March 22 - Overview -- Operating performance at U.S. fitness club operator Town Sports improved in 2011, resulting in part from higher member count and growth in ancillary revenue, in conjunction with lower operating expenses. -- The performance helped drive an improvement in adjusted leverage of around 1x and a slight improvement in interest coverage, which we believe are sustainable. -- We are raising our corporate credit rating on Town Sports to 'B+' from 'B'. -- The stable rating outlook reflects our expectation that, despite an expected acceleration of new club openings over the next few years, adjusted leverage will remain below 6.0x and interest coverage remain around 2.0x. Rating Action On March.22, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on New York City-based fitness club operator Town Sports International Holdings Inc. to 'B+' from 'B'. The rating outlook is stable. At the same time, we raised our issue-level rating on Town Sports' $350 million credit facility, consisting of a $50 million revolver due 2016 and a $300 million term loan due 2018, to 'B+', from 'B'. The recovery rating remains '3', indicating our expectation of meaningful (50% to 70%) recovery for lenders in the event of a payment default. Rationale The rating upgrade reflects our expectation that recent improvements in operating trends, which, along with modest debt reduction, drove a decline in adjusted leverage of around 1x in 2011, will continue over the intermediate term. Under our current performance expectations and incorporating continued modest debt reduction, as required under Town Sports' credit agreement, we believe Town Sports will maintain adjusted leverage below 6x (our operating lease adjustment adds approximately 2.5x to leverage) and interest coverage around 2.0x. We view these thresholds as supportive of a 'B+' corporate credit rating, based on our assessment of Town Sports' business risk profile. The upgrade also reflects our belief that the planned acceleration in new club openings over the next few years (management has indicated their intention to open one club in the second half of 2012, three to six clubs in 2013, and six to 12 clubs in 2014) will be funded through internally generated cash, and that remaining cash flow, if any, would be used for modest debt reduction. Our 'B+' corporate credit rating on Town Sports reflects our assessment of the company's business risk profile as "weak" and its financial risk profile as "aggressive," according to our criteria. Our assessment of Town Sports' business risk profile as "weak" reflects its susceptibility to shifts in demand during economic cycles, the competitive operating environment, and the high member attrition rates characteristic of the fitness club industry. Town Sports' position as the largest owner and operator of fitness clubs in the Northeast and mid-Atlantic regions of the U.S., and the third largest in the U.S. in terms of number of clubs, partly offsets these risks. Our assessment of the company's financial risk profile as "aggressive" reflects our expectation for operating lease-adjusted interest coverage to remain around 2x, adjusted leverage to improve towards the low 5x area, and adjusted funds from operations to total debt to be maintained in the low- to mid-teens percentage area, over the intermediate term. It also reflects our belief that capital expenditures will be funded through internally generated cash, and that Town Sports will prioritize growth capital expenditures and debt reduction over shareholder distributions. Our rating currently incorporates our expectation for revenue and EBITDA to grow in the low-single-digit percentage area in 2012 and for revenue to grow in the mid-single-digit percentage area and EBITDA to be about flat in 2013. This forecast factors in an expectation for one new club opening in 2012 and up to six in 2013, and also considers our economists' current forecast for 2.0% growth in consumer spending in each of 2012 and 2013 and an improvement in unemployment rates to 8.2% this year and to 8.0% by the end of 2013. We expect continued economic improvement will result in a stabilization of the annual attrition rate around its current level (39.9%), and will also lead to continued growth in higher-margin, ancillary services such as personal and small group training. We also factor in an expectation for continued softness in monthly membership dues in 2012 because of the increased proportion of restricted membership, with limited growth in 2013. We believe this partly will be offset by continued increases in the average joining fees collected. On the expense side, our rating incorporates an expectation for modest increases in payroll expense related to higher joining fees and increases in new members (both at existing and new clubs), as well as higher club operating costs associated with incremental rent expense and other operating costs related to new clubs. It typically takes around 12 months before a new club reaches profitability, and we believe Town Sports may experience a slight EBITDA margin decline in 2012 and 2013 as a result. Nevertheless, we believe EBITDA margin will be maintained in the high-teens percent area. In 2011, revenue and EBITDA grew about 1% and 18%, respectively. The revenue growth was driven by a 6.1% increase in membership count, partly reflecting an increase in the number of restricted members and a decline in the attrition rate to 39.9%, the lowest level in the last four years. This growth was partially offset by continued softness in membership dues rates. The revenue increase also reflected a 2.5% increase in personal training revenue (or 6.2% adjusted for unused sessions recognized in 2010), and a 14.6% increase in other ancillary revenue (this includes small group training and other member activities). The growth in EBITDA was driven in part by the revenue growth, particularly in ancillary services, and by lower payroll and general and administrative expenses. As of Dec. 31, 2011, operating lease-adjusted leverage was 5.8x and interest coverage was 1.9x. Liquidity Based on the likely sources and uses of cash over the next 12 to 18 months and incorporating our performance expectations, Town Sports has a strong liquidity profile, according to our criteria. Our assessment of its liquidity position includes the following expectations and assumptions: -- We expect sources of liquidity (including cash and revolver availability) over the next 12 months to exceed uses by at least 1.5x. -- We expect net sources to be positive, even if EBITDA declines 30% over the next 12 months. -- Compliance with covenants would survive a 30% decline in EBITDA. At Dec. 31, 2011, sources of liquidity included $47.9 million of cash on hand and $40.4 million of availability under its $50 million revolver, after accounting for letters of credit. Free operating cash flow increased $15 million to about $44 million in 2011 versus 2010, despite a $9 million increase in capital expenditures, primarily associated with the opening of two new clubs. Given our expectation for 2012 EBITDA and management's guidance for 2012 capital expenditures of up to $28 million (including one new club opening at an expected cost of around $2.5 million), we believe free cash flow will be sufficient to fund $15 million in term loan amortization payments and modest incremental debt reduction through required excess cash flow sweep provisions. Term loan amortization payments reduce to $3 million per year if Town Sports' leverage, as measured under its credit agreement, improves to a below 2.75x. Under our forecast, Town Sports does not achieve this until the beginning of 2013. Notwithstanding our expectation for limited EBITDA growth in 2013, we expect operating cash flow to be sufficient to fund a stepped up level of capital expenditures related to up to six new club openings, as well as required term loan amortization payments. We expect any remaining cash will be used for further debt reduction, rather than to fund any shareholder distributions. Town Sports benefits from a lack of meaningful debt maturities until 2018, when its term loan matures. Outlook Our stable rating outlook reflects our expectation that, notwithstanding an expected acceleration of new club openings over the next few years, operating lease-adjusted leverage will be sustained below 6x and interest coverage around 2x, over the intermediate term. Lower ratings would be considered if operating performance deteriorates and/or if the company adopts a more aggressive expansion strategy than we currently anticipate, resulting in interest coverage falling below 2x and/or operating lease-adjusted leverage being sustained above 6x for an extended period. Given our assessment of Town Sports' business risk profile as weak, a higher rating would necessitate adjusted leverage being maintained in the low 4.0x area or below, in conjunction with our belief the company will continue to fund its expansion strategy through internally generated funds. Related Criteria And Research -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Upgraded; Outlook Action To From Town Sports International Holdings Inc. Corporate Credit Rating B+/Stable/-- B/Positive/-- Senior secured debt B+ B Recovery Rating 3 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.