S&P Global Ratings revised the rating outlook on Chanhassen, Minn.-based fitness club operator Life Time Inc. to negative from developing. The rating agency believes there are significant near-term downside risks, and it no longer believes it could raise ratings in the next 12 months.
S&P is affirming its ‘CCC+’ issuer credit rating on Life Time, its ‘B’ issue-level rating on the company’s senior-secured credit facility, and its ‘CCC-’ issue-level rating on the company’s senior unsecured 8.5% notes. The recovery ratings remain ’1′ and ’6′, respectively.
“We affirmed the ‘CCC+’ rating because the company raised incremental liquidity that gives it a longer runway to cope with the closure of some of its resorts, despite our assumption that Life Time will experience a significant spike in leverage due to its cash burn while gyms were closed and possibly during the early months of re-opening that might result in an unsustainable capital structure,” S&P said.
Even though Life Time currently has reopened about 85% of gyms, we assume that as a result of the recent surge in COVID-19 cases, and California’s July 13, 2020 order that fitness clubs in 30 counties close, Life Time will be required to re-close indoor operations at its recently reopened gyms located in California, and may be required to partially or fully reclose gyms in states in the U.S. South, Southwest, and West, possibly through the third quarter of 2020. In its updated base case, S&P estimates revenue could decline 40% or more in 2020 (compared with about one-third previously) as a result of partial gym re-closures, the recession, and member concerns around returning safely to the gym, and the rating agency now expects its measure of the company’s lease adjusted gross leverage could be above 7x through 2021 (compared with below 7x previously), even under its base case for recovery in 2021.
“It is our understanding the company had approximately $335 million of total cash and revolving credit facility availability as of its June 24, 2020 lender update, including the $101.5 million in cash raised from its ownership. This level of cash might be sufficient to cover anticipated cash burn in a scenario in which the company has to partially shut down a portion of its clubs in the third quarter of 2020 and potentially if they remain closed through the remainder of the year,” S&P said.
“We have assumed anticipated cash needs include debt service, significantly reduced labor costs, and non-rent occupancy costs at clubs that remain closed. Depending on how much revenue recovers, we assume the company might burn cash for several months after clubs fully re-open while the company brings its employees back from furloughs, pays vendors to remain current, and brings facilities back online,” the rating agency said.
An extended period of gym closures beyond the third quarter of 2020 as a result of a longer-term COVID-19 mitigation effort, or a potential second wave of infections, could leave the company vulnerable to a near-term default unless it completes an additional liquidity transaction or extends the maturity of the 364-day $101.5 million loan it received from its owner group on June 24, 2020. S&P believes that similar to other operators in the fitness club space, Life Time has been able to nearly completely scale back growth capital expenditures (capex) and furlough and lay off employees to slow cash burn. S&P also believes that Life Time negotiated with its landlords for temporary rent relief over the next several months in the rating agency’s updated base case forecast. While S&P believes the company might have the capability to complete additional sale-leaseback transactions in 2020, the rating agency has not assumed them as a source of liquidity because they are not committed.
A recession and potential consumer behavioral changes might compound financial risk and result in heightened leverage through 2021 and potentially beyond. In addition to the impact of the coronavirus pandemic and partial gym closures, the recession might limit Life Time’s ability to ramp up its gyms and operate them profitably and at positive cash flow over the next few months, which might result in continued reliance on the company’s cash balances and revolver availability. S&P believes Life Time will generate negative operating cash flow and increase its debt balances in 2020, and lease adjusted gross leverage will remain elevated above 7x through 2021. S&P believes that increasing COVID-19 cases in the U.S. will result in membership declines greater than the company’s reported 7.2% decline from April 30 to May 31, 2020, and the rating agency currently assumes the company ends 2020 with total memberships down in the 10%-15% range compared with 2019 and access memberships (the company’s active member base) down 15%-20% compared with 2019. S&P anticipates revenue improving in 2021, but still remaining 15%-20% below 2019, as a result of some market share gain in areas where competitors have closed clubs, significantly offset by membership declines stemming from a recessionary environment, and customer attrition as club members become more comfortable with in-home fitness options.” Depending on the longevity of possible gym closures, and of the U.S. recession, the range of outcomes might vary widely for revenue, EBITDA, leverage, and liquidity in coming months and this year. It is also possible that revenue and EBITDA declines could be harsher than S&P’s base case scenario if partial club closures continue beyond the third quarter of 2020, or containment efforts continue into 2021.
The negative outlook reflects very high leverage through 2021 and the potential for significant revenue disruption caused by intermittent mandatory regional club closures as a result of the COVID-19 pandemic. While Life Time’s recently issued $101.5 million term loan from its owners has provided incremental liquidity, the 364-day term means it will need to be refinanced in 2021 unless the company’s equity holders choose to extend the maturity, which S&P believes they are likely to do if the company does not have enough cash to pay the loan. In addition, recent growth in COVID-19 cases and the recent partial shut down of gyms in Arizona and California. indicate that another wave of fitness club closures is plausible and that the company could face another reduced revenue scenario in the coming months. In this scenario, if S&P believed a distressed exchange or conventional default were likely in the next year, the rating agency would lower the rating.
Environmental, Social, and Governance (ESG) credit factors for this credit rating change:
— Health and safety factors
The negative outlook reflects very high leverage through 2021 and the potential for significant revenue disruption caused by intermittent mandatory regional club closures as a result of the COVID-19 pandemic.
“We could lower ratings if we believed the company’s liquidity position would worsen, or we believed it were likely the company would default or enter into a debt restructuring of some form in the next 12 months,” S&P said.
“Although unlikely over the next several quarters and until a significant portion of gyms can reopen and ramp up revenue, we could consider a one-notch upgrade or more if we believed the company could sustain positive cash flow and were likely to materially reduce leverage to below 7x following the COVID-19 containment period,” the rating agency said.