Town Sports is tiny compared to many stocks, with a market cap of about $60 million. With a recent stock price around $2.75 and a three month average daily trading volume of about 120,000 shares, smaller investors should be able to find sufficient liquidity.
Town Sports is the fourth largest owner and operator of health clubs in the U.S. with 166 locations. Its locations are concentrated in and around New York, Boston, Philadelphia and Washington. Monthly membership dues are about 80% of total revenues and provide a predictable recurring stream of cash flows.
In fiscal year 2008, the company generated $96 million in cash flows from operations (CFO), or $92 million if we exclude changes in working capital. Of the $96 million in CFO, only $33 million was spent on things we would consider maintenance capital expenditures (i.e. repairing and replacing fitness equipment, upgrading information systems and health club remodeling). This left $66 million of what we consider "discretionary" cash flows, or those with which management can redeploy to enhance shareholder value.
The company's 2009 annual 10-K report should be available in the next few weeks, but third quarter numbers showed $59 million in CFO year-to-date ($51 million excluding changes in working capital), with $40 million in capital expenditures (no breakdown provided for maintenance and discretionary capex in quarterly reports).
According to the 2009 proxy statement, company insiders and companies that insiders are affiliated with own approximately 45% of total shares. This creates very large communities of interest between insiders and passive minority investors.
Of course, every potential investment has something wrong with it. And Town Sports is no exception. With a soft U.S. economy (163 of 166 clubs based in U.S.), membership and ancillary revenues are down. Because the health club business model has mostly fixed costs and a lot of operating leverage, cash flows are down significantly year-over-year.
With families looking to reduce household budgets in these challenging times, health club memberships are often viewed as discretionary and can be substituted with home fitness, jogging, biking and other activities. Other families facing layoffs are forced to eliminate this expense.
Although the company has generated significant "discretionary" cash flow over the past few years, it has used substantially all of that cash flow for expansion. Not until recently has the company reduced expansion-related expenditures and focused capital allocation on debt reduction and stock repurchases.
Here is the main problem the company faces: as of 09/30/09, the company had $328 million of debt. This included $138 million principal amount of 11% senior discount notes and $180 million term loan facility. The 11% senior notes are due in 2014 and the term loan facility is due in August 2013 if the senior notes are still outstanding at that time. Otherwise, the term loan facility is due February 2014.
How will the company pay this debt down to a manageable level? It could stop expansion-related expenditures (which we recommend in the face of economic headwinds), issue more shares (effectively a highly dilutive debt-for-equity swap), or try to refinance into later maturities sometime in the next few years.
The company's 2009 discretionary cash flow yield should well exceed 30% and could end up much, much higher. Based on fiscal 2008 numbers, the company's discretionary cash flows were about 100% of its current market cap. Should the company stabilize its debt situation and return to 2008 recession performance, the stock could be considered very cheap.
If we take the company's debt into consideration and look at a recent enterprise value of about $375 million, the company could also be considered for a buyout (although this may be difficult considering the large stake by insiders).
Should the company stop expansion-related expenditures and focus on debt reduction, there is still plenty of time to bring debt levels down to a manageable level. The good news is that there is still time with large maturities in late-2013 and 2014. In fact, more conservative investors may want to look into the company's 11% Senior Discount Notes for a more senior position in the capital structure. The last time we checked, they were trading at a large discount and offered an equity-like return.
Our full report and fair value range for Town Sports International is available to All-Access subscribers at IgnoreTheMarket.com.
Disclosure: The author does not currently hold a position in any of the securities mentioned, but has recently published a report recommending a small position in CLUB for aggressive investors.