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FITNESS INTERNATIONAL: Moody’s Cuts CFR to Caa3, Outlook Still Neg.

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Moody’s Investors Service downgraded Fitness International, LLC’s Corporate Family Rating to Caa3 from Caa1, Probability of Default Rating to Caa3-PD from Caa2-PD, and first lien bank credit facilities to Caa3 from B3. The outlook is negative.

The downgrade reflects the recent surge in coronavirus cases in states on the West coast, South, Southwest and the resultant mandated re-closing of gyms in California and Arizona as well as the possibility of additional mandated gym closures in other states. California and Arizona-based clubs combined generate slightly over 20% of Fitness International’s total revenue.

Moody’s views the possibility of intermittent mandated gym closures in the US to be high for the rest of 2020 and into 2021. This would result in weak earnings for a more prolonged period than anticipated back when the company was downgraded in April and continued depletion of cash and liquidity. Moody’s now expects lease adjusted debt-to-EBITDA to rise to well above 8.0x by year end 2020 and leverage will remain high over the next year.

Furthermore, the downgrade of the CFR to Caa3 reflects Moody’s view that prolonged gym closures in critical geographic regions and the potential for continued membership declines due to the ongoing coronavirus crisis will further erode Fitness International’s earnings base and liquidity. Rent previously deferred during gym closures is coming due over the next few months and will add to cash utilization. Because the revolver is fully drawn and free cash flow is negative, the company is dependent on its existing but declining cash balance for liquidity.

Moody’s views the company’s capital structure with about $1.7 billion of total funded debt as well as the high financing and operating lease obligations as becoming increasingly unsustainable in the current environment. The Caa3 CFR reflects Moody’s view that the possibility of a default under Moody’s definition including a pre-emptive restructuring such as a distressed exchange is high over the next 12 to 18 months. Additionally, the instrument rating downgrades reflect Moody’s expectation that recovery values for the first lien credit facilities will be weaker than previously anticipated in the event of a default in the current economic environment.

Moody’s took the following rating actions:

Issuer: Fitness International, LLC

Corporate Family Rating, downgraded to Caa3 from Caa1

Probability of Default Rating, downgraded to Caa3-PD from Caa2-PD

Senior Secured First Lien Revolving Credit Facility, downgraded to Caa3 (LGD3) from B3 (LGD2)

Senior Secured First Lien Term Loans (A and B), downgraded to Caa3 (LGD3) from B3 (LGD2)

Outlook Actions:

Issuer: Fitness International, LLC

Outlook, remains Negative

RATINGS RATIONALE

Fitness International’s Caa3 CFR broadly reflects its high leverage, with Moody’s lease adjusted debt/EBITDA expected to rise to well above 8.0x by year end 2020. Leverage is expected to remain high over the next year due to significant earnings decline as a result of the ongoing coronavirus pandemic that is leading to gym closures, low utilization because of social distancing precautions, and lower discretionary consumer income.

The rating is also constrained by the highly fragmented and competitive fitness club industry with high attrition rates, Fitness International’s positioning in the industry’s more pressured mid-tier price point, as well as exposure to cyclical shifts in discretionary consumer spending.

Furthermore, the credit profile is constrained by Fitness International’s weak liquidity. Although the company has taken aggressive actions to reduce expenses and preserve cash since mid-March including seeking forbearance and waivers from its lenders through the end of the August, the extent of the cash burn is driven by uncertain factors such as the length of club closures and the ability to rebuild membership once the clubs reopen. Liquidity is also constrained by the mandatory 5% amortization for its $950 million first lien term loan A, a fully drawn revolver and the high likelihood of a covenant violation. There is also the uncertainty whether the founders or minority shareholders would provide cash and liquidity support to the company.

However, the rating is supported by a well-recognized brand name, the company’s position as the largest non-franchisee fitness center by number of clubs, as well as the longer-term positive fundamentals for the fitness club industry such as its apparent under penetration and an increased awareness of the importance of fitness.

The rapid spread of the coronavirus outbreak, deteriorating global economic outlook, low oil prices, and high asset price volatility have created an unprecedented credit shock across a range of sectors and regions. Moody’s regards the coronavirus outbreak as a social risk under its ESG framework, given the substantial implications for public health and safety. Its action reflects the impact on Fitness International, given its exposure to gym closures, mandated stay at home orders, increased social distancing measures and reductions in discretionary consumer spending, which have left the company vulnerable to shifts in market demand and sentiment in these unprecedented operating conditions.

Technology developments are creating new competitors for traditional facilities-based fitness clubs including changes in consumer habits toward rapidly growing at-home, social-based services. Moody’s believes fitness clubs provide a service that will continue to attract consumers, but that the coronavirus is accelerating the transition to new technology-based services during gym closures. This will make it more challenging to return to pre-coronavirus membership levels without enhancing service levels and reducing membership fees.

The negative outlook reflects Fitness International’s high leverage, as well as Moody’s view that the company remains vulnerable to coronavirus disruptions and unfavorable shifts in discretionary consumer spending over the next year. In addition, the negative outlook reflects Moody’s concern that the company’s capital structure is becoming increasingly unsustainable and the possibility of a default including a pre-emptive restructuring such as a distressed exchange that Moody’s view as high over the next 12 to 18 months.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

Ratings could be upgraded should operating performance, credit metrics and liquidity improve.

The ratings could be downgraded if the operating performance or liquidity remains weak, the potential for distressed exchange or other default increases for any reason, or estimated recovery values weaken.

The principal methodology used in these ratings was Business and Consumer Service Industry published in October 2016.

Fitness International, LLC is the largest non-franchised fitness club operator in the United States with about 734 clubs in 27 US states, the District of Columbia, and 2 Canadian provinces under the LA Fitness brand name. When considering the franchise operators, the company’s chain size is second to the franchised Planet Fitness brand. Common equity in the company is wholly owned by founding members and the Seidler family. Revenue for the LTM period ended March 31, 2020 was about $2.1 billion.

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