina explained:
"I think customers get bored…people don't like to exercise, so you have to have enough variety to keep people moving into different functions. So 25 years ago, some of us may remember step programs. They were popular. Before that, it was Jazzercise. Today it is kettlebells. So the box has to stay flexible, and that is what I love about our product. The box is flexible. What we put in the box can move around. So we have to stay close to the members. We have to understand what their needs are."
Unfortunately, the location-based convenience that helped create Town Sports' moat also threatens its moat. Boutique-type studio is the dominant trend in the last several years. Over 600 private studios like yoga or CrossFit were opened in New York City in the last several years. Giardina talked about the changing customer behavior in the last conference call:
"Market research on the industry is also telling us that club members are gravitating toward using multiple workout options. They are joining a traditional fitness club and then using studios to supplement it."
Societal change is a big concern for Town Sports. Private studios seem more accessible to customers both physically and financially. Town Sports' cluster of clubs may become irrelevant. It's possible that the boom in private studios will eventually burst. But Town Sports' high leverage can result in a bad lollapalooza effect.
But Not a Threat to Life Time Fitness
Boutique-type studios also made it difficult for Life Time Fitness to acquire new customers in 2014. Bahram Akradi talked about the impact of studios in a conference call:
"So there is a significant amount of fragmentation in the industry. There are a number of studios opening up, from just workout studios to yoga studios, to cycle studios, et cetera. That really has accelerated significantly in the last 12, 24 months. The other types of stores, like the Snaps and Anytime Fitness and the Planet Fitness, they really have not been a factor to our types of member and our types of facilities. But the number of studios that are serving the higher kind of a level customer, the customer who really wants that higher-end, boutique-style classes and programs, have really been ramping up in the last couple of years…
And this has happened for the last 20, 30 years, with variety of different styles of low barrier-to-entry models. And our strategy has been to build something that doesn't -- again, high barrier to entry for our model. And then sometimes, just have to go through these short periods of time. We intend, clearly, to continue to grow our same store."
Life Time Fitness experienced a slight decline in full-access memberships in early 2014 and only had a small growth in the fourth quarter. However, Life Time Fitness' customer experience-based moat remains intact. The company targets customers who prefer having a lot of amenities. In the long run, these boutiques won't be different from small clubs that compete with Life Time Fitness. In the short run, Life Time Fitness is trying to improve customer service and retention rate. Membership growth and revenue growth will continue to drive revenue growth.
Different Outcomes
We concluded that Life Time Fitness and Town Sports were undervalued for 2 different reasons.
Life Time Fitness is a good and growing business. We think that the company can grow 10% for 15 years. It's driven by square footage growth and revenue per membership growth. Last year, total square footage grew 6% and revenue per membership grew 7%.
We also think that the number of membership is below Life Time's capacity. Last year, membership stayed almost flat despite a 6% growth in square footage. I still think membership is far below normal. Bahram Akradi seems to agree with me.
Private equity firms are paying over $4 billion for Life Time Fitness. Including capitalized leases, the deal value is about $4.3 billion. Bahram Akradi has also committed to invest $125 million in the company. We valued the company at $4.5 billion, including capitalized leases. He and his investors must think Life Time Fitness is worth far more than that to pay $4.3 billion.
Town Sports is different. Town Sports has little growth opportunity outside of its core markets. It's very popular among value investors as a deep value stock. We noticed the risk of high leverage, but we were attracted by the level of EBITDA Town Sports can generate. However, revenue declined while operating cost increased in 2014. Societal change may destroy its moat. The management is considering a sale of the company. But perhaps its shareholders won't enjoy a premium like shareholders of Life Time Fitness.
We wrote about Life Time Fitness in November of 2013 when the stock price was $48.51 a share. Today's share price is $70.75. The stock has gained 46%.
We wrote about Town Sports in February of 2014 when the stock price was $10.50 a share. Today's share price is $6.23. The stock has lost 41%.
