UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

þ Annual Report pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2007

 

o Transition Report pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the transition period from

 

Commission file number: 000-52013

Town Sports International Holdings, Inc.

(Exact name of Registrant as specified in its charter)

 

(212) 246-6700

(Registrant’s telephone number,
including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o No þ

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days.  Yes þ No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part IV of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

                         (Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No þ

 

The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2007 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $224.9 million (computed by reference to the last reported sale price on The Nasdaq National Market on that date). The registrant does not have any non-voting common stock outstanding.

 

As of February 25, 2008, there were 26,305,173 shares of Common Stock of the Registrant outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement for the 2008 Annual Meeting of Stockholders, to be filed not later than April 29, 2008, are incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

TOWN SPORTS INTERNATIONAL HOLDINGS, INC.

 

FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding future financial results and performance, potential sales revenue, legal contingencies and tax benefits, and the existence of adverse litigation and other risks, uncertainties and factors set forth under Item 1A., entitled “Risk Factors”, of this Annual Report on Form 10-K and in our reports and documents filed with the Securities and Exchange Commission (“SEC”). These statements are subject to various risks, and uncertainties, many of which are outside our control, including the level of market demand for our services, competitive pressure, the ability to achieve reductions in operating costs and to continue to integrate acquisitions, environmental matters, the application of Federal and state tax laws and regulations, and other specific factors discussed herein and in other SEC filings by us. We believe that all forward-looking statements are based on reasonable assumptions when made; however, we caution that it is impossible to predict actual results or outcomes or the effects of risks, uncertainties or other factors on anticipated results or outcomes and that, accordingly, one should not place undue reliance on these statements. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to update these statements in light of subsequent events or developments. Actual results may differ materially from anticipated results or outcomes discussed in any forward-looking statement.

 

 

In this Form 10-K, unless otherwise stated or the context otherwise indicates, references to “TSI Holdings,” “Town Sports,” “TSI,” “the Company,” “we,” “our” and similar references refer to Town Sports International Holdings, Inc. and its subsidiaries, and references to “TSI, LLC” and “TSI, Inc.” refer to Town Sports International, LLC (formerly known as Town Sports International, Inc.), our wholly-owned operating subsidiary.

 

General

 

Based on the number of clubs, we are the second largest operator of fitness clubs in the Northeast and Mid-Atlantic regions of the United States and the fourth largest fitness club operator in the United States. As of December 31, 2007, the Company, through its subsidiaries, operated 161 fitness clubs under our four key brand names; “New York Sports Clubs,” “Boston Sports Clubs,” “Philadelphia Sports Clubs” and “Washington Sports Clubs”. These clubs collectively served approximately 486,000 members, excluding pre-sold, short-term and seasonal memberships, as of December 31, 2007. We are the largest fitness club operator in Manhattan with 41 locations (more than twice as many as our nearest competitor) and operated a total of 111 clubs under the “New York Sports Clubs” brand name within a 120-mile radius of New York City as of December 31, 2007. We operated 22 clubs in the Boston region under our “Boston Sports Clubs” brand name, 18 clubs (two of which are partly-owned) in the Washington, D.C. region under our “Washington Sports Clubs” brand name and seven clubs in the Philadelphia region under our “Philadelphia Sports Clubs” brand name as of December 31, 2007. In addition, we operated three clubs in Switzerland as of December 31, 2007. We employ localized brand names for our clubs to create an image and atmosphere consistent with the local community and to foster recognition as a local network of quality fitness clubs rather than a national chain.

 

We have developed and refined our fitness club model through our clustering strategy, offering fitness clubs close to our members’ workplaces and homes. Our club model targets the “upper value” market segment, comprising individuals aged between 21 and 50 with income levels between $50,000 and $150,000 per year. We believe that the upper value segment is not only the broadest segment of the market, but also the segment with the greatest growth opportunities. Our goal is to be the most recognized health club network in each of the four major metropolitan regions we serve. We believe that our strategy of clustering clubs provides significant benefits to our members and allows us to achieve strategic operating advantages. In each of our markets, we have developed

clusters by initially opening or acquiring clubs located in the more central urban markets of the region and then branching out from these urban centers to suburbs and neighboring communities.

 

We offer two types of memberships in our clubs, “Passport” and “Gold”. As of December 31, 2007, approximately 41% of our members participated in our Passport Membership plan allowing unlimited access to all of our clubs and 59% of our members participate in a Gold Membership plan allowing unlimited access to a designated or “home” club and access to all of our other clubs during off-peak hours.

 

Over our 34-year history, we have developed and refined our club formats that allow us to cost-effectively construct and efficiently operate our fitness clubs in the different real estate environments in which we operate. Our fitness-only clubs average approximately 20,000 square feet, while our multi-recreational clubs average 40,000 square feet. The aggregate average size of all of our clubs is approximately 25,000 square feet. Our clubs typically have an open fitness area to accommodate cardiovascular and strength-training equipment, as well as special purpose rooms for group fitness classes and other exercise programs. We seek to provide a broad array of high-quality exercise programs and equipment that are popular and effective, promoting the quality exercise experience that we strive to make available to our members. When developing clubs, we carefully examine the potential membership base and the likely demand for supplemental offerings such as swimming, basketball, children’s programs, tennis or squash and, provided suitable real estate is available, we will add one or more of these offerings to our fitness-only format. For example, a multi-recreational club in a family market may include Sports Clubs for Kids programs, which can include swim lessons and sports camps for children.

 

Industry Overview

 

Total U.S. fitness club industry revenues increased at a compound annual growth rate, or CAGR, of 7.7% from $9.0 billion in 1997 to $17.6 billion in 2006, according to the International Health, Racquet and Sportsclub Association, or IHRSA. Total U.S. fitness club memberships increased at a compound annual growth rate of 4.7% from 28.3 million in 1996 to 42.7 million in 2006, according to IHRSA.

 

Demographic trends have helped drive the growth experienced by the fitness industry over the past decade. The industry has benefited from the aging of the “baby boomer” generation and the coming of age of their offspring, the “echo boomers” (the generation born between 1982 and 1994). Government-sponsored reports, such as the Surgeon General’s Report on Physical Activity & Health (1996) and the Call to Action to Prevent and Decrease Overweight and Obesity (2001), have helped to increase the general awareness of the benefits of physical exercise to these demographic segments over those of prior generations. Membership penetration (defined as club members as a percentage of the total U.S. population over the age of six) has increased significantly from 12.0% in 1996 to 16.0% in 2006, according to the IHRSA/American Sports Data Health Club Trend Report. The industry continues to attract new members, with 41% of members indicating that they were “first-time” members in 2006 according to the IHRSA/American Sports Data Health Club Trend Report. On January 30, 2008, the New York Senate proposed a Bill, which would allow New York health club goers to receive a $50 credit against their personal income tax for individual membership fees and up to a $200 benefit for family memberships, was referred to the Committee on Investigations and Government Operations on January 30th. Active and fit lifestyles result in decreased health care costs, reduced governmental spending, fewer illnesses, and improved worker productivity. On February 14, 2008, the New Jersey Senate proposed a Bill which would allow for a 10% tax credit for an employer to provide its workers with qualifying fitness benefits. IHRSA is working to best position this Bill for passage.

 

As a large operator with recognized brand names, leading regional market shares and an established operating history, we believe we are well positioned to benefit from these favorable industry dynamics.

 

Competitive Strengths

 

We believe the following competitive strengths are instrumental to our success:

 

Strong market position with leading brands.  Based on the number of clubs, we are the fourth largest fitness club operator in the United States and the second largest fitness club operator in the Northeast and Mid-Atlantic regions of the United States. We are the largest fitness club owner and operator in the New York and Boston regions, the second largest owner and operator in the Washington, D.C. region and the third largest operator in the

Philadelphia region. We attribute our leadership positions in these markets in part to the strength of our localized brand names, which foster recognition as a local network of quality fitness clubs.

 

Regional clustering strategy providing significant benefits to members.  By operating a network of clubs in a concentrated geographic area, the value of our memberships is enhanced by our ability to offer members access to any of our clubs through our Passport Membership, which provides the convenience of having fitness clubs near a member’s workplace and home. Approximately 41% of our members have a Passport Membership plan, and because these memberships offer enhanced privileges and greater convenience, they generate higher monthly dues than single club memberships. Regional clustering also allows us to provide special facilities within a local area, such as swimming pools and squash, tennis and basketball courts, without offering them at every location.

 

Regional clustering strategy designed to maximize revenues and achieve economies of scale.  We believe our regional clustering strategy allows us to maximize revenue and earnings growth by providing high-quality, conveniently located fitness facilities on a cost-effective basis, which new entrants into the market will have difficulty achieving. Regional clustering is attractive to corporations seeking group memberships and has allowed us to create an extensive network of clubs in our core markets, in addition to a widely recognized brand with strong local identity. We believe that potential new entrants would need to establish or acquire a large number of clubs in a market to effectively compete with us. We believe that this would be difficult given the relative scarcity of suitable sites in our markets. Our clustering strategy also enables us to achieve economies of scale with regard to sales, marketing, purchasing, general operations and corporate administrative expenses, and to reduce our capital spending needs. Regional clustering also provides the opportunity for members who relocate from one of our regions to another to remain members of our clubs, thus aiding in member retention.

 

Expertise in site selection and development process.  We believe that our expertise in site selection and development provides a significant advantage over our competitors given the complex real estate markets in the metropolitan areas in which we operate and the relative scarcity of suitable sites. Before opening or acquiring a new club, we undertake a rigorous process involving demographic and competitive analysis, financial modeling, site selection, and negotiation of lease and acquisition terms to ensure that a location meets our criteria for a model club. We believe our flexible club formats are well suited to the challenging real estate environments in our markets.

 

Proven and predictable club-level economic model.  We opened or acquired 129 clubs, net of closures, from the inception of our business through December 31, 2002. Of these, our 116 wholly owned clubs that have been in operation from January 1, 2003 through December 31, 2007 generated revenues and operating income (after corporate expenses allocated on a revenue basis) of $349.9 million and $42.3 million, respectively, for the year ended December 31, 2007, as compared to $261.0 million and $26.8 million, respectively, for the year ended December 31, 2003. We believe that the track record of our mature clubs provides a reasonable basis for expected improved performance in our recently opened clubs. In addition, for the year ended December 31, 2007, revenues from clubs that have been open for more than 24 months grew at 3.9%. Further, we have demonstrated our ability to deliver similar club-level returns in varying club formats and sizes.

 

Business Strategy

 

We intend to continue to grow our revenues, earnings and cash flows using the following strategies:

 

Drive comparable club revenue and profitability growth.  For the year ended December 31, 2007, our comparable club revenue growth was 5.2%. We define comparable club revenues as revenues at those clubs that were operated by us for over 12 months and comparable club revenue growth as revenues for the thirteenth month and thereafter as compared to the same period during the prior year. Our comparable club revenues increased as a result of our strategic initiatives, including our commit membership plan and focus on growing ancillary revenues. The “commit” membership model that we implemented in 2003 encourages new members to commit to a one- or two-year membership at a discount to our month-to-month plan. Since the implementation of the membership model, attrition rates have declined and have contributed to comparable club revenue increases. We intend to capitalize on this momentum to drive revenue and profitability growth by increasing our membership base as well as the amount of revenue that we generate from each member. Once per year, we increase membership dues 1% to 3% on average, contributing to comparable club revenue growth.

Increase number of clubs by expanding within regional clusters.  We intend to strengthen our market position and to increase revenues and earnings in our existing markets through the opening of new clubs and the acquisition of existing clubs. Our expertise in the site selection and development process combined with our proven and predictable club-level economic model enables us to generate attractive returns from the opening of new clubs. We have currently identified over 175 fitness-only and multi-recreational locations in our existing and secondary markets that we believe possess the criteria for a model club.

 

Grow ancillary and other non-membership revenues.  We intend to grow our ancillary and other non-membership revenues through a continued focus on increasing the additional value-added services that we provide to our members as well as capitalizing on the opportunities for other non-membership revenues such as in-club advertising and retail sales. Non-membership revenues have increased from $51.1 million, or 15.0% of revenues for the year ended December 31, 2003, to $86.0 million, or 18.2% of revenues for the year ended December 31, 2007. We intend to continue to expand the current range of value-added services and programs that we offer to our members, such as personal training, “Sports Clubs for Kids” and small group training. These sources of ancillary and other non-membership revenues generate incremental profits with minimal capital investment and assist in attracting and retaining members.

 

Realize benefits from maturation of recently opened clubs.  From January 1, 2006 to December 31, 2007, we opened or acquired 26 clubs. Based on our experience, a new club tends to achieve significant increases in revenues during its first three years of operation as the number of members grows. Because there is relatively little incremental cost associated with such increasing revenues, there is a greater proportionate increase in profitability. We believe that the revenues and profitability of these 26 clubs will improve as the clubs reach maturity.

 

Execute new business initiatives.  We continually undertake initiatives to improve our business by offering new products and services. For example, we have strengthened our focus on our corporate and group sales division, which targets companies or groups with more than 100 people. In addition, we have recently begun offering introductory personal training sessions at discounted prices. We expect all of these new initiatives to attract new members and result in an increase in our revenues.

 

Company History

 

We were founded in 1973. In the mid-1990s, we began a period of rapid growth by acquiring individual clubs and between two and six club chains in suburban regions. Since 1990 through the end of 2007:

 

 

Recent Events

 

On October 4, 2007, we announced the resignation of Robert Giardina as our Chief Executive Officer, due to personal and health reasons. Mr. Giardina’s resignation was effective October 31, 2007. He continues to serve as a member on our Board of Directors and began working with us in an advisory capacity effective November 1, 2007. Alexander Alimanestianu, who has been with us since February 1990, most recently as our President and Chief Development Officer, succeeded Mr. Giardina as our Chief Executive Officer. In connection with his promotion, on October 2, 2007, the size of our Board of Directors was increased to nine persons, and Mr. Alimanestianu was elected to fill the newly created position.

 

On January 14, 2008, we announced the resignation of Randall Stephen as our Chief Operating Officer. We are currently conducting a search for a new Chief Operating Officer.

On January 22, 2008, we announced the resignation of Richard Pyle as our Chief Financial Officer. Mr. Pyle’s resignation will be effective March 31, 2008. Mr. Pyle will provide consulting services to us from September 1, 2008 through August 31, 2009. Daniel Gallagher, who has been in our finance department for nine years, most recently as our Senior Vice President — Finance, will succeed Mr. Pyle as our Chief Financial Officer effective April 1, 2008.

 

Marketing

 

Our marketing campaign is currently geared toward increasing awareness of our brand names. We believe our advertising strategies convey each of our regionally branded networks as the premier network of fitness clubs in its region. Our goal is to achieve broad awareness of our regional brand names primarily through radio, newspaper, billboard and direct mail advertising. We believe that clustering clubs creates economies in our marketing and advertising strategy that increase the efficiency and effectiveness of these campaigns.

 

Our advertisements generally feature creative messages that communicate the serious approach we take toward fitness in a humorous tone, rather than pictures of our clubs, pricing specials or members exercising. Promotional marketing campaigns will typically feature opportunities to participate in value-added services such as personal training. From time to time, we also offer reduced initiation fees to encourage enrollment. Additionally, we frequently sponsor member referral incentive programs.

 

We also engage in public relations and special events to promote our image in the local communities. We believe that these public relations efforts enhance the image of our local brand names in the communities in which we operate. We also seek to build our community image through advertising campaigns with local and regional retailers. In January 2008, we organized and recruited sponsors, including Snapple and JetBlue Airways, to the Company’s 24-hour spin-a-thon and fundraiser in Grand Central Terminal, Manhattan. The event netted over $250,000 for New York - based HealthCorps and will fund additional school based programs in our markets.

 

Our principal web site, www.mysportsclubs.com, provides information about club locations, program offerings, exercise class schedules and on-line promotions. The site also allows our members to give us direct feedback on all of our services and offerings and allows prospective members to sign-up for a two week trial membership in our clubs. We also use the site to promote career opportunities with us.

 

Sales

 

Sales of new memberships are generally handled either at the club level or through our corporate and group sales division. We employ approximately 410 “in-club” membership consultants who are responsible for new membership sales. Each club generally has between two and four consultants. These consultants report directly to the club general manager, who in turn reports to a district manager. We provide additional incentive-based compensation in the form of bonuses contingent upon individual, club and company-wide enrollment goals. Membership consultants must successfully complete a two-month, in-house training program through which they learn our sales strategy. In making a sales presentation, membership consultants emphasize:

 

 

Our corporate and group sales division consists of 20 full-time employees located throughout our markets, who concentrate on building long-term relationships with local and regional companies and groups with over 100 employees. We offer numerous programs to meet our client’s needs including an online program as well as a fully operational call center for enrollment. We believe this focus on relationship building, providing the

customer with options for enrollment as well as our clustering strategy, will continue to lead to new group participation in the future.

 

We believe that clustering clubs allows us to sell memberships based upon the opportunity for members to utilize multiple club locations near their workplace and their home. As of December 31, 2007, our existing members were enrolled under two principal types of memberships:

 

 

By operating a network of clubs in a concentrated geographic area, the value of our memberships is enhanced by our ability to offer members access to any of our clubs through a Passport Membership, which provides the convenience of having fitness clubs near a member’s workplace and home. Approximately 41% of our members have the Passport Membership plan, and because these memberships offer broader privileges and greater convenience, they generate higher monthly dues than single club memberships. Regional clustering also allows us to provide special facilities within a local area, such as swimming, basketball, children’s programs, tennis and squash, without offering them at each location.

 

Historically, we have sold month-to-month membership payment plans that are generally cancelable by our members at any time with 30 days notice. We implemented a “commit” membership model in October 2003 in an effort to improve our membership retention and to offer our members a wider range of membership types. The model encourages new members to commit to a one- or two-year membership, because these memberships are priced at a moderate discount to the month-to-month plan. During 2007, 98% of our newly enrolled members opted for a commit membership program. As of December 31, 2007, approximately 19% of our members originated under a month-to-month non-commit membership plan and 81% originated under a commit membership plan. We believe members prefer to have the choice to commit for a year or two or to have the flexibility of the month-to-month non-commit plan.

 

In joining a club, a new member signs a membership agreement that obligates the member to pay a one-time initiation fee, a one-time processing fee and monthly dues on an ongoing basis. Monthly electronic funds transfer, or EFT, of individual membership dues on a per-member basis averaged approximately $71.00 per month for the year ended December 31, 2007. Together, initiation fees and processing fees collected for new EFT members averaged approximately $72.00 for the year ended December 31, 2007. We collect approximately 95.0% of all monthly membership dues through EFT and EFT revenue constituted approximately 74.7% of consolidated revenue for the year ended December 31, 2007. Substantially all other membership dues are paid in full in advance. Our membership agreements call for monthly dues to be collected by EFT based on credit card or bank account debit authorization contained in the agreement. During the first week of each month, we receive the EFT dues for that month after the payments are initiated by a third-party EFT processor. Discrepancies and insufficient funds incidents are researched and resolved by our in-house account services department. Our EFT program enables us to increase our existing member dues in an efficient and consistent manner, which we typically do annually by between 1% and 3% on average, in line with increases in the cost of living.

 

Non-Membership Revenue

 

Over the past five years, we have expanded the level of ancillary club services provided to our members. Non-membership club revenue has increased by $34.9 million from $51.1 million in 2003 to $86.0 million in 2007. Increases in personal training revenue in particular have contributed $24.9 million of the increase in ancillary revenue during this period. In addition, we have added Sports Clubs for Kids and Small Group Training (both additional fee for service programs) at selected clubs. Non-membership club revenue as a percentage of total

revenue has increased from 15.0% for the year ended December 31, 2003 to 18.2% for the year ended December 31, 2007. Personal training revenue as a percentage of total revenue increased from 9.1% of revenue in 2003 to 11.9% of total revenue in 2007.

 

 

Club Format and Locations

 

Our clubs are typically located in middle- or upper-income residential, commercial, urban and suburban neighborhoods within major metropolitan areas that are capable of supporting the development of a cluster of clubs. Our clubs generally have high visibility and are easily accessible. In the New York City, Boston, Washington, D.C. and Philadelphia markets, we have created clusters of clubs in urban areas and their commuter suburbs aligned with our operating strategy of offering our target members the convenience of multiple locations close to where they live and work, reciprocal use privileges and standardized facilities and services.

 

Approximately 73% of the clubs we operate are fitness-only clubs and the remainder are multi-recreational. Our fitness-only clubs generally range in size from 10,000 to 35,000 square feet and average approximately 20,000 square feet. Our multi-recreational clubs vary in size from 15,000 square feet to 90,000 square feet, with one club being 200,000 square feet. The average multi-recreational club size is approximately 40,000 square feet. Membership for each club generally ranges from 2,000 to 4,500 members at maturity. Although club members represent a cross-section of the population in a given geographic market, our target member is college-educated, between the ages of 21 and 50 and has an annual income of between $50,000 and $150,000.

 

We have experienced significant growth over the past five years primarily through developing and opening new club locations that we have constructed. In addition, we have acquired existing, privately owned single and multi-club businesses. From January 1, 2003 to December 31, 2007, we acquired seven existing clubs and opened 37 new clubs. In addition, during this period, we relocated or closed 11 clubs and sold one club to increase our total clubs under operation from 129 to 161. For the year ended December 31, 2007, we opened 14 new clubs, acquired one club, and closed three clubs, to increase our total clubs under operation from 149 to 161.

 

We engage in detailed site analyses and selection processes based upon information provided by our development software to identify potential target areas for additional clubs based upon population demographics, psychographics, traffic and commuting patterns, availability of sites and competitive market information. Since December 31, 2007, we have opened two clubs. In addition, we currently have 13 lease commitments and 11 signed term sheets and have identified approximately 175 target areas in which we may add clubs under our New York Sports Clubs, Boston Sports Clubs, Washington Sports Clubs or Philadelphia Sports Clubs brand names. In addition, we have identified further growth opportunities in secondary markets located near our existing markets. In the future, we may explore expansion opportunities in other markets in the United States that share similar demographic characteristics to those in which we currently operate.

 

Our facilities include a mix of state-of-the-art cardiovascular equipment, including upright and recumbent bikes, steppers, treadmills and elliptical motion machines; strength equipment and free weights, including Cybex, Nautilus, TechnoGym, Strive, Precor, Star Trac and Hammer Strength equipment; group exercise and cycling studios; the Sportsclub Network entertainment system; locker rooms, including shower facilities, towel service and

other amenities, such as saunas; babysitting; and a pro-shop. Each of our clubs is equipped with automated external defibrillators. Personal training services are offered at all locations for an additional charge. At certain locations, additional facilities are also offered, including swimming pools and racquet and basketball courts. Also, we have significantly expanded the availability of fee-based programming at many of our clubs, including programs targeted at children, members and non-member adult customers.

 

We also offer our Xpressline strength workout at all of our clubs. Xpressline is a trainer-supervised, eight-station total-body circuit workout designed to be used in 22 minutes and to accommodate all fitness levels. This service is provided for free to our members. We also recently implemented ActiveTrax, which is an online personal training tool available to our members for an additional charge.

 

We have over 7,100 Sportsclub Network personal entertainment units installed in our clubs. The units are typically mounted on cardiovascular equipment and are equipped with a color screen for television viewing. The Sportsclub Network also broadcasts our own personalized music video channel that provides us with a direct means of advertising products and services to our membership base.

 

Club Services and Operations

 

We emphasize consistency and quality in all of our club operations, including:

 

Management.  We believe that our success is largely dependent on the selection and training of our staff and management. Our management structure is designed, therefore, to support the professional development of highly motivated managers who will execute our directives and support growth.

 

Our business is divided into regional operating lines with each reporting to a Vice President of Operations for that region. Reporting to these officers are regional functional departments as well as district managers. Reporting to these district managers are the individual club general managers. General managers are responsible for the day-to-day management of each club. At each level of responsibility, compensation is structured to align our goals for profitability with those of each region, district or club.

 

Corporate functional departments have been established to complement each specific area of our clubs’ services, such as sales, training, group exercise programs, fitness equipment, programming, personal training, facility and equipment maintenance, procurement and laundry. We have established a Learning and Development department to assume the management of existing sales and fitness training programs and to build training programs to support training in leadership, operations management, information technology and customer service. This centralization allows local general managers at each club to focus on sales, customer service, club staffing and providing a high-quality exercise experience.

 

Our club support group acts as the coordinator for all departments, and ensures consistency of policies and procedures across the entire organization.

 

Personal Training.  All of our fitness clubs offer one-on-one personal training, which is sold by the single session or in multi-session packages. We have implemented a comprehensive staff education curriculum, which progresses from basic knowledge and practical skills to advanced concepts and training techniques. Our education program provides professional standards to ensure that our personal trainers provide superior service and fitness expertise to our members. We believe the qualifications of the personal training staff helps ensure that members receive a consistent level of quality service throughout our clubs and that our personal training programs provide valuable guidance to our members and a significant source of incremental revenue for us. There are four levels of professional competency for which different levels of compensation are paid, with mandatory requirements trainers must meet in order to achieve and maintain such status. We recently implemented a revenue split pay structure for personal trainers, providing a compensation package based on a percentage of revenue earned from their sessions. We have also recently begun offering introductory personal training sessions at discounted prices. We believe that members who participate in personal training programs typically have a longer membership life.

 

Group Fitness.  Our commitment to providing a quality workout experience to our members extends to the employment of program instructors, who teach aerobics, cycling, strength conditioning, boxing, yoga, Pilates and step aerobics classes, among others. All program instructors report to a centralized management structure, headed

by the Director of Group Exercise whose department is responsible for overseeing auditions and providing in-house training to keep instructors current in the latest training techniques and program offerings. We also provide small group training offerings to our members, which are for fee based programs that have smaller groups and provide more focused, and typically more advanced, training classes. Some examples of these offerings include Pilates, boxing camps and cycling camps.

 

Sports Clubs for Kids.  During 2000, we began offering programs for children under the Sports Clubs for Kids brand. As of December 31, 2007, Sports Clubs for Kids was being offered in 24 locations throughout our New York Sports Clubs, Boston Sports Clubs and Philadelphia Sports Clubs regions. In addition to extending fitness offerings to a demographic group not previously served by us, we expect that Sports Clubs for Kids programming will help position our multi-recreational clubs as family clubs, which we believe will provide us with a competitive advantage. Depending upon the facilities available at a location, Sports Clubs for Kids programming can include traditional youth offerings such as day camps, sports camps, swim lessons, hockey and soccer leagues, gymnastics, dance and birthday parties. It also can include sports performance based programming such as our Ignite Program, which specializes in training young athletes ages eight to 17 years of age to improve their athletic skills and increase their speed, agility and strength and non-competitive “learn-to-play” sports programs.

 

Employee Compensation and Benefits.  We provide performance-based incentives to our management. Senior management compensation, for example, is tied to our overall performance. Departmental directors, district managers and general managers can achieve bonuses tied to financial and member retention targets for a particular club or group of clubs. We offer our employees various benefits including health, dental and disability insurance; pre-tax healthcare, commuting and dependent care accounts; and a 401(k) plan. We believe the availability of employee benefits provides us with a strategic advantage in attracting and retaining quality managers, program instructors and professional personal trainers and that this strategic advantage in turn translates into a more consistent and higher-quality workout experience for those members who utilize such services.

 

Centralized Information Systems

 

We use an integrated information system to sell memberships, bill our members, track and analyze sales and membership statistics, the frequency and timing of member workouts, cross-club utilization, member life, value-added services and demographic profiles by member, which enables us to develop targeted direct marketing programs and to modify our broadcast and print advertising to improve consumer response. This system also assists us in evaluating staffing needs and program offerings. In addition, we rely on certain data gathered through our information systems to assist in the identification of new markets for clubs and site selection within those markets.

 

Information System Developments

 

We recognize the value of enhancing and extending the uses of information technology in virtually every area of our business. After developing an information technology strategy to support our business strategy, we developed a comprehensive multi-year plan to replace or upgrade key systems and to improve upon them.

 

We currently utilize a club management system that incorporates functionality for member services, contract management, electronic billing, point of sale, scheduling resources and reservations. This club management system extends support for new business functionalities and new club models, and integrates with other applications. During 2005, we developed a related application utilizing business intelligence tools and data warehousing capabilities to enable enhanced managerial and analytical reporting of sales and operations. Currently we are developing a comprehensive enterprise management system that we expect to be fully deployed by late 2009. We expect this system to incorporate sufficient functionality to support all club sales and operations, customer relationship management, document management, work flow management, and additional executive information management capabilities. This system is intended to consolidate various internal legacy systems and internet systems to provide enhanced capabilities for managing the business, improving productivity, and expanding and enriching the member experience and increasing revenues.

 

In 2007, we implemented a human resources management system that provides enhanced capabilities for talent management, including recruiting, employee and manager self service, and evaluations and financial planning for staffing. The system was merged with the existing timekeeping system and integrated with payroll

and relevant financial applications for complete automation of compensation processing and management for all employees.

 

In 2005, we re-launched our web site utilizing new architecture to allow for flexibility in product offerings, online corporate and group sales, promotion and contest presentations, member self service, surveying and enhanced member options. The internet capabilities were expanded to include more member focused features and sales of trial memberships. We have built an intranet to provide a portal for the various browser-based applications that we utilize internally. Our intranet features support for corporate communications, human resources programs and training.

 

We have implemented numerous infrastructure changes to accommodate our growth, provide network redundancy, better manage telecommunications and data costs, increase efficiencies in operations and improve management of all components of our technical architecture. In 2005, we brought our disaster recovery site online. The disaster recovery facility utilizes replication tools to provide fail over capabilities for supporting our club operations and company communications. During 2007, we deployed several advanced tools for enhanced management and monitoring of our infrastructure for compliance and improved security.

 

During 2007, we enhanced both internal and external reporting capabilities with the implementation of the Oracle suite of accounting programs throughout the organization. We replaced legacy general ledger and accounts payable and fixed asset accounting systems with Oracle systems that include a fully integrated suite of accounting applications as well as lease management and cash management capabilities. Migration of our current construction accounting system to the Oracle systems and expanded on-line procurement are also in progress.

 

Intellectual Property

 

We have registered various trademarks and service marks with the U.S. Patent and Trademark Office, including NEW YORK SPORTS CLUBS and NYSC, WASHINGTON SPORTS CLUBS and WSC, BOSTON SPORTS CLUBS and BSC, PHILADELPHIA SPORTS CLUBS and PSC, COMPANIESGETFIT.COM, SPORTS CLUBS FOR KIDS, “        BETTER.”, and TOWN SPORTS INTERNATIONAL. We continue to register other trademarks and service marks as they are created. We believe that our rights to these properties are adequately protected.

 

Competition

 

The fitness club industry is competitive and continues to become more competitive. The number of health clubs in the U.S. has increased from 13,097 in 1997 to 29,357 in January 2007. In each of the markets in which we operate, we compete with other fitness clubs, physical fitness and recreational facilities established by local governments, hospitals and businesses for their employees, amenity and condominium clubs, the YMCA and similar organizations and, to a certain extent, with racquet and tennis and other athletic clubs, country clubs, weight reducing salons and the home-use fitness equipment industry.

 

The principal methods of competition include pricing and ease of payment, required level of members’ contractual commitment, level and quality of services, training and quality of supervisory staff, size and layout of facility and convenience of location with respect to access to transportation and pedestrian traffic.

 

We consider our service offerings to be in the mid-range of the value/service proposition and designed to appeal to a large portion of the population who attend fitness facilities. Competitors offering lower pricing and a lower level of service could attract members away from us.

 

Furthermore, smaller and less expensive weight loss facilities present a competitive alternative for consumers. We also face competition from club operators offering comparable or higher pricing with higher levels of service. The trend to larger outer-suburban family fitness centers, in areas where suitable real estate is more likely to be available, could also compete effectively against our suburban fitness-only formats.

Competitive Position Measured by Number of Clubs

 

 

We also compete with other entertainment and retail businesses for the discretionary income in our target demographics. There can be no assurance that we will be able to compete effectively in the future in the markets in which we operate. Competitors, who may include companies that are larger and have greater resources than us, may enter these markets to our detriment. These competitive conditions may limit our ability to increase dues without a material loss in membership, attract new members and attract and retain qualified personnel. Additionally, consolidation in the fitness club industry could result in increased competition among participants, particularly large multi-facility operators that are able to compete for attractive acquisition candidates and/or newly constructed club locations. This increased competition could increase our costs associated with expansion through both acquisitions and for real estate availability for newly constructed club locations.

 

We believe that our market leadership, experience and operating efficiencies enable us to provide the consumer with a superior product in terms of convenience, quality service and affordability. We believe that there are significant barriers to entry in our metropolitan areas, including restrictive zoning laws, lengthy permit processes and a shortage of appropriate real estate, which could discourage any large competitor from attempting to open a chain of clubs in these markets. However, such a competitor could enter these markets more easily through one, or a series of, acquisitions.

 

Government Regulation

 

Our operations and business practices are subject to federal, state and local government regulation in the various jurisdictions in which our clubs are located, including: (1) general rules and regulations of the Federal Trade Commission, state and local consumer protection agencies and state statutes that prescribe certain forms and provisions of membership contracts and that govern the advertising, sale, financing and collection of such memberships and (2) state and local health regulations.

 

Statutes and regulations affecting the fitness industry have been enacted in jurisdictions in which we conduct business; many others into which we may expand have adopted or likely will adopt similar legislation. Typically, these statutes and regulations prescribe certain forms and provisions of membership contracts, afford members the right to cancel the contract within a specified time period after signing, require an escrow of funds received from pre-opening sales or the posting of a bond or proof of financial responsibility, and may establish maximum prices for membership contracts and limitations on the term of contracts. In addition, we are subject to numerous other types of federal and state regulations governing the sale of memberships. These laws and regulations are subject to varying interpretations by a number of state and federal enforcement agencies and courts. We maintain internal review procedures in order to comply with these requirements, and believe that our activities are in substantial compliance with all applicable statutes, rules and decisions.

 

Under state “cooling-off” statutes, a new member has the right to cancel his or her membership for a short period after joining, set by the applicable law in the relevant jurisdiction and, in such event, is entitled to a refund of any initiation fee and dues paid. In addition, our membership contracts provide that a member may cancel his or her membership at any time for medical reasons or relocation a certain distance from the nearest club. The specific procedures and reasons for cancellation vary due to differing laws in the respective jurisdictions. In each instance, the canceling member is entitled to a refund of unused prepaid amounts only. Furthermore, where permitted by law, a fee is due upon cancellation and we may offset such amount against any refunds owed.

In recent years, certain of the states in which we operate have passed legislation to require sales tax to be collected on our membership dues. This has had the effect of increasing the monthly payments our members are required to remit.

 

Employees

 

At December 31, 2007, we had approximately 9,000 employees, of whom approximately 3,100 were employed full-time. Approximately 400 employees were corporate personnel working in our Manhattan, Boston, Philadelphia or Washington, D.C. offices. We are not a party to any collective bargaining agreement with our employees. We have never experienced any significant labor shortages or had any difficulty in obtaining adequate replacements for departing employees. We consider our relations with our employees to be good.

 

Available Information

 

We make available through our web site at www.mysportsclubs.com in the “Investor Relations — SEC Filings” section, all reports and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

The foregoing information regarding our website and its content is for convenience only. The content of our website is not deemed to be incorporated by reference into this report nor should it be deemed to have been filed with the SEC.

 

 

Investors should carefully consider the risks described below and all other information in this Annual Report on Form 10-K. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business and operations. If any of the following risks actually occur, our business, financial condition, cash flows or results of operations could be materially adversely affected.

 

Risks Related to Our Business

 

We may be unable to attract and retain members, which could have a negative effect on our business.

 

The performance of our clubs is dependent on our ability to attract and retain members and we may not be successful in these efforts. Many of our members can cancel their club membership at any time under certain circumstances. In addition, there are numerous factors that have in the past and could in the future lead to a decline in membership levels at established clubs or that could prevent us from increasing our membership at newer clubs, including harm to our reputation, a decline in our ability to deliver quality service at a competitive cost, the presence of direct and indirect competition in the areas in which the clubs are located, the public’s interest in sports and fitness clubs and general economic conditions. A general economic downturn may affect our consumers’ discretionary spending, which could adversely affect our business. As a result of these factors, membership levels might not be adequate to maintain or permit the expansion of our operations. In addition, a decline in membership levels may have a material adverse effect on our business, financial condition, cash flows or results of operations.

 

Our geographic concentration heightens our exposure to adverse regional developments.

 

As of December 31, 2007, we operated 111 fitness clubs in the New York metropolitan market, 22 fitness clubs in the Boston market, 18 fitness clubs in the Washington, D.C. market, seven fitness clubs in the Philadelphia market and three fitness clubs in Switzerland. Our geographic concentration in the Northeast and Mid-Atlantic regions and, in particular, the New York area, heightens our exposure to adverse developments related to competition, as well as, economic and demographic changes in these regions. Our geographic concentration might result in a material adverse effect on our business, financial condition, cash flows or results of operations in the future.

The level of competition in the fitness club industry could negatively impact our revenue growth rates and profits.

 

The fitness club industry is competitive and continues to become more competitive. In each of the markets in which we operate, we compete with other fitness clubs, physical fitness and recreational facilities established by local governments, hospitals and businesses for their employees, amenity and condominium clubs, the YMCA and similar organizations and, to a certain extent, with racquet and tennis and other athletic clubs, country clubs, weight reducing salons and the home-use fitness equipment industry. We also compete with other entertainment and retail businesses for the discretionary income in our target demographics. We might not be able to compete effectively in the future in the markets in which we operate. Competitors may include companies that are larger and have greater resources than us, and they may enter these markets to our detriment. These competitive conditions may limit our ability to increase dues without a material loss in membership, attract new members and attract and retain qualified personnel. Additionally, consolidation in the fitness club industry could result in increased competition among participants, particularly large multi-facility operators that are able to compete for attractive acquisition candidates or newly constructed club locations, thereby increasing costs associated with expansion through both acquisitions and lease negotiation and real estate availability for newly constructed club locations.

 

Competitors offering lower pricing and a lower level of service could compete effectively against our facilities if such operators are willing to accept operating margins that are lower than ours. Furthermore, smaller and less expensive weight loss facilities present a competitive alternative for consumers. We also face competition from competitors offering comparable or higher pricing with higher levels of service. The trend to larger outer-suburban, multi-recreational family fitness centers, in areas where suitable real estate is more likely to be available, could also compete effectively against our suburban, fitness-only models.

 

In addition, large competitors could enter the urban markets in which we operate to attempt to open a chain of clubs in these markets through one, or a series of, acquisitions.

 

If we are unable to identify and acquire suitable sites for new clubs, our revenue growth rate and profits may be negatively impacted.

 

To successfully expand our business, we must identify and acquire sites that meet the site selection criteria we have established. In addition to finding sites with the right geographical, demographic and other measures we employ in our selection process, we also need to evaluate the penetration of our competitors in the market. We face competition from other health and fitness center operators for sites that meet our criteria, and as a result, we may lose those sites, our competitors could copy our format or we could be forced to pay higher prices for those sites. If we are unable to identify and acquire sites for new clubs, our revenue growth rate and profits may be negatively impacted. Additionally, if our analysis of the suitability of a site is incorrect, we may not be able to recover our capital investment in developing and building the new club.

 

We may experience prolonged periods of losses in our recently opened clubs.

 

We have opened a total of 24 new club locations that we have constructed in the 24-month period ended December 31, 2007. Upon opening a club, we typically experience an initial period of club operating losses. Enrollment from pre-sold memberships typically generates insufficient revenue for the club to generate positive cash flow. As a result, a new club typically generates an operating loss in its first full year of operations and substantially lower margins in its second full year of operations than a club opened for more than 24 months (“mature club”). These operating losses and lower margins will negatively impact our future results of operations. This negative impact will be increased by the initial expensing of pre-opening costs, which include legal and other costs associated with lease negotiations and permitting and zoning requirements, as well as depreciation and amortization expenses, which will further negatively impact net income. We may, at our discretion, accelerate or expand our plans to open new clubs, which may temporarily adversely affect results from operations.

 

We could be subject to claims related to health or safety risks at our clubs.

 

Use of our clubs poses some potential health or safety risks to members or guests through exertion and use of our services and facilities, including exercise equipment. Claims against us for injury suffered by, or death of

members or guests while exercising at a club might be asserted. We might not be able to successfully defend such claims. As a result, we might not be able to maintain our general liability insurance on acceptable terms in the future or maintain a level of insurance that would provide adequate coverage against potential claims.

 

Depending upon the outcome, these matters may have a material effect on our consolidated financial position, results of operations or cash flows.

 

Loss of key personnel and/or failure to attract and retain highly qualified personnel could make it more difficult for us to generate cash flow from operations and service our debt.

 

We are dependent on the continued services of our senior management team, particularly Alexander A. Alimanestianu, our Chief Executive Officer. We believe the loss of Mr. Alimanestianu could have a material adverse effect on us and our financial performance. Currently, we do not have any long-term employment agreements with any of our executive officers, and we may not be able to attract and retain sufficient qualified personnel to meet our business needs.

 

We are subject to extensive government regulation and changes in these regulations could have a negative effect on our financial condition.

 

Our operations and business practices are subject to Federal, state and local government regulation in the various jurisdictions in which our clubs are located, including: (1) general rules and regulations of the Federal Trade Commission, state and local consumer protection agencies and state statutes that prescribe certain forms and provisions of membership contracts and that govern the advertising, sale, financing and collection of such memberships and (2) state and local health regulations.

 

Statutes and regulations affecting the fitness industry have been enacted in jurisdictions in which we conduct business; many others into which we may expand have adopted or likely will adopt similar legislation. Typically, these statutes and regulations prescribe certain forms and provisions of membership contracts, afford members the right to cancel the contract within a specified time period after signing, require an escrow of funds received from pre-opening sales or the posting of a bond or proof of financial responsibility, and may establish maximum prices for membership contracts and limitations on the term of contracts. In addition, we are subject to numerous other types of federal and state regulations governing the sale of memberships. These laws and regulations are subject to varying interpretations by a number of state and federal enforcement agencies and courts. We maintain internal review procedures in order to comply with these requirements, and believe that our activities are in substantial compliance with all applicable statutes, rules and decisions.

 

Under state “cooling-off” statutes, a new member has the right to cancel his or her membership for a short period after joining set by the applicable law in the relevant jurisdiction and, in such event, is entitled to a refund of any initiation fee and dues paid. In addition, our membership contracts provide that a member may cancel his or her membership at any time for medical reasons or relocation a certain distance from the nearest club. The specific procedures and reasons for cancellation vary due to differing laws in the respective jurisdictions. In each instance, the canceling member is entitled to a refund of unused prepaid amounts only. Furthermore, where permitted by law, a fee is due upon cancellation and we may offset such amount against any refunds owed.

 

Changes in any statutes, rules or regulations could have a material adverse effect on our financial condition and results of operations.

 

Terrorism and the uncertainty of armed conflicts may have a material adverse effect on clubs and our operating results.

 

Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, and other acts of violence or war may affect the markets in which we operate, our operating results or the market on which our common stock trades. Our geographic concentration in the major cities in the Northeast and Mid-Atlantic regions and, in particular, the New York and Washington, D.C. areas, heightens our exposure to any such future terrorist attacks, which may adversely affect our clubs and result in a decrease in our revenues. The potential near-term and long-term effect these attacks may have for our members, the markets for our services and the market for

our common stock are uncertain; however, their occurrence can be expected to further negatively affect the United States economy generally, and specifically the regional markets in which we operate. The consequences of any terrorist attacks or any armed conflicts are unpredictable; and we may not be able to foresee events that could have an adverse effect on our business.

 

Disruptions and failures involving our information systems could cause customer dissatisfaction and adversely affect our billing and other administrative functions.

 

The continuing and uninterrupted performance of our information systems is critical to our success. Our members may become dissatisfied by any systems disruption or failure that interrupts our ability to provide our services to them, including programs and adequate staffing. Disruptions or failures that affect our billing and other administrative functions could have an adverse affect on our operating results.

 

We use a fully integrated information system to sell memberships, bill our members, track and analyze sales and membership statistics, the frequency and timing of member workouts, cross-club utilization, member life, value-added services and demographic profiles by member. This system also assists us in evaluating staffing needs and program offerings. Correcting any disruptions or failures that affected our proprietary system could be difficult, time-consuming or expensive because we would need to use contracted consultants familiar with our system.

 

We have implemented numerous infrastructure changes to accommodate our growth, provide network redundancy, better manage telecommunications and data costs, increase efficiencies in operations and improve management of all components of our technical architecture. In 2005, we brought our disaster recovery site online. The disaster recovery facility utilizes replication tools to provide fail over capabilities for supporting our club operations and company communications. Fire, floods, earthquakes, power loss, telecommunications failures, break-ins, acts of terrorism and similar events could damage either our primary or back-up systems. In addition, computer viruses, electronic break-ins or other similar disruptive problems could also adversely affect our online sites. Any system disruption or failure, security breach or other damage that interrupts or delays our operations could cause us to lose members and adversely affect our business and results of operations.

 

The opening of new clubs by us in existing locations may negatively impact our comparable club revenue increases and our operating margins.

 

We currently operate clubs throughout the Northeast and Mid-Atlantic regions of the United States. We opened 15 clubs in 2007, and two clubs since December 31, 2007. In addition, we currently have 13 clubs for which we have signed lease commitments and an additional 11 for which we have signed term sheets. Each of these projected 24 openings is in an existing market. With respect to existing markets, it has been our experience that opening new clubs may attract some memberships away from other clubs already operated by us in those markets and diminish their revenues. In addition, as a result of new club openings in existing markets, and because older clubs will represent an increasing proportion of our club base over time, our mature club revenue increases may be lower in future periods than in the past.

 

Another result of opening new clubs is that our club operating margins may be lower than they have been historically while the clubs build a membership base. We expect both the addition of pre-opening expenses and the lower revenue volumes characteristic of newly opened clubs to affect our club operating margins at these new clubs.

 

Our continued growth could place strains on our management, employees, information systems and internal controls, which may adversely impact our business.

 

Over the past five years, we have experienced significant growth in our business activities and operations, including an increase in the number of our clubs. Future expansion will place increased demands on our administrative, operational, financial and other resources. Any failure to manage growth effectively could seriously harm our business. To be successful, we will need to continue to improve management information systems and our operating, administrative, financial and accounting systems and controls. We will also need to train new employees and maintain close coordination among our executive, accounting, finance, marketing, sales and operations functions. These processes are time-consuming and expensive, increase management responsibilities and divert management attention.

Our cash and cash equivalents are concentrated in one bank.

 

Our cash and cash equivalents are held, primarily, in a single commercial bank. These deposits are not collateralized. In the event the bank becomes insolvent, we would be unable to recover most of our cash and cash equivalents deposited at the bank. Cash and cash equivalents held in a single commercial bank as of December 31, 2007 were $3.9 million.

 

Delays in new club openings could have a material adverse effect on our financial performance.

 

In order to meet our objectives, it is important that we open new clubs on schedule. A significant amount of time and capital expenditures is required to develop and construct new clubs. If we are significantly delayed in the opening of these clubs, our competitors may be able to open new clubs in the same market before we open ours. This change in the competitive landscape could negatively impact our pre-opening sales of memberships. In addition, delays in opening new clubs could hurt our ability to meet our growth objectives. Our ability to open new clubs on schedule depends on a number of factors, many of which are beyond our control. These factors include:

 

 

Risks Related to Our Leverage

 

Our leverage may impair our financial condition and we may incur significant additional debt.

 

We currently have a substantial amount of debt. As of December 31, 2007, our total consolidated debt was $316.0 million. Our substantial debt could have important consequences, including:

 

 

These limitations and consequences may place us at a competitive disadvantage to other less-leveraged competitors.

 

Subject to specified limitations, the indenture governing our 11% Senior Discount Notes due in 2014 (“Senior Discount Notes”) will permit us and our subsidiaries to incur substantial additional debt. In addition, as of December 31, 2007, we had $54.5 million of unutilized borrowings under our senior secured revolving credit facility. If new debt is added to our and our subsidiaries’ current debt levels, the related risks that we and they now face could intensify.

We may not have access to the cash flow and other assets of our subsidiaries that may be needed to make payments on our outstanding Senior Discount Notes.

 

Our operations are conducted through our subsidiaries and our ability to make payments on our outstanding Senior Discount Notes is dependent on the earnings and the distribution of funds from our subsidiaries. However, none of our subsidiaries are obligated to make funds available to us for payment on our outstanding Senior Discount Notes. In addition, the terms of the Credit Agreement dated as of February 27, 2007 (the “New Credit Agreement”) governing the $260.0 million senior secured credit facility (the “New Senior Credit Facility”), significantly restrict TSI, LLC and its subsidiaries from paying dividends and otherwise transferring assets to us. Furthermore, our subsidiaries are permitted under the terms of the New Credit Agreement and other indebtedness (including under the Senior Discount Notes indenture) to incur additional indebtedness that may severely restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to us.

 

We cannot assure you that the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide TSI, LLC with sufficient dividends, distributions or loans to fund scheduled interest and principal payments on the New Credit Agreement when due.

 

Covenant restrictions under our indebtedness may limit our ability to operate our business and, in such an event, we may not have sufficient assets to settle our indebtedness.

 

The indenture governing our Senior Discount Notes, New Credit Agreement and certain of our other agreements regarding our indebtedness contain, among other things, covenants that may restrict our ability to finance future operations or capital needs or to engage in other business activities. The indenture governing our Senior Discount Notes, the New Credit Agreement and certain of our other agreements regarding our indebtedness restrict, among other things, our ability and the ability of our restricted subsidiaries to:

 

 

In addition, the New Credit Agreement requires the Company, on a consolidated basis, to maintain a specified financial ratio and satisfy certain financial condition tests that may require us to take action to reduce our debt or to act in a manner contrary to our business objectives. The New Credit Agreement requires the Company, on a consolidated basis, to maintain a maximum total leverage ratio not greater than 4.25:1.00 of consolidated indebtedness to consolidated EBITDA, as defined in the New Credit Agreement. As of December 31, 2007, we were in compliance with such ratio, which ratio was 2.98:1.00.

 

Events beyond our control, including changes in general economic and business conditions, may affect our ability to meet certain financial ratios and financial condition tests. We may be unable to meet those tests and the lenders may decide not to waive any failure to meet those tests. A breach of any of these covenants would result in a default under the indenture governing our senior discount notes, the New Credit Agreement. If an event of default under the New Credit Agreement occurs, the lenders could elect to declare all amounts outstanding thereunder, together with accrued interest, to be immediately due and payable. If an event of default occurs under the indenture governing our Senior Discount Notes, the note holders could elect to declare due all amounts outstanding

thereunder, together with accrued interest. If any such event should occur, we might not have sufficient assets to pay our indebtedness.

 

 

None

 

 

We own the 151 East 86th Street location, which houses a fitness club and a retail tenant that generated $1.1 million of rental income for us for the year ended December 31, 2007. We lease the remainder of our fitness clubs pursuant to long-term leases (generally 15 to 25 years, including options). As of December 31, 2007, there were leases for seven locations due to expire in the next five years (ending December 31, 2012) without any renewal options. In each case, we will endeavor to extend the lease or relocate the club or its membership base if appropriate.

 

We lease approximately 47,000 square feet of office space in New York City, and have smaller regional offices in Fairfax, VA, and Boston, MA, for administrative and general corporate purposes. We also lease warehouse and commercial space in Brooklyn, NY and Queens, NY for storage purposes and for the operation of a centralized laundry facility for certain of our clubs in the New York metropolitan area.

 

In June 2007, the Company’s corporate headquarters office in New York City moved to a new location within Manhattan occupying approximately 25,000 square feet. Corporate headquarters office in Manhattan that the Company previously occupied was approximately 18,000 square feet.

 

The following table provides information regarding our club locations:

 

 

 

On or about March 1, 2005, in an action styled Sarah Cruz, et al v. Town Sports International, dba New York Sports Club, plaintiffs commenced a purported class action against the Company in the Supreme Court, New York County, seeking unpaid wages and alleging that TSI LLC violated various overtime provisions of the New York State Labor Law with respect to the payment of wages to certain trainers and assistant fitness managers. On or about November 2, 2005, the complaint and the lawsuit were stayed upon agreement of the parties pending mediation. On or about November 28, 2006, the plaintiffs gave notice that they wished to lift the stay. On or about June 18, 2007, the same plaintiffs commenced a second purported class action against the Company in the Supreme Court, New York County, seeking unpaid wages and alleging that TSI LLC violated various wage payment and overtime provisions of the New York State Labor Law with respect to the payment of wages to all New York purported hourly employees. While we are unable at this time to estimate the likelihood of an unfavorable outcome or the potential loss to the Company in the event of such an outcome, we intend to contest these cases vigorously. Depending upon the ultimate outcome, these matters may have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

 

On or about June 12, 2001, TSI LLC and several other third parties were named as defendants in an action styled Carlos Urbina et ano v. 26 Court Street Associates, LLC et al., filed in the Supreme Court, New York County, seeking damages for personal injuries. Following a trial, TSI LLC received a directed verdict for indemnification against one of TSI LLC’s contractors and the plaintiffs received a jury verdict of approximately $8.9 million in their favor. Both of those verdicts were appealed and were argued on May 16, 2006. TSI LLC filed an appeal bond in the amount of $1.8 million in connection with those appeals. On December 6, 2007, the Appellate Division of New York State, First Department unanimously decided to (i) reduce the plaintiffs’ damages award by $1.3 million, thereby bringing the claim within the limits of the insurance coverage available to TSI LLC’s contractor and (ii) uphold TSI LLC’s claim for indemnification from TSI LLC’s contractor. While the contractor has the right to appeal to the New York Court of Appeals, such appeal can only be made with the permission from the Appellate Division, which we believe is unlikely. The contractor obligated to indemnify TSI, LLC has not yet moved for leave to go to the Court of Appeals or moved to reargue the Appellant Division’s decision. We understand that the

insurance carrier for the contractor who is obligated to indemnify TSI, LLC for this loss is discussing with plaintiff the mechanics of making the payment of the damages award and therefore there will be no payment obligation from TSI, LLC.

 

In addition to the litigation discussed above, we are involved in various other lawsuits, claims and proceedings incident to the ordinary course of business. The results of litigation are inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in diversion of significant resources. The results of these other lawsuits, claims and proceedings cannot be predicted with certainty. We believe, however, that the ultimate resolution of these current matters will not have a material adverse effect on our financial statements taken as a whole.

 

 

Not applicable

 

 

Price Range of Common Stock

 

Our common stock currently trades on The NASDAQ Global Market, a new market tier created by The NASDAQ Stock Market that became effective on July 1, 2006 under the symbol CLUB. Our common stock commenced trading on The NASDAQ National Market under the symbol CLUB on June 2, 2006, the first trading day of our common stock following our initial public offering (“IPO”). The following table sets forth, for each quarterly period since our initial public offering, the high and low sales prices (in dollars per share) of our common stock as quoted or reported on The NASDAQ National Market or The NASDAQ Global Market:

 

 

Holders

 

As of February 25, 2008, there were approximately 76 holders of record of our common stock. There are additional holders who are not “holders of record” but who beneficially own stock through nominee holders such as brokers and benefit plan trustees.

 

Dividend Policy

 

We intend to retain future earnings, if any, to finance the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Consequently, stockholders will need to sell shares of our common stock to realize a return on their investment, if any. No dividends were paid by the Company in the fiscal years ended December 31, 2006 and 2007.

 

The terms of the indenture governing our Senior Discount Notes and the New Senior Credit Facility significantly restrict the payment of dividends by us. Our subsidiaries are permitted under the terms of the New Senior Credit Facility (including under the indenture governing our Senior Discount Notes) to incur additional indebtedness that may severely restrict or prohibit the payment of dividends by such subsidiaries to us. Our substantial leverage may impair our financial condition and we may incur significant additional debt (see “Item 1A. Risk Factors”).

 

Issuer Purchases of Equity Securities

 

We did not repurchase any of our securities during the quarter ended December 31, 2007.

 

Recent Sales of Unregistered Securities

 

We did not sell any securities during the quarter ended December 31, 2007 that were not registered under the Securities Act of 1933, as amended.

Securities Authorized for Issuance under Equity Compensation Plans

 

The information about securities authorized for issuance under our equity compensation plans is incorporated by reference to Item 12 of this Form 10-K, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”.

 

Stock Performance Graph

 

The graph depicted below compares the annual percentage change in our cumulative total stockholder return with the cumulative total return of the Russell 2000 and the NASDAQ composite indexes.

 

COMPARISON OF 19 MONTH CUMULATIVE TOTAL RETURN*
Among Town Sports International Holdings, Inc, The NASDAQ Composite Index
And The Russell 2000 Index

 

 

 

 

Notes:

 

 

Notwithstanding anything to the contrary set forth in any of our previous or future filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate by reference this Annual Report on Form 10-K or future filings made by the Company under those statutes, the Stock

Performance Graph is not deemed filed with the Securities and Exchange Commission, is not deemed soliciting material and shall not be deemed incorporated by reference into any of those prior filings or into any future filings made by the Company under those statutes, except to the extent that the Company specifically incorporates such information by reference into a previous or future filing, or specifically requests that such information be treated as soliciting material, in each case under those statutes.

 

 

SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
(In thousands, except share, per share, club and membership data)

 

The selected consolidated balance sheet data as of December 31, 2006 and 2007 and the selected consolidated statement of operations and cash flow data for the years ended December 31, 2005, 2006 and 2007 have been derived from our audited consolidated financial statements included elsewhere herein. The selected consolidated balance sheet data as of December 31, 2003, 2004 and 2005 and the selected consolidated statement of operations and cash flow data for the years ended December 31, 2003 and 2004 have been derived from our audited consolidated financial statements not included herein. Other data and club and membership data for all periods presented have been derived from our unaudited books and records. Our historical results are not necessarily indicative of results for any future period. You should read these selected consolidated financial and other data, together with the accompanying notes, in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this annual report and our consolidated financial statements and the related notes appearing at the end of this annual report.

 

 

 

 

 

 

 

 

 

 

The following table reconciles net income (loss), the most directly comparable GAAP measure, to EBITDA:

 

 

 

 

You should read the following discussion and analysis of our financial condition and consolidated results of operations in conjunction with the “Selected Consolidated Financial and Other Data” section of this annual report and our consolidated financial statements and the related notes appearing at the end of this annual report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth in “Item 1A. Risk Factors” of this annual report.

 

Overview

 

We are the second largest owner and operator of fitness clubs in the Northeast and Mid-Atlantic regions of the United States. As of December 31, 2007, we owned and operated 161 clubs that collectively served approximately 486,000 members. We develop clusters of clubs to serve densely populated major metropolitan regions and we service such populations by clustering clubs near the highest concentrations of our target customers’ areas of both employment and residence. Our clubs are located for maximum convenience to our members in urban or suburban areas, close to transportation hubs, or office or retail centers. Our target customer is college-educated, typically between the ages of 21 and 50 and earns an annual income of between $50,000 and $150,000. We believe that the upper value segment is not only the broadest segment of the market, but also the segment with the greatest growth opportunities.

 

Our goal is to be the most recognized health club network in each of the four major metropolitan regions we serve. We believe that our strategy of clustering clubs provides significant benefits to our members and allows us to achieve strategic operating advantages. In each of our markets, we have developed clusters by initially opening or acquiring clubs located in the more central urban markets of the region and then branching out from these urban centers to suburbs and neighboring communities. Capitalizing on this clustering of clubs, as of December 31, 2007, approximately 41% of our members participated in our passport membership plan that allows unlimited access to all of our clubs in our clusters for a higher monthly membership fee. The remaining 59% of our members participate in a gold membership plan that allows unlimited access to a designated club and access to all other clubs in the chain during off-peak hours.

 

We have executed our clustering strategy successfully in the New York region through the network of fitness clubs we operate under our New York Sports Clubs brand name. We are the largest fitness club operator in Manhattan with 41 locations (more than twice as many as our nearest competitor) and operated a total of 111 clubs under the New York Sports Clubs brand name within a 120-mile radius of New York City as of December 31, 2007. We operated 22 clubs in the Boston region under our Boston Sports Clubs brand name, 18 clubs (two of which are partly-owned) in the Washington, D.C. region under our Washington Sports Clubs brand name and seven clubs in the Philadelphia region under our Philadelphia Sports Clubs brand name as of December 31, 2007. In addition, we operated three clubs in Switzerland as of December 31, 2007. We employ localized brand names for our clubs to create an image and atmosphere consistent with the local community and to foster recognition as a local network of quality fitness clubs rather than a national chain.

 

We consider that we have two principal sources of revenue:

 

 

In addition, we receive revenue (approximately 1.2% for the year ended December 31, 2007) from the rental of space in our facilities to operators who offer wellness-related offerings, such as physical therapy. In addition, we sell in-club advertising and sponsorships and generate management fees from certain club facilities that we do not wholly own. We refer to this as Fees and Other revenue.

 

Revenue (in $’000s) is comprised of the following:

 

 

Our revenues, operating income, net income and EBITDA for the year ended December 31, 2007 were $472.9 million, $57.8 million, $13.6 million and $105.6 million, respectively. Our revenues, operating income, net income and EBITDA for the year ended December 31, 2006 were $433.1 million, $53.0 million, $4.6 million and $95.7 million, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Non-GAAP Financial Measures” for a discussion on our use of EBITDA.

 

Our operating and selling expenses are comprised of both fixed and variable costs. Fixed costs include club and supervisory salary and related expenses, occupancy costs, including certain elements of rent, housekeeping and contracted maintenance expenses, as well as depreciation. Variable costs are primarily related to payroll associated with ancillary club revenue, membership sales compensation, advertising, utilities, certain facility repairs and club supplies.

 

General and administrative expenses include costs relating to our centralized support functions, such as accounting, insurance, information systems, purchasing and member relations, legal and consulting fees and real estate development expenses.

 

As clubs mature and increase their membership base, fixed costs are typically spread over an increasing revenue base and operating margins tend to improve.

 

Our primary capital expenditures relate to the construction or acquisition of new club facilities and upgrading and expanding our existing clubs. The construction and equipment costs vary based on the costs of construction labor, as well as the planned service offerings and size and configuration of the facility. We perform routine improvements at our clubs and partial replacement of the fitness equipment each year for which we budget approximately 4.0% of projected annual revenue. Expansions of certain facilities are also performed from time to time, when incremental space becomes available on acceptable terms, and utilization and demand for the facility dictate. In this connection, facility remodeling is also considered where appropriate.

 

During the last several years, we have increased revenues, operating income, cash flows provided by operating activities and EBITDA by expanding our club base in New York, Boston, Washington, D.C. and Philadelphia. As a result of expanding our club base and the relatively fixed nature of our operating costs, our operating income has increased from $42.6 million for the year ended December 31, 2003 to $57.8 million for the year ended December 31, 2007. Cash flows provided by operating activities increased from $58.9 million in 2003 to $83.0 million in 2007. EBITDA increased from $78.9 million in 2003 to $105.6 million in 2007. Net income was $7.4 million in 2003 and $13.6 million in 2007.

 

We have focused on building or acquiring clubs in areas where we believe the market is underserved or where new clubs are intended to replace existing clubs at their lease expiration. Based on our historical experience, a new club tends to experience a significant increase in revenues during its first three years of operation as it reaches maturity. Because there is relatively little incremental cost associated with such increasing revenue, there is a greater proportionate increase in profitability. We believe that the revenues and operating income of our immature clubs will increase as they mature. As a result of our expansion, however, operating income margins may be negatively impacted in the near term, as further new clubs are added.

 

As of December 31, 2007, 159 of the existing fitness clubs were wholly owned by us and our consolidated financial statements include the operating results of all such clubs. Two locations in Washington, D.C. were managed and partly owned by us, with our profit sharing percentages approximating 20% (after priority distributions) and 45%, respectively, and are treated as unconsolidated affiliates. In addition, we provide management services at five fitness clubs located in colleges and universities in which we have no equity interest.

 

Historical Club Growth

 

 

 

 

Comparable Club Revenue

 

We define comparable club revenue as revenue at those clubs that were operated by us for over 12 months and comparable club revenue growth as revenue for the 13th month and thereafter as applicable as compared to the same period at the prior year.

 

 

Key determinants of comparable club revenue growth are new memberships, member retention rates, pricing and ancillary revenue growth.

 

Non-GAAP Financial Measures

 

We use the terms “EBITDA” and “EBITDA margin” throughout this annual report. EBITDA consists of net income (loss) plus interest expense, net of interest income, provision for corporate income taxes, depreciation and amortization and loss on extinguishment of debt. This term, as we define it, may not be comparable to a similarly titled measure used by other companies and is not a measure of performance presented in accordance with GAAP. EBITDA margin is the ratio of EBITDA to total revenue.

 

We use EBITDA and EBITDA margin as measures of operating performance. EBITDA should not be considered as a substitute for net income, operating income, cash flows provided by operating activities or other income or cash flow data prepared in accordance with GAAP. The funds depicted by EBITDA are not necessarily available for discretionary use if they are reserved for particular capital purposes, to maintain compliance with debt covenants, to service debt or to pay taxes.

 

We believe EBITDA is useful to an investor in evaluating our operating performance because:

 

 

Our management uses EBITDA:

 

 

 

We have provided reconciliations of EBITDA to net income (loss), the most directly comparable GAAP measure, in footnote 4 under “Selected Consolidated Financial and Other Data.”

 

Results of Operations

 

The following table sets forth certain operating data as a percentage of revenue for the periods indicated:

 

 

YEAR ENDED DECEMBER 31, 2007 COMPARED TO
YEAR ENDED DECEMBER 31, 2006

 

Revenues

 

Revenues.  Revenues increased $39.8 million, or 9.2%, to $472.9 million for the year ended December 31, 2007 from $433.1 million for the year ended December 31, 2006. This increase in revenue was driven primarily by growth in membership revenue and ancillary club revenue. For the year ended December 31, 2007, revenues increased $16.1 million, or 3.9%, at our clubs opened or acquired prior to December 31, 2005. For the year ended December 31, 2007, revenue increased $25.7 million at the 26 clubs opened or acquired subsequent to December 31, 2005. These increases in revenue were offset by a $2.3 million revenue decrease related to the six clubs that were closed and/or relocated subsequent to January 1, 2006.

 

Comparable club revenue increased 5.2% for the year ended December 31, 2007. Of this 5.2% increase, 2.7% was due to an increase in membership, 1.0% was due to an increase in price and 1.5% was due to an increase in ancillary club revenue and fees and other revenue.

Operating Expenses

 

Operating expenses increased $35.0 million, or 9.2%, to $415.1 million for the year ended December 31, 2007, from $380.1 million for the year ended December 31, 2006. The increase was due to the following factors:

 

Payroll and related.  Payroll and related expenses increased $14.7 million, or 9.0%, to $177.4 million for the year ended December 31, 2007, from $162.7 million for the year ended December 31, 2006. This increase was attributable to a 4.6% increase in the total months of club operation from 1,720 to 1,799 as well as the following:

 

 

Club operating.  Club operating expenses increased $10.4 million, or 7.1%, to $156.7 million for the year ended December 31, 2007, from $146.3 million for the year ended December 31, 2006. This increase was principally attributable to the following:

 

 

General and administrative.  General and administrative expenses increased $4.8 million, or 16.0%, to $35.1 million for the year ended December 31, 2007 from $30.3 million during the same period in the prior year.

 

 

Offsetting these increases was a decrease of $1.2 million related to the examination of strategic financing alternatives. For the year ended December 31, 2006, we incurred $1.7 million of such costs, while similar costs for the year ended December 31, 2007 were $545,000.

 

Depreciation and amortization.  Depreciation and amortization increased $5.1 million, or 12.5%, to $46.0 million for the year ended December 31, 2007 from $40.9 million for the year ended December 31, 2006, principally due to new and expanded clubs.

Loss on Extinguishment of Debt

 

For the year ended December 31, 2007, loss on extinguishment of debt was $12.5 million compared to $16.1 million for the year ended December 31, 2006. The proceeds from the New Senior Credit Facility obtained on February 27, 2007 were used to repay $170.0 million, representing the remaining outstanding principal of the Old Senior Notes. We incurred $8.8 million of tender premium and $215,000 of call premium together with $335,000 of fees and expenses related to the tender of the Old Senior Notes. Net deferred financing costs related to the Old Senior Credit Facility and the Old Senior Notes totaling approximately $3.2 million were expensed in the first quarter of 2007.

 

During the second quarter of 2006, we paid $93.0 million to redeem $85.0 million of the outstanding principal of the Old Senior Notes, together with $6.8 million of early termination fees and $1.2 million of accrued interest. Deferred financing costs totaling $1.6 million were written off and fees totaling $222,000 were incurred in connection with this early extinguishment of debt. During the third quarter of 2006, we paid $62.9 million to redeem 35% of the Senior Discount Notes. The aggregate accreted value of the Senior Discount Notes on the redemption date totaled $56.6 million and early termination fees totaled $6.2 million. Deferred financing costs totaling $1.2 million were written off and fees totaling $24,000 were incurred in connection with this early extinguishment.

 

Interest Expense

 

Interest expense decreased $9.1 million to $26.4 million for the year ended December 31, 2007 from $35.5 million for the year ended December 31, 2006. This decrease is a result of the repayment of our debt in connection with the IPO completed on June 7, 2006 and the refinancing of our debt at a lower interest rate in February 2007. On June 8, 2006, we redeemed $85.0 million of the Old Senior Notes and on July 7, 2006 we redeemed $56.6 million of the Senior Discount Notes.

 

Interest Income

 

Interest income decreased $1.0 million to $1.1 million for the year ended December 31, 2007 from $2.1 million for the year ended December 31, 2006 due to a decrease in the average cash balance for the year ended December 31, 2007 when compared to the year ended December 31, 2006.

 

Provision for Corporate Income Taxes

 

We have recorded an income tax provision of $8.1 million for the year ended December 31, 2007 compared to $715,000 for the year ended December 31, 2006. For the year ended December 31, 2007 we recognized a $251,000 tax benefit principally related to Federal employment credits and relief for federal surcharges on our communication expenses previously incurred. Also in 2007, we recognized state tax benefits of $538,000 principally related to adjustments to our estimated 2006 tax positions, including adjustments that were made to our Net Operating Loss Carryforwards. For the year ended December 31, 2006, an income tax charge totaling $751,000 was recorded to reflect the reduction in state tax assets that we believed were not more likely than not to be realized in association with the interest related to the pay-down of debt, resulting from our use of the proceeds from the IPO, which was closed on June 7, 2006.

 

YEAR ENDED DECEMBER 31, 2006 COMPARED TO
YEAR ENDED DECEMBER 31, 2005

 

Revenues

 

Revenues increased $44.5 million, or 11.5%, to $433.1 million for the year ended December 31, 2006 from $388.6 million for the year ended December 31, 2005. Revenues increased for the year ended December 31, 2006 by $25.9 million, or 7.0%, at our clubs opened or acquired prior to December 31, 2004. For the year ended December 31, 2006, revenue increased $25.5 million at the 18 clubs opened or acquired subsequent to December 31,

2004. These increases in revenue were offset by a $6.9 million revenue decrease related to the six clubs that were closed and relocated subsequent to January 1, 2005.

 

Comparable club revenue increased 7.9% for the year ended December 31, 2006 when compared to the year ended December 31, 2005. This increase in comparable club revenue is due to a 4.9% increase in membership, a 1.9% increase in price and a 1.7% increase in ancillary revenue, offset by a 0.6% decrease in initiation fee revenue recognized. Effective January 1, 2006 the estimated average-life of our memberships increased from 24 months to 30 months. This increase in membership life is due to a favorable trend in membership attrition rates, and it has the effect of decreasing initiation fees revenue recognized because a longer amortization period is being applied.

 

Operating Expenses

 

Operating expenses increased $31.8 million, or 9.1%, to $380.1 million for the year ended December 31, 2006, from $348.3 million for the year ended December 31, 2005. The increase was due to the following factors:

 

Payroll and related.  Payroll and related expenses increased by $10.8 million, or 7.1%, to $162.7 million for the year ended December 31, 2006, from $151.9 million for the year ended December 31, 2005. This increase was attributable to a 3.9% increase in the total months of club operation from 1,655 to 1,720, as well as the following:

 

 

Club Operating.  Club operating expenses increased by $16.0 million, or 12.3%, to $146.2 million for the year ended December 31, 2006, from $130.2 million for the year ended December 31, 2005. This increase was attributable to a 3.9% increase in the total months of club operation from 1,655 to 1,720, as well as the following:

 

 

General and administrative.  General and administrative expenses increased $3.6 million, or 13.8%, to $30.2 million for the year ended December 31, 2006 from $26.6 million for the year ended December 31, 2005.

 

 

 

Depreciation and amortization.  Depreciation and amortization increased by $1.3 million, or 3.2%, to $40.9 million for the year ended December 31, 2006, from $39.6 million for the year ended December 31, 2005 principally due to new and expanded clubs.

 

Loss on Extinguishment of Debt

 

Loss on extinguishment was $16.1 million for the year ended December 31, 2006. During the second quarter of 2006, the Company paid $93.0 million to redeem $85.0 million of the outstanding principal of the Old Senior notes, together with $6.8 million of early termination fees and $1.2 million of accrued interest. Deferred financing costs totaling $1.6 million were written off and fees totaling $0.2 million were incurred in connection with this early extinguishment of debt. During the third quarter of 2006, the Company paid $62.9 million to redeem 35% of the Senior Discount Notes. The aggregate accreted value of the Senior Discount Notes on the redemption date totaled $56.6 million and early termination fees totaled $6.2 million. Deferred financing costs totaling $1.2 million were written off and fees totaling $24,000 were incurred in connection with this early extinguishment.

 

Interest Expense

 

Interest expense decreased $6.1 million to $35.5 million for the year ended December 31, 2006 from $41.6 million for the year ended December 31, 2005. This decrease results from the June 8, 2006 redemption of $85.0 million of Old Senior Notes and the July 7, 2006 redemption of $56.6 million of the 35% of Senior Discount Notes.

 

Interest Income

 

Interest income decreased $0.2 million to $2.1 million for the year ended December 31, 2006 from $2.3 million for the year ended December 31, 2005 due to lower cash balances for the year ended December 31, 2006.

 

Provision for Corporate Income Taxes

 

The Company recorded an income tax provision of $0.7 million for the year ended December 31, 2006 compared to $1.0 million last year. A nonrecurring tax benefit of $2.0 million was recorded in the fourth quarter of 2006 as a result of a restructuring which will allow the Company to recognize certain state deferred tax assets which were previously reserved through a valuation allowance. This restructuring also required the Company to re-measure certain state deferred tax assets. Additionally the Company incurred $0.8 million of nonrecurring income tax charges, in the first and second quarters, to reflect the reduction in tax benefits associated with its use of the proceeds from the IPO, which closed on June 7, 2006.

 

Liquidity and Capital Resources

 

Historically, we have satisfied our liquidity needs through cash generated from operations and various borrowing arrangements. Principal liquidity needs have included the acquisition and development of new clubs, debt service requirements and other capital expenditures necessary to upgrade, expand and renovate existing clubs.

 

Operating Activities.  Net cash provided by operating activities for the year ended December 31, 2007 was $83.0 million compared to $75.2 million for the year ended December 31, 2006, for an increase of 10.3%. Net cash flows from operations have increased due to the increase in operating income excluding the effects of accreted interest expense, depreciation and amortization. For the year ended December 31, 2006, the Company paid interest of $13.0 million on payment-in-kind notes related to the Senior Discount Notes. Total cash paid for interest

decreased $18.2 million from $35.3 million to $17.1 million. Net changes in operating assets and liabilities, including smaller increases in accounts receivable and prepaid and other current assets further contributed to the overall increase in cash. The decrease in corporate income taxes payable offset the increase in cash flows from operations. Cash paid for income taxes increased $16.0 million to $20.7 million for the year ended December 31, 2007.

 

Net cash provided by operating activities for the year ended December 31, 2006 was $75.2 million compared to $63.3 million during the year ended December 31, 2005, for an increase of 18.9%. This increase was a result of higher operating income in 2006, excluding the effects of accreted interest expense, depreciation and amortization. Net changes in operating assets and liabilities, including the increase in deferred revenue, and a decrease in prepaid income taxes, further contributed to the overall increase. As stated above, for the year ended December 31, 2006, cash flows from operations were decreased by $13.0 million related to payment of interest on payment-in-kind notes.

 

Excluding the effects of cash and cash equivalent balances, we normally operate with a working capital deficit principally because we receive dues and program and services fees either (i) during the month services are rendered, or (ii) when paid-in-full, in advance. As a result, we typically do not have significant accounts receivable. We record deferred liabilities for revenue received in advance in connection with dues and services paid-in-full and for initiation fees paid at the time of enrollment. Initiation fees received are deferred and amortized over a 30-month period, which represents the approximate life of a member. At the time a member joins our club we incur enrollment costs which are deferred over 30 months. These costs typically offset the impact initiation fees have on working capital. We do not believe we will have to finance this working capital deficit in the foreseeable future, because as we increase the number of clubs open, we expect we will continue to have deferred revenue balances that reflect services and dues that are paid-in-full in advance at levels similar to, or greater than, those currently maintained. The deferred revenue balances that give rise to this working capital deficit represent cash received in advance of services performed, and do not represent liabilities that must be funded with cash.

 

Investing Activities.  Investing activities consist primarily of construction of new clubs and the purchase of new fitness equipment. In addition, we make capital expenditures to expand and remodel our existing clubs. Net cash used in investing activities was $97.2 million and $67.1 million for the years ended December 31, 2007 and 2006, respectively. The increase in capital expenditures is due to the increase in the number of clubs under construction in 2007 compared to 2006. For the year ending December 31, 2008, we estimate we will invest a total of $95.0 million in capital expenditures. This amount includes $19.0 million to continue to upgrade existing clubs, $9.0 million to enhance our management information systems and $6.0 million for the construction of a new regional laundry facility in our NYSC market. The remainder of our 2008 capital expenditures will be committed to building, acquiring or expanding clubs. These expenditures will be funded by cash flow provided by operations, available cash on hand and, to the extent needed, borrowings from the $75.0 million revolving credit facility (the “Revolving Loan Facility”).

 

Net cash used in investing activities was $67.1 million and $66.3 million during the years ended December 31, 2006 and 2005, respectively. During the year ended December 31, 2006, we spent $17.0 million on upgrading existing clubs, $4.3 million on management information enhancements, $0.9 million for the acquisition of a club, $0.9 million for the remodeling of an acquired club, and the remaining $44.0 million for the building of new clubs or the expansion of existing clubs.

 

Financing Activities.  Net cash provided by financing activities was $12.9 million for the year ended December 31, 2007 compared to cash used in financing activities of $52.6 million for the year ended December 31, 2006 for an increase in financing cash of $65.5 million.

 

In June 2006, we filed a registration statement with the SEC in connection with our IPO. Our sale of 7,650,000 shares of Common Stock resulted in net proceeds of $91.8 million. The IPO proceeds were used for the redemption of 35% of the aggregate principal amount of our outstanding Senior Discount Notes, and the remainder of the proceeds together with cash on hand was used to consummate a tender offer for $85.0 million of the Old Senior Notes. These transactions, including premium and fees in connection with the extinguishment of debt of $13.3 million, totaled approximately $50.2 million.

This increase can also be attributed to the refinancing of our debt on February 27, 2007. The net proceeds after issuance costs from the New Senior Credit Facility of $182.4 million were used to repay the remaining principal of $170.0 million of the outstanding principal of the Old Senior Notes. In addition, we paid a premium and fees in connection with the extinguishment of debt of $9.3 million. These transactions accounted for a $3.1 million increase in cash related to financing activities for the year ended December 31, 2007. In addition, for the year ended December 31, 2007, there was a $2.1 million increase in cash received upon the exercise of stock options when compared to the year ended December 31, 2006 and a $9.0 million increase for borrowings on the Revolving Loan Facility in December 2007.

 

February 4, 2004 Offering of Senior Discount Notes

 

On February 4, 2004, TSI Holdings completed an offering of the Senior Discount Notes that will mature in February 2014. TSI Holdings received a total of $124.8 million in connection with this issuance. Fees and expenses related to this transaction totaled approximately $4.4 million. No cash interest is required to be paid prior to February 2009. The accreted value of each discount note will increase from the date of issuance until February 1, 2009, at a rate of 11.0% per annum compounded semi-annually. Subsequent to February 1, 2009 cash interest on the Senior Discount Notes will accrue and be payable semi-annually in arrears February 1 and August 1 of each year, commencing August 1, 2009. The discount notes are structurally subordinated and effectively rank junior to all indebtedness of TSI LLC (formerly TSI, Inc.). The debt of TSI Holdings is not guaranteed by TSI, LLC and TSI Holdings relies on the cash flows of TSI, LLC, subject to restrictions contained in the indenture governing the senior notes, to service its debt.

 

On July 7, 2006, the Company paid $62.9 million to redeem 35% of the Senior Discount Notes. The aggregate accreted value of the Senior Discount Notes on the redemption date totaled $56.6 million and early termination fees totaled $6.2 million. Deferred financing costs totaling $1.2 million were written off and fees totaling $24,000 were incurred in connection with this early extinguishment. On February 1, 2009, the accreted value will equal $138.5 million, the principal value at maturity.

 

Old Senior Credit Facility

 

On April 16, 2003 the Company completed a refinancing of its debt. This refinancing included an offering of $255.0 million of the Old Senior Notes that would have matured April 15, 2011, and the entering into of the Old Senior Credit Facility that would have expired on April 15, 2008. The transaction fees of approximately $9.6 million have been accounted for as deferred financing costs. The Old Senior Notes accrued interest at 95/8% per annum and interest was payable semiannually on April 15 and October 15. Effective July 7, 2006, the Old Senior Credit Facility was amended to increase permitted borrowings from $50.0 million to $75.0 million. Also, in July, the Company paid commitment fees totaling $125,000 related to this amendment. Loans under the Old Senior Credit Facility would have at TSI’s option, bore interest at either the administrative agent’s base rate plus 3.0% or the Eurodollar rate plus 4.0%, as defined in the related credit agreement. TSI was required to pay a commitment fee of 0.75% per annum on the daily unutilized amount.

 

On May 18, 2006 the Senior Credit Facility was amended to consent to: (1) the use by TSI Holdings of the net cash proceeds received by TSI Holdings from an IPO to redeem the Senior Discount Notes in an aggregate amount not to exceed 35% of the original principal amount at maturity of such notes, and with the balance of such net cash proceeds not so used to be contributed as a common equity contribution to TSI; (2) the use by TSI of the cash proceeds received pursuant to clause (1) above and cash on hand to tender for a portion of the Old Senior Notes and (3) the amendments of, and the waivers with respect to, certain provisions of the Indenture governing the Old Senior Notes.

 

On June 8, 2006 the Company paid $93.0 million to redeem $85.0 million of the outstanding principal of the Old Senior Notes, together with $6.8 million of early termination fees and $1.2 million of accrued interest. Deferred financing costs totaling $1.6 million were written off and fees totaling $222,000 were incurred in connection with this early extinguishment.

New Senior Credit Facility

 

On February 27, 2007, TSI, LLC entered into the $260.0 million New Senior Credit Facility. The New Senior Credit Facility consists of a $185.0 million term loan facility (the “Term Loan Facility”), the $75.0 million Revolving Loan Facility, and an incremental term loan commitment facility in the maximum amount of $100.0 million, under which borrowing is subject to compliance with certain conditions precedent by TSI LLC and agreement upon certain terms and conditions thereof between the participating lenders and TSI LLC. The Revolving Loan Facility replaced the previously existing revolving credit facility of $75.0 million that was to mature on April 16, 2008.

 

A portion of the proceeds were used to purchase $165.5 million aggregate principal amount of the Old Senior Notes outstanding on February 27, 2007 and the balance of the proceeds were irrevocably deposited in an escrow account to purchase the remaining $4.5 million, together with a call premium of $0.2 million, on April 15, 2007, the redemption date. Accrued interest on the Old Senior Notes totaling $6.0 million was also paid at closing. The Company incurred $8.8 million of tender premium and approximately $0.3 million fees and expenses related to the tender of the Old Senior Notes.

 

Deferred financing costs related to the Old Senior Notes totaling approximately $3.2 million were expensed in the first quarter of 2007.

 

As of December 31, 2007, TSI LLC had $183.6 million outstanding under the Term Loan Facility. Borrowings under the Term Loan Facility will, at TSI LLC’s option, bear interest at either the administrative agent’s base rate plus 0.75% or its Eurodollar rate plus 1.75%, each as defined in the related credit agreement. The interest rate on these borrowings was 6.9% as of December 31, 2007. The Term Loan Facility matures on the earlier of February 27, 2014, or August 1, 2013, if the Senior Discount Notes are still outstanding. TSI LLC is required to repay 0.25% of principal, or $462,500, per quarter beginning June 30, 2007. Total principal payments of $1.4 million have been paid as of December 31, 2007.

 

The Revolving Loan Facility expires on February 27, 2012 and borrowings under the facility currently, at TSI LLC’s option, bear interest at either the administrative agent’s base rate plus 1.25% or its Eurodollar rate plus 2.25%, each as defined in the related credit agreement. TSI LLC’s applicable base rate and Eurodollar rate margins, and commitment commission percentage, vary with our consolidated secured leverage ratio, as defined in the related credit agreement. TSI LLC is required to pay a commitment fee of 0.50% per annum on the daily unutilized amount. The Revolving Loan Facility contains a maximum total leverage covenant ratio of 4.25:1.00, which covenant is subject to compliance, on a consolidated basis, only during the period in which borrowings and letters of credit are outstanding thereunder. There were $9.0 million in borrowings outstanding under the Revolving Loan Facility at December 31, 2007, at an interest rate of 8.5%, and outstanding letters of credit issued totaled $11.5 million. The unutilized portion of the Revolving Loan Facility as of December 31, 2007 was $54.5 million.

 

As of December 31, 2007, we were in compliance with our debt covenants in the related credit agreement and given our operating plans and expected performance for 2008, we expect we will continue to be in compliance during 2008. These covenants may limit TSI LLC’s ability to incur additional debt. As of December 31, 2007, permitted borrowing capacity of $75.0 million was not restricted by the covenants.

 

In addition, our operations are conducted through our subsidiaries and our ability to make payments on our outstanding Senior Discount Notes is dependent on the earnings and distribution of funds from our subsidiaries; however, our subsidiaries are not obligated to make funds available to us for payment on the outstanding Senior Discount Notes. The terms of the indenture governing our Senior Discount Notes and the New Senior Credit Facility significantly restrict the payment of dividends by us. Our subsidiaries are permitted under the terms of the New Senior Credit Facility (including under the indenture governing our Senior Discount Notes) to incur additional indebtedness that may severely restrict or prohibit the payment of dividends by such subsidiaries to us. Our substantial leverage may impair our financial condition and we may incur significant additional debt (see “Item 1A. Risk Factors”).

 

As of December 31, 2007 we had $123.3 million of 11% Senior Discount Notes outstanding.

 

As of December 31, 2007, we had $5.5 million of cash and cash equivalents.

Consolidated Debt

 

As of December 31, 2007, our total consolidated debt was $316.0 million. This substantial amount of debt could have significant consequences, including:

 

 

These limitations and consequences may place us at a competitive disadvantage to less-leveraged competitors.

 

We believe that we have, or will be able to, obtain or generate sufficient funds to finance our current operating and growth plans through the end of 2008. Any material acceleration or expansion of our plans through newly constructed clubs or acquisitions (to the extent such acquisitions include cash payments) may require us to pursue additional sources of financing prior to the end of 2008. There can be no assurance that such financing will be available, or that it will be available on acceptable terms.

 

Notes payable were incurred upon the acquisition of various clubs and are subject to possible post acquisition reductions arising out of operations of the acquired clubs. As of December 31, 2007, one such note remained outstanding. This note, which bears interest at 7%, is non-collateralized and is due in 2009.

 

TSI, LLC’s applicable base rate and Eurodollar rate margins, and commitment commission percentage vary with the Company’s consolidated secured leverage ratio. The following table summarizes the interest rate margins and commitment commission percentages applicable at three separate secured ratio levels as follows: