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
-- We are raising our corporate credit rating on Town Sports to 'B+' from
-- 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.
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.
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.
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
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.
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
Upgraded; Outlook Action
Town Sports International Holdings Inc.
Corporate Credit Rating B+/Stable/-- B/Positive/--
Senior secured debt B+ B
Recovery Rating 3 3
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