This article acts as a follow-up to an article I recently wrote on Life Time Fitness Inc. (NYSE:LTM-OLD), "Life Time Fitness: A Value Stock In Shape For Large Upside." I summarize below my initial investment thesis, describe how the recent announcement affects the company, and present a new outlook for the stock. This article will not repeat my valuation or detailed long-term outlook in the prior article, which I believe remain applicable.
Life Time Fitness Inc. "is engaged in designing, building and operating distinctive and large, multi-use sports and athletic, professional fitness, family recreation and spa centers in a resort-like environment." The company currently has 112 centers in operation throughout North America (almost all in the U.S.), and the company is planning on expanding its footprint. The company plans on building seven more centers in FY 2015. The company's stock price closed at $46.64/share on August 27, 2014, its current 52-week trading range is $38.01 to $56.78, and the company does not currently have a dividend.
LTM's Recent Announcement:
At approximately 9:00am on August 25th, Life Time Fitness, Inc., "The Healthy Way of Life Company, [announced] that its board of directors and senior management team have initiated a process to explore a potential conversion of real estate assets into a Real Estate Investment Trust (REIT)." In addition, "the Company's board adopted a shareholder rights plan to prohibit ownership of more than 9.8% of its outstanding shares in order to safeguard its ability to pursue a pro rata dividend in connection with a REIT conversion." This shareholder rights plan, or "poison pill," will protect the company against takeover attempts. However, the shareholder rights plan will expire on August 21, 2015, or the first business day after a REIT conversion is complete (whichever comes first), so the protection won't last forever.
This news report caught many investors by surprise and prompted numerous financial news articles, including a Wall Street Journal article. Investors reacted very positively to the news, and LTM surged 16.25% higher during the day (10%+ in pre-market trading) on 5.77x average trading volume. Although the announcement came as a surprise to many, it wasn't the first news report related to LTM and the formation of a REIT. For example, on May 22, 2014, "Piper Jaffray tip[ped] off that Life Time Fitness could announce a plan to form a REIT during its analyst day on June 4." Surprisingly enough, these news reports came months after "Chief Executive Bahram Akradi indicated that he didn't think a REIT structure made sense strategically for the company," in March 2014. Clearly Mr. Akradi changed his mind, and it would appear as though Piper Jaffray analysts were right (even though they were wrong about the timing). When asked what changed since Mr. Akradi's discussion in March, company spokesman Jason Thunstorm said "…that the decision to explore a REIT spinoff was a result of management's 'support of a more efficient capital structure and our growth.'" LTM's board will be meeting with its financial advisers, Wells Fargo Securities and Guggenheim Securities, soon to review the idea.
Life Time Fitness still needs to make sure that it will qualify as a REIT, but that shouldn't be a problem. In order to qualify as a REIT, "…a corporation must meet a series of stringent requirements, including that at least 75 percent of its assets be cash items and 'real estate assets'…and that at least 75 percent of its gross income be derived from real estate, such as rental income." LTM should be able to qualify as a REIT quite easily.
One final note: "The Company says that it won't make further statements about its plans to convert to a REIT until its board has approved a specific transaction for converting it to a REIT."
What The Announcement Means For LTM and Investors:
The REIT structure "…was set up by Congress half a century ago to make it easier for the public to invest in office buildings and shopping malls, but its use to reduce tax bills has spread." LTM's announcement comes at a crucial time, because the Treasury Department is attempting to stem the flow of international companies that are attempting to "…relocate to foreign tax jurisdictions via mergers." However, the U.S. government is much more accepting of candidates for a REIT, so I do not believe that LTM will encounter government resistance if it attempts to do a REIT spin-off.
As previously mentioned, LTM currently operates 112 centers across the U.S. and Canada, and the company "…had $2.3 billion in net property and equipment assets as of June 30, according to a regulatory filing." A conversion of assets into a REIT "…would result in two publicly traded companies: one for club operations, and a REIT for owning, acquiring and leasing real estate." The REIT would then be eligible for tax benefits if it pays out at least 90% of its net income as a dividend.
By adopting a shareholder rights plan, LTM has provided a timeline for when investors can expect the conversion to take place (if it is approved, of course). The shareholder rights plan gives LTM's board 12 months of freedom, which they will be able to use to approve a conversion of assets into a REIT. If LTM's board gives its approval, the conversion "…could take nine to 12 months to complete," which coincides with the timeline set out by the shareholder rights plan. Therefore, it appears clear that this entire situation will wrap up in approximately the next nine months.
The Asset Conversion and REIT Spin-off: Outlook
A REIT spin-off would be very beneficial for LTM. The company has experienced increasing levels of competition recently, and a REIT provides an excellent hedge for the company. Investors clearly agree, as LTM's share price jumped significantly on the news.
How would current or new investors profit from a REIT spin-off? Well, after reading the following quote from mondaq.com I'm sure you will understand how a REIT spin-off will benefit LTM.
"In the current genre of REIT Spin-Off transactions, generally:
- An operating corporation that otherwise could not qualify as a REIT (the 'OpCo') contributes its real estate assets into a subsidiary (the 'PropCo');
- OpCo then distributes PropCo shares to its shareholders in a tax-free spin-off for U.S. federal income tax purposes; and
- PropCo then leases the real estate assets back to OpCo under a master lease. Typically, this would be a 'triple net lease' under which the tenant (i.e., OpCo) is responsible for all maintenance, insurance, and taxes of the leased properties.
Structured properly, the rent payments made by OpCo under the master lease would be deductible by OpCo, but exempt from corporate-level tax in the hands of PropCo (assuming all REIT taxable income is distributed to its shareholders). For this reason, the possibility of a REIT Spin-Off is an exciting development for companies that have significant real estate assets but could not otherwise qualify as a REIT, since it provides a potential way to unlock value in such assets by taking advantage of the tax-free spin-off rules."
In the scenario described above, LTM is the "OpCo" and the REIT spin-off entity is the "PropCo." As previously mentioned, LTM has approximately "$2.3 billion in net property and equipment assets" so I think that LTM fits the bill perfectly when it comes to companies that can benefit from a REIT spin-off.
And the hedge against a drop in performance? REITs are free from U.S. federal income tax, so long as they follow all of the standards mentioned above. Morningstar.com lists LTM's current tax rate (TTM) as 39.13%, and these savings go right to the company's bottom line.
The announcement comes at a crucial time for the company because its financial performance has begun to suffer recently. "Life Time last month posted second-quarter profit that trailed analysts' estimates and cut its sales forecast for the year as revenue at fitness centers open at least 13 months slid 0.6 percent." As mentioned in my first article on LTM, I believe that LTM's growth will pick up in the short term, but the company also has a lot of long-term obstacles that may seriously impede the company's growth in the long-run. One such obstacle, which I failed to include in my previous article, is the large amount of debt that will be added to the company's balance sheet when its operating leases are capitalized. This will hurt the company directly in terms of ROA and ROIC, but I believe that a REIT spin-off will significantly help the company's long-term outlook. This "obstacle" is actually not specific to LTM -- it is something that every company in the industry needs to deal with, and LTM does a much better job than most other companies in the industry in terms of dealing with these kinds of problems.
Potential Downside To A REIT Spin-off:
I would be remiss if I did not mention some potential downsides to doing a REIT spin-off. To that end, below is a quote from mondaq.com that describes "Some Potential Issues Of REIT Spin-offs":
- "Business Purpose: A spin-off generally must have a non-tax related business purpose to qualify for tax-free treatment. Depending on the situation, this might be, for example, the REIT's better access to broader capital sources.
- Active Business: Following the spin-off, the controlled corporation in a tax-free spin-off generally must conduct an active business that was historically conducted by the OpCo group. In the case of a REIT Spin-Off, the PropCo might not satisfy this requirement as the lessor under a 'triple net lease.' Thus, OpCo generally must contribute additional operating assets to PropCo as part of the spin-off. These operating assets generally could be held by one or more 'taxable REIT subsidiaries' ('TRSs') of PropCo to avoid jeopardizing PropCo's REIT status, although the TRSs would be subject to corporate-level tax on their income.
- Qualifying REIT Assets: Although recent guidance by the IRS confirms that assets such as outdoor advertising displays and certain components of solar generation facilities could constitute 'real estate assets' for purpose of the REIT Asset Test, uncertainties remain as to the qualification of other non-traditional real properties (e.g., those held by companies in the technology sector).
- Qualifying Rental Income: For purpose of the REIT Income Test, rents received from certain related parties are excluded. Generally this means a single shareholder cannot own (taking into account applicable attribution rules) 10 percent or more of both OpCo and PropCo.
- E&P 'Purging' Distribution: PropCo generally must make an earnings and profits ('E&P') 'purging' distribution to its shareholders before it can qualify as a REIT. This 'purging' distribution generally is taxable to the shareholders. To the extent a significant amount of E&P is apportioned to PropCo in the spin-off, PropCo shareholders would receive a large taxable 'purging' distribution, which reduces the overall tax appeal of the spin-off."
As previously mentioned, in the scenario described above LTM is the "OpCo" and the REIT spinoff entity is the "PropCo."
I included this second quote from Mondaq because I did not want to give the impression that I am completely biased. I think that it is very important to consider both sides of every situation, and fully understand all of the risks involved.
Changes To My Investment Thesis Due To Recent Announcement:
In my first article on LTM, published on August 13, 2014 (available to SA PRO subscribers for 24 hours prior to that), I outlined the four points of my investment thesis as follows:
- Life Time Fitness is an excellent value stock poised for upside of 30%-40% over the next twelve months.
- LTM strongly differentiates itself from its competitors by creating high barriers to entry in an industry that typically has few such barriers.
- As one of two publicly traded gym companies, LTM has experienced solid growth over the last five years and presents the best investment opportunity in the industry.
- The leisure industry benefits significantly in an improving economy, and LTM is well-positioned to leverage these positive economic tailwinds, with long-term growth potential.
LTM's recent announcement affects my entire original investment thesis for the company, because it provides a completely new set of drivers for the company's stock price. LTM's price will now be largely driven by news related to a REIT spin-off, rather than being driven by other external factors (like macroeconomic news and valuation). This takes a lot of the control out of analysts' hands and puts the company in charge of its stock price's destiny, because its board will ultimately decide whether or not they want to pursue a REIT conversion.
Other than educated guesses, analysts have no real way of knowing what will happen to LTM's stock price and this uncertainty is risky. I would now say that, conservatively, LTM trades at an approximate 10%-14% premium to the price that it would probably be at right now if the company hadn't made the announcement. This gives investors who are buying shares of LTM now much more risk (10%-14% more) than if they had bought shares of LTM when my first article on the company came out.
Going forward, I expect that any news relating to the company's board approving the decision to do a REIT spin-off will be met with a rise in LTM's price. Conversely, any news relating to the company's board not approving the decision to do a REIT spin-off will be met with a decline in LTM's price.
My Outlook For LTM:
Consistent with the title of this article, my general outlook for LTM has not changed. I still believe that LTM is undervalued. However, it is not as undervalued now as it was when my first article was published. My price target, which remains at $53, now only provides 13.64% of upside. In terms of downside potential, with support at $38, I see downside potential of approximately 18.52% (most extreme case). This can be seen in the chart below, which is an updated version of the chart from my first article on LTM:
Data Source: Stock price data and indicators from Stockcharts.com
- Notes: Data for the chart goes through August 27, 2014, so please understand that all the data is "incomplete" due to the fact that this chart uses "weekly" time intervals. My "Entry Price" would be approximately $39.55 (LTM's opening price on August 14, 2014), and my "Price Target" is set at $53.
In the interest of full disclosure, my average purchase price for my position in LTM is $39.777. I opened my position in LTM shortly before my article on LTM was published, and I have not touched my position since it was opened.
When using technical analysis (as seen in the chart above), LTM appears to be in great shape (no pun intended). LTM has a lot of support around its 200 Week Moving Average ($44.75), and a break above $47 would be great from a technical analysis perspective. The only downside that I can see is that there's a huge "gap" in LTM's price chart, from around $45 to $39. Chartists, who specialize in technical analysis, love to talk above gaps getting "filled," so I think it is worrisome that there is such a huge gap in the weekly chart for LTM. I think it is possible that the gap could get filled before LTM moves higher in price, but for that to happen LTM would need to break major support in the $45 range. Ultimately, I view the chart above as very positive, and I see the maximum downside risk of 18.52% as rather unlikely.
However, with upside potential of 13.64% and downside potential of 18.52% (most extreme case), I no longer see LTM as offering an asymmetric risk/return profile. Therefore, I am changing my rating for LTM to a "Conservative Buy" from my prior rating of "Strong Buy" (from my previous article on LTM). I am also changing my price target timeline to nine months, from twelve months, because I believe that the fundamental drivers behind LTM's price have now changed and that warrants a change in timeline. It is very likely that LTM could reach my PT in a much shorter period of time than nine months, and if my PT is reached, I would then rate LTM as a "Hold."
Why do I still give LTM a "BUY" rating if it no longer offers an asymmetric risk/return profile? Well, I believe that there is a very high likelihood that LTM's board will approve the conversion of assets to a REIT, and create a REIT spin-off. I believe that an announcement to that effect would provide a significant boost to LTM's share price, which would help LTM reach my price target. Therefore, I believe that there is a very high probability that investors in LTM will see further stock price gains as a result of news related to a REIT spin-off, and this leads me to believe that LTM is still a BUY at its current price.
Life Time Fitness, Inc. is at a major crossroad, and the decisions it makes now will likely have a huge impact on the company's future prospects. I believe that a REIT spin-off would be very beneficial for LTM, and it would likely help the company in the intermediate term (3+ years).
My investment thesis for LTM is now different, because it provides a completely new set of drivers for the company's stock price. I now believe that LTM's price will now be largely driven by news related to a REIT spin-off, rather than being driven by other external factors (like macroeconomic news and valuation). Going forward, I expect that any news relating to the company's board approving the decision to do a REIT spin-off will be met with a rise in LTM's price. Conversely, any news relating to the company's board not approving the decision to do a REIT spin-off will be met with a decline in LTM's price.
My outlook for LTM is roughly the same, and I still rate LTM as a BUY (although a more conservative one). I maintain my price target at $53, but I now have a nine-month timeline for my price target (instead of my prior 12-month timeline).
Disclosure: The author is long LTM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.