When Bally Total Fitness tabled plans to find a buyer, lowered its cash flow projections by 10 to 20 percent and dismissed Paul Toback, chairman and CEO, the fitness chain's top two shareholders jumped into action.

Pardus Capital Management, which owns 14.8 percent of Bally's shares, and Liberation Investment Group, which has an 11.2 percent stake in Bally, both signed confidentiality agreements with the company to gain access to “certain nonpublic information about the company for the purpose of evaluating and negotiating a possible strategic transaction with the company,” according to an Aug. 24 filing with the Securities and Exchange Commission (SEC). These shareholders can nominate individuals for election to Bally's board of directors, bring business before a stockholders' meeting and conduct a proxy solicitation in support of director nominees. As part of the agreement, Liberation and Pardus can't sell stock until three business days after Oct. 16 so they don't influence Bally's stock performance.

Pardus and Liberation are looking after their own investment in the company by offering a helping hand with the transaction, says Kim Noland, director of high-yield research at Gimme Credit, an independent research firm on corporate bonds, and a Bally analyst. With more than $700 million of debt, the shareholders would not get a substantial return on their investment if the company filed for bankruptcy, she says.

“If the company goes into a restructuring, the shareholders are the first ones to be hurt because bondholders are always paid before shareholders,” she says. “[Pardus and Liberation] have a high degree of interest in finding a way to turn this thing around, get better management and find a buyer.”

In a July report, she predicted that the fitness chain would have less cash flow because of a stagnation in new member numbers. In mid-August, Bally lowered its cash flow projections. The chain needs to find a way to lower its debt so it can continue to operate, she says.

“It's clear the company has to reduce the amount of debt because they are not able to maintain their clubs and do what's necessary to ultimately repay their creditors,” Noland says. “They don't have a liquidity crisis going on, but if they have a negative cash flow and run out of cash, they're going to hit the wall. Bally generally breaks even, so it has a modest amount of flexibility where they can pull a rabbit out of a hat with better management over the next few quarters.”

During Toback's four-year reign at Bally, the company has not been able to prove its business model and has been continually strapped for cash, says Rick Caro, president of Management Vision.

“They continue to be pressured by the huge amount of debt that they've attracted over the years,” Caro says. “I think there will be some interim steps to get an injection of funds and a financial reworking of the balance sheet. I'm not sure that there will be a quick solution to the successful operation of the business. While I hope they can find a solution for the sake of the industry, I don't think it will be available.”

Unlike other analysts, Caro doesn't think the confidentiality agreements will necessarily lead to a transaction but instead are ways for the company's top two shareholders to take a more active role and take a closer look at the books. Currently, Liberation and Pardus have to file documents with the SEC to gain access to certain documents.

The stock market, however, tells a different story, says Michael Scott Scudder, owner of MSS Fit Biz Connection, an online-based club consulting and training service. On the day Liberation entered into the confidentiality agreement, the stock price rose by 10 percent, and the trading volume shot up.

“Someone believes that these confidentiality agreements are the first steps to the reorganization of the company, and Bally, in some way, shape or form, will still stay around and be rescued,” says Scudder, who was a stockbroker for 13 years. “Whenever you see extreme volume on the upside with stock, the market is expecting something and saying that there are some positive developments inside the company. Otherwise, the stock would still be going down, or volume would have dried up.”

Future of Bally

After forming a strategic alternatives committee, hiring financial advisors and spending seven months searching for a buyer for the company, the fitness chain came up empty-handed. Bally is a cross between a health club business and a consumer finance company, which clouds the chain's financial picture and makes it difficult to find a buyer, Caro says. While Bally's future is still uncertain, Caro expects the company to pursue a rights offering in which the shareholders would put up additional capital for some additional stock.

With Bally's stock dropping 57 percent since Toback became CEO in 2002, the company could also opt to go private. The looming question, however, is how Bally will go private — through a legal filing for a bankruptcy or a direct purchase by an equity firm. If the company goes private, it shouldn't have an effect on how Bally is run, says John Maxwell, an analyst for Merrill Lynch in New York.

By going private, Bally could be less focused on quarterly earnings and create a solution to improve the health of the company in the long run, Caro says.

“Their market share has been dismal,” Caro says. “With a private ownership situation, they would be less under the microscope and more able to follow a strategy that would be understandable to all kinds of public forces.”

Bally filing for bankruptcy would be the least desirable situation for the shareholders, Caro says.

Bally's announcement that it would miss its sales projections, and that it only had enough cash reserves to last it until January or February of next year, however, makes Scudder wonder about the future of the company.

“It's a jigsaw puzzle with some of the pieces missing,” he says. “From a shareholder standpoint, will they be able to pay the debt down and pay the interest, and what will their sales look like for the balance of this year? I'm almost certain they'll have no net income whatsoever. Where will the cash come from to keep this operation going?”

Scudder questions whether Bally can pay the debt immediately in front of it, pay interest on the debt with no earnings on its revenue and finance the day-to-day operations. If Bally wants to keep the company running, it must cut expenses.

“You have to get rid of the losers and cut your losses,” he says. “If you cut this operation in half, you may be able to save the company, but the big question is the debt. If you bankrupt the company, your shareholders won't get dollar for dollar on their debt, and their stock wouldn't have any value.”

New Leadership

Bally's challenges are three-fold — to map out the future of the company, increase cash flow and find a new CEO following the dismissal of Paul Toback (see Bally Ousts Toback as CEO at right). Bally fired Toback in mid-August, but the CEO could have been ousted sooner rather than later due to a proxy battle waged at the company's annual shareholder meeting in January. Bally's second largest shareholder, Liberation, didn't receive the necessary 75 percent of shareholder votes for its proposal to fire Toback, but Pardus' proposal to nominate two new board members passed. Those two board members — Don Kornstein, the founder and managing partner of Alpine Advisors, and Barry Elson, the former acting CEO and director of Telewest Global — are now in the No. 1 and No. 2 positions at Bally. Kornstein, who was supported by Liberation, is now the company's interim chairman, and Elson, who was nominated by Pardus and supported by Bally, is serving a stint as the company's interim CEO.

“The new interim chairman and CEO, who are familiar with the two largest shareholders, will pursue each and every avenue they can for a decision that would help the company in the short run,” Caro says. “I think their patience level is at the end of its course. They are now seeking immediate action and are going to sponsor some changes. We'll have to see what they are.”

When an interim chairman and CEO are appointed to lead a company, one of three things often happens, Caro says. A company extends the temporary leaders' term so the temporary leaders have time to make some changes, it goes on an immediate search for one or both positions, or it hires the chairman to stay on board if it's not able to find a suitable CEO outside the company.

“It's not uncommon for companies to ask one of the board members to become the permanent CEO or chairman because they are familiar with the company and have often won over the rest of their board with respect to their credentials and decision making,” Caro says. “They have an in-depth knowledge of the company greater than an outsider who may be brought in and take more time to be brought up to speed.”

The company's interim CEO and chairman have the confidence and support of the major shareholders and should be able to make changes sooner rather than later, Caro says.

“The major shareholders fought a long and protracted battle just a few months ago,” he says. “What the interim chairman and CEO need to do is to win over the shareholders with positive action in the short run.”

The company is currently in a balancing act trying to satisfy its shareholders, pay off its debt, keep its existing operations running, and find a new chairman and CEO. Whether the company goes private, files for bankruptcy, sells off its underperforming clubs or ultimately finds a buyer remains to be seen. Until then, Bally's future hangs in the balance.

Note: Barry Elson, Don Kornstein, Emmanuel Pearlman and Karim Samii did not return calls for comment as of press time. For continuing news coverage about Bally Total Fitness, please see our Web site at www.fitnessbusinesspro.com.

Bally Ousts Toback as CEO

After a drop in sales projections and a fall in the stock price, Bally dismissed Paul Toback, the chairman and CEO of Bally, in August. While he may have lost his job, Toback walked away with a severance package of $3.8 million, and Bally vested 135,000 shares of his restricted stock. The company will also provide Toback and his family with health insurance coverage for the next nine years and pay him any unpaid base salary and accrued and unused vacation time through Aug. 11.

Toback's severance package was out of line considering the financial performance of the company, says Jim Booker, a Bally investor who sold 20 of his 50 fitness clubs to Bally.

“While the company has improved very strongly over the last few years, like a lot of these packages, it was totally unwarranted for Toback's performance,” Booker says. “In a sales and service organization, he did not fit. He was a good man not in a good industry. He was not for the fitness business and would have worked better in some other corporate setting.”

Booker looks forward to the day when Bally hires a CEO with a strong sales and fitness background. Toback spent the majority of his career in politics and spent two years at an engineering firm, but he didn't have any previous fitness industry experience before joining the team at Bally. By hiring the right person for the job, Bally may be able to successfully turn around the debt-laden company, he says.

“I still think the company has great potential,” Booker says. “Bally is a recognized name in the industry with great locations. The company just has to get its top level management together, solve its cash issue and restructure its debt.”

Three things led to Toback's dismissal — no imminent sale of the overall company, news that earnings were going to be 10 to 20 percent less than originally forecasted and pressure from Bally's top shareholders to make a change in leadership, says Rick Caro, president of Management Vision. Bally's new CEO must have experience in downsizing financially strapped companies, he says.

New Interim Bally Leaders

Don Kornstein, interim chairman

Kornstein was elected to the Bally Board of Directors in January 2006. He is founder and managing partner of Alpine Advisors LLC, a strategic, financial and management consulting firm serving a broad range of companies. Prior to founding Alpine Advisors, Kornstein served as chief executive officer, president and director of Jackpot Enterprises Inc., a New York Stock Exchange-listed company. He was also a senior managing director in the investment banking department of Bear, Stearns & Co. Inc. for 17 years.

Barry Elson, interim CEO

Elson was elected to the Bally Board of Directors in January 2006 and is a member of the Strategic Alternatives Committee. He served as acting chief executive officer and director of Telewest Global, Inc., a provider of entertainment and communication services. Elson earlier also held the posts of chief operating officer of Urban Media, president of Conectiv Enterprises, executive vice president at Cox Communications and vice president of the New York Nets, New York Islanders and Colorado Rockies.

Source: Bally Total Fitness

Executive and Board Member Departures at Bally

Paul Toback isn't the first executive to exit Bally. The fitness chain has experienced a wave of voluntary and involuntary resignations over the past few years. Two of its most recent departures are its chief executive officer (CFO) and a board member.

Bally is now on its fourth CFO in four years. Carl J. Landeck, CFO, who was hired in March of 2005, left the company in April 2006. He replaced William Fanelli, who served as acting CFO from April 2004 to March 2005 following the resignation of John Dwyer after eight years with the company.

Several board members have also come and gone. James McAnally, the medical director of nephrology services at Trinitas Hospital in Elizabeth, NJ, resigned in mid-August. Bally appointed 57-year-old McAnally to the board in 1996 when it first went public.

McAnally started long before many of the other board members, Caro says. “He has every right to step down since he has been through all kinds of challenges as a board member for years,” he says. “He probably wants a less stressful experience than continuing on as a Bally board member.”