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Lifetime Fitness, Inc. (NYSE:LTM)

Q1 2008 Earnings Call

April 24, 2008 10:00 am ET

Executives

Ken Cooper – Senior Director Finance

Bahram Akradi – President & CEO

Michael Robinson – Executive VP & CFO

Analysts

Edward Aaron - RBC Capital Markets

Tony Gikas - Piper Jaffray

Paul Lejuez - Credit Suisse

Scott Mushkin - Bank of America Securities

Sharon Zackfia - William Blair & Company

Karen Howland - Lehman Brothers

Operator

Good day ladies and gentlemen and welcome to the first quarter 2008 Lifetime Fitness earnings conference call. (Operator Instructions) I would now like to turn the presentation over to Mr. Ken Cooper, Senior Director of Finance; please proceed sir.

Ken Cooper

Good morning and thank you for joining us on today’s conference call to discuss the first quarter 2008 financial results for Lifetime Fitness. We issued our earnings press release this morning. If you did not obtain a copy you may access it at our website which is www.lifetimefitness.com. In a moment Bahram Akradi, our Chairman and CEO will discuss his thoughts on our first quarter and our underlying business trends. Following that Michael Robinson, our CFO will review our financial highlights. Once we have completed our prepared remarks we will take your questions until 11:00 am ET. At that point in the call the operator will provide instructions on how to ask a question. I will close with a tentative date of our second quarter 2008 earnings call. Finally a replay of this teleconference will be available on our website at approximately 1:00 pm ET today.

I’d like to remind everyone that this conference call contains forward-looking statements and future results could differ materially from the forward-looking statements made. Actual results may be affected by many factors including the risks and uncertainties identified in this morning’s earnings release and in our SEC filings. Concurrent with the issuance of our first quarter earnings results we have filed a Form 8-K with the SEC. Certain information in our earnings release and information disclosed on this call constitute non-GAAP financial measures including EBITDA. We have included reconciliations of the differences GAAP and non-GAAP measures in our earnings release and our Form 8-K. Other required information about our non-GAAP data is included in our Form 8-K.

Before I turn the call over to Bahram I would like to take a moment to remind you that we are having our Annual Shareholder Meeting at 2:00 pm ET today. Accordingly we will be preparing for and conducting that meeting and will not begin responding to emails and telephone inquiries until after that meeting or approximately 3:00 pm ET. Your patience and flexibility are greatly appreciated.

With that let me turn the call over to our Founder and CEO, Bahram Akradi.

Bahram Akradi

Thanks Ken. On behalf of all Lifetime Fitness I’m very pleased to provide you with an update on our business. We are off to a solid start to the year. Revenue was up over 20% and we delivered over 23% growth in net income. We hit on our membership growth expectations and we continued to see strong dues growth. The metrics with which I was most pleased were the growth of average revenue per membership and average in-center revenue per membership. Both were slightly ahead of our internal plans. Mike will provide greater detail on our financial performance shortly.

Since our last call on February 22, we have received two primary questions from the investment community. One is obtaining funding to support our growth plan; Mike will share his update with you within his financial highlights. The second is with regards to how our membership base has reacted to our business value proposition and economy. Short answer is great; now let me give you some color.

First, our existing member base is responding well. Usage level remains high across the system which is always a great sign. We added over 21,000 net memberships in the quarter. These memberships came in with a higher average dues and higher propensity to use in-center businesses and we see increase of average revenue per membership and average in-center revenue per membership to support that. For example we saw an increase of 13.3% in average in-center revenue per membership in the quarter which is impressive.

What’s encouraging to me is that we did not use our typical levers of enrollment fee and marketing to full advantage until the second half of March. I would like to take a moment to share the rational for this strategy. In keeping with our commitment to the member experience, we know that January and February are the busiest time of the year in terms of club usage therefore it is difficult to justify heightened promotion to bring in even more people in the clubs if we are to stay true to our membership experience initiatives. However we have begun to use lower enrollment fees and marketing more in late March and April and I am pleased with the response to date.

We had an approximate 10% membership growth in the first quarter. Our internal plans and guidance have similar goals in place for the second quarter. This is based on the fact that we are at the tail end of the effects of the dues increase letters and managing memberships down in over capacity clubs which should be complete at the end of the second quarter. Plus we will complete a number of remodels for our acquired clubs towards the end of second quarter which should provide membership growth in those centers in the second half of the year.

We are simply using our tools to be proactive to the environment that we are in. Undoubtedly the environment is more challenging but we find the accomplishment of our goal is very doable. And using the levers should set us up nicely to see the growth rate improve in the second half of the year. One of the more interesting questions I have received from our investors is would we do anything different had we known a year ago what we know today. If we had a crystal ball we would have avoided our planned branding campaign and use of our marketing dollars solely for direct mail and call to action advertising. However I feel great about the fact that we have pivoted at this point and we are comfortable with the new results.

As far as pricing action there are perhaps a couple of clubs that in the hindsight we may have delayed our price changes. Of the 31 clubs that we seen change in classification in the past year or so, but that means that the vast majority are doing what we planned which is also encouraging. Another way we are reacting to the current environment is that over the past couple of months we have stepped up our connectivity initiatives into a higher gear. One of the most important things I have learned in the over 25 years of operating health clubs is that the more connected a member, the better for the member, their experience and results and better for the business. It is a clear win-win.

In support of our efforts in this area we are in the pilot phase of several initiatives at the corporate center here in Chanhassen. I’m pleased with the progress that our team has made in a short time. Lastly we look at several metrics to make sure our plan is working. For instance we delivered over 900 basis point of dues growth over membership growth. That is a great sign and we saw revenue per membership and in-center revenue per membership grow at its best rate in over a year. This is another great sign that we are accomplishing our goals of delivering an unparalleled experience to our membership base.

With that I would like to turn the call over to our CFO, Michael Robinson who will provide more color on our financial performance to date.

Michael Robinson

Thanks Bahram. As Bahram indicated we had a solid start to the year. I’d like to start my comments with an update on our capital structure. First we have increased our revolver by $21 million to $421 million at our current pricing. We are also working with our bank group to increase the revolving line by a further $100 million. The full revolver pricing is still to be driven by the market but we expect it to be below our long-term models especially since it’s driven off of LIBOR which is currently below 3%.

In addition we are working to finalize mortgage deals ranging from approximately $20 million to $50 million per transaction. Again we expect pricing either fixed or floating to be at or below our internal return models.

Finally we are negotiating specific sale of leaseback facilities ranging from $25 million to $100 million which we expect to be P&L neutral. This solidifies our needs for 2008 and a good portion of 2009.

Moving to our P&L performance for the first quarter total revenue was up 20.5% from last first quarter. This growth was due to several factors including membership dues growth of 19%. This was driven mainly by upgrades dues we have enacted for new memberships in clubs where we are actively managing capacities. In addition during the first quarter we applied a dues increase of approximately 3% to 4% to about 40% of our membership base; a big chunk of which were in the 20 clubs where we are actively managing capacities.

Also as Bahram mentioned we saw over 900 basis points of gap between our dues growth and the 9.9% membership growth for the quarter. In-center revenue grew by 25.9% for the quarter led by personal training. We continue to deploy new products, programs and services in each of our in-center businesses which also support our growth. Highlights from other revenue metrics include first quarter same-store sales which were at the low end of our expected range. For the quarter we generated 4.3% increase in same-store sales and had a 1.8% decline in our 37-month mature same-store sales.

Excluding the centers in which we are managing memberships at our mature same-store sales were down 1% in the quarter. This was driven by a softer spa business as well as some revenue loss at some of our lower demographic locations. In the first quarter we had two centers enter the 13-month comp base. There were no additions to the 37-month comp base.

With respect to revenue per membership we generated an 8.7% increase to $363 in the quarter. In-center revenue per membership increased in the first quarter to $111 or a 13.3% increase over last first quarter. Both are at the high end of our expectations and are a good indicator we are executing on our strategies.

Moving to our margin analysis, the company’s operating margin improved 70 basis points to 19.5% for the quarter. The main drivers of this margin improvement were 110 basis points of G&A leverage and 20 basis points improvement in our center operations. Offsetting the G&A in the center ops improvement were approximately 30 basis points of increased spend in marketing and 10 basis points of increased depreciation expense.

Our center operating margin increased from 41.5% to 41.7% as a percent of total revenue for the quarter. This improvement is related to the operating efficiencies realized around operation staffing models and purchasing power on supplies. As we make our way down the P&L interest expense net of interest income increased to $7.2 million from $5.5 million last first quarter. As we continue to grow our new center base and our average debt balances growth. Our tax rate for the quarter was 40.2%. We expect our 2008 effective tax rate to be approximately 40%.

That brings us to net income from the quarter of $17.4 million which is up 23.1%. Our net income margin for the quarter increased 20 basis points to 9.4%. Total common shares outstanding as of March 31, 2008 were 39.5 million shares. Weighted average fully diluted shares totaled 39.4 million shares for the first quarter. We expect our total weighted average diluted share count for 2008 to be approximately 39.8 million to 40.2 million shares.

Based on the 2008 first quarter weighted average share count our diluted EPS for the quarter was $0.44, up from $0.38 in the first quarter last year or 16%. As a reminder the difference between our net income growth and our EPS growth is related to the equity offering we completed in August, 2007.

Moving to our operating data, the number of open centers at March 31, 2008 was 71 compared to 60 at March 31, 2007. Of these 71 centers 39 are current model centers and 54% have been open three years or more which we classify as mature centers. As of March 31, 2008 we had approximately 7 million square feet which is 19.9% greater than we had March 31, 2007 when we had approximately 5.8 million square feet.

EBITDA totaled $52.9 million in Q1, up 23.8% from last first quarter. EBITDA margin improved from 27.9% to 28.7%. Memberships at March 31, 2008 totaled 521,177 compared to 474,364 memberships last Q1, up 9.9%. Regarding memberships I want to update you on our attrition rate. For the first quarter our trailing 12 month attrition rate was slightly above one percentage point above our run rate for 2007. We believe this step-up is directly related to the existing membership price increases that were implemented in the first quarter.

Cash flow from operations totaled $49.3 million, up from $39 million in the first quarter 2007. This 26.4% increase is driven by our EBITDA growth rate as well as working capital control. Turning the balance sheet highlights the largest activity continues to be driven by our continued growth in new center construction. Cash outlays for capital expenditures for the quarter were $102 million which includes approximately $83 million related to growth or construction of new centers, $10 million for remodeled centers of acquired and $9 million for the maintenance of our existing clubs and corporate initiatives.

To finance our growth we will continue to use a strong operating cash flow and debt. During the first quarter our overall debt balances grew by approximately $66 million to $631 million as of March 31. This includes $367 million outstanding on our $421 million revolver. Our net debt to capital ratio increased slightly during the first quarter to 51%.

Other balance sheet variances to note include other assets increased by approximately $10 million primarily related to the reclassification of land available for sale from current assets to long-term and an increase in lease deposits. Working capital is down by approximately $20 million with about half coming from reduction in current assets such as collection of accounts receivables and reduction in inventory and half coming from an increase in our current liabilities such as the expected increase in construction accounts payable.

As it related to deferred revenue and deferred membership origination costs we increased deferred revenue by approximately $4 million and increased deferred membership origination costs by approximately $2 million.

Now let me discuss our updated guidance for 2008. We expect to open 10 more centers in 2008 to finish the year with a total of 81. We expect three centers to open in the second and the third quarters and four to open in the fourth quarter. Our next club to open will be in May in Johns Creek, Georgia which is a suburb of Atlanta. Our revenue guidance is maintained at 19% to 22% which equates to approximately $780 million to $800 million. We expect net income growth of 21% to 23% which equates to approximately $82 million to $83.5 million, up from 20% to 22% or $81.5 million to $83 million. This results in diluted EPS guidance of 16% to 18% growth which equates to approximately $2.06 to $2.09 a share up from 15% to 17% growth or $2.05 to $2.08 per share guidance previously issued.

Regarding our CapEx guidance we maintain our expectations of $440 million to $460 million for the year. This includes approximately $380 million to $400 million for growth which works out to approximately $35 million per club for the class of 2008. It also includes $30 million to $35 million in maintenance CapEx of our existing club base and $25 million to $30 million of one-time remodel costs for our recently acquired clubs. For the second quarter we are expecting revenue growth slightly below 20% and net income growth of approximately 20%.

Before moving into the Q&A session I want to address an item which has been posed as a question to us more than once via our many discussions. Are you really planning to accept lower returns for your Florham Park Club? Its one that I found most interesting and the answer is no. The investments we have made and continue to make on the East Coast are higher than typical however there is a corresponding higher than typical cost of living adjustment that we plan to use to our advantage in terms of pricing. Thus we will be pricing our North Eastern clubs higher than our normal in the Midwest which will be in the $89 to $119 range. This will allow us to invest more but maintain our expectations of 15% returns by the time the clubs hit maturity.

Other than how is the economy affecting our business and funding the return aspect of our business is the most prevalent question we receive. Clearly as our initial investment in construction progress continues to increase as we’ve expanded in different areas of the country we have seen a lower consolidated return profile. The biggest reason for this is it takes three years for a club to reach maturity and there is a significant drag due to the large amount of construction in progress at any given time. So a large part of our asset base in fact over 50%, is not yet producing returns or is still ramping to its targeted returns.

We break our internal return analysis into three major categories. First mature centers which continue to run in excess of our 15% hurdle rate. Second centers in ramp are centers in their first three years of operation actually improved slightly in 2007 as a group. And finally land and construction in progress continues to grow at a fast pace with over $200 million in growth assets yet to be yielding returns. It’s the weighting of these assets and the mix of centers in ramp which have driven the lower consolidated returns. I call these assets return in backlog. Interestingly if we were to stop expansion which we are not planning to do, and complete the ramp of our existing membership base, we near 15% return for the company within four to five years and it would still be growing thereafter. We feel that the inherent power of returns is hidden by our current expansion efforts.

That concludes our prepared remarks regarding our first quarter 2008 financial results. We are off to a good start. With that, we are happy to take your questions now.

Question-and-Answer Session

Operator

Your first question comes from Edward Aaron - RBC Capital Markets

Edward Aaron - RBC Capital Markets

Nice execution on the quarter. I was hoping you could talk a little bit more about the improvement in the in-center revenue metrics. How much of that do you think might be attributable to just having a more committed membership base than what you might have had last year? Because you can make a case that in this environment some of your more marginal customers might be getting weeded out as a result of price increases and a tough economy. Do you think that contributed at all?

Michael Robinson

I think it’s a combination of many things. Certainly strategically as we move in some demographics to a higher price profile, that’s exactly what we’re seeing. The higher demographic has a higher propensity to spend and we’re seeing that. If you go through the results of the in-center businesses our personal training business remains very strong and I know you’ve heard me say this in the past, it’s a high price point business. We are talking $75, $85, $95 an hour. Yet and that tends to stratify our membership base a little bit for those that can afford it but clearly they are and they are coming back to it. We are also doing some things that Bahram indicated a little bit earlier on connectivity. When we can work with people through group training classes and they understand the value of personal training in many cases they’ll opt up to one-on-one types of classes. So again it improves our take and the revenue growth within personal training.

We have also seen as you go down to the other businesses. Our café which frankly we were disappointed in its revenue production last year; that bounced back very, very well, really we believe driven by execution. Its something that we don’t believe we were executing as well as we could. We still don’t believe we’re executing as well as we could but we’re making improvements there. We did see some weakness in our spas predominately in the massage area. We think that’s an area that the economy has impacted the business. But at the end of the day it’s a pretty small piece of our overall business.

Bahram Akradi

I want to add to what Mike said, when you look at our cafés and some of the other parts of our business, one of the things about our company that I am most proud of is our management team being very candid about the things we don’t do well. So last year we rolled out a new menu in our cafés and frankly we did a very poor job of executing that rollout. The net result was actually negative in terms of the customer reaction and satisfaction. Right now we are testing new menu and a new game plan for what we are going to rollout with a mission for Life cafés to provide great tasting food that is really good for our customer and doing it friendly and doing it fast. When the pilot clubs that this is happening the sales are dramatically more than the clubs that are not – that are still operating mostly on the last year’s menu. We have made some of the changes and execution like Mike said better this first quarter but we are not even near, we’re just really not even close to what the outcomes could be in overall revenue per café as well as the overall satisfaction of our customer not just in the café but in the overall business because of course every piece of the business affects the whole thing.

So we are really, really excited about staying focused and improving on the areas of the business that we recognize we have room for improvement.

Edward Aaron - RBC Capital Markets

You mentioned in your prepared remarks that your same-center metrics were at the lower end of your expectations and I’m trying to reconcile that with the aggregate number is actually looking overall pretty favorably because you had mentioned some impact from memberships for a lower demographic as well as softer spa, but you said the membership numbers overall were consistent with expectations and the in-center was better, so should we just assume that the new clubs are performing further above planned and that the older clubs might be lagging a little bit more?

Michael Robinson

I think you can assume that the new clubs are performing at or potentially a little bit above and frankly we’d like to see same-store sales at 5% or above. We clearly got some effect by some lower spa sales. We clearly got effect especially in some of the lower demographic areas on just regular due sales.

Bahram Akradi

We did a couple of – and again we’re not going to get into the details of exactly which clubs, there were a couple of clubs that we rolled out the dues increase and like Mike talks about the more sensitive economic areas, the reaction was probably a little more severe in terms of the drop-out than we would normally see in the majority of the clubs. So you may have had 28 of the 31 clubs reacting exactly the way we wanted it and a few clubs were softer than that. But those are easy adjustments to make back up. We overall feel really solid about the guidance that we give you guys and we are as always focused on delivering what we promise.

Edward Aaron - RBC Capital Markets

Thank you.

Operator

Your next question comes from Tony Gikas - Piper Jaffray

Tony Gikas - Piper Jaffray

Congratulations as well on the quarter. Maybe just a little bit of an update on pricing changes, will they be as significant in the forward 12 months as they were in the trailing 12 months? The second question member acquisition for the balance of the year, it looks like you’re still targeting a low double-digit growth rate there, could you help us out by weighting that by quarter a little bit and then are there any centers that are underperforming, perhaps in some low demographic areas that maybe you consider the sale of at some point in time, help you raise some capital and improve margins or really nothing there on the low end of the range?

Michael Robinson

Regarding pricing changes the vast majority of our pricing changes have been implemented. There may be some that we look at again depending on ramp and the demographics and the success of these clubs, but the vast majority of that is behind us in the first quarter. Regarding membership growth and how we expect that, I think we talked quite a bit about the fact that the first half of the year we expect about 10% membership growth; that continues to hold true for the second quarter. We expect increase in the second half for a variety of reasons most of which include the fact that we’ve got a significant amount of clubs opening in the second half of the year. We are getting through major remodels on acquired centers in Dallas and in the Twin Cities that we expect an uptick for. And frankly there should be some easier comparisons as you move into the second half of the year. I would right now put that in the – we would expect it to grow maybe in the 12% to 15% range over that second half. I’m going to let Bahram talk about any centers that are underperforming that we would consider selling.

Bahram Akradi

Tony that’s a great question and let me give you two answers. In the event we have a facility that doesn’t fit our profile, it doesn’t work, we made a mistake in putting it into place; we will obviously be responsible about getting rid of that center. So that’s something that I want to assure there is no misunderstanding that we are going to be emotionally attached to something that doesn’t make sense. If it doesn’t make sense we are going to get rid of it.

Having said that even in some of these centers that we have seen some harsher response than normal to the dues increase letter et cetera, that we see some drag on the same-store sales et cetera, there are still making a lot of money. If they were not profitable, then I think you start kind of looking about what can we do with this. But they are making a lot of money. They are not making no money, they are not breakeven, they are still making a lot of money. So that if we get to the point where we should really look at the facility that is not as profitable, doesn’t have the promise of becoming profitable in our system we will think about how to get ourselves detached from that facility. Does that answer your question Tony?

Tony Gikas - Piper Jaffray

Yes, that’s great. Thanks.

Operator

Your next question comes from Paul Lejuez - Credit Suisse

Paul Lejuez - Credit Suisse

Related to your comment about Florham Park, stepping back, last year’s centers had a higher average cost to build and I’m wondering if you’re seeing the revenues associated with those clubs, if the revenues have been at the levels to justify the greater investment and then secondly can you tell us what the attrition rates were at the clubs where you weren’t managing members down?

Bahram Akradi

I’m going to respond to you this way; we go through an exhaustive level of analyzing a club in terms of any investment. Every time we do a club we build a complete business plan. It goes to a review of all the management and then through the finance committee and the Board to get approval on building a new club. Our [inaudible] rates are 15% ROIC and 22% IRR the way we calculate that, I’m sure you guys have gone through that with my team on how that calculation takes place. We are disciplined and so when we take a look at a facility we will think about what we are going to spend then we have some obviously contingencies about costs, all of that is in the business plan so when we spend more money in a club we expect to get more money coming in. More memberships, with higher dues, we basically think about is this a capacity of 9,000, 10,000, 11,000 memberships and at what dues levels we want those customers. When we execute to those plans we will end up hitting the returns we are looking for. Now we have had in 2007, 2006 we had some facilities that came in at a higher cost than our initial plans because we were doing a business plan, going through and by the time we were in the middle of construction, construction cost may have risen 15% or 20% accumulatively by that time. So you will see some but I also believe very strongly that these clubs have the ability to generate the revenues to give us the return that we are after as a corporate goal. As Mike said, we are looking at this regularly and we feel very confident that these investments will result in 15% ROIC by the time these facilities get to the maturity stage. We have no signs of any of the more expensive facilities not having the ability to get there.

Michael Robinson

Let me put just a little bit more color on that. If you look at an expensive facility like a Scottsdale, Arizona or Columbia, Maryland or something like that, frankly the expected range of annual revenues on something like that is $17 million to $20 million. And obviously you would also expect at maturity, and you would expect an increased EBITDA rate off of our averages also. And those clubs are trending to that, trending toward those as you would expect in their state of maturity.

You had a second question and that was on the attrition rates in some of the lower demographic clubs I believe that was the focus of the question. We obviously don’t give specific attrition rates by clubs but it would be correct to assume that the attrition rate in a lower demographic club, especially one that we would have hit with a price increase you would have seen rather than the one point bump on average you probably saw in the neighborhood of a couple of points increase.

Paul Lejuez - Credit Suisse

Thank you good luck.

Operator

Your next question comes from Scott Mushkin - Bank of America Securities

Scott Mushkin - Bank of America Securities

Mike quickly I didn’t really fully understand that attrition stuff you went through earlier in your prepared remarks, I was wondering if you could kind of go over it again?

Michael Robinson

We have talked to you about the fact that we generally expect and have seen over the last several years attrition rates ranging from in the 33% to 34%, 34.5% range annually. We closed last year around 34% on a rolling 12 month. The first quarter of this year we saw that go up a little over a point annually. The primary reason for that and its something that we see every time we put out a dues increase letter is when you send out a dues increase letter in effect you awaken what I call some of the sleeping members; those that haven’t utilized the club in the last three, four, five, six months and they look at that letter and they say, “you know I haven’t utilized it, I’m going to opt out. I’m going to take advantage of that month to month membership agreement” that we offer. And so invariably we will see a spike for generally 60 days or so on that as you go in that particular club and that’s exactly what we saw as we went through the first quarter. As we look at it, its something that we are aware of, we are focused on but not something that we expect to continue for the long run.

Scott Mushkin - Bank of America Securities

Bahram you said that ’06 and ’07 there were some clubs that came in above budget and the CapEx when we go around talking to investors, CapEx budget is a topic and some things that we hear people are struggling with is that kind of the bigger, better model in most stocks has ended not well. In other words you go keep pushing the square footage up, you keep pushing the investment up and then all of a sudden you end up with some white elephants. So as we look at ’08 what are the chances that that CapEx budget would come in at the low to mid end and are you seeing any relief on your cost per square foot in this environment? Mike maybe you want to talk about why sale leasebacks have always been your least preferred option and also the impact as you see it on those lease step-up provisions that usually come along with them?

Bahram Akradi

First and foremost my personal approach as I design and lead the design team is always to build the right product for the customer experience and then try to get it – and then once you determine what that design is the appropriate product, then you go out and try to execute the best execution you possibly can to lower the cost of acquiring that whatever it is that you’re coveting. We did have some facilities that were due to timing, opening of the clubs, pressing the schedule et cetera in that time period where we ended up actually spending more money than we normally spend. I would still argue that compared to having that box built by somebody else, they still came in at a good cost but nevertheless, it’s more than we wanted to spend initially.

We since then again have focused on what can we do better and have put together much, much tighter controls and processes in the class of construction that is coming up let’s say – because of the gestation time I can always tell you, you can make a decision to change a process or something but you are going to see the real effect of that 1 ½, 2 years down the road. So right now I feel extremely confident of the construction team and the process. We should be able to meet our aggregate number that we have in the business plans of all these clubs this year. We are within their range to hit our target.

In response to your question I expect to see opposing forces in the cost of construction going forward. That means you have a little bit of an advantage with the fact that the commercial construction seems to also taking a breather this year and we should be able to find some hungrier subcontractors who are willing to work for skinnier profit margins in order to just keep themselves busy where that hasn’t been the case up to last year – towards the end of even last year in the commercial side.

And then again you have to think about all the oil-based products and stuff that is inevitable that you would see some price increases on some of the materials and therefore I feel like we are going to be able to see close to flat within 2% or 3% one way or the other, change in the construction costs. So I feel good about where we are going with those. Your comment about the fact that many of the other guys who are smarter, more seasoned and more years ahead of us in terms of a large successful brand names have maybe gone bigger, bigger, bigger and then retreated back to some smaller prototypes, that’s a valid concern. We don’t see right now excessive capacity in our prototype two-storey boxes at all. We just don’t see that and I have many of clubs – I was in Scottsdale for four hours three, four weeks ago, just standing around and literally watching different parts of the club and see if we’re getting the proper utilization and the answer is yes.

We have a number of clubs; no more than about four I think where we have the expanded basketball side to it. The idea there is to test all sorts of activity programs for youth, for teens, for adults, functional training, et cetera. I can tell you right now that I would give us probably a two or a three on the scale of zero to 10, in having properly programmed that. So you can’t – we will not be going out and building 40 more of those facilities with that expanded side until we prove out that in those three or four models that we have developed we can actually run programs that justifies better membership as well as additional in-center revenues, better connectivity. If we cannot prove that out, we’re not going to expand the size of these clubs.

I’m also working as last year we created the three-storey model for the markets where it just made more sense to have that larger box with better demographics, more density, et cetera, I’m working on a variety of models right now with my design team where it brings maybe a tighter format but only at 110,000 square feet. Another one that I’m going to be working on in the next few months is at maybe 80,000 or 90,000 square feet. This is not to say that our boxes are not working what it really says is that you really need to have variety of different boxes to build the appropriate product for the demographic as well as the density traffic patterns et cetera. So we’re slowing working our ways but I don’t see a negative, I’m very, very confident that the bulk are based on where we are building the clubs, the bulk of increase in the cost of these centers is geographical reasons and we will be able to get the returns to make great results.

Michael Robinson

Scott your second question on this was sale leasebacks and why historically hasn’t that been something at the top of our list and has anything changed, it’s all really a cost of capital question. It ultimately is what’s the financing costs, what’s the differences et cetera. As we have seen over the last several years as our balance sheet has improved, our credit has improved et cetera, we are actually seeing fairly significant improvement in the cap rates that people are offering us and so if you work through that and the full P&L impact of those cap rates compared to alternative costs, i.e. mortgages, things like that, we are at a point now where it’s relatively neutral and that is a difference from the past. Now you also asked how do we look at the bumps and things like that, from an accounting perspective you calculate the total rent over the entire lease and you straight-line it so you incorporate that in the analysis and you determine from there whether you’ve got something that from an overall cost to capital perspective is neutral to a favorable neutral of worse than alternative forms of financing. And to date as we see it right now it comes in about neutral. So thus it’s another avenue of funding that we will look at.

Bahram Akradi

And we may do as a practice, a couple, two, three sale leasebacks from time to time to keep all of the financial metrics in the right levers so that as an example if your revolver is based on certain price at a certain debt ratio et cetera you may do just a one or two sale leasebacks to keep everything at the optimum metrics for the company particularly since the P&L impact of that would be neutral. Did that answer you question Scott?

Scott Mushkin - Bank of America Securities

No you did, thanks for the thorough answer actually.

Operator

Your next question comes from Sharon Zackfia - William Blair & Company

Sharon Zackfia - William Blair & Company

What a relief to have a company beat numbers. I guess I’m curious Bahram on the – did you adjust enrollment fees towards the end of the month of March or towards the end of the March quarter, I was a little confused there?

Bahram Akradi

Good question, only towards the end of the month of March. We had committed to branding campaign early part of ’07 and we spent a significant amount of money in the fourth quarter of ’07 and first quarter of ’08 and we basically as I mentioned earlier very focused on the customer experience not wanting to overcrowd the clubs over the January, February time period. We really didn’t start pushing harsh campaigns of membership, lower initiation fees, and more aggressive direct mail towards the second half of March and the results are phenomenal. I can tell you we know this, we’ve told – since we went public and in the IPO period I have told people I’ve been doing this business for 25 plus years and during the recessionary time people are insensitive about spending their $50, $60, $70, $80 a month as long as they’re utilizing the club.

They can skip one travel for $800 three days and then pay for their membership dues for the entire year and have all that entertainment available to them and pastime. So the key is not make it difficult for them to get in on the initiation fee and we were kind of tough on not lowering those during the first couple of months of the year and now that we have been able to get past those two quarters that we had commitments in advance on TV campaigns et cetera, we are in a great position for remainder of the year to pivot as necessary on the marketing, types of marketing and adjustments of the enrollment fees to get the membership counts we want to get in the door and then with the improved programs that I’m working on right now with connectivity, we feel very comfortable we can keep the members and therefore solid in terms of confidence about delivering what we have promised you guys with our plan for the year.

Sharon Zackfia - William Blair & Company

And have you done that enrollment fee adjustment just at the clubs that are struggling a little bit more or was that something that was done across the board?

Bahram Akradi

What we’ve done with those is just recently again, we’ve kind of taken a club that was a little more challenged with memberships and you kind of break it up, we’re not doing the same price on enrollment fee across the country. Depending on the market we have different level of discount on the initiation fee and like I said the results are very much coming in exactly as we had expected.

Sharon Zackfia - William Blair & Company

Okay and then can you just remind us on the branding campaign, was that incremental dollars you spent or was that just a reallocation of your marketing dollars?

Bahram Akradi

We spent a lot of our dollars in 4Q and first half of 1Q this year, we spent a lot of our dollars on branding and so I took a little bit extra dollars towards the last half of March and added just a little bit of dollars in March to our kind of a direct mail acquisition. As a result the total marketing spend, Mike how much was it over the year before?

Michael Robinson

It was 3/10ths over.

Bahram Akradi

Yes, so it wasn’t a significant amount Sharon.

Sharon Zackfia - William Blair & Company

Okay, thank you.

Operator

Your final question comes from Karen Howland - Lehman Brothers

Karen Howland - Lehman Brothers

Congratulations on a good quarter. I was wondering Bahram if you could give a little bit more detail as far as the pilot phase for increase in connectivity with you customers, any insight as to what that might look like.

Bahram Akradi

I want to be guarded on all the things we have – we are working on what I would call a whole thought, it’s a complete thought about all the different things that involves the improvement of member connectivity as well as member communication. If I go back and I say what would give on a scale of zero to 10 for Lifetime Fitness’ member communication, I would give us probably a very, very weak low number of maybe two or three on a scale of zero to 10. If you look at what’s happening, how we communicate with our members, its kind of a stone age archaic. What we are working on feverishly right now that will come about – my goal is to rollout by the first part of the third quarter systematically across the – it’s a new web design that increases the connectivity, new way that we will connect with each and every member in a way that is much more relevant to their interest area, better communication towards the launch of our LTF Vision which is our own TV network. So I feel really great. I don’t want to give you too much details but I can tell you we are working on that right now pretty much seven days a week and we feel that the results will be dramatic. It will really take an area of our company that has been absolutely nothing to brag about compared to the shape and offering of our facilities and programs, its been really not even in the same league and bringing it up to this as good as everything else is or better.

Karen Howland - Lehman Brothers

It sounds likes it more communication though as compared to new programs that are being rolled out, is that right?

Bahram Akradi

That’s not true, it is both. It is both more programs, better programming, depending on the area of your interest and better connectivity with those groups as well as better communication.

Karen Howland - Lehman Brothers

Okay great. Talking about the 15% ROIC that you’re expecting to get when you get to a mature center, I was wondering if with the more expensive centers that you’ve been opening that hitting maturity is taking any longer or is it still just taking the three years to achieve?

Bahram Akradi

They looked about the same.

Michael Robinson

Yes, the ramp looks about the same, we don’t expect any difference.

Bahram Akradi

And it’s the same kind of mix. Some will look like they get there sooner and some will get there a little later and the average will be about the same.

Karen Howland - Lehman Brothers

And them Mike if you wouldn’t mind talking quickly a little bit about the financing, am I right that you said that you’re going to look for another $100 million of increased revolver from your lenders right now?

Michael Robinson

That’s correct.

Karen Howland - Lehman Brothers

And then another $20 to $50 million in mortgage financing this year?

Michael Robinson

Actually we are pursuing several alternatives that range from 20 to 50 and I expect we’re going to close on several of those so its not just 20 to 50, there will be quite a bit more than that that we would expect.

Karen Howland - Lehman Brothers

Okay so it’s presumably each one of those is over a grouping of centers.

Michael Robinson

From one to four centers or so, yes.

Karen Howland - Lehman Brothers

And that would be the actual financing that you get not the value that it’s attributable to?

Michael Robinson

That’s correct, that’s the financing that we would get and in addition to that as I talked about we are negotiating on sale leasebacks in the range of $25 million to $100 million.

Karen Howland - Lehman Brothers

And that $25 to $100 is all in not a grouping of multiple – that’s going to be the total sale leaseback its not as if there’s going to be multiple --?

Michael Robinson

There could be, there could be multiple of that also but again we’re looking at things that go from a $25 million deal to a $100 million deal.

Karen Howland - Lehman Brothers

Okay, when looking at the [well bridge] and remodels that are I believe coming through will be finalized after the end of the second quarter will those immediately be in the comp base or post remodel are those not included?

Michael Robinson

They are in the 13 or 14 month comp base right now and have been since July of last year.

Karen Howland - Lehman Brothers

Okay great, I wasn’t sure how that with the remodels if that got impacted at all and then finally looking at the center operations margin, do you think that that improvement is maintainable as you shift more towards in-center revenue as a higher percentage of your overall revenue or would you expect that to decrease with time?

Michael Robinson

On a center operating line, I mean we obviously have in overall operating margin we continue to expect to see improvement and that is going to be driven by leverage of our G&A line. If you focus directly on the center operating line, there clearly will be pressure down as our in-center revenues grow but at the same time we continue to feel that we’ve got opportunities through scale and labor efficiencies and centralized processing and things like that to be able to hold so generally I would expect it should be relatively neutral.

Karen Howland - Lehman Brothers

Perfect, thanks so much.

Operator

Ladies and gentlemen this concludes the question and answer session of today’s presentation. I would now like to turn the presentation back over to Mr. Ken Cooper for closing remarks.

Ken Cooper

Thank you for participating. Our Annual Shareholders Meeting occurs later today at 2:00 pm ET and will be webcast live. We look forward to reporting to you our second quarter 2008 results which tentatively has been scheduled for Thursday, July 24th, at 10:00 am ET. For these and other key dates, please see the Events section within the Investor Relations section of our website. Thank you and good bye.

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Source: Lifetime Fitness, Inc. F1Q08 (Qtr End 03/31/08) Earnings Call Transcript
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