Town Sports' 'High-Value Low-Price' Strategy Is Doomed To Fail

Summary

• The New York Sports Club parent is trying to win back market share from low-priced competitors with $20 & $40/month "high-value low-price" no-contract plans.
• Most existing members will switch from $60-125/month memberships to these low-priced packages.
• Members of low-cost competitors unlikely to switch for same or higher cost, with little if any difference in amenities/service at CLUB.
• With generous assumptions, CLUB needs to increase membership 50% from 505,000 at 3/31/15 to 755,000 just to realize break-even operating income.
• It is extremely unlikely that CLUB will break even, let alone turn a profit any time in the foreseeable future.

Town Sports (CLUB), the parent of New York, Boston, Philly, and Washington (D.C.) Sports Clubs has a problem: Most customers don't (and aren't going to) pay $60-$120 a month when hundreds of low-cost, amenity-filled gyms from competitors like Planet Fitness, Crunch, Lifetime Fitness, Retro Fitness, 24 Hour Fitness, and LA Fitness (to name a few) having opened just in the past few years.

The company's solution, way late in the game, is to try to compete on price. This strategy will not, and cannot work.

Why?

• High operating costs: 2014 EBITDA margin was 11% vs. 29% for its only public competitor, Lifetime Fitness.
• It doesn't own, but leases all of its facilities, the majority of which are in high-cost, space-constrained urban and metro suburban areas.
• High interest expense from a high debt load. 4.4% of revenue vs. 3.4% for Lifetime.
• CLUB gyms are comfortably in the middle of the pack in terms of offerings, quality, convenience, and the like, so even for the same price, there is little if any reason for members of competing gyms to switch. (The author is currently, and has been a member of New York Sports Clubs on and off since 2007.)
• US gym memberships grew at a rate of 3.7% per year from 2000-2013. Gym turnover/attrition is also in the low single-digits.
• Competing gym memberships run $10-30/month.
• The new HVLP memberships are $20 or $40 month (the latter without an initiation fee), and, just as an example of value, don't even include towel service.
• Existing members pay about $60-120/month. In 2014, gym operations, the bulk of revenue, came out to about $77/month per member.
• As existing members switch to the HVLP plans, we expect average monthly revenue per member to decline into the mid $40/month range.
• CLUB needs A LOT more members just to break even.

How many more members?

With little if any reason for members of competitors to switch and a relatively small number of people without gym memberships likely to join, CLUB is extremely unlikely to offset the lower-cost memberships with enough new members.

Realistically, it won't even come close. CLUB will lose A LOT of money for the foreseeable future.

How much will it lose?

We are generously projecting 2015 FY operating income will be around minus $50 million, assuming a relatively slow shift of existing members to the HVLP plans and 9-19% membership growth. For perspective, the firm began offering the HVLP plans late in 2014. Membership only grew 4.3% in the first quarter of this year vs. the end of 2014.

While we do not think the HVLP strategy will work, we are sympathetic to the company's plight. It's being squeezed from both the bottom, by the dozen or so low-cost competitors, and from the top, by gyms like Equinox. It's stuck between the proverbial rock and a hard place. Ultimately, trying to compete on price in a competitive industry with little cost flexibility and a levered balance sheet is a recipe for disaster.

We think a lot of the bullish sentiment is anchored in some sort of misguided optimism, as there are a lot of "what-ifs" to this story.

• What if CLUB didn't have a ton of debt?
• What if it owned its facilities instead of leased?
• What if operating expenses could be materially reduced (maybe, though the new strategy requires higher marketing expenses)?
• What if it had responded to the proliferation of low-cost competitors 10 or even 5 years ago?

Unfortunately for bulls, we can't change the past, and there's not a lot of wiggle room to change the current or the future. Nostalgia and ego are a dangerous combination.

CLUB should (key word!) have enough cash to meet its interest payments for the next 2-3 years while it loses money. That said, default and bankruptcy risk are real concerns, though not imminent.

While we often find opportunity in restructurings, we see far more risk than reward in CLUB, and suggest investors avoid the name.

The stock was a screaming short going into earnings, however, after a 20% drop the past two days, that trade has become less obvious. Activist involvement, low volume and short-term volatility make a long-term bearish opportunity like this a risky short at today's price, but if you're comfortable with the possibility of a margin call or two while you take the long view, a short can still pay off. Can the company and its activist investors turn it around and drive the stock up? Maybe, though we've shown with simple math that a successful turn-around is unlikely.

As always,

CAVEAT EMPTOR

Analyst’s Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

The opinions presented herein are solely those of Stone Street Advisors LLC. Neither Stone Street Advisors LLC nor any of its members has a position in CLUB or CLUB derivatives, nor any plans to initiate a position. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Stone Street Advisors LLC makes no representation or warranty as to the accuracy, completeness or timeliness of the information contained herein, and disclaims all liability arising from errors or omissions contained in this presentation. This presentation is for informational purposes only and does not constitute investment advice. Stone Street Advisors LLC is not an Investment Advisor.

Comments

[Martin Keck]

"High operating costs: 2014 EBITDA margin was 11% vs. 29% for its only public competitor, Lifetime Fitness."

[Stone Street Advisors]

You're missing the forest for the trees. I spent 99% of the article focusing on operating profit, EBIT...

[Martin Keck]

Maybe I was not precise. I like most of your article. This one line out of your article should have been omitted imho. EBITDA comparison does not make sense. Did not mean to be rude.

[Stone Street Advisors]

You're not being rude, you're just obsessing over something that does not matter, and I don't understand why.

EBITDA comparison makes perfect sense when you're comparing firms that own v. lease in this context. I could capitalize CLUB's leases but I doubt that'd change the conclusion.

[Martin Keck]

You write CLUB does not own the real estate yet compare their EBITDA margin to LTM who own most of their real estate. That does not make sense to me.

[Stone Street Advisors]

What do you mean? I focused on operating income (EBIT).

[Twixer]

Thanks a lot. Agree with you, their marketing is terrible.

They need a marketing person who will take advantage of social networks and mobile technology to increase membership. Now people can easily track health parameters and post on social networks. In addition to pictures and videos. Gym operator can use that data to attract new members.

I have a look at their facebook pages. Only members post pictures. No content or marketing initiatives from the operator. They are not even responding to complains. TSI should encourage members to post pics, encourage competition and award members who post quality content, share experience, win competitions or achieve certain goals.

Their commercials, I looked at youtube, are wierd. They show guys in bad shape who should join ANY gym instead to present good looking people who improved their look and health in TSI gyms.

They have no youtube channel.

In my opinion health improvement industry will be one of the fastest growing. However, operaters and marketers with little or no understanding of new technologies will not be able to take advantage of the trend.

[Stone Street Advisors]

Here's the health club membership in millions for the U.S. 2000-2013 with the growth rates y/y.

2000 32.8
2001 33.8 3.0%
2002 36.3 7.4%
2003 39.4 8.5%
2004 41.3 4.8%
2005 41.3 0.0%
2006 42.7 3.4%
2007 46.7 9.4%
2008 45.6 -2.4%
2009 45.3 -0.7%
2010 50.2 10.8%
2011 51.4 2.4%
2012 50.2 -2.3%
2013 52.9 5.4%
CAGR 3.7%

What makes you think the industry is going to grow faster?

[Twixer]

I think that technology change will be very supportive for club membership growth. Some public policies which aim to reduce healthcare cost and increase productivity are also very supportive for gym membership.

Thanks to mobile technologies people can now consume much more content and be much better connected while in gym. The entertainment content is personalized since members bring their own phones/tablets or gym operator provides access monitors. Members don't miss messages, scores, favorite shows, news, stock moves, ... The better member is connected, the easier becomes for him/her to integrate gym in daily routine.

People waste a lot of time watching trashy shows, reading fiction books, hanging on social networks, … They usually do that at home on a couch. While combination of mobile technology and gym can’t help you get rid of those highly addictive activities, it can help bundle them with gratifying experience of exercising. Research paper by Wharton School shows that both gym attendance and fees can be increased if gym operator provides effective bundling of temptations and exercise. ("Holding the Hunger Games Hostage at the Gym" Milkman, Minson, Volpp)

Smart watches and the other wearables enable better measurement and tracking of health parameters. That will motivate many to engage in health improvement activities and join gyms. Moreover, those parameters can be recorded and shared online. Proliferations of health related data on social networks is also very supportive for gym membership and can be used for marketing purposes.

Other reasons I’m interested in this business are local. In Canada we have child fitness tax credit and the government is considering adult fitness tax credit. A small incentive to taxpayers can potentially yield considerable gains in healthcare savings and increased productivity. Also in recent months many retailers closed stores in Canada and there is plenty of real-estate available.

I researched TSI and the other operators. In my opinion TSI is not a good operator, has very poor marketing and show little understanding of new technologies.

[Twixer]

My brother is interested in opening gym. So we are researching this area. His motivations are:

1) Rents are dropping because retailers are closing.
2) Growing interest in exercise and healthy living
3) Temptation bundling. Thanks to mobile technology people are better connected and don’t miss news, messages, favorite shows, and sports while in gym. Hence, more willing to go to gym.
4) Smart watches provide better measurement and tracking of health parameters. People will be naturally tempted to improve those parameters and exercise more.
5) Wearables enable people to record their achievements and share online. Proliferation of smart watches will increase number of exercise related posts on social networks. It will be highly promotional for gyms. Smart marketing can take advantage of growing exercise/health discussion on social media and increase membership.

In my opinion gym membership growth should accelerate considerably in future years. Improved ability to measure and track health parameters combined with opportunity to easily share exercising results should be very supportive for gym business.

What are the prospects of this industry in your opinion?

I don’t live close to TSI gyms and never been in one. I don’t own CLUB shares.

[miketn6]

The health club market is really crowded and being actively disrupted by low price low overhead operators, and the low price clubs are driving down profit as a percentage of revenue across the industry. This is one industry where you really need a 20 year plus operator who grew up in the sales side of the industry to make a company work. CLUB lacks that today. Overall, the industry is unusually fragmented, and in addition to the low price clubs, high price niche players with low member counts and low profit seem to be taking members from big clubs. Nearly all of the big players in the health club industry are private companies.

[miketn6]

This is a good summary analysis, but the actual situation is slightly worse than indicated. CLUB is losing monthly dues revenue with an incremental direct contribution to profit of 95 plus percent. The contribution on join fees (after sales commissions and bonuses), personal training (after cost to service plus any sales commission and bonus), and other ancillary revenue is much less than dues. If anything, the new members CLUB needs to make HVLP work are higher than the numbers presented above, and CLUB is off to a very bad start with 21,000 net new members after blowing a big wad on 1Q advertising.

[Stone Street Advisors]

Thank you for the insightful comment.

As I mentioned, we're giving CLUB some undeserved benefit of the doubt, more giving the HF activists some credit, but probably undeserved nonetheless.

They are in trouble no matter how you slice it. There is literally zero chance they can make the HVLP strategy work. There simply aren't enough people who are could sign up, let alone will.

The question though, is there any alternative? Continue on with the previous strategy and watch membership dwindle? They desperately need Chainsaw Al or similar to come in a cut costs, otherwise they don' stand a chance (if they do at all).

[miketn6]

CLUB should never have gone public, and they'd have a much better chance of fixing the mess as a private company. Realistically, their model is being disrupted, and profit is probably going to decline no matter what they do. The only real alternative to HVLP was to make the clubs more exclusive, raise dues, and try to get by with fewer members, but that might be hard to pull off across so many clubs. GAAP treatment of deferred revenue complicates and distorts health club financial reporting, and most of the large successful chains are private companies. Unless Planet pulls off an IPO, with LTM going private, there may not be any pubic health club companies in 18 months. If I were on CLUB's board, I'd be trying to auction off each market area to the highest bidder, and that might have worked before the bet the company strategy shift to HVLP. It's hard to see any credible buyers stepping in until the HVLP shift plays out, and that isn't good for shareholders.

[Stone Street Advisors]

The only thing I can think of is they're going to try to juice membership #'s as much as possible, try desperately to reduce debt a little, shop to PE with pitch that OpEx can be cut and membership prices can rise because "membership is sticky and attrition is only 3.5%!" or some such nonsense.

The folks at PW, HG Vora aren't dumb, so what's your read? What do they see that we don't, or is this an ego-driven thing primarily (moreso than any turnaround/activist campaign)?