Town Sports International Holdings, Inc.

Why I bought a few CLUB shares

Published on:
September 22, 2019
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"Gyms need their members not to come, but they can't just lock the doors," notes Caitlin Kenney in Planet Money, NPR's economics podcast. "So they have to rely on consumer psychology to get you excited enough that you'll sign up for a gym membership, but not so excited that you'll get up an hour early to do some crunches before work."

Indeed, ask any physical trainers and Yogis: owning a fitness center is a straight forward business model. You lease 2,000 to 20,000 SF space, buy or lease some fitness equipment and get as many customers signed up. 

The fitness industry's rule of thumb is that if you can sign up 20 times the capacity of the studio, you will be in good shape [1]. 

But it's a tough business. First, not unlike the hotel business, customers' expectations and standards increase with time. Hotel guests now demand flat-screen TVs and a queen-sized bed at a minimum.  And gym members expect Peloton machines and shiny, new barbells. In short, you always reinvest cash in the business.

The fitness business is tough. Owners have to reinvest earnings and customers are unwilling to pay more for the upgrades.

Another drawback is that the operating costs - specifically, lease payments and labor wages - increase over time. And while these expenses rise, customers are unwilling to pay more than roughly $40 a month.

If gym owners increase prices, there are plenty of alternatives. People can exercise outside at no cost; they can subscribe to an app [2] for a fraction of the cost, or they may go on a diet and give up on physical exercise.

Buying a few CLUB shares      

While the fitness business is competitive with little barriers to entry [3], I bought a few shares in Town Sports International Holdings (CLUB on Nasdaq), a fitness company with a pygmy market capitalization of $54 million or about $2 per share.

I calculated the 2018 free cash flow to be $15.1 million or $0.57 per share and the 2017 free cash flow to be $18.9 million or $0.73 per share. In other words, if the last two years serve as a proxy, Town Sports' cash flow will pay back investors their original investment in less than four years.

Town Sports International: income statement snapshot
Snapshot of CLUB's income statement

There are a few publicly-traded fitness companies. A glance at Planet Fitness shows that buying Town Sports is for the bargain hunter.

In 2018, Planet Fitness traded as low as $29 and as high as $57. The company generated pre-tax earnings of $131.8 million, or $1.51 per share, which translates to price to pre-tax earnings ratio range of 19 times to 38 times.

Compare that to Town Sports, which earned $38.6 million in pre-tax earnings, or $1.45 per share. CLUB's stock traded as low as $5 and as high as $15 - a range of 10 times to 3 times the price to pre-tax earnings. Today, at about $2 per share, CLUB is trading at 1.4 times the 2018 earnings.

Trading at four times the enterprise value to free cash flow, Town Sports is for the bargain- hunters.

Where's the catch? 

CLUB's bargain stock price comes alongside serious red flags. The list of concerns includes:
(1) The company's CFO, Carolyn Spatafora, has been selling the stock. She sold about 96 thousand shares this year [4], over 60% of her vested interest in the company.
(2) The company's debt matures in August 2020. Read: if the U.S. economy is in recession in a year, it is questionable whether lenders will finance the operations.
(3) Two-thirds of CLUB's gym members are on a month-to-month basis. To me, this shows that there is hardly any brand loyalty and that customers are unwilling to commit.
(4) Management decided this year to hide critical information from the financial statements. For many investors, that act alone would deter investment. I hope that management action is because it would like to hide information from competitors.

Town Sports International debt to assets ratio is high
CLUB's alarming debt to assets ratio

But that is probably wishful thinking. Michael Shearn, who wrote the excellent The Investment Checklist: The Art of In-Depth Research would be appalled by my action. In his words: 

I have learned that if the strategy of the business is based more on hiding information from competitors rather than outperforming competitors, it is far less likely that the business will have a long term success.

Careful readers of CLUB's prior annual reports would detect a deterioration in key metrics. So, it is little surprise why management would want to hide them.

A few examples: in 2013, the average revenue per member was $78 per month. As of 2017, the metric dropped by 24%, to $59. In 2013, the annual attrition [5] was 41.9%, while in 2017, it was 47%.

Finally, in 2013, the revenue per weighted average club was $2.97 million. The revenue dropped to 11% in 2017 to $2.64 million.

Management decided this year to hide key information from readers of its financial statements. The action alone deters investment.

The remedies

Patrick Walsh, who Forbes Magazine describes as a "Warren Buffett enthusiast," writes to CLUB's shareholders that "patience is a minor form of despair, disguised as a virtue."

I take a less cynical approach and estimate that there are few things good happening now and a few things worthwhile to be patient for.

First, Walsh is fiercely buying the stock. He bought 643 thousand shares this year at a weighted cost of $2.5. This amount was added to his already 3.1 million shares, which represent about 14% of the common stock outstanding.

Second, managing gym clubs does not require sophistication or expertise. I believe it is a matter of time before financial results return to a net profit margin of 10%, with Walsh in leadership or without him.

***

A year ago, the sports center across the street from my office, increased by almost two-fold the monthly membership rate, from $32 to $57. Infuriated by the price increase, I said to Jillian, the members' relationship manager at the time, that I would take my business elsewhere.

I never did. The convenience of having the JCC across the street from my office, and the community of people I became friends with, far outweighed the price hike. It is my hope members of CLUB fitness centers have the same experience.   

FOOTNOTES: [1] No pun intended. [2] I recently downloaded XPT Life, an app designed by legendary waterman Laird Hamilton. [3] Barriers to entry are the obstacles that make it difficult to enter a given market. [4] If the shares are, indeed, such a bargain at $2, would she not have preferred to hold them?[5] Page 37 in the 2017 10-k report notes that annual attrition is total member losses for the year divided by the average monthly member count. Read: the higher the ratio, the worse it is.