Town Sports International: "Passing" in Feb. 2014
Traveling Through Time | 15 min read | What I learned from "passing" on Town Sports in Feb. 2014
Originally published on midstoryventures.com in July 2021.
This is part three in a ten-part series. Before reading this segment in the Traveling Through Time case study series — please read the Introduction post here.
Essentially, I simulated an investment opportunity from many years ago based on Geoff Gannon’s Singular Diligence newsletter. The write-up below is a record of my thought process and a reflection on what happened.
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Simulating the Past: Arriving to a decision
WOULD I HAVE INVESTED 20% OF MY CAPITAL INTO TOWN SPORTS ON FEBRUARY 28, 2014?
Town Sports International is a chain of local fitness centers mainly focused on urban markets on the East Coast.
Town Sports has a total of 160 outlets. It generates approx. 80% of its sales from memberships and 20% from personal training and other services. It generates about $500M in sales per year with a 20% EBITDA margin.
Town Sports is cheap compared to the average business.
The average business trades at a 10x owners earnings multiple. Town Sports trades at 7x owners earnings.
In this case, free cash flow is also similar to owners earnings. So Town Sports trades at 7x price to free cash flow.
Town Sports has very similar economics to Life Time Fitness, despite having a very different business model. Life Time Fitness trades at 8x owners earnings.
The best way to evaluate Town Sports is through a waterfall analysis. In other words, the value of the company is determined by the return of capital to shareholders.
Town Sports does not need to grow in order to generate a return for its investors.
The gym business is capital intensive. Town Sports generates a ROIC between 10-15%.
Its reinvestment opportunities are limited. Town Sports has saturated the urban markets of New York, Boston, Washington DC, and Philadelphia. It is the largest in NYC, Boston, and Washington DC and second-largest in Philadelphia. It could add 50 more locations, but that would only be 30% unit growth over the next 5-10 years.
Therefore, growth will not be the biggest driver of value. Future returns will mostly come from the return of capital to shareholders.
The company’s normalized earnings (EBITDAR) prior to the Great Recession was $225M. About $25M is required for maintenance capex and $150M is required for fixed charges (rent and interest). This leaves $60M of pre-tax profit for shareholders ($38M after-tax). This cash can be used to pay dividends (special or regular) or buy back stock.
An investor would have an initial yield of 14% if they were to invest in the stock.
Town Sports is not in the safest industry; however, Town Sports is safer than most of its peers.
The biggest risk for the industry is financial risk. Most gyms become insolvent because they either can’t cover their fixed charges (operational leverage) and/or can't pay their debt (financial leverage).
Fixed charges include rent and interest expense. A small decline in sales can lead to a sharp decline in profit. A 4% drop in sales can lead to a 30% drop in EBITDA.
Furthermore, most gyms take on debt for two reasons.
First, a stand-alone gym does not have attractive unit economics. The advertising and administrative burden is typically too much for one location to bear.
Second, the most successful gyms have local network effects. Most gyms strive to have multiple locations so they can offer more options to its members. The fastest way to have multiple locations, and build the moat, is through debt financing.
Town Sports currently seems to be less exposed to insolvency risk than its peers. The company recently sold its only-owned property, so its current Net Debt-to-EBITDA ratio is the lowest it has ever been.
Additionally, the company seems like it will open fewer locations than it has in the past. Therefore, the company will have a greater ability to self-finance the new locations as existing locations mature without needing any new debt.
Life Time Fitness is in a better financial position than Town Sports. It owns most of its real estate. It has less debt. And it has much lower fixed charges.
Town Sports seems to have a strong competitive position in New York, Boston, Washington DC, and even Philadelphia. It only competes for customers within the 2-3 block radius.
Town Sports is a different from the investment opportunities I normally look at.
It has a decent business. It seems to be less risky every month. And it trades at a discount.
I could see this stock generating adequate returns given the immediate yield and potential for multiple expansion.
However, I like to make investments in quality businesses whose stock price and competitive position are durable enough to withstand the vicissitudes of life.
There seems to be an asymmetric risk ever-present within all gym businesses that the discount doesn’t adequately account for. Life Time Fitness has the best business model in the gym business, given its unit economics and reinvestment opportunity. And it only trades at a multiple slightly higher than Town Sports.
Therefore, I will be passing up the opportunity to put 20% of my net worth into the business.
Back to the Present: What actually happened
HOW WOULD HAVE THE DECISION PLAYED OUT ON JULY 2, 2021?
First, let’s talk about how the business has performed.
Town Sports added a lot more locations.
The company had 160 locations at the beginning of 2013. The company spent $252M over the next 7 years and ended with 186 stores in 2019. Over the same period, they closed 40 stores. This means that they actually introduced 66 new stores.
The overwhelming majority of these locations were introduced in the last 3 years. And the overwhelming majority of these were through means of acquisition, which are inherently more expensive. In 2013, Gross PPE / Stores was $4.4M; in 2019, it was $7.3M.
The additional locations drove more members per location. The number of members per location grew from 3,190 to 3,250. However, sales per location decreased from $2.9M to $2.5M.
At a high level, the company’s revenue declined from $470M in 2013 to $467M in 2019. Gross margin declined from 24% to 14%. And the company’s EBITDA plummeted from $88M in 2013 to $39M in 2019.
Management issued $323M in 2013. By 2019, they paid long-term down debt to the point where it was half of what it was in 2013.
Management also initiated a quarterly dividend at the end of 2013. The dividend program only paid out three quarters before it was cut.
The company filed for bankruptcy in September 2020. They said they were not able to make payments related to the 2013 debt security because of affected operations from the government-wide shutdown during COVID-19.
Now, let’s see the return investors received at the investment date.
When the Singular Diligence Report was published in February 2015, the market cap was approximately $320M. Today’s market cap is now at $14M.
Even before the pandemic, the company was trading closer to $50M in 2019.
Reflecting for the Future: On getting better
HOW WOULD I HAVE CHANGED MY PROCESS, GIVEN THE RESULTS?
At first, I thought this would be a quick decision.
From the very beginning, I knew I probably wouldn’t like Town Sports as a business.
I didn’t like the gym industry.
I have been a member of a gym for most of my life. And I spent one summer working at a gym. I knew the relationship customers had with their gym and I was never impressed by what I saw.
Gym memberships are unique because it is a product that most of their members don’t use. About 20% of gym members actually use their gym membership consistently. Only 50% of them claim to use it twice a week. There is more than one billion dollars spent every year on unused gym memberships.
Gym memberships are also unique because it is a product whose value is dependent upon the customer’s practical knowledge and application of the product. Gym memberships sell the idea of a “healthier lifestyle.” But a gym member will only receive the benefits if they know how to use the gym and have a specific diet. Most gym members do not know how to workout effectively. And most people aren’t disciplined to go on diets. A member’s lack of practical knowledge impairs the value that gym memberships actually offer.
I also didn’t like the fact that gyms lacked strong stand-alone unit economics. I have found that I like businesses that have inherently strong unit economics. This is usually the product of the industry that they are in. Generally, it is rare for a gym to be able to retain its customers without offering a larger network. Additionally, it is difficult for the average operator to offset the large customer acquisition costs with one location.
The need to offer a large network of locations also encouraged the industry’s habitual use of debt. Debt was used to expand more and expand faster.
The combination of these things affected me before I even picked up the report.
Then I realized, this decision might be harder than I thought. You can’t let biases cloud your judgement.
No matter how I felt about the industry, I needed to look at the business for what it was, not how I wanted to see it.
It was clear that the business had created some value from the 2003 - 2012 time period. Sales compounded at 4%. EBITDA compounded at 3%. The business threw off $695M in OCF from that 10-year period.
The company established itself as a leader in its markets by 1995. They were still the #1 gym in the NY and Boston markets by 2012.
So there was something to this business.
And the business was trading at a 7x owners earnings, which made it more of a value-type play. There was potential for a bet.
However, I ended up passing because of the asymmetric risk.
There was some upside to the stock, but there was the potential for catastrophic loss.
The catastrophic risk was related to the debt situation. Many of the company’s peers have gone into bankruptcy at one point or another.
While Town Sports had survived the Great Recession, the debt was ever-present if they wanted to grow. The company didn’t have many quality growth opportunities. However, the company had just gone public 6 year prior. There was no way management was going to reduce their debt and sit on the cash flow of mature locations. They would have stayed private if that were the case.
Like every other gym company, the financial risk would remain. And I didn’t believe that 7x owners earnings provided an adequate margin of safety for that type of risk.
For starters, I had never considered buying a stock with that much leverage trading above 5x owners earnings.
There was also no point in the company’s history where an investor would have earned a return in the stock at 7x owners earnings. In fact, the business hadn’t created any market value since the time it went public in 2006.
I believed that there were only three ways the stock could go.
First, the company could have slowed their growth, focused on quality markets, reduced their debt, and returned capital to shareholders. This would have likely produced a consistent return above 10%.
Second, the company could have maintained their growth, entered poor markets, maintained their debt, and maintained their payout philosophy to shareholders. This would have likely produced returns below 10%.
Third, the company could have gone bankrupt.
Even before the pandemic hit, the stock was looking like it was taking path #2. Then, when the pandemic hit, the stock took path #3.
Even though my assessment was correct, this case study helped reinforce some very important principles.
#1 Hammer and nail syndrome — I have a strong preference for businesses in high-quality industries, with strong unit economics, and showed conservative balance sheets. Town Sports did not fit the bill at all. However, that did not mean it was an investment opportunity. I had to get my mind out of the quality camp so that I could look at the stock for what it was: a value play. Only then was I able to focus on the things that mattered: safety of cash flows and safety of capital allocation. Those are the things that mattered the most in a value stock.
#2 Inversion — I came into the investment with certain beliefs about gyms and the gym industry. It is important to acknowledge those to make a clear decision. As I was reading the Singular Diligence report, I found myself having already made a decision without the proper evidence. It was only until I stepped back and looked at the trees (the individual components) that I could actually develop a sound argument to pass on the investment. At one point, I even forced myself to answer this question: “What kind of gym would you be willing to buy at 7x owners earnings?” I came up with an answer: “A half-leveraged company with gym operations in captive markets where network effects (multiple gym access) was less needed to acquire and retain the customer.”
#3 Black Swans — COVID-19 was a negative factor for a lot of industries, including the gym industry. However, I don’t think it is appropriate to say that COVID-19 was the reason that I was right (I knew I would have been right anyways judging by 2019 results). It is always impossible to predict what black swan events will occur. However, if you are planning to hold for 10 years, you should always expect some type of black swan event to occur. Prepare for black swan events by having an adequate margin of safety baked into the price. In a situation where a company needs a significant amount of debt (not by preference, but by intrinsic nature), it is very hard to protect yourself from catastrophic loss even with a 30%+ margin of safety (from intrinsic value).
This was a perfect case study for situations that look like they have a margin of safety to intrinsic value, but have a significant amount of debt. It is also the perfect case study for underwriting for black swan events.
The case study took about 10 hours over the course of one week. 50% of the time was spent on actively reading and thinking about the Singular Diligence write-up, 25% analyzing the 7-year period after the publish date, and 25% writing the newsletter.
I recommend that anyone looking to improve their process find their own way to do case studies like these.
If you want to read write-ups similar to Geoff Gannon’s Singular Diligence newsletter, please visit focusedcompounding.com where Geoff and Andrew currently publish their content.
Hey Ralph, it seems you've posted the Tandy write-up rather than Town? Love the series.