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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
    FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
 For the quarterly period ended September 30, 2004 or o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
 For the Transition period from                    to                    . Commission File Number 333-40907 TOWN SPORTS INTERNATIONAL HOLDINGS, INC. (Exact name of registrant as specified in its charter)
 Delaware
(State or other Jurisdiction of
Incorporation or organization)
    
    20-0640002
(I.R.S. Employer
Identification Number)
 888 Seventh Avenue
New York, New York 10106
Telephone: (212) 246-6700
(Address, zip code, and telephone number, including
area code, of registrants principal executive office.) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 and 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter periods that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. o Yes x No Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). o Yes x No As
of November 10, 2004 there were 1,312,289 shares of Class A Common
Stock of the Company outstanding.




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED September 30, 2004 INDEX  
 PagePART I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)a) Condensed Consolidated Balance Sheets as of December 31, 2003 and September 30, 2004
    
    
    2b) Condensed Consolidated Statements of Operations for the three and nine months ended
September 30, 2003 and 2004
    
    
    3c) Condensed Consolidated Statements of Cash Flows for the nine months ended September 30,
2003 and 2004
    
    
    4d) Notes to Condensed Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Conditions and Results of Operations
    
    
    18Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4. Controls and Procedures
    
    
    28PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    28Item 2. Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    29Item 3. Defaults upon Senior Securities
    
    
    29Item 4. Submission of Matters to a Vote of Security Holders
    
    
    29Item 5. Other Information
    
    
    29Item 6. Exhibits
    
    
    29SIGNATURES
    
    
    29Section 302 certificationSection 302 certificationSection 302 certificationSection 906 certificationSection 906 certificationSection 906 certificationCERTIFICATIONCERTIFICATIONCERTIFICATIONCERTIFICATIONCERTIFICATIONCERTIFICATION
  1




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
December 31, 2003 and September 30, 2004
(All figures $000s, except share and per share data)
(Unaudited) December 31,
    
    September 30,2003
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    40,802
    
    
    $
    62,410Accounts receivable (less allowance for doubtful accounts of $822 and $2,151
as of December 31, 2003 and September 30, 2004, respectively)
    
    
    1,469
    
    
    
    2,545Inventory
    
    
    750
    
    
    
    707Prepaid corporate income taxes
    
    
    4,062
    
    
    
    8,710Prepaid expenses and other current assets
    
    
    5,322
    
    
    
    4,641Total current assets
    
    
    52,405
    
    
    
    79,013Fixed assets, net
    
    
    223,599
    
    
    
    219,806Goodwill
    
    
    45,864
    
    
    
    47,221Intangible assets, net
    
    
    630
    
    
    
    1,114Deferred tax asset, net
    
    
    16,771
    
    
    
    14,932Deferred membership costs
    
    
    13,038
    
    
    
    12,396Other assets
    
    
    9,892
    
    
    
    13,140Total assets
    
    $
    362,199
    
    
    $
    387,622Liabilities, Redeemable Preferred Stock and Stockholders DeficitCurrent liabilities:Current portion of long-term debt and capital lease obligations
    
    $
    3,486
    
    
    $
    1,805Accounts payable
    
    
    5,379
    
    
    
    4,280Accrued expenses
    
    
    20,849
    
    
    
    22,551Accrued interest
    
    
    5,157
    
    
    
    11,321Deferred revenue
    
    
    26,621
    
    
    
    30,150Total current liabilities
    
    
    61,492
    
    
    
    70,107Long-term debt and capital lease obligations
    
    
    258,391
    
    
    
    391,891Deferred lease liabilities
    
    
    25,856
    
    
    
    26,750Deferred revenue
    
    
    3,002
    
    
    
    3,257Other liabilities
    
    
    7,862
    
    
    
    10,006Total liabilities
    
    
    356,603
    
    
    
    502,011Commitments and contingencies (Note 7)Redeemable preferred stock:Series A redeemable preferred stock, $1.00 par value; at liquidation value;
authorized 200,000 shares, 153,637 and no shares issued and outstanding at
December 31, 2003 and September 30, 2004, respectively
    
    
    39,890
    
    
    
    39,890
    
    
    
    Stockholders deficit:Series B preferred stock, $1.00 par value; at liquidation value; 109,540 and
no shares issued and outstanding at December 31, 2003 and September 30, 2004,
respectively
    
    
    9,961
    
    
    
    Class A voting common stock, $.001 par value; issued and outstanding
1,176,043 and 1,312,289 shares at December 31, 2003 and September 30, 2004,
respectively
    
    
    1
    
    
    
    1Paid-in capital
    
    
    (45,627
    )
    
    
    (114,113
    )Unearned compensation
    
    
    (172
    )
    
    
    (142
    )Accumulated other comprehensive income (currency translation adjustment)
    
    
    596
    
    
    
    579Retained earnings (accumulated deficit)
    
    
    947
    
    
    
    (714
    )Total stockholders deficit
    
    
    (34,294
    )
    
    
    (114,389
    )Total liabilities, redeemable preferred stock and stockholders deficit
    
    $
    362,199
    
    
    $
    387,622
 See notes to the condensed consolidated financial statements. 2




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the three and nine months ended September 30, 2003 and 2004
All figures $000s
(Unaudited) Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Revenues:Club operations
    
    $
    84,436
    
    
    $
    88,205
    
    
    $
    254,219
    
    
    $
    261,126Fees and other
    
    
    2,335
    
    
    
    1,878
    
    
    
    5,511
    
    
    
    4,27486,771
    
    
    
    90,083
    
    
    
    259,730
    
    
    
    265,400Operating Expenses:Payroll and related
    
    
    32,647
    
    
    
    33,813
    
    
    
    98,623
    
    
    
    104,256Club operating
    
    
    28,761
    
    
    
    29,848
    
    
    
    82,115
    
    
    
    86,665General and administrative
    
    
    5,677
    
    
    
    6,104
    
    
    
    15,917
    
    
    
    18,228Depreciation and amortization
    
    
    8,782
    
    
    
    8,851
    
    
    
    25,535
    
    
    
    27,271Goodwill impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,00275,867
    
    
    
    78,616
    
    
    
    222,190
    
    
    
    238,422Operating income
    
    
    10,904
    
    
    
    11,467
    
    
    
    37,540
    
    
    
    26,978Loss on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    7,773
    
    
    
    Interest expense
    
    
    6,760
    
    
    
    10,311
    
    
    
    17,106
    
    
    
    29,174Interest income
    
    
    (179
    )
    
    
    (221
    )
    
    
    (397
    )
    
    
    (510
    )Income
(loss) before provision (benefit) for corporate income taxes
    
    
    4,323
    
    
    
    1,377
    
    
    
    13,058
    
    
    
    (1,686
    )Provision (benefit) for corporate income taxes
    
    
    1,989
    
    
    
    687
    
    
    
    6,004
    
    
    
    (808
    )Net income (loss)
    
    
    2,334
    
    
    
    690
    
    
    
    7,054
    
    
    
    (878
    )Accreted dividends on preferred stock
    
    
    (1,631
    )
    
    
    
    
    
    
    (9,269
    )
    
    
    (783
    )Net income (loss) attributable to common stockholders
    
    $
    703
    
    
    $
    690
    
    
    $
    (2,215
    )
    
    $
    (1,661
    )Statement of Comprehensive Income (Loss)Net income (loss)
    
    $
    2,334
    
    
    $
    690
    
    
    $
    7,054
    
    
    $
    (878
    )Foreign currency translation adjustments
    
    
    62
    
    
    
    14
    
    
    
    107
    
    
    
    (17
    )Comprehensive income (loss)
    
    $
    2,396
    
    
    $
    704
    
    
    $
    7,161
    
    
    $
    (895
    )
 See notes to the condensed consolidated financial statements. 3




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES 
 Condensed Consolidated
Statements of Cash Flows
For the nine months ended September 30, 2003 and 2004
All figures $000s
(Unaudited) Nine months endedSeptember 30,2003
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    7,054
    
    
    $
    (878
    )Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization
    
    
    25,535
    
    
    
    27,271Noncash interest
expense
    
    
    
    
    
    
    9,146Goodwill impairment write-off
    
    
    
    
    
    
    2,002Compensation expense in connection with stock options
    
    
    207
    
    
    
    29Noncash rental expense, net of noncash rental income
    
    
    1,311
    
    
    
    363Share of net income in affiliated companies
    
    
    (592
    )
    
    
    (375
    )Loss on extinguishment of debt
    
    
    7,773
    
    
    
    Amortization of debt issuance costs
    
    
    1,300
    
    
    
    1,178Net changes
in operating assets and liabilities
    
    
    12,215
    
    
    
    6,617Decrease in deferred tax asset
    
    
    2,079
    
    
    
    1,839Decrease in deferred membership costs
    
    
    48
    
    
    
    643Other
    
    
    542
    
    
    
    559Total adjustments
    
    
    50,418
    
    
    
    49,272Net cash provided by operating activities
    
    
    57,472
    
    
    
    48,394Cash flows from investing activities:Capital expenditures
    
    
    (29,131
    )
    
    
    (23,754
    )Proceeds from sale of equipment
    
    
    153
    
    
    
    Acquired businesses
    
    
    
    
    
    
    (3,726
    )Landlord contributions
    
    
    617
    
    
    
    2,112Net cash used in investing activities
    
    
    (28,361
    )
    
    
    (25,368
    )Cash flows from financing activities:Proceeds
from
95/8% Senior Note Offering
    
    
    255,000
    
    
    
    Proceeds from 11.0% Senior Discount Notes
    
    
    
    
    
    
    120,756Proceeds from stock option exercises
    
    
    
    
    
    
    512Repayment of
93⁄4% Senior Notes
    
    
    (125,000
    )
    
    
    Premium paid on extinguishment of debt and other costs
    
    
    (4,064
    )
    
    
    Redemption of redeemable senior preferred stock
    
    
    (66,977
    )
    
    
    Transaction costs related to 95/8% Senior Notes
    
    
    (9,597
    )
    
    
    Net line of credit repayment
    
    
    (14,500
    )
    
    
    Net subordinated credit repayments
    
    
    (9,000
    )
    
    
    Repurchase of preferred stock
    
    
    (583
    )
    
    
    Redemption of preferred stock
    
    
    
    
    
    
    (50,634
    )Common stock distribution
    
    
    
    
    
    
    (68,944
    )Repurchase of common stock
    
    
    
    
    
    
    (53
    )Repayments of borrowings
    
    
    (4,157
    )
    
    
    (3,055
    )Net cash (used in) provided by financing activities
    
    
    21,122
    
    
    
    (1,418
    )Net increase in cash and cash equivalents
    
    
    50,233
    
    
    
    21,608Cash and cash equivalents at beginning of period
    
    
    5,551
    
    
    
    40,802Cash and cash equivalents at end of period
    
    $
    55,784
    
    
    $
    62,410Summary of change in certain operating assets and liabilities:Decrease (increase) in accounts receivable
    
    $
    331
    
    
    $
    (1,111
    )Decrease in inventory
    
    
    345
    
    
    
    43Decrease (increase) in prepaid expenses, prepaid income taxes, and other current assets
    
    
    647
    
    
    
    (3,590
    )Increase in accounts payable, accrued expenses and accrued interest
    
    
    9,200
    
    
    
    8,448Increase in deferred revenue
    
    
    1,692
    
    
    
    2,827Net changes in certain operating assets and liabilities
    
    $
    12,215
    
    
    $
    6,617Supplemental disclosures of cash flow information:Noncash investing and financing activities:During the
nine months ended September 30, 2004, Notes to acquire businesses issued totaled
$921.
 See notes to the condensed consolidated financial statements. 4




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation Town Sports International Holdings, Inc. (TSI Holdings) was incorporated
in January 2004, principally for the purpose of issuing debt that is
structurally subordinated to the debt of its wholly owned subsidiary, Town
Sports International, Inc. (TSI). In conjunction with the financing TSI
Holdings entered into a Restructuring Agreement, redeemed Series A and Series B
Preferred Stock, and paid a common stock distribution (See Note 6). As used
herein, the Company refers to TSI Holdings, and its consolidated subsidiaries
including TSI. The condensed consolidated financial statements included herein have been
prepared by the Company pursuant to the rules and regulations of the Securities
and Exchange Commission (SEC). The condensed consolidated financial
statements should be read in conjunction with the TSI Holdings December 31, 2003
consolidated financial statements and notes thereto, included on Form
S-4. The
year-end condensed balance sheet data was derived from audited financial
statements, but does not include all disclosures required by accounting
principles generally accepted in the United States of America. Certain
information and footnote disclosures which are normally included in financial
statements prepared in accordance with generally accepted accounting principles
(GAAP) have been condensed or omitted pursuant to SEC rules and regulations.
Certain reclassifications were made to the reported amounts at December 31,
2003 to conform to the presentation at September 30, 2004. The Company believes
that the disclosures made are adequate to make the information presented not
misleading. The information reflects all adjustments which, in the opinion of
Management, are necessary for a fair presentation of the financial position and
results of operations for the interim periods set forth herein. All such
adjustments are of a normal and recurring nature. The results for the three and
nine months ended September 30, 2004 are not necessarily indicative of the
results for the entire fiscal year ending December 31, 2004. 2. Long-Term Debt and Capital Lease Obligations December 31,
    
    September 30,2003
    
    2004($ 000s)
    
    ($ 000s)Senior Notes
9 5/8%, due 2011
    
    $
    255,000
    
    
    $
    255,000Senior Discount Notes 11.0%, due 2014
    
    
    
    
    
    
    133,954Notes payable for acquired businesses
    
    
    4,358
    
    
    
    4,562Capital lease obligations
    
    
    2,519
    
    
    
    180261,877
    
    
    
    393,696Less, Current portion due within one year
    
    
    3,486
    
    
    
    1,805Long-term portion
    
    $
    258,391
    
    
    $
    391,891
 On February 4, 2004 TSI Holdings successfully completed an offering of
11.0% Senior Discount Notes (the Discount Notes) that will mature in February
2014. TSI Holding received a total of $124,807 in connection with this
issuance. Fees and expenses related to this transaction totaled approximately
$4,318. 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
such that on February 1, 2009 the accreted value will equal $213,000, the
principal value due at maturity. Subsequent to February 1, 2009 cash interest
on the 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. TSI Holdings debt is not collateralized by TSI, and TSI
Holdings relies on the cash flows of TSI, which are subject to certain
restrictions contained in the Senior Note Indenture, to service its debt. In April 2003 TSI successfully completed a refinancing of its debt. This
refinancing included an offering of $255,000 of
95/8% Senior Notes (Notes) that
will mature April 15, 2011, and the entering into of a new $50,000 senior
secured revolving credit facility (the Senior Credit Facility) that will
expire April 15, 2008. The transaction fees of $9,572 have been accounted for
as deferred financing costs. The Notes accrue interest at 95/8% per annum and
interest is payable semiannually on April 15 and October 15. In connection with
this refinancing, in April 2003 TSI wrote-off $3,709 of deferred financing
costs related to extinguished debt, paid a call premium of $3,048 and incurred
$1,016 of interest on the previously outstanding 93⁄4% Notes representing the
interest incurred during the 30 day redemption notification period. In
September 2004, TSI Holdings unconditionally guaranteed the
Notes. 5




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) The Senior Credit Facility contains various covenants including limits on
capital expenditures, the maintenance of a consolidated interest coverage ratio
of not less than 2.50:1.00 during 2004, and a maximum permitted total leverage
ratio of 4.00:1.00 through December 30, 2004 and 3.75 to 1.00
from December 31, 2004 through December 30, 2005.
TSIs interest coverage and leverage ratios were 3.0 to 1.00 and
3.6 to 1.00 respectively as of September 30, 2004. Given the Companys
operating plans and expected performance for 2005, the Company
expects it will continue to be in compliance with its covenants. These covenants limit TSIs ability to incur
additional debt, and as of September 30, 2004 TSIs permitted borrowing
capacity under the line of credit totaled $34,257. Loans under the Senior
Credit Facility will, at TSIs option, bear interest at either the banks prime
rate plus 3.0% or the Eurodollar rate plus 4.0%, as defined. There were no
borrowings outstanding at September 30, 2004 and outstanding letters of credit
issued totaled $3,496. TSI is required to pay a commitment fee of 0.75% per
annum on the daily unutilized amount. The unutilized portion of the Senior
Credit Facility as of September 30, 2004 was $46,504. 3. September 11, 2001 Events The terrorist attacks of September 11, 2001 (the September 11 events),
resulted in a tremendous loss of life and property. Secondarily, those events
interrupted the operations at four clubs located in downtown Manhattan. Three
of the affected four clubs were back in operation by October 2001, while the
fourth club reopened in September 2002. The Company carries business interruption insurance to mitigate certain
lost revenue and profits experienced with the September 11 events. In the first
and third quarters of 2003 the Company received $1,300 and $1,500 respectively
from its insurer. In connection with the third quarter 2003 payment the Company
entered into a final settlement agreement. These payments were classified with
Fees and Other revenue when received. 4. Goodwill and Other Intangibles Goodwill has been allocated to reporting units that closely reflect the
regions served by our four trade names; New York Sports Club, Boston Sports
Club, Washington Sports Club and Philadelphia Sports Club, with certain more
remote clubs that do not benefit from a regional cluster being considered
single reporting units. In the quarter ended March 31, 2004, the Company performed its annual
impairment test. Goodwill impairment testing requires a comparison between the
carrying value and fair value of reportable goodwill. If the carrying value
exceeds the fair value, goodwill is considered impaired. The amount of the
impairment loss is measured as the difference between the carrying value and
the implied fair value of goodwill, which is determined using discounted cash
flows. As a result of this review, the Company determined that the goodwill at
one of its remote clubs was not recoverable. The goodwill impairment associated
with this underperforming club amounted to $2,002. A deferred tax benefit of
$881 has been recorded in connection with this impairment. Since this club is
remote from one of the Companys clusters, it does not benefit from the
competitive advantage that our clustered clubs have, and as a result it is more
susceptible to competition. We have reduced our projections of future cash
flows of this club to take into account the impact of a recent opening of a
competitor. While this club is expected to generate cash flow in the future, we
no longer expect it to operate at the levels that were projected at the time
the club was acquired. The change in the carrying amount of goodwill from December 31, 2003
through September 30, 2004 is as follows: Balance December 31, 2003
    
    $
    45,864Changes due
to foreign currency exchange rate fluctuations
    
    
    (5
    )Acquired goodwill
    
    
    3,364Goodwill impairment
    
    
    (2,002
    )Balance September 30, 2004
    
    $
    47,221
 6




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Below is a summary of the Companys acquired intangible assets as of
December 31, 2003 and September 30, 2004. As of December 31, 2003($000s)Acquired Intangible Assets
    
    Gross Carrying Amount
    
    Accumulated Amortization
    
    Net IntangiblesMembership lists
    
    $
    10,205
    
    
    $
    (9,630
    )
    
    $
    575Covenants-not-to-compete
    
    
    876
    
    
    
    (871
    )
    
    
    5Beneficial lease
    
    
    223
    
    
    
    (173
    )
    
    
    50$
    11,304
    
    
    $
    (10,674
    )
    
    $
    630
 As of September 30, 2004($000s)Gross Carrying Amount
    
    Accumulated Amortization
    
    Net IntangiblesMembership lists
    
    $
    11,008
    
    
    $
    (10,206
    )
    
    $
    802Covenants-not-to-compete
    
    
    1,150
    
    
    
    (879
    )
    
    
    271Beneficial lease
    
    
    223
    
    
    
    (182
    )
    
    
    41$
    12,381
    
    
    $
    (11,267
    )
    
    $
    1,114
 The amortization expense of the above acquired intangible assets for each
of the five years ended December 31, 2008 is as follows: Aggregate Amortization Expense
($000s)For the year ended 12/31/04(a)
    
    $
    777For the year ended 12/31/05
    
    
    467For the year ended 12/31/06
    
    
    300For the year ended 12/31/07
    
    
    65For the year ended 12/31/08
    
    
    62Thereafter
    
    
    36$
    1,707
    5. Stock-Based Employee Compensation For financial reporting purposes, the Company accounts for stock-based
compensation in accordance with the intrinsic value method (APB No. 25). In
accordance with this method, no compensation expense is recognized in the
accompanying financial statements in connection with the awarding of stock
option grants to employees provided that, as of the grant date, all terms
associated with the award are fixed and the fair value of the Companys stock
is not greater than the amount an employee must pay to acquire the stock as
defined; however, to the extent that stock options are granted to employees
with variable terms or if the fair value of the Companys stock as of the
measurement date is greater than the amount an employee must pay to acquire the
stock, then the Company will recognize compensation expense. The following table illustrates the effect on net income (loss) attributed
to common stockholders if the Company had applied the fair value recognition
provisions of Financial Accounting Standards Board issued Statement No. 123
(SFAS 123), Accounting for Stock-Based Compensation, to stock-based employee
compensation. 7




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,($000s)
    
    ($000s)2003
    
    2004
    
    2003
    
    2004Net income (loss) attributed to common stockholders, as
reported
    
    $
    703
    
    
    $
    690
    
    
    $
    (2,215
    )
    
    $
    (1,661
    )Add:Stock-based employee compensation expense included in
reported net income (loss) attributed to common
stockholders, net of related tax effects
    
    
    5
    
    
    
    5
    
    
    
    112
    
    
    
    15Deduct:Total stock-based employee compensation expense determined
under fair value based method for all stock option awards
net of related tax effects
    
    
    (67
    )
    
    
    (27
    )
    
    
    (88
    )
    
    
    (85
    )Pro forma net income (loss) attributed to common stockholders
    
    $
    641
    
    
    $
    668
    
    
    $
    (2,191
    )
    
    $
    (1,731
    )
 6. Equity Transactions and Restructuring On January 26, 2004, warrants to purchase 71,631 shares of Class A common
stock were exercised. On February 4, 2004 TSI, and affiliates and TSI Holdings, entered into a
Restructuring Agreement (Restructuring). In connection with this
Restructuring, the holders of the TSIs Series A preferred stock, Series B
preferred stock, and Class A common stock contributed their shares of the
capital stock to TSI Holdings in exchange for an equal amount of newly issued
shares of the same classes in TSI Holdings. Immediately following this
exchange, TSI Holdings contributed to TSI the certificates representing all of
the shares of the TSIs capital stock contributed in the aforementioned
exchange. In return, TSI issued 1,000 shares of common stock to TSI Holdings
and cancelled all the certificates representing the shares of the TSIs capital
stock contributed to it by TSI Holdings. In addition, as part of the
Restructuring, all holders of options to purchase Class A common stock of the
TSI exchanged their options for options to purchase an equal number of shares
of Class A common stock of TSI Holdings at strike prices adjusted to reflect
the Restructuring. On February 4, 2004, TSI Holdings successfully completed an offering of
11.0% Senior Discount Notes that will mature in February 2014 (See Note 2). On February 6, 2004, all of TSI Holdings outstanding Series A and Series
B Preferred stock were redeemed for a total of $50,634. On March 12, 2004, 65,536 vested common stock options of TSI Holdings were
exercised. TSI Holdings received $512 in cash related to these exercises. On March 15, 2004, the Board of Directors of TSI Holdings approved a
common stock distribution of $52.50 per share to all shareholders of record on
March 15, 2004. This distribution totaled $68,944 and was paid on March 17,
2004. Also, in lieu of a common stock distribution, TSI Holdings vested common
option holders were paid a total of $1,100 recorded as payroll expense at
the TSI level under GAAP. 7. Commitments and Contingencies On February 13, 2003, in an action styled Joseph Anaya vs Town Sports
International, Inc. et al., an individual filed suit against TSI in the Supreme
Court, New York County, alleging that on January 14, 2003, he sustained serious
bodily injury at one of our club locations. He filed an amended complaint on
September 17, 2003 seeking two billion dollars in damages for personal
injuries. His cause of action seeking punitive damages, in the amount of two
hundred and fifty million dollars, was dismissed on January 26, 2004. While the
company is unable to determine the ultimate outcome of the above action it
intends to contest the matter vigorously. 8




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) We have in force fifty one million dollars of insurance to cover claims of
this nature. If any such judgment exceeds the amount for which we are covered
by insurance by $2,500 we would be in default under the credit agreement
governing TSIs Senior Credit Facility. Also, if any uninsured
judgment, when aggregated with any other judgment not covered by insurance
equals $5,000 or more, the judgment would constitute an event of default under
the indentures governing the Senior Notes and the Discount Notes. We
anticipate that these matters will be covered by insurance. The Company does not believe this matter will have a material effect on
its consolidated financial position, results of operation or cash flows. The Company is a party to various other lawsuits arising in the normal
course of business. Management believes that the ultimate outcome of these
matters will not have a material effect on the Companys consolidated financial
position, results of operations or cash flows. 8. Guarantors TSI Holdings and all of TSIs domestic subsidiaries have unconditionally
guaranteed the $255,000 9 5/8% Senior Notes discussed in Note 2. However,
TSIs foreign subsidiaries have not provided guarantees for these Notes. Each guarantor of the Notes is a wholly owned subsidiary of TSI and the
guarantees are full and unconditional and joint and severable. In January 2004 TSI Holdings was incorporated solely for the purpose of issuing the Discount Notes. The following
schedules set forth condensed consolidating financial information as required
by Rule 3-10d of Securities and Exchange Commission
Regulation S-X at December 31, 2003 and September 30, 2004 and for the three and nine month periods ending
September 30, 2003 and September 30, 2004. The financial information
illustrates the composition of the combined guarantors. 9




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Condensed Consolidating Balance Sheet December 31, 2003
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assetsCash and cash equivalents
    
    $
    
    
    
    $
    420
    
    
    $
    39,006
    
    
    $
    1,376
    
    
    $
    
    
    
    $
    40,802Accounts receivable, net
    
    
    
    
    
    
    2,230
    
    
    
    1,235
    
    
    
    133
    
    
    
    (2,129
    )
    
    
    1,469Inventory
    
    
    
    
    
    
    
    
    
    
    720
    
    
    
    30
    
    
    
    
    
    
    
    750Prepaid corporate income taxes
    
    
    
    
    
    
    4,062
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,062Intercompany receivable (payable)
    
    
    
    
    
    
    7,068
    
    
    
    (5,451
    )
    
    
    (1,617
    )
    
    
    
    
    
    
    Prepaid expenses and other current assets
    
    
    
    
    
    
    6,493
    
    
    
    2,329
    
    
    
    
    
    
    
    (3,500
    )
    
    
    5,322Total current assets
    
    
    
    
    
    
    20,273
    
    
    
    37,839
    
    
    
    (78
    )
    
    
    (5,629
    )
    
    
    52,405Investment in subsidiaries
    
    
    
    
    
    
    238,166
    
    
    
    

    
    
    
    
    
    
    
    (238,166
    )
    
    
    Fixed assets, net
    
    
    
    
    
    
    11,671
    
    
    
    210,477
    
    
    
    1,451
    
    
    
    
    
    
    
    223,599Goodwill
    
    
    
    
    
    
    
    
    
    
    45,058
    
    
    
    806
    
    
    
    
    
    
    
    45,864Intangible assets, net
    
    
    
    
    
    
    
    
    
    
    630
    
    
    
    
    
    
    
    
    
    
    
    630Deferred tax assets, net
    
    
    
    
    
    
    17,399
    
    
    
    (491
    )
    
    
    (137
    )
    
    
    
    
    
    
    16,771Deferred membership costs
    
    
    
    
    
    
    
    
    
    
    13,038
    
    
    
    
    
    
    
    
    
    
    
    13,038Other assets
    
    
    
    
    
    
    9,005
    
    
    
    887
    
    
    
    
    
    
    
    
    
    
    
    9,892Total assets
    
    $
    
    
    
    $
    296,514
    
    
    $
    307,438
    
    
    $
    2,042
    
    
    $
    (243,795
    )
    
    $
    362,199LIABILITIES, REDEEMABLE PREFERRED
STOCK AND STOCKHOLDERS DEFICITCurrent liabilitiesCurrent portion of long-term debt and
capital lease obligations
    
    $
    
    
    
    $
    3,486
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    3,486Accounts payable
    
    
    
    
    
    
    220
    
    
    
    5,159
    
    
    
    
    
    
    
    
    
    
    
    5,379Accrued expenses
    
    
    
    
    
    
    6,261
    
    
    
    13,960
    
    
    
    628
    
    
    
    
    
    
    
    20,849Accrued interest
    
    
    
    
    
    
    5,155
    
    
    
    2,131
    
    
    
    
    
    
    
    (2,129
    )
    
    
    5,157Deferred revenue
    
    
    
    
    
    
    
    
    
    
    26,621
    
    
    
    
    
    
    
    
    
    
    
    26,621Total current liabilities
    
    
    
    
    
    
    15,122
    
    
    
    47,871
    
    
    
    628
    
    
    
    (2,129
    )
    
    
    61,492Long-term debt and capital lease
obligations
    
    
    
    
    
    
    274,947
    
    
    
    (13,056
    )
    
    
    
    
    
    
    (3,500
    )
    
    
    258,391Deferred lease liabilities
    
    
    
    
    
    
    563
    
    

    
    25,293
    
    
    
    
    
    
    
    
    
    
    
    25,856Deferred revenue
    
    
    
    
    
    
    (64
    )
    
    
    2,973
    
    
    
    93
    
    
    
    
    
    
    
    3,002Other liabilities
    
    
    
    
    
    
    350
    
    
    
    7,512
    
    
    
    
    
    
    
    
    
    
    
    7,862Total liabilities
    
    
    
    
    
    
    290,918
    
    
    
    70,593
    
    
    
    721
    
    
    
    (5,629
    )
    
    
    356,603Redeemable preferred stock
Series A preferred stock
    
    
    
    
    
    
    39,890
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    39,890
    
    
    
    39,890
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    39,890Stockholders deficitSeries B preferred stock
    
    
    
    
    
    
    9,961
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,961Common stockholders deficit
    
    
    
    
    
    
    (44,851
    )
    
    
    236,845
    
    
    
    725
    
    
    
    (237,570
    )
    
    
    (44,851
    )Accumulated other comprehensive income
    
    
    
    
    
    
    596
    
    
    
    
    
    
    
    596
    
    
    
    (596
    )
    
    
    596Total stockholders deficit
    
    
    
    
    
    
    (34,294
    )
    
    
    236,845
    
    
    
    1,321
    
    
    
    (238,166
    )
    
    
    (34,294
    )Total liabilities, redeemable
preferred stock and stockholders
deficit
    
    $
    
    
    
    $
    296,514
    
    
    $
    307,438
    
    
    $
    2,042
    
    
    $
    (243,795
    )
    
    $
    362,199
 10




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Condensed Consolidating Balance Sheet September 30, 2004
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assetsCash and cash equivalents
    
    $
    448
    
    
    $
    741
    
    
    $
    59,031
    
    
    $
    2,190
    
    
    $
    
    
    
    $
    62,410Accounts receivable, net
    
    
    
    
    
    
    3,547
    
    
    
    1,272
    
    
    
    118
    
    
    
    (2,392
    )
    
    
    2,545Inventory
    
    
    
    
    
    
    
    
    
    
    677
    
    
    
    30
    
    
    
    
    
    
    
    707Prepaid corporate income taxes
    
    
    
    
    
    
    8,710
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,710Intercompany receivable (payable)
    
    
    
    
    
    
    14,243
    
    
    
    (12,613
    )
    
    
    (1,630
    )
    
    
    
    
    
    
    Prepaid expenses and other current assets
    
    
    1,128
    
    
    
    4,345
    
    
    
    2,668
    
    
    
    
    
    
    
    (3,500
    )
    
    
    4,641Total current assets
    
    
    1,576
    
    
    
    31,586
    
    
    
    51,035
    
    
    
    708
    
    
    
    (5,892
    )
    
    
    79,013Investment in subsidiaries
    
    
    9,950
    
    
    
    257,815
    
    
    
    
    
    
    
    
    
    
    
    (267,765
    )
    
    
    Fixed assets, net
    
    
    
    
    
    
    10,367
    
    
    
    208,165
    
    
    
    1,274
    
    
    
    
    
    
    
    219,806Goodwill
    
    
    
    
    
    
    
    
    
    
    46,421
    
    
    
    800
    
    
    
    
    
    
    
    47,221Intangible assets, net
    
    
    
    
    
    
    
    
    
    
    1,114
    
    
    
    
    
    
    
    
    
    
    
    1,114Deferred tax assets, net
    
    
    4,101
    
    
    
    11,458
    
    
    
    (491
    )
    
    
    (136
    )
    
    
    
    
    
    
    14,932Deferred membership costs
    
    
    
    
    
    
    
    
    
    
    12,396
    
    
    
    
    
    
    
    
    
    
    
    12,396Other assets
    
    
    4,158
    
    
    
    7,909
    
    
    
    1,073
    
    
    
    
    
    
    
    
    
    
    
    13,140Total assets
    
    $
    19,785
    
    
    $
    319,135
    
    
    $
    319,713
    
    
    $
    2,646
    
    
    $
    (273,657
    )
    
    $
    387,622LIABILITIES AND STOCKHOLDERS DEFICITCurrent liabilitiesCurrent portion of long-term debt and
capital lease obligations
    
    $
    
    
    
    $
    
    
    
    $
    1,805
    
    
    $
    
    
    
    $
    
    
    
    $
    1,805Accounts payable
    
    
    
    
    
    
    197
    
    
    
    4,083
    
    
    
    
    
    
    
    
    
    
    
    4,280Accrued expenses
    
    
    220
    
    
    
    5,185
    
    
    
    16,513
    
    
    
    633
    
    
    
    
    
    
    
    22,551Accrued interest
    
    
    
    
    
    
    11,319
    
    
    
    2,394
    
    
    
    
    
    
    
    (2,392
    )
    
    
    11,321Deferred revenue
    
    
    
    
    
    
    
    
    
    
    30,150
    
    
    
    
    
    
    
    
    
    
    
    30,150Total current liabilities
    
    
    220
    
    
    
    16,701
    
    
    
    54,945
    
    
    
    633
    
    
    
    (2,392
    )
    
    
    70,107Long-term debt and capital lease
obligations
    
    
    133,954
    
    
    
    290,642
    
    
    
    (29,205
    )
    
    
    
    
    
    
    (3,500
    )
    
    
    391,891Deferred lease liabilities
    
    
    
    
    
    
    511
    
    
    
    26,239
    
    
    
    
    
    
    
    
    
    
    
    26,750Deferred revenue
    
    
    
    
    
    
    351
    
    
    
    2,814
    
    
    
    92
    
    
    
    
    
    
    
    3,257Other liabilities
    
    
    
    
    
    
    980
    
    
    
    9,026
    
    
    
    
    
    
    
    
    
    
    
    10,006Total liabilities
    
    
    134,174
    
    
    
    309,185
    
    
    
    63,819
    
    
    
    725
    
    
    
    (5,892
    )
    
    
    502,011Stockholders deficitCommon stockholders deficit
    
    
    (114,968
    )
    
    
    9,371
    
    
    
    255,890
    
    
    
    1,346
    
    
    
    (266,607
    )
    
    
    (114,968
    )Accumulated other comprehensive income
    
    
    579
    
    
    
    579
    
    
    
    4
    
    
    
    575
    
    
    
    (1,158
    )
    
    
    579Total stockholders deficit
    
    
    (114,389
    )
    
    
    9,950
    
    
    
    255,894
    
    
    
    1,921
    
    
    
    (267,765
    )
    
    
    (114,389
    )Total liabilities, redeemable
preferred stock and stockholders
deficit
    
    $
    19,785
    
    
    $
    319,135
    
    
    $
    319,713
    
    
    $
    2,646
    
    
    $
    (273,657
    )
    
    $
    387,622
 11




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Condensed Consolidating Statement of Operations For three months ended September 30, 2003
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedRevenues:Club operations
    
    $
    
    
    
    $
    44
    
    
    $
    83,319
    
    
    $
    1,073
    
    
    $
    
    
    
    $
    84,436Fees and other
    
    
    
    
    
    
    1,825
    
    
    
    1,521
    
    
    
    
    
    
    
    (1,011
    )
    
    
    2,335
    
    
    
    1,869
    
    
    
    84,840
    
    
    
    1,073
    
    
    
    (1,011
    )
    
    
    86,771Operating expenses:Payroll and related
    
    
    
    
    
    
    5,553
    
    
    
    26,666
    
    
    
    428
    
    
    
    
    
    
    
    32,647Club operating
    
    
    
    
    
    
    448
    
    
    
    28,926
    
    
    
    258
    
    
    
    (871
    )
    
    
    28,761General and administrative
    
    
    
    
    
    
    
    
    
    
    5,714
    
    
    
    103
    
    
    
    (140
    )
    
    
    5,677Depreciation and amortization
    
    
    
    
    
    
    1,098
    
    
    
    7,596
    
    
    
    88
    
    
    
    
    
    
    
    8,782
    
    
    
    7,099
    
    
    
    68,902
    
    
    
    877
    
    
    
    (1,011
    )
    
    
    75,867Operating income (loss)
    
    
    
    
    
    
    (5,230
    )
    
    
    15,938
    
    
    
    196
    
    
    
    
    
    
    
    10,904Interest expense
    
    
    
    
    
    
    6,672
    
    
    
    88
    
    
    
    
    
    
    
    
    
    
    
    6,760Interest income
    
    
    
    
    
    
    (179
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (179
    )Income (loss) before provision (benefit)
for corporate income taxes
    
    
    
    
    
    
    (11,723
    )
    
    
    15,850
    
    
    
    196
    
    
    
    
    
    
    
    4,323Provision (benefit) for corporate income tax
    
    
    
    
    
    
    (5,919
    )
    
    
    7,850
    
    
    
    58
    
    
    
    
    
    
    
    1,989Income (loss) before equity earnings
    
    
    
    
    
    
    (5,804
    )
    
    
    8,000
    
    
    
    138
    
    
    
    
    
    
    
    2,334Equity earning from subsidiaries
    
    
    
    
    
    
    8,138
    
    
    
    
    
    
    
    
    
    
    
    (8,138
    )
    
    
    Net income (loss)
    
    $
    
    
    
    $
    2,334
    
    
    $
    8,000
    
    
    $
    138
    
    
    $
    (8,138
    )
    
    $
    2,334
 12




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS (continued) Condensed Consolidating Statement of Operations For three months ended September 30, 2004
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedRevenues:Club operations
    
    $
    
    
    
    $
    879
    
    
    $
    86,175
    
    
    $
    1,151
    
    
    $
    
    
    
    $
    88,205Fees and other
    
    
    
    
    
    
    416
    
    

    
    2,438
    
    
    
    
    
    
    
    (976
    )
    
    
    1,878
    
    
    
    1,295
    
    
    
    88,613
    
    
    
    1,151
    
    
    
    (976
    )
    
    
    90,083Operating expenses:Payroll and related
    
    
    
    
    
    
    5,328
    
    
    
    28,035
    
    
    
    450
    
    
    
    
    
    
    
    33,813Club operating
    
    
    
    
    
    
    271
    
    
    
    30,143
    
    
    
    270
    
    
    
    (836
    )
    
    
    29,848General and administrative
    
    
    3
    
    
    
    46
    
    
    
    6,098
    
    
    
    97
    
    
    
    (140
    )
    
    
    6,104Depreciation and amortization
    
    
    
    
    
    
    951
    
    
    
    7,802
    
    
    
    98
    
    
    
    
    
    
    
    8,8513
    
    
    
    6,596
    
    
    
    72,078
    
    
    
    915
    
    
    
    (976
    )
    
    
    78,616Operating income (loss)
    
    
    (3
    )
    
    
    (5,301
    )
    
    
    16,535
    
    
    
    236
    
    
    
    
    
    
    
    11,467Interest expense
    
    
    3,673
    
    
    
    6,609
    
    
    
    88
    
    
    
    (1
    )
    
    
    (58
    )
    
    
    10,311Interest income
    
    
    (2
    )
    
    
    (277
    )
    
    
    
    
    
    
    
    
    
    
    58
    
    
    
    (221
    )Income before provision (benefit) for
corporate income taxes
    
    
    (3,674
    )
    
    
    (11,633
    )
    
    
    16,447
    
    
    
    237
    
    
    
    
    
    
    
    1,377Provision (benefit) for corporate income tax
    
    
    (1,617
    )
    
    
    (5,305
    )
    
    
    7,548
    
    
    
    61
    
    
    
    
    
    
    
    687Income (loss) before equity earnings
    
    
    (2,057
    )
    
    
    (6,328
    )
    
    
    8,899
    
    
    
    176
    
    
    
    
    
    
    
    690Equity earning from subsidiaries
    
    
    2,747
    
    
    
    9,075
    
    
    
    
    
    
    
    
    
    
    
    (11,822
    )
    
    
    Net income (loss)
    
    $
    690
    
    
    $
    2,747
    
    
    $
    8,899
    
    
    $
    176
    
    
    $
    (11,822
    )
    
    $
    690
 13




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS-(continued) Condensed Consolidating Statement of Operations For nine months ended September 30, 2003
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedRevenues:Club operations
    
    $
    
    
    
    $
    98
    
    
    $
    250,707
    
    
    $
    3,414
    
    
    $
    
    
    
    $
    254,219Fees and other
    
    
    
    
    
    
    3,691
    
    
    
    4,908
    
    
    
    
    
    
    
    (3,088
    )
    
    
    5,511
    
    
    
    3,789
    
    
    
    255,615
    
    
    
    3,414
    
    
    
    (3,088
    )
    
    
    259,730Operating expenses:Payroll and related
    
    
    
    
    
    
    16,718
    
    
    
    80,628
    
    
    
    1,277
    
    
    
    
    
    
    
    98,623Club operating
    
    
    
    
    
    
    (1,058
    )
    
    
    85,048
    
    
    
    793
    
    
    
    (2,668
    )
    
    
    82,115General and administrative
    
    
    
    
    
    
    (679
    )
    
    
    16,717
    
    
    
    299
    
    
    
    (420
    )
    
    
    15,917Depreciation and amortization
    
    
    
    
    
    
    2,862
    
    
    
    22,404
    
    
    
    269
    
    
    
    
    
    
    
    25,535
    
    
    
    17,843
    
    
    
    204,797
    
    
    
    2,638
    
    
    
    (3,088
    )
    
    
    222,190Operating income (loss)
    
    
    
    
    
    
    (14,054
    )
    
    
    50,818
    
    
    
    776
    
    
    
    
    
    
    
    37,540Loss on extinguishment of debt
    
    
    
    
    
    
    7,773
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,773Interest expense
    
    
    
    
    
    
    17,117
    
    
    
    164
    
    
    
    
    
    
    
    (175
    )
    
    
    17,106Interest income
    
    
    
    
    
    
    (572
    )
    
    
    
    
    
    
    
    
    
    
    175
    
    
    
    (397
    )Income (loss) before provision (benefit)
for corporate income taxes
    
    
    
    
    
    
    (38,372
    )
    
    
    50,654
    
    
    
    776
    
    
    
    
    
    
    
    13,058Provision (benefit) for corporate income tax
    
    
    
    
    
    
    (18,982
    )
    
    
    24,782
    
    
    
    204
    
    
    
    
    
    
    
    6,004Income (loss) before equity earnings
    
    
    
    
    
    
    (19,390
    )
    
    
    25,872
    
    
    
    572
    
    
    
    
    
    
    
    7,054Equity earning from subsidiaries
    
    
    
    
    
    
    26,444
    
    
    
    
    
    
    
    
    
    
    
    (26,444
    )
    
    
    Net income (loss)
    
    $
    
    
    
    $
    7,054
    
    
    $
    25,872
    
    
    $
    572
    
    
    $
    (26,444
    )
    
    $
    7,054
 14




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##### Table of Contents



TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS (continued) For nine months ended September 30, 2004
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedRevenues:Club operations
    
    $
    
    
    
    $
    1,285
    
    
    $
    256,221
    
    
    $
    3,620
    
    
    $
    
    
    
    $
    261,126Fees and other
    
    
    
    
    
    
    1,190
    
    
    
    5,696
    
    
    
    
    
    
    
    (2,612
    )
    
    
    4,274
    
    
    
    2,475
    
    
    
    261,917
    
    
    
    3,620
    
    
    
    (2,612
    )
    
    
    265,400Operating expenses:Payroll and related
    
    
    
    
    
    
    16,768
    
    
    
    86,124
    
    
    
    1,364
    
    
    
    
    
    
    
    104,256Club operating
    
    
    
    
    
    
    945
    
    
    
    87,075
    
    
    
    837
    
    
    
    (2,192
    )
    
    
    86,665General and administrative
    
    
    40
    
    
    
    (122
    )
    
    
    18,423
    
    
    
    307
    
    
    
    (420
    )
    
    
    18,228Depreciation and amortization
    
    
    
    
    
    
    3,008
    
    
    
    23,970
    
    
    
    293
    
    
    
    
    
    
    
    27,271Goodwill impairment
    
    
    
    
    
    
    
    
    
    
    2,002
    
    
    
    
    
    
    
    
    
    
    
    2,00240
    
    
    
    20,599
    
    
    
    217,594
    
    
    
    2,801
    
    
    
    (2,612
    )
    
    
    238,422Operating income (loss)
    
    
    (40
    )
    
    
    (18,124
    )
    
    
    44,323
    
    
    
    819
    
    
    
    
    
    
    
    26,978Interest expense
    
    
    9,341
    
    
    
    19,865
    
    
    
    203
    
    
    
    (2
    )
    
    
    (233
    )
    
    
    29,174Interest income
    
    
    (59
    )
    
    
    (684
    )
    
    
    
    
    
    
    
    
    
    
    233
    
    
    
    (510
    )Income (loss) before provision for
corporate income taxes
    
    
    (9,322
    )
    
    
    (37,305
    )
    
    
    44,120
    
    
    
    821
    
    
    
    
    
    
    
    (1,686
    )Provision (benefit) for corporate income tax
    
    
    (4,102
    )
    
    
    (15,131
    )
    
    
    18,225
    
    
    
    200
    
    
    
    
    
    
    
    (808
    )Income (loss) before equity earnings
    
    
    (5,220
    )
    
    
    (22,174
    )
    
    
    25,895
    
    
    
    621
    
    
    
    
    
    
    
    (878
    )Equity earning from subsidiaries
    
    
    4,342
    
    
    
    26,516
    
    
    
    
    
    
    
    
    
    
    
    (30,858
    )
    
    
    Net income (loss)
    
    $
    (878
    )
    
    $
    4,342
    
    
    $
    25,895
    
    
    $
    621
    
    
    $
    (30,858
    )
    
    $
    (878
    )
 15




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TOWN SPORTS INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS (continued) Condensed Consolidating Statement of Cash Flow For nine months ended September 30, 2003
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    
    
    
    $
    7,054
    
    
    $
    25,872
    
    
    $
    572
    
    
    $
    (26,444
    )
    
    $
    7,054Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    
    
    
    
    2,862
    
    
    
    22,404
    
    
    
    269
    
    
    
    
    
    
    
    25,535Compensation expense in connection with stock
options
    
    
    
    
    
    
    207
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    207Noncash rental expense, net of noncash rental
income
    
    
    
    
    
    
    (62
    )
    
    
    1,373
    
    
    
    
    
    
    
    
    
    
    
    1,311Loss on extinguishment of debt
    
    
    
    
    
    
    7,773
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,773Amoritzation of debt issuance costs
    
    
    
    
    
    
    1,300
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,300Changes in operating assets and liabilities
    
    
    
    
    
    
    10,840
    
    
    
    3,604
    
    
    
    (102
    )
    
    
    
    
    
    
    14,342Other
    
    
    
    
    
    
    (27,023
    )
    
    
    421
    
    
    
    108
    
    
    
    26,444
    
    
    
    (50
    )Total adjustments
    
    
    
    
    
    
    (4,103
    )
    
    
    27,802
    
    
    
    275
    
    
    
    26,444
    
    
    
    50,418Net cash provided by operating activities
    
    
    
    
    
    
    2,951
    
    
    
    53,674
    
    
    
    847
    
    
    
    
    
    
    
    57,472Net cash used in investing activities
    
    
    
    
    
    
    (3,713
    )
    
    
    (24,480
    )
    
    
    (168
    )
    
    
    
    
    
    
    (28,361
    )Net cash provided by financing activities
    
    
    
    
    
    
    238
    
    
    
    20,858
    
    
    
    26
    
    
    
    
    
    
    
    21,122Net increase (decrease) in cash and cash
equivalents
    
    
    
    
    
    
    (524
    )
    
    
    50,052
    
    
    
    705
    
    
    
    
    
    
    
    50,233Cash and cash equivalents at beginning of period
    
    
    
    
    
    
    1,575
    
    
    
    3,635
    
    
    
    341
    
    
    
    
    
    
    
    5,551Cash and
cash equivalents at end of period
    
    $
    
    
    
    $
    1,051
    
    
    $
    53,687
    
    
    $
    1,046
    
    
    $
    
    
    
    $
    55,784
 16




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##### Table of Contents



TOWN SPORTS
INTERNATIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Condensed Consolidating Statement of Cash Flow For nine months ended September 30, 2004
(All figures in $000s)
(Unaudited) Non-Subsidiary
    
    GuarantorTSI Holdings
    
    TSI
    
    Guarantors
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    (878
    )
    
    $
    4,342
    
    
    $
    25,895
    
    
    $
    621
    
    
    $
    (30,858
    )
    
    $
    (878
    )Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    
    
    
    
    3,008
    
    
    
    23,970
    
    
    
    293
    
    
    
    
    
    
    
    27,271Goodwill impairment write-off
    
    
    
    
    
    
    
    
    
    
    2,002
    
    
    
    
    
    
    
    
    
    
    
    2,002Compensation expense in connection with stock
options
    
    
    
    
    
    
    29
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29Noncash rental expense, net of noncash rental
income
    
    
    
    
    
    
    (67
    )
    
    
    430
    
    
    
    
    
    
    
    
    
    
    
    363Noncash interest expense
    
    
    9,146
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,146Amortization of debt issuance costs
    
    
    194
    
    
    
    984
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,178Changes in operating assets and liabilities
    
    
    (5,306
    )
    
    
    809
    
    
    
    13,569
    
    
    
    27
    
    
    
    
    
    
    
    9,099Other
    
    
    (4,345
    )
    
    
    (26,246
    )
    
    
    (98
    )
    
    
    15
    
    
    
    30,858
    
    
    
    184Total adjustments
    
    
    (311
    )
    
    
    (21,483
    )
    
    
    39,873
    
    
    
    335
    
    
    
    30,858
    
    
    
    49,272Net cash provided by (used in) operating
activities
    
    
    (1,189
    )
    
    
    (17,141
    )
    
    
    65,768
    
    
    
    956
    
    
    
    
    
    
    
    48,394Net cash used in investing activities
    
    
    
    
    
    
    (1,702
    )
    
    
    (23,524
    )
    
    
    (142
    )
    
    
    
    
    
    
    (25,368
    )Net cash provided by (used in) financing
activities
    
    
    1,637
    
    
    
    19,164
    
    
    
    (22,219
    )
    
    
    
    
    
    
    
    
    
    
    (1,418
    )Net increase in cash and cash equivalents
    
    
    448
    
    
    
    321
    
    
    
    20,025
    
    
    
    814
    
    
    
    
    
    
    
    21,608Cash and cash equivalents at beginning of period
    
    
    
    
    
    
    420
    
    
    
    39,006
    
    
    
    1,376
    
    
    
    
    
    
    
    40,802Cash and
cash equivalents at end of period
    
    $
    448
    
    
    $
    741
    
    
    $
    59,031
    
    
    $
    2,190
    
    
    $
    
    
    
    $
    62,410
 17




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##### Table of Contents



Item 2.Managements Discussion and Analysis of Financial Condition and
Results of Operations Introduction We are one of the two leading owners and operators of fitness clubs in the
Northeast and Mid-Atlantic regions of the United States. As of September 30,
2004, we operated 136 clubs that collectively served approximately 379,000
members. We develop clusters of clubs to serve densely populated major
metropolitan regions in which a high percentage of the population commutes to
work. We service such populations by clustering clubs near the highest
concentrations of our target customers areas of both employment and residence.
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. Each club facility is subject to a long-term facility lease with a third
party landlord, with the exception of our East 86th Street, New York City,
where we own the underlying real estate. Our principal capital investment is
thus in
the facility improvements and equipment and furnishings of each facility. 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 goal is to develop the premier health club network in each of the
major metropolitan regions we enter. We believe that clustering clubs allows us
to achieve strategic operating advantages that enhance our ability to achieve
this goal. In entering new regions, we develop these 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 suburban commuter
communities. Capitalizing on this clustering of clubs, as of September 30,
2004, approximately 50% of our members participated in a membership plan that
allows unlimited access to all of our clubs for a higher membership fee. Clustering of clubs also affords us significant additional benefits, including:  1.
    
    Providing our members access to an extensive network of locations;2.
    
    Lower capital investment overall, by locating special programs,
such as pools, racquet sports, etc. at selected clubs only;3.
    
    More cost effective regional management and control;4.
    
    Allocating certain costs such as advertising in a focused region
over multiple locations;5.
    
    Strengthening brand awareness. We have executed this strategy successfully in the New York region through
the network of clubs we operate under our New York Sports Club (NYSC) brand
name. We are the largest fitness club operator in Manhattan with 37 locations
and operate a total of 92 clubs under the NYSC name within a 50 mile radius of
New York City. We operate 19 clubs in the Boston region and 16 clubs in the
Washington, DC region under our Boston Sports Club (BSC) and Washington
Sports Club (WSC) brand names, respectively, and have begun establishing a
similar cluster in the Philadelphia region with six clubs under our
Philadelphia Sports Club (PSC) brand name. In addition, we operate three
clubs in Switzerland. We employ localized brand names for our clubs to create
an image and atmosphere consistent with the local community, and to foster the
recognition as a local network of quality fitness clubs rather than a national
chain. We consider that we have three principal sources of revenue: 1. Our largest sources of revenue are dues and initiation fees paid by our
members. This comprises 83.8% of our total revenue for the nine months ended
September 30, 2004. We recognize revenue from membership dues in the month when
the services are rendered. Approximately 90% of our members pay their monthly
dues by Electronic Funds Transfer, while the balance pay annually in advance.
We recognize revenue from initiation fees over the expected average life of the
membership, which is approximately 24 months. Our initiation fees recognized per new 18




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member sale have been depressed by our efforts to combat discounting by
competitors in certain of our markets, as well as our offering of term
commitment memberships at a discounted initial fee. 2. We
generated approximately 14.6% of our revenue for the nine months
ended September 30, 2004, referred to as other club revenue, at our facilities
from fees for personal training, programming for children, group fitness
training and other member activities, as well as sales of miscellaneous sports
products. This revenue stream has increased as a percentage of total revenue
more recently as we have focused on increasing revenue per member from our
maturing club base. 3. The
balance of our revenue (approximately 1.6% for the nine months
ended September 30, 2004) principally relates to rental of space in our
facilities to operators who offer wellness-related offerings such as physical
therapy. In addition, we generate management fees for income from investments
in club facilities that we do not wholly own. Revenue from sales of in-club
advertising and sponsorships is also included. We refer to this as Fees and
Other revenue. Settlements from our business interruption insurance claim associated with
the September 11 events and totaled $1.5 million and $2.8 million for the three
and nine months ended September 30, 2003 respectively, while no such revenue
was received in 2004. Revenue, (in $000s) is comprised of the following: Three Months
    
    Nine MonthsEnded
    
    EndedSeptember, 30
    
    September, 302003
    
    2004
    
    2003
    
    2004Membership dues
    
    $
    69,105
    
    
    $
    70,842
    
    
    $
    207,709
    
    
    $
    210,491Initiation
fees
    
    
    3,482
    
    
    
    4,068
    
    
    
    10,425
    
    
    
    11,794Other Club revenue
    
    
    11,849
    
    
    
    13,295
    
    
    
    36,085
    
    
    
    38,841Fees and Other
    
    
    2,335
    
    
    
    1,878
    
    
    
    5,511
    
    
    
    4,274Total revenue
    
    $
    86,771
    
    
    $
    90,083
    
    
    $
    259,730
    
    
    $
    265,400
 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,
contracted maintenance expenses as well as depreciation. General and
administrative expenses include costs relating to our centralized support
functions, such as accounting, information systems, purchasing and member
relations, consulting fees, as well as real estate development expenses. Variable costs are primarily related to ancillary club revenue related
payroll, membership sales compensation, advertising, utilities, insurance and
club supplies. 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 of new club
facilities and upgrading and expanding our existing clubs. The construction and
equipment costs for a new club approximate $3.0 million, on average, which
could 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 replacement of the fitness equipment each
year for which we budget approximately 4.0% of each clubs annual revenue.
Expansions of certain facilities are also performed from time to time, when
incremental space becomes available on attractive terms, and utilization and
demand for the facility dictates. In this connection, facility remodeling is
also considered where appropriate. 19




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Historical Club Growth The following table sets for our club growth during each of the quarters
in 2003 and the first three quarters of 2004. 2003
    
    2004Q1
    
    Q2
    
    Q3
    
    Q4
    
    Total
    
    Q1
    
    Q2
    
    Q3Clubs at beginning of period
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    132
    
    
    
    134Greenfield clubs (a)
    
    
    
    
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    3
    
    
    
    3
    
    
    
    1
    
    
    
    Acquired clubs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    2Relocated or closed clubs
    
    
    
    
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    Clubs at end of period
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    129
    
    
    
    132
    
    
    
    134
    
    
    
    136Number of partly-owned clubs included at the end of the period (b)
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2
   (a)
    
    A Greenfield club is a new location constructed by us.(b)
    
    We include in the club count wholly and partly-owned clubs. In addition
to the above count, as of December 31, 2003 and September 30, 2004 we
managed two and three additional clubs, respectively, in which we did not
have an equity interest. Results of Operations The following table sets forth certain operating data as a percentage of
revenue for the periods indicated: Three Months
    
    Nine MonthsEnded
    
    EndedSeptember, 30
    
    September 30,2003
    
    2004
    
    2003
    
    2004Revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expensesPayroll and related
    
    
    37.7
    
    
    
    37.6
    
    
    
    38.0
    
    
    
    39.2Club operating
    
    
    33.1
    
    
    
    33.1
    
    
    
    31.6
    
    
    
    32.7General and administrative
    
    
    6.5
    
    
    
    6.8
    
    
    
    6.1
    
    
    
    6.9Depreciation and amortization
    
    
    10.1
    
    
    
    9.8
    
    
    
    9.8
    
    
    
    10.3Goodwill Impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.7Operating income
    
    
    12.6
    
    
    
    12.7
    
    
    
    14.5
    
    
    
    10.2Loss on extinguishment of debt
    
    
    
    
    
    
    
    
    
    
    3.0
    
    
    
    Interest expense
    
    
    7.8
    
    
    
    11.5
    
    
    
    6.6
    
    
    
    11.0Interest income
    
    
    (0.2
    )
    
    
    (0.3
    )
    
    
    (0.1
    )
    
    
    (0.2
    )Income (loss) before provision (benefit) for corporate income taxes
    
    
    5.0
    
    
    
    1.5
    
    
    
    5.0
    
    
    
    (0.6
    )Provision (benefit) for corporate income taxes
    
    
    2.3
    
    
    
    0.8
    
    
    
    2.3
    
    
    
    (0.3
    )Net income (loss)
    
    
    2.7
    
    
    
    0.7
    
    
    
    2.7
    
    
    
    (0.3
    )Accreted dividends on preferred stock
    
    
    (1.9
    )
    
    
    
    
    
    
    (3.6
    )
    
    
    (0.3
    )Net income (loss) attributable to common stockholders
    
    
    0.8
    %
    
    
    0.7
    %
    
    
    (0.9
    )%
    
    
    (0.6
    )%
 20




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##### Table of Contents



Three Months Ended September 30, 2004 Compared to Three Months Ended September
30, 2003 Revenues.Revenues increased $3.3 million or 3.8%, to $90.1 million
during the quarter ended September 30, 2004 from $86.8 million in the quarter
ended September 30, 2003. Revenues increased during the quarter
by $1.7 million,
or 2.1% at the Companys mature clubs (clubs owned and operated for at least 24
months). The 2.1% increase in mature club revenue is due to a 4.1% increase in
membership and a 1.3% increase in ancillary revenue offset by a 3.3% decrease
in price. The twelve clubs opened or acquired after September 2002 increased
revenue by $2.7 million during the quarter. These revenue increases were offset
by a decrease of $577,000 related to the closure and relocation of three clubs
in 2003. Fees and Other revenue decreased $457,000 during the quarter due to a
$1.5 million final business interruption insurance settlement payment received
in 2003 while no such settlement was received in 2004. The decrease
in Fees and
Other revenue related to business interruption insurance was partially offset
by increases in promotion and marketing revenue. Operating Expenses.Operating expenses increased $2.7 million, or 3.6%,
to $78.6 million in the quarter ended September 30, 2004, from $75.9 million in
the quarter ended September 30, 2003. The increase was due to the following
factors: Payroll and related expenses increased by $1.2 million, or 3.6% to $33.8
million in the quarter ended September 30, 2004, from $32.6 million in the
quarter ended September 30, 2003. This increase was principally attributable to
the following:  
    
    In an effort to increase membership satisfaction and improve
our membership retention rates we have increased the level of
in-house training and club support personnel; and we have moved from
contracted housekeeping and equipment maintenance services to
internally sourced employees. These customer service efforts resulted
in a $643,000 increase.
    
    Personal training and Sports Clubs for Kids programming payroll
increased $646,000 or 13.0% to support increases in revenue generated
by these programs and services. Club operating expenses increased by $1.1 million or 3.8% to $29.8
million in the quarter ended September 30, 2004, from $28.8 million in the
quarter ended September 30, 2003. This increase was principally attributable
to the following:  
    
    A $547,000 increase in rent expense principally resulting from
increases related to clubs that have opened or expanded since
September 2003.
    
    Facility repairs and maintenance costs increased $735,000 or
40%. In the third quarter, we made a conscious effort to complete
more of our renovation work in the summer months when member usage is
lower than the rest of the year. Incremental costs to serve our
initiative to increase member satisfaction and improve member
retention have also contributed to this increase.
    
    The aforementioned increases in club operating expense were
partially offset by an $80,000 decrease in equipment maintenance
costs which were predominately outsourced to third parties in 2003
and moved to in-house staffing in 2004. General and administrative expenses increased by $427,000 or 7.5% to
$6.1 million in the quarter ended September 30, 2004 from $5.7 million in the
quarter ended September 30, 2003. This increase was principally attributable
to the following:  
    
    An increase in data communication costs of $114,000. These
costs have increased due to data-line redundancies created at our
clubs to safeguard against single line outages. Furthermore, data-line
traffic has increased in 2004 with the completion of our Club
Networks system rollout in 2003. 21




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##### Table of Contents




    
    In an effort to increase member satisfaction and improve member
retention rates we have increased staff development and recruiting
costs. These customer service efforts resulted in an increase of $206,000 over the prior year. Depreciation and amortization increased by $69,000, or 0.8% to $8.9
million in the quarter ended September 30, 2004, from $8.8 million in the
quarter ended September 30, 2003. Interest Expense.Interest expense increased $3.6 million to $10.3
million during the quarter ended September 30, 2004, from $6.8 million in the
quarter ended September 30, 2003. This increase is due to the issuance of the
Discount Notes in February of 2004. Interest Income.Interest income increased $42,000 to $221,000 in the
quarter ended September 30, 2004 from $179,000 in the quarter ended September
30, 2003 due to increases in cash and cash equivalents as well as increases in the rate of
interest earned on invested cash. Provision for Income Tax.We have recorded a net income tax provision of
$687,000 in the quarter ended September 30, 2004 compared to $2.0 million in
the quarter ended September 30, 2003. Accreted Dividends on Preferred Stock.Prior to the second quarter of
2004, all previously outstanding preferred stock were redeemed. These
redemptions were made in connection with the redemption of the redeemable
senior preferred stock in April 2003 and the Restructuring of the Series A and
Series B preferred stock in February 2004. Therefore, no preferred stock
dividends were recorded in this third quarter of 2004 while in the third
quarter of 2003 we recorded $1.6 million of accreted dividends. Nine Months Ended September 30, 2004, Compared to Nine Months Ended
September 30, 2003. Revenues.Revenues increased approximately $5.7 million, or 2.2% to $265.4
million for nine months ended September 30, 2004, from $259.7 million for the
nine months ended September 30, 2003. Mature clubs (clubs open over 24 months)
increased by $2.4 million, or 1.0%. The 1.0% increase in mature club revenue is
due to a 2.2% increase in membership and a 0.8% increase in ancillary revenue
offset by a 2.0% decrease in price. Revenue from the twelve clubs open or
acquired since September 2002 increased by $7.0 million. These club revenue
increases were offset by decreases of $2.5 million related to the closure and
relocation of three clubs in 2003. Fees and Other revenue decreased
$1.3 million due to $2.8 million of business interruption insurance payments
received in 2003 while no payments were received in 2004. The decrease in Fees
and Other revenue related to business interruption insurance was partially
offset by increases in promotion and marketing revenue. Operating Expenses.Operating expenses increased $16.2 million, or 7.3%
to $238.4 million for the nine months ended September 30, 2004, from $222.2
million for the nine months ended September 30, 2003. The increase was due to
the following factors: Payroll and related expenses increased by $5.6 million, or 5.7% to $104.3
million for the nine months ended September 30, 2004 from $98.6 million for the
nine months ended September 30, 2003. This increase was attributable to the
following factors:  
    
    In connection with Restructuring and distribution to common
stockholders of TSI Holdings, vested option holders, who did not
exercise their options were paid a one-time bonus recorded as payroll
expense in TSI under GAAP. This one-time payment totaled $1.1
million.  
    
    Our initiation fees received were lower during the first
quarter of 2004, while our variable costs of sale rose slightly, due
to increased commission rates paid. When the initial fees do not
exceed the related costs of sale, GAAP requires that we must
recognize the net loss immediately. This immediate loss effect,
together with increased costs of membership sales accounted for a
$677,000 increase over the nine months ended September 30, 2004 when
compared to the same period of the prior year. 22




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##### Table of Contents




    
    In an effort to increase membership satisfaction and improve
our membership retention rates we have increased the level of
in-house training and club support personnel; and we have moved from
third-party contracted equipment maintenance and housekeeping
services to in-house supplied labor for these services. These
customer service efforts resulted in $1.8 million increase.  
    
    Personal training and Sports Clubs for Kids programming payroll
increased $1.0 million or 6.6% to support increases in revenue
generated by these programs and services. Club operating expenses increased by $4.6 million or 5.5% to $86.7 million for
the nine months ended September 30, 2004, from $82.1 million for the nine
months ended September 30, 2003. This increase is principally attributable to
the following:  
    
    A $2.6 million increase in rent expense principally resulting
from increases related to clubs that have opened since or expanded
after September 2003.  
    
    Facility repairs and maintenance costs increased $1.5 million
or 29.6%. We have made a conscious effort to complete a larger
proportion of annual club renovations during the summer months when
member usage is lower than the remainder of the year. This has
resulted in an increase in the year to date September 2004 renovation
expense when compared to prior year. Incremental costs to serve
our initiative to increase member satisfaction and improve member
retention have also contributed to this increase.  
    
    Increased advertising efforts resulted in a $395,000 increase
in advertising expense for the nine months ended September 30, 2004,
compared to the same period of the prior year.  
    
    In addition, we experienced a $506,000 increase in utilities
due to increases in utility rates, and a 3.5% increase in square
footage in operation.  
    
    The aforementioned increases in club operating expense were partially offset
by a $222,000 decrease in equipment maintenance costs which were
predominately outsourced to third parties in 2003 and moved to
in-house labor in 2004. General and administrative increased by $2.3 million, or 14.5% to $18.2 million
for the nine months ended September 30, 2004 from $15.9 million for the nine
months ended September 30, 2003. This increase was principally attributable to
the following:  
    
    Liability insurance expense increased by $682,000. Premiums
increased $319,000 coupled with a favorable adjustment of $363,000
recorded in the first quarter of 2003, where we had adjusted our
reserves related to premium audits.  
    
    We also experienced an increase of $618,000 in data
communication line costs. This relates to the correction of our
service providers billing errors in the first half of 2004 amounting
to approximately $429,000. These costs have also increased due to
data-line redundancies created at our clubs to safeguard against
single line outages. Furthermore, data-line traffic has increased in
2004 with the completion of our Club Networks system rollout in 2003.  
    
    Legal fees increased by $216,000 principally due to an increase
in new club leases and expansion projects.  
    
    In an effort to increase member satisfaction and improve member
retention rates we have increased staff development and recruiting
costs.
These customer service efforts resulted in an increase of $337,000
over the prior year. 23




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##### Table of Contents



Depreciation and amortization increased by $1.7 million or 6.8% to $27.3
million for the nine months ended September 30, 2004, from $25.5 million for
the nine months ended September 30, 2003, periodically attributable to
increases in depreciation related to new, expanded and remodeled clubs. Goodwill Impairment. In the quarter ended March 31, 2004 the Company
performed its annual impairment test and determined that the goodwill at one of
its remote clubs was not recoverable. The goodwill impairment amounted to $2.0
million. A deferred tax benefit of $881,000 has been recorded in connection
with this impairment. Since this club is remote from one of the companys
clusters, it does not benefit from the competitive advantage that our clustered
clubs have, and as a result it is more susceptible to competition. We have
reduced our projections for future cash flows of this club to take into account
the impact of a recent opening of a competitor. While this club is
expected to generate cash flow in the future, we no longer expect it to
operate at the levels that were projected at the time the club was acquired.
There was no goodwill impairment from the annual impairment testing in 2003. Interest Expense. Interest expense increased $12.1 million to $29.2
million during the nine months ended September 30, 2004, from $17.1 million for
the nine months ended September 30, 2003. This increase is due to the issuance
of 11% Senior Discount Notes in February of 2004 and
$255 million of 95/8%
Senior Notes, which refinanced $125 million of 93⁄4% Senior Notes in April
2003. Provision for Income Tax. We have recorded a net income tax benefit of
$808,000 for the nine months ended September 30, 2004 compared to a tax
provision of $6.0 million for the nine months ended September 30, 2003. Accreted Dividends on Preferred Stock. Accreted dividends on preferred
stock decreased $8.5 million to $783,000 during the nine months ended September
30, 2004, from $9.3 million for the nine months ended September 30, 2003. This
decrease is due to the redemption of the redeemable senior preferred stock in
April 2003 and the Restructuring of the Series A and Series B preferred stock
in February 2004. Liquidity and Capital Resources Historically, we have satisfied our liquidity needs through cash 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
nine months ended September 30, 2004 was $48.4 million
compared to $57.5
million during the nine months ended September 30, 2003. Net cash flows from
operations have decreased due to the decrease in operating income excluding the
effects of depreciation and amortization and goodwill impairment. The interest
charged on our Discount Notes accretes towards the principal balance through
2009. This non-cash interest expense is reflected in cash flows from operating
activities. The increase in prepaid income
taxes has increased our working capital and has negatively impacted
cash flows from operations. The Company awaits income tax payment
refunds and the effect will be reversed when such refunds are
received. We normally
operate with a working capital deficit 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 do 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 24-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 24 months. These costs typically offset
the impact initiation fees have on working capital. We do not believe we will have to meet 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.We invested $25.4 million and $28.4 million in
capital expenditures and club acquisitions during the nine months ended September 30, 2004 and 2003,
respectively. Our capital expenditures are net of landlord contributions of
$2.1 million and $617,000 for the nine months ended September 30, 2004 and
2003, respectively. We estimate that for the year ended December 31, 2004, we
will invest an additional $20.0 million in capital expenditures, which 24




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##### Table of Contents



includes
$3.8 million that management intends to invest to expand and renovate certain
existing clubs, $8.2 million to continue to upgrade existing clubs and $737,000
to enhance our management information systems. The remainder of our 2004
capital expenditures will be committed to build or acquire clubs. Forecasted
capital expenditures for the year ended December 31, 2004 totals $45.4 million.
We expect that these expenditures, net of landlord contribution will be funded
by cash flow provided by operations and available cash on hand. Financing Activities.Net cash used in financing activities was $1.4
million for the nine months ended September 30, 2004 compared to net cash
provided by financing activities of $21.1 million for the same period in 2003. On February 4, 2004 TSI Holdings successfully completed an offering of
11.0% Senior Discount Notes (the 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
$4.3 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 such
that on February 1, 2009 the accreted value will equal $213.0 million, the
principal value due at maturity. Subsequent to February 1, 2009 cash interest
on the 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. TSI Holdings debt is not collateralized by TSI, and TSI
Holdings relies on the cash flows of TSI, with restrictions contained in the
Senior Note Indenture, to service its debt. On February 6, 2004, all of TSI Holdings outstanding Series A stock and
Series B stock were redeemed for a total of $50.6 million. On March 12, 2004, 65,536 vested common stock options of TSI Holdings were
exercised. TSI Holdings received $512,000 in cash related to these exercises. On March 15, 2004, the Board of Directors of TSI Holdings approved a
common stock distribution of $52.50 per share to all shareholders of record on
March 15, 2004. This distribution totaled $68,944 and was paid on March 17,
2004. Also, in lieu of a common stock distribution, TSI
Holdings vested common option
holders were paid a total of $1.1 million recorded as payroll expense at the
TSI level under GAAP. As of September 30, 2004, our total consolidated debt was $393.7 million.
This substantial amount of debt could have significant consequences, including:  
    
    Making it more difficult to satisfy our obligations;
    
    Increasing our vulnerability to general adverse economic and industry conditions;
    
    Limiting our ability to obtain additional financing to fund future
working capital, capital expenditures, acquisitions of new clubs and
other general corporate requirements;
    
    Requiring cash flow from operations for the annual payment of $24.5
million interest on our Senior Notes and reducing our ability to use our
cash flow to fund working capital, capital expenditures, acquisitions of
new clubs and general corporate requirements; and
    
    Limiting our flexibility in planning for, or reacting to, changes in
our business and the industry in which we operate. These limitations and consequences may place us at a competitive
disadvantage to other less-leveraged competitors. 25




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##### Table of Contents



As of September 30, 2004, we had $255.0 million of Senior Notes
outstanding. The Senior Notes bear interest at a rate of 9 5/8% and mature in
2011. Under the provisions of the Senior Note Indenture, we may not issue
additional Senior Notes without modification of the indenture with the
bondholders consent. Our line of credit with our principal bank provides for
direct borrowings and letters of credit of up to $50.0 million. The line of
credit carries interest at our option based upon the Eurodollar borrowing rate
plus 4.0% or the banks prime rate plus 3.0% as defined, and we are required to
pay a commitment fee of 0.75% per annum on the daily unutilized amount. As of
September 30, 2004, no borrowings were outstanding under this line. As of
September 30, 2004 outstanding letters of credit totaled $3.5 million. As of
September 30, 2004, we had approximately $46.5 million unutilized under the
line of credit, which matures in April 2008, and has no scheduled amortization
requirements. As of September 30, 2004 we also had
$62.4 million of cash and cash equivalents. The credit agreement governing the line of credit contains restrictive
covenants including a leverage ratio and interest coverage ratio and dividend
payment restrictions and is collateralized by all the assets of TSI. As of
September 30, 2004 our Net Leverage Ratio, and Net Interest Coverage Ratio, as
defined by the terms of the credit agreement are 3.5 and 3.0 to 1.0,
respectively. Our ability to incur additional debt is limited by the terms of
the
credit agreement in that the Net Leverage Ratio, as defined, cannot exceed
4.0 to 1.0 and the Net Interest Coverage Ratio must be greater than 2.5 to 1.0,
accordingly the availability under this facility was restricted to $34.3
million as of September 30, 2004. Our common stock is not publicly traded and therefore our ability to raise
equity financing is not as readily available as it is for companies that have
publicly traded common stock. 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
2006. Any material acceleration or expansion of that plan through additional
greenfields or acquisitions (to the extent such acquisitions include cash
payments) may require us to pursue additional sources of financing prior to the
end of 2006. There can be no assurance that such financing will be available,
or that it will be available on acceptable terms. The line of credit accrues
interest at variable rates based on market conditions, accordingly, future
increases in interest rates could have a negative impact on net income should
borrowings be required. Notes payable were incurred upon the acquisition of various clubs and are
subject to possible post acquisition adjustments
arising out of operations of the acquired clubs. These notes bear interest at
rates between 5% an 9%, and are non-collateralized. The notes are due on
various dates through 2012. The aggregate long-term debt, capital lease, and operating lease
obligations as of September 30, 2004 were as follows: Payments Due by Period
(in $000)Less than
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 year
    
    1-3 years
    
    4-5 years
    
    5 yearsLong-Term Debt (1)
    
    $
    393,517
    
    
    $
    1,626
    
    
    $
    1,734
    
    
    $
    525
    
    
    $
    389,632Capital Lease Obligations (2)
    
    
    179
    
    
    
    179
    
    
    
    
    
    
    
    
    
    
    
    Operating Lease Obligations (3)
    
    
    636,506
    
    
    
    50,555
    
    
    
    104,266
    
    
    
    99,179
    
    
    
    382,506Total Contractual Cash Obligations
    
    $
    1,030,202
    
    
    $
    52,360
    
    
    $
    106,000
    
    
    $
    99,704
    
    
    $
    772,138
 26




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##### Table of Contents



Notes:(1)
    
    The long-term debt contractual cash obligations include principal payment
requirements only. Interest on our 9 5/8% Senior Notes amounts to $24.5
million annually.(2)
    
    Capital lease obligations represent principal and interest payments.(3)
    
    Operating lease obligations include base rent only. Certain leases
provide for additional rent based on increases in real estate tax
indexation, utilities, and defined amounts based on the operating results
of the lessee. Equity Transactions and Restructuring On January 26, 2004 warrants to purchase 71,631 shares of Class A common
stock were exercised. On February 4, 2004 TSI and its shareholders and TSI Holdings, entered
into a Restructuring Agreement (Restructuring). In connection with this
Restructuring, the holders of TSIs Series A preferred stock, Series B
preferred stock, and Class A common stock contributed their shares of the
TSIs capital stock to TSI Holdings in exchange for an equal amount of newly
issued shares of the same form in TSI Holdings. Immediately following this
exchange TSI Holdings contributed to TSI the certificates representing all of
TSIs shares contributed in the aforementioned exchange. In return, TSI issued
1,000 shares of common stock to TSI Holdings, and cancelled the certificate
representing TSI Shares contributed to it by TSI Holdings. In addition as part
of the Restructuring, all holders of options to purchase Class A common stock
of TSI exchanged their options for options to purchase an equal number of
shares of Class A common stock of TSI Holdings at strike prices adjusted to
reflect the Restructuring. On February 4, 2004 TSI Holdings successfully completed an offering of
11.0% Senior Discount Notes (the 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
$4.3 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 such that on February 1, 2009 the accreted value will equal
$213.0 million, the principal value due at maturity. Subsequent to February 1,
2009 cash interest on the 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. On February 6, 2004, all of TSI Holdings outstanding Series A and Series
B Preferred stock were redeemed for a total of $50.6 million. On March 12, 2004, 65,536 vested common stock options of TSI Holdings were
exercised. TSI Holdings received $512,000 in cash related to these exercises. On March 15, 2004, the Board of Directors of TSI Holdings approved a
common stock distribution of $52.50 per share to all shareholders of record on
March 15, 2004. This distribution totaled $68,944 and was paid on March 17,
2004. Also, in lieu of a common stock distribution, vested common option
holders were paid a total of $1.1 million recorded as payroll expense at the
TSI level under GAAP. Forward-Looking Statements Certain statements in this report on Form 10-Q of the Company for the
three and nine month periods ended September 30, 2004 are forward-looking
statements, including, without limitation, statements regarding future
financial results and performance, capital expenditures, liquidity and
potential sales revenue. These statements are subject to various risks and
uncertainties, many of which are outside the control of the Company, including
the level of market demand for the Companys services, competitive pressures,
the ability to achieve reductions in operating 27




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costs and to continue to
integrate acquisitions, the application of Federal and state tax laws and
regulations, and other specific factors discussed herein and in other
Securities and Exchange Commission filings by the Company. The information
contained herein represents managements best judgment as of the date hereof
based on information currently available; however, the Company does not intend
to update this information, except as required by law to reflect development or
information obtained after the date hereof and disclaims any legal obligation
to the contrary. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk We do not believe that we have any significant risk related to interest rate
fluctuations since we currently only carry fixed-rate debt. We invest our
excess cash in highly liquid short-term investments. These investments are not
held for trading or other speculative purposes. Changes in interest rates
affect the investment income we earn on our cash equivalents and, therefore
impact our cash flows and results of operations. If short-term interest rates
were to have increased by 100 basis points during 2003, our interest income
from cash equivalents would have increased by approximately $500,000. These
amounts are determined by considering the impact of the hypothetical interest
rates on our cash equivalents balance during 2003. 
 Item 4.Controls and Procedures. (a) At
the end of the period, the Company carried out an evaluation, under the supervision and with
the participation of the Companys management, including the Chairman, Chief
Executive Officer along with the Chief Financial Officer, of the effectiveness
of the design and operation of the Companys disclosure controls and procedures
pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our Chief
Executive Officer and Chief Financial Officer have concluded that, as of
September 30, 2004 the Companys disclosure controls and procedures (1) were
effective in timely alerting them to material information relating to the
Company (including its consolidated subsidiaries) required to be included in
the Companys periodic SEC filings and (2) were adequate to ensure that
information required to be disclosed by the Company in the reports filed or
submitted by the Company under the Exchange Act is recorded, processed and
summarized and reported within the time period specified in the SECs rules and
forms. (b) There have been no significant changes in the Companys internal
controls over financial reporting during the three months ended September 30,
2004 that have materially affected or are reasonably likely to materially
affect our internal controls over financial reporting. 
 PART II. OTHER INFORMATION 
 Item 1.Legal Proceedings. On February 13, 2003, in an action styled Joseph Anaya vs Town Sports
International, Inc. et al. an individual filed suit against TSI in the Supreme
Court, New York County, alleging that on January 14, 2003, he sustained serious
bodily injury at one of our club locations. He filed an amended complaint on
September 17, 2003 seeking two billion dollars in damages for personal
injuries. His cause of action seeking punitive damages, in the amount of two
hundred and fifty million dollars, was dismissed on January 26, 2004. While the
Company is unable to determine the ultimate outcome of the above action, it
intends to contest the matter vigorously. We have in force fifty one million dollars of insurance to cover claims of
this nature. If any such judgment exceeds the amount for which we are covered
by insurance by $2.5 million, we would be in default under the credit agreement
governing TSI senior secured revolving credit facility. Also, if any uninsured
judgment, when aggregated with any other judgment not covered by insurance
equals $5.0 million or more, the judgment would constitute an event of default
under the indentures governing the Senior Notes and the Discount Notes. We
anticipate that these matters will be covered by insurance. The Company does not believe this matter will have a material effect on
its consolidated financial position, results of operation or cash
flows. 28




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The Company is a party to various other lawsuits arising in the normal
course of business. Management believes that the ultimate outcome of these
matters will not have a material effect on the Companys consolidated financial
position, results of operations or cash flows. 
 Item 2.Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities. Not applicable. 
 Item 3.Defaults Upon Senior Securities. Not applicable. 
 Item 4.Submission of Matters to a Vote of Security Holders. Not applicable. 
 Item 5.Other Information. Not applicable. 
 Item 6.Exhibits. (a) Exhibits Exhibit 31.1
    
    Certification by Robert Giardina pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification by Richard Pyle pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.3
    
    Certification by Mark Smith pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certification by Robert Giardina pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.Exhibit 32.2
    
    Certification by Richard Pyle pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.Exhibit 32.3
    
    Certification by Mark Smith
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 SIGNATURES Pursuant to requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. TOWN SPORTS INTERNATIONAL
HOLDINGS, INC.DATE:
November 10, 2004
    
    By:
    
    /s/ Richard PyleRichard PyleChief Financial Officer, Office of the President(principal financial, accounting officer)DATE:
November 10, 2004
    
    By:
    
    /s/ Robert GiardinaRobert GiardinaChief Executive Officer, Office of the President(principal executive officer)
 29