Citron takes Lifetime Fitness (NYSE:LTM) for a workout

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Join the Club – At Your Own Risk

Citron receives email every day from investors asking us what to look for in companies to avoid.  It is our opinion that in the current economic climate any company is that highly debt-leveraged with high fixed costs that depends on the US consumer will have big problems.  Add into that equation a business model that NO ONE has ever proven successful and we have Lifetime Fitness.  (NYSE:LTM). 

Even though this stock is badly beaten down this year, we believe the equity will eventually go away as this chain of 77 health clubs will carry a debt load that will weigh on them like a 300 pound barbell and leave investors sweating.

Before we go into the financials, let us look at a few key fundamental points about the health club industry.

1.  Health Clubs are the ultimate discretionary purchase.  In 2007, as soon as the economy turned soft, gym memberships dropped for the first time in more than a decade. http://www.usatoday.com/money/advertising/adtrack/2008-11-16-gyms-recession-ads_N.htm

2. Lifetime’s strength is also their biggest weakness: their customers are not obligated to long-term contracts but instead pay monthly.  As Lifetime’s CFO told the Denver Post, “When somebody looks at that Visa statement and they know that times are tougher, they’re making a decision a little bit quicker to leave the club if they’re not utilizing it,”   http://www.examiner.com/a-1694083~Health_clubs_offer_discounts_as_economy_falters.html

3. Operating high-end health clubs is a business model that no public company has proven successful in the best of economic times.  How will Lifetime hold up in these recessionary times?  Lifetime’s model is also becoming increasingly dependent on “other income” – spa and trainer services, currently 1/3rd of total revenue, which are just as vulnerable to a spending downturn.

Attrition 

From LTM’s recent 10-Q:

“During 2008, our attrition rate increased, driven primarily by inactive members leaving earlier than in the past.”  The attrition rate of LTM is north of 40% and with industry high membership rates and a declining economy, one does not need tea leaves to guess what the next 12 months will look like.

Real Estate Play

As Lifetime builds out 110,000 sq. ft. mega-clubs at the cost north of $30 mil per club it has become more and more of a leveraged real estate speculation.  Until now, they have been able to pay back some debt by executing sale-leasebacks.  LTM’s actual piggy bank is its ability to execute sale-leaseback transactions to raise cash.  It did this on six units during Q3, raising $107m.  In a best case scenario, this raises cash while raising operating expenses.  But with the explosion in CMBS rates currently in play, LTM’s ability to continue to execute these sale leasebacks at all is highly questionable and therefore the asset values on the books become suspect.  After all, what is the liquid market for a 100,000 square foot health club in a bedroom community in Texas?

Debt

Even with Lifetime’s planned reduction in new centers it plans to open in 2009 (from 11 to 6), the company will require $400 million of new financing to hit these marks.  That would take the debt of LTM of close to $1 billion.  That is why Citron believes that even with a recent slide in LTM’s stock price, Lifetime’s overall condition is far more fragile than Wall Street currently recognizes. 

With over $647 million of long term debt, Lifetime’s debt load amounts to over $8.25 million per health club.  Expressed another way, Lifetime’s net debt is $1312 per member.  In a time of collapsing discretionary consumer spending and tightening credit, Citron believes this simply unsustainable.  If Lifetime holds to its plan of $400 million capex expenditures in 2009, this debt load will rise substantially. 

Management

While we give CEO Bahram Akradi credit for building a chain of beautiful health clubs, we question his ability to navigate the company through these difficult times. Already due to margin loans that he could not meet, Mr. Akardi has had forced sales on nearly 2.5 million shares of stock over the past few months alone – approaching half his stake.

Citron also notes recent resignations of board members Sefton(director, audit committee) in October 2008, Halpin (October 2008), and more recently Raymond (November 2008).

Interestingly enough, management has experience in high capex spending.

CFO Michael R. Robinson hails from Next Generation Network, Inc .  While he was CFO there, the company “capexed” its way into oblivion before being bought on the cheap by The Anschutz Company.
http://www.accessmylibrary.com/coms2/summary_0286-27341448_ITM

Chief Accounting Office and Controller John M Hugo hails from Completel LLC (Completel Europe NV). He was appointed Controller and Chief Accounting Officer in March 2000.  By May 2002, it files for bankruptcy, having also “capexed” its way into Dutch bankruptcy court.
http://www.opticalkeyhole.com/eventtext.asp?ID=25303&pd=5/15/2002&bhcp=1

The interesting thing about these two former companies is that they met their demise in essentially the same way:  building out a huge, expensive plant that could never justify the capital investment.   Then things fell apart.

Cash is the bottom line

The game of capitalizing expenses and understating depreciation can go on for a long time.  But in an environment where commercial credit is collapsing, access to real cash from operations takes on new significance.  LTM’s cash flow from operations per member was at the lowest point for the year at the end of the last qtr.  Free cash flow per member, after capex, is a solid -$129 per member.

Conclusion

These huge debt-heavy and capex-heavy club operations are the antithesis of the agile, nimble and cash-flow positive companies that will survive a severe downturn in consumer discretionary spending.  Bally’s couldn’t do it, and Citron believes Lifetime won’t be able to either. In part 2, Citron will overlay the financials of Bally’s Total Fitness before they went bankrupt with those of Lifetime, and show what we believe the future holds.

Citron believes the company is caught between the pressure to offset declining membership rates with increased marketing, and market forces pressuring the company to regard deferred maintenance as capex. 

Citron believes Lifetime’s free cash flow per member is an early warning of cashless paper earnings being buoyed up by unsustainable growth.  Inability to perform sale/leaseback transactions on clubs will send it on a downward spiral from which it is unlikely to escape.

Cautious investing to all.