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Town Sports’ “High-Value Low-Price Strategy is Doomed to Fail. Horribly.

Jordan S. Terry

May 8th, 2015

Town Sports (NASDAQ:CLUB), the parent of New York, Boston, Philly, and Washington

(D.C.) Sports Clubs has a problem: Most customers don't (and aren't going to) pay $60-$120 a

month when hundreds of low-cost, amenity-filled gyms from competitors like Planet Fitness,

Crunch, Lifetime Fitness, Retro Fitness, 24 Hour Fitness, and LA Fitness (to name a few) having

opened just in the past few years.

The company's solution, way late in the game, is to try to compete on price. This strategy will

not, and cannot work.

Why?

High operating costs: 2014 EBITDA margin was 11% vs. 29% for its only public

competitor, Lifetime Fitness.

It doesn't own, but leases all of its facilities, the majority of which are in high-cost, space-

constrained urban and metro suburban areas.

High interest expense from a high debt load. 4.4% of revenue vs. 3.4% for Lifetime.

CLUB gyms are comfortably in the middle of the pack in terms of offerings, quality,

convenience, and the like, so even for the same price, there is little if any reason for

members of competing gyms to switch. (The author is currently, and has been a member

of New York Sports Clubs on and off since 2007.)

US gym memberships grew at a rate of 3.7% per year from 2000-2013. Gym

turnover/attrition is also in the low single-digits.

Competing gym memberships run $10-30/month.

The new HVLP memberships are $20 or $40 month (the latter without an initiation fee),

and, just as an example of value, don't even include towel service.

Existing members pay about $60-120/month. In 2014, gym operations, the bulk of

revenue, came out to about $77/month per member.

As existing members switch to the HVLP plans, we expect average monthly revenue per

member to decline into the mid $40/month range.

CLUB needs A LOT more members just to break even.

How many more members?

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With little if any reason for members of competitors to switch and a relatively small number of

people without gym memberships likely to join, CLUB is extremely unlikely to offset the lower-

cost memberships with enough new members.

Realistically, it won't even come close. CLUB will lose A LOT of money for the foreseeable

future.

How much will it lose?

We are generously projecting 2015 FY operating income will be around minus $50 million,

assuming a relatively slow shift of existing members to the HVLP plans and 9-19% membership

growth. For perspective, the firm began offering the HVLP plans late in 2014. Membership only

grew 4.3% in the first quarter of this year vs. the end of 2014.

While we do not think the HVLP strategy will work, we are sympathetic to the company's plight.

It's being squeezed from both the bottom, by the dozen or so low-cost competitors, and from the

top, by gyms like Equinox. It's stuck between the proverbial rock and a hard place. Ultimately,

trying to compete on price in a competitive industry with little cost flexibility and a levered

balance sheet is a recipe for disaster.

We think a lot of the bullish sentiment is anchored in some sort of misguided optimism, as there

are a lot of "what-ifs" to this story.

What if CLUB didn't have a ton of debt?

What if it owned its facilities instead of leased?

What if operating expenses could be materially reduced (maybe, though the new strategy

requires higher marketing expenses)?

What if it had responded to the proliferation of low-cost competitors 10 or even 5 years

ago?

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Unfortunately for bulls, we can't change the past, and there's not a lot of wiggle room to change

the current or the future. Nostalgia and ego are a dangerous combination.

CLUB should (key word!) have enough cash to meet its interest payments for the next 2-3 years

while it loses money. That said, default and bankruptcy risk are real concerns, though not

imminent.

While we often find opportunity in restructurings, we see far more risk than reward in CLUB,

and suggest investors avoid the name.

The stock was a screaming short going into earnings, however, after a 20% drop the past two

days, that trade has become less obvious. Activist involvement, low volume and short-term

volatility make a long-term bearish opportunity like this a risky short at today's price, but if

you're comfortable with the possibility of a margin call or two while you take the long view, a

short can still pay off. Can the company and its activist investors turn it around and drive the

stock up? Maybe, though we've shown with simple math that a successful turn-around is

unlikely.

As always,

CAVEAT EMPTOR

Additional disclosure: The opinions presented herein are solely those of Stone Street Advisors

LLC. Neither Stone Street Advisors LLC nor any of its members has a position in CLUB or

CLUB derivatives, nor any plans to initiate a position. Nothing contained herein shall constitute

a solicitation, recommendation or endorsement to buy or sell any security or other financial

instrument. Stone Street Advisors LLC makes no representation or warranty as to the accuracy,

completeness or timeliness of the information contained herein, and disclaims all liability arising

from errors or omissions contained in this presentation. This presentation is for informational

purposes only and does not constitute investment advice. Stone Street Advisors LLC is not an

Investment Advisor.