NOT AN ANALYST

Investment Thesis Short Town Sports International (NASDAQ:CLUB) common stock and buy the Company’s 11% Senior Discount Notes. The amount of off-balance sheet liabilities adds a significant risk to equity holders, as the Company could face Bankruptcy (small chance but tangible). On the other hand, the Notes are undervalued with strong multiple and coverage ratios.

Intro Town is the second largest owner and operator of fitness clubs in the Northeast and Mid-Atlantic regions of the United States and the fifth largest fitness club owner and operator in the United States. The Company operates 161 fitness clubs under four key regional brand names; “New York Sports Clubs” (NYSC), “Boston Sports Clubs” (BSC), “Philadelphia Sports Clubs” (PSC) and “Washington Sports Clubs” (WSC).

Industry Description The US fitness club industry is a growth industry and in the last decade has experienced a moderated growth with a CAGR of 6.8%, higher than the overall economy. According to the most recent information released by the International Health, Racquet and Sports club Association, or IHRSA, the industry grew from $10.6 billion in 1999 to $19.1 billion in 2008. During the economic recession of the last two years, attendance at health clubs has increased nearly 7%.

Competition The level of competition comes on the basis of price, level of service and convenience of location. Primary competitors include Equinox Holdings, Inc., Lifetime Fitness (NASDAQ:LTM), Inc., Crunch, New York Health and Racquet, LA Fitness International LLC, 24 Hour Fitness Worldwide, Inc., Bally Total Fitness Holding Corporation and other YMCA/small privately held clubs. Town is in the mid-range of the value/service ratio as prices are affordable and designed to appeal to a large portion of the population who utilize fitness facilities.

Capital Structure As of March 31 2010, Consolidated Debt amounts to $317,900M and it’s comprised of $185,000M TL Facility (almost fully drawn), $75,000M Revolver and $138,500M of 11% Senior Discount Notes. The Notes (Hold Co Notes) are unsecured, structurally subordinated and ranked junior to the Bank Debt. Cash on hand is 25,000M and equity (shares outstanding) amounts to 60,356M. The Company has significant amount of operating leases from rentals (PV of minimum lease payments amounts to $844,911M), which represent off-balance sheet liabilities that need to be capitalized.

Valuation Based on estimated 2010 EBITDA of $84,700M , Town  trades at an adjusted multiple of EBITDA of 9.43, which is much higher compared to the only true publicly traded company, Life Time Fitness (NASDAQ:LTM), which trades at multiple of 7.6. Town’s equity is overvalued on a relative bases, considering that the Company has a lower growth rate and higher required rate of return Life Time Fitness. For this reasons, Town should be trading at a multiple of 5-6 after adjustment for off-balance sheet liabilities. In this scenario, the equity should be zero. On the other hand, the 11% Hold Co notes are undervalued because of a low leverage and high coverage ratios. The Notes are subordinated to bank debt but they are well covered from a valuation prospective and can enjoy a significant recovery in a reorganization scenario.  

Catalysts Refinancing and improving fundamentals (higher EBITDA from increasing membership revenue) will be the two major catalysts for an appreciation of the Notes up to par. The Company expects to refinance the Notes prior to their maturity date in 2014. If they are refinanced before August 2013, which is the last day to keep the TL in place, the annualized return is 16%.

Risks There is a small but tangible chance of Bankruptcy. Deterioration in memberships due to a decrease in consumer spending and increasing competition could severely affect the Company’s fundamentals and force bankruptcy. A deterioration in the Company’s credit rating could impair the ability to access capital markets.

AOL Spin-off On December 10 2009, AOL started to operate as a standalone entity and began trading on NYSE under the ticker “AOL”.  The Company has been spun off from Time Warner, which AOL acquired for 164 billion a decade ago. I am not going to go over the reason of the separation, but it became evident how AOL has been losing market share since the consolidation with Time Warner in 2000.

Investment thesis It’s hard to see any potential price appreciation, given the continuing deteriorating fundamentals. The stock can trade lower on a series of catalysts: additional goodwill impairments, higher than expected deterioration in subscription and/or advertising revenue and a rise in price without any fundamental change. I will keep it under the “stocks to short” list for 2010.

Shift in Business Given the declining revenue base and negative EBITDA growth experienced in the last 5 years, mainly attributable to a steep decline in subscription based revenue, the Company decided in 2006 to shift its core operation from subscription to advertising. However, results have not been great as competition from other popular sites like Google and Yahoo and/or social networking sites like Facebook and Twitter has been very intense. AOL’s new business focuses on five core business segments:  

• Web content; create and publish new original web content through its various site categories.
• Local and Mapping; provide local content, platforms and services covering geographic levels ranging from neighborhoods to major metropolitan areas like MapQuest,  Local Entertainment Guides, Local Directories and Local Events.
• Communications; email and instant messaging products and services like AOL Mail, ICQ and AIM.
• Online Search; offered through AOL Search and AOL Media, currently outsourced to Google.
• AOL Ventures; the investment/acquisition arm of AOL

Valuation I expect advertising revenue to decline 5% in 2009 and continue to decrease at a 5% rate every year after. Subscription based revenue will be 1,350 mm in 2009 and continue to decline at a 30% rate each year after. EBITDA margin will be 30% in 2009 and shrink 1% each year after, as a result of the continuation of the historical trend that saw operating revenue decline more than COGS and operating expenses. The Company is expecting to receive 250 mm Credit Facility with a maximum consolidated leverage ratio (total debt to EBITDA) not greater than 1.5 to 1.0 and a minimum consolidated interest coverage ratio (EBITDA to consolidated cash interest expense) of at least 4.0 to 1.0. Under the financial covenants, the Company can use up to 100 mm a year for acquisitions. Other than that, AOL has almost no debt; total fixed obligations due before the end of 2014 total 622 mm and are comprised of property and other operating leases. Liquidity doesn’t seem to be an issue; FCF will be the positive but decline in the coming years due to deteriorating fundaments. Given 823 mm of EBITDA in 2010, the Company currently trades at 3x 2010 EV/EBITDA, a discount compared to the average 2010 EV/EBITDA multiple for the top Internet Advertising Companies (7.9x) and Media Companies (7.3x). Cash generated from working capital in 2009 was mainly driven by changes in accrued compensation as the Company decided not to pay annual bonuses to employees related to 2008 performance.

Catalysts for a short sale An advance in price to 30 dollars per share or higher due to overall market appreciation without any change in fundamentals is the signal for a potential short opportunity.

If the Company deems that 50% of the fair value of goodwill is lower than then its carrying value, therefore impaired, the share price should drop by 10 dollars. In accordance with FAS 142, goodwill is tested for impairment at least annually. The fair value of the reporting unit is calculated using a DCF approach and a market approach. For the 2008 goodwill impairment analysis, the Company increased the discount rates utilized in the DCF analysis to a range of 13% to 15% from 12% in 2007, while the terminal growth rates for the advertising revenues were decreased to a range of 2.5% to 3% from 4.5% in 2007. What does this mean? Higher discount rates and lower growth rates produce a lower current value. There is a good chance of further adjustment in growth rates and/or discount rates, therefore potential impairments charges, if subscription based and/or advertising revenue deteriorates further from current levels. As of September 30 2009, 50% of the total asset or 2,175 mm is comprised of goodwill.

Conclusion I am keeping AOL under my list of stocks to short as it faces many challenges: The market place where it operates is highly competitive especially from Companies like Google, Yahoo, Microsoft, Facebook and Twitter and fundamentals are deteriorating quickly, increasing the chance of further impairments. The shift is strategy implemented in 2006 is towards the right direction but the company doesn’t seem to do enough to win market shares, mostly due to negative user experience built during the past years poor search results and lack of innovation.

The attachment below explains the reasons why Pershing Square is shorting Realty Income Corp. I don’t really agree that, with a 7.50% drop in NOI and a Cap Rate of 9.50%, the price should be 14 dollar per share. The company is currently valued with a very conservative Cap Rate, around 11%, which accounts for all the risks and unknowns. In my previous post, I wrote that 26 dollar per share is a fair price for the Company at this moment. I don’t see 40% premium to NAV as Pershing Square indicates. It’s also interesting how, during the Q1 and Q2 earnings call Q&A, the Company Representative wouldn’t even talk about the name of the tenants. I agree with the fact that the SEC may require to disclose the name of the lessees, which is another catalyst for a large drop in value. Well, enjoy the reading.

The Catalyst About a month ago we talked about Realty Income Corp as a good candidate for a short play, but since then the stock hasn’t really move in any direction. Let’s take a closer look at what can be the catalyst for a significant drop in value. The latest 10K reports that there are no maturities due until March 2013; therefore the company doesn’t need to refinance its debt anytime soon. But if the company wants to sustain or raise the common dividend, it would need to issue equity or new notes as the cash on hands and the operating income generated is not sufficient. I seriously doubt the company could raise funds early next year, so the only option would be to cut the dividend dramatically, which would cause a significant drop in price.

Tough Short It’s inevitable that the company will cut the common dividend, the problem is when. Keeping a short position open on Reality Income Corp it’s very expensive. You have to pay the big dividend to the long and it is an expensive stock to borrow because the amount of shares short as a percentage of the float is pretty high, around 22%.

NOI and Price There is no misprice at the moment between the intrinsic value and the market value. If NOI for next year is projected to drop 20%-25% from 2009 levels, the company should be valued around 19 dollars per share, but accounting for 303 mm in NOI for 2009, which seems accurate based on the latest 10Q, the company it’s correctly priced at 26 dollars per share. We calculate the Market Value as NOI/Cap Rate and the share price as the MV/shares outstanding. The cap rate is r (required rate of return) – g (growth rate). The required rate of return is simply the WACC = wd*D (1-T) + we*E. The capital structure consists of 47% debt and 53% equity. The yield on the latest bond issued, which is the 6.75% note issued on September 2007, is 6.50%. The tax rate is minimal as REITs are exempt from federal income tax, so I am going to ignore it. The yield on the common shares is now 6.54%. This gives us a WACC of 6.52%. The growth rate is calculated as the retention rate (b)*ROE. Net Income available to common shareholders for 2009 will be around 105 mm with cash dividends for the year amounting to 178 mm, which give us a retention rate (b) of -69%. ROE for 2009 is going to be around 6.7% and we arrive at a negative growth rate of 4.6%. Therefore the cap rate, calculated as r-g, it is 11.12%. Now we have all the data, with 104 mm shares outstanding and assuming NOI for 2009 remains at 303 mm, the Company is valued at 2,725 mm and the price per share is 26.2, which is around what it’s currently trading. However, if NOI drops 20% or 25%, which is a possible scenario accounting for the poor quality of lessees and their questionable capacity to pay, then the share price should be at least 6-7 dollars lower.

I have been browsing the market for the last two weeks in search of a stock to short when I came across Realty Income Corp (ticker “O”) on Distressed Debt Investing.com, one of my favorite blogs, where the author reported some notes from the “Best Ideas Symposium” on October 11 in Dallas. The Company was presented as a short play and it seemed like an interesting idea, so I did my due diligence and here is what I have found.

Business Model The Company’s primary objective is to generate a dependable monthly dividend to shareholders supported by cash flow income from a portfolio of properties leased to regional and national retail chains. The firm doesn’t really have any other type of operation, their only source of revenue is rent and it’s highly dependable on the lessees’ capacity to pay.

Free Cash Flows The firm generates all the operating cash flow from rental income and it’s all used to pay dividends to common and preferred shareholders and obligations. Note that FCFE is cash available before common shareholders are paid.

Table 1

The dividend has been raised every year since 1994 and has now reached a level where the amount is more then what the company can pay with cash on hand. In fact, in 2003 the Company started to explore other ways to raise capital such as issuing equity and debt. There is nothing wrong with raising funds though offerings but if you don’t reinvest the proceeds at a higher rate, eventually you will be forced to rollover debt continuously, and then burn all of your cash.

Capital Structure The capital structure changed dramatically in 2003, when the company started to issue unsecured notes to finance its dividend payments, and that’s when solvency and liquidity ratios deteriorated, we will look at that later.

Table 2

In September 2008, the company issued shares of common stock (at a price of $26, which is almost record high, an indication of the stock being overvalued) and used the proceeds, about 75mm, to repay of 120mm in notes outstanding at par.

Table 3

Covenants On the 2008 10K report, the Company reported to be “in compliance” with the bond covenants for the Senior Unsecured Notes outstanding, but after a closer look, it doesn’t seem the case. The issue lies with the way assets are recorded. Land and commercial properties are reported at book value, which can be significantly different then fair value, especially in a real estate downturn. If assets are reduced by 15% to 20%, the debt to asset ratio would rise to 65%, which is above 60% limit imposed by the bond covenants.

Liquidity Cash levels are on average 1% or less of total assets, which is very low and that raises some liquidity concerns. Also the current ratio, except for 2007, has been historically around 0.7 or less and this doesn’t account the 355 mm credit facility originated in 2008 which has no outstanding balance now, but if used could significantly increase short-term liabilities and further deteriorate liquidity.

Lessees I wasn’t able to find any information about the lessees but few names are identifiable if you read the 10K report or the Company website. There is Office Max, rated “B” at S&P, Wawa Convenience Store, Jiffy Lube, basically unknown local stores, it’s a joke! Because all of the firm’s revenue is generated from lease payments, it’s important to know who the lessees are and the capacity to meet their obligations. Poor financial performances of a lessee, solvency issues or failure to make payments on time, could result in material losses. For example, on January 22, 2008, Buffets Holdings Inc filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code and Realty Income owned 116 properties.

Conclusion The Company will have to cut the dividend of $1.71/share because it doesn’t have cash on hand to pay for it and is using proceeds from stock or debt offerings. The Company might be forced to sell assets at a loss to generate cash but that would deteriorate debt to asset ratios, which could cause a default on the terms of the debt covenants set in the indenture. The names and financial conditions of the lessees are a key ingredient to firm’s profitability but are a big unknown. This seems to be easy money, I don’t see the stock going higher, but there is one downside: when you are short, you PAY the dividend, a big one in this case. Target price $12 within 6 months. I will provide discount cash flow analysis in future posts. Have a good day.