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TEXT-S&P raises Town Sports International rating to B+
March 22, 2012 / 3:05 PM / 6 years ago

TEXT-S&P raises Town Sports International rating to B+

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.

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