The long-awaited 2006 annual report that Bally Total Fitness, Chicago, released on June 29 may be one of the final financial reports the troubled company makes public. If Chapter 11 bankruptcy reorganization goes as planned for Bally, its stock will become worthless, and the company will become private, no longer under the scrutiny of the Securities and Exchange Commission.

The reorganization will likely change the second-largest club company in the United States, especially if speculation that Bally will sell its underperforming clubs is true. Whether those clubs would go to one investor or be sold piecemeal to a variety of investors or club owners is unknown, but a large sell-off to one company could create another larger player in the industry while a piecemeal sale could create opportunity for a variety of club companies or investors. Either way, the employees and members from sold Bally clubs could be available in the open market.

Had Bally's announcement of a possible bankruptcy occurred a few years ago, the industry may have suffered more, says Rick Caro, president of the consulting company Management Vision. With so many quality companies in the industry today, Caro says, the industry will keep going strong.

“I believe that Wall Street and the financial community really understands that Bally had a certain business model and is very different from the rest of the industry and is not representative of the industry,” Caro says. “People would understand the context of where Bally fit in the industry and decide that it was a Bally situation, not an industry situation.”

Bally first announced plans to file for Chapter 11 protection on May 31 after noteholders of more than 80 percent of the company's 9 7/8 percent senior subordinated notes agreed in principle to swap $150 million of the $300 million notes (which mature in October 2007) for new subordinated notes, common equity and the right to participate in a rights offering that totaled $77.5 million. (The rights offering has since been increased to$90 million.) The restructuring has allowed Bally to retain the cash it would have used to make a July 15 interest payment on the 10 1/2 percent senior notes due 2011. (Bally did not plan to make the July 15 payment.)

Tennenbaum Capital Partners LLC, Anschutz Investment Co. and Goldman Sachs & Co. hold more than 80 percent of the senior subordinated notes, and they along with noteholders of the 10 1/2 percent senior notes due 2011 have entered an agreement to vote in favor of a restructuring plan. Bally has asked all noteholders to vote on the approved prepackaged plan by July 27.

“We are pleased that so many of our noteholders have expressed support for the [reorganization] plan and look forward to executing it and emerging promptly from Chapter 11 protection,” Bally Interim Chairman and Chief Restructuring Officer Don Kornstein said in a company press release. “The restructuring process laid out in the plan will allow us to maximize our resources and enhance our capital structure, better enabling us to invest in our clubs to meet the needs of our members and thereby facilitate operating performance improvements.”

The time it will take for Bally to complete the restructuring plan or the exact date as to when Bally will file with the courts is unknown. Plus, since Bally also announced that its stockholders will receive nothing for its shares (which has angered its second-largest shareholder to the point of threatening a lawsuit), the future of the company is even less certain.

Throughout the past several weeks, Bally has maintained it will continue normal business operations. That might be easier said than done, according to Michael Scott Scudder, an industry analyst and owner of the online-based firm MSS FitBiz Connection. Scudder recently visited five Bally stores in the Midwest and came away unimpressed.

“They're in terrible condition. There's barely a skeleton crew staffing them,” Scudder says. “For the most part, there are not many sales people, where they used to have a lot of sales people. The old saying is, ‘Will the last person in the building please turn out the lights and lock the door?’ Well, it looks to me like they're beginning to turn out the lights. It's ugly. It's real ugly. We all anticipated the ugly.”

A handful of general managers at Bally clubs randomly picked by Club Industry's Fitness Business Pro did not want to comment for this story and referred the magazine to Bally's corporate office. One general manager, before suggesting a call to the corporate office, did say that his club is “doing fine” and that members and staff are “all thinking positively.” He added that he wasn't aware of the financial problems Bally was having.

Despite its troubles, Bally did report a 6 percent increase in total net revenue in 2006 from the year before, to$1.059 billion. But the company also said in its report that its “financial and liquidity positions have been deteriorating and are expected to continue to deteriorate.” Bally also said that it “does not have sufficient operating cash flows to meet its expected needs for working capital, capital investment in operations, interest expense and debt repayments through Dec. 31, 2007.”

Bally reported that membership cash collections were down 3.4 percent($25.4 million) for 2006 from 2005 collections of $783 million. About 43 percent ($10.9 million) of the year-over-year decline in total membership cash collections occurred in the fourth quarter of 2006. In the first quarter of 2007, membership cash collections were down 6 percent (approximately $12 million) from the same period in 2006.

As of May 31, Bally's total consolidated debt was more than $811 million. As of June 15, liquidity was about $61 million, most of which was listed as cash on hand.

Bally will be getting help from Morgan Stanley Senior Funding Inc., which will be the sole lead arranger and sole bookrunner for $292 million of super-priority secured debtor-in-possession (DIP) and senior secured exit credit facilities. Both facilities will provide for a $50 million revolving credit facility and a $242 million term loan that is not to exceed five years, Bally said in a July 2 release. The DIP facility will refinance the existing senior secured credit facility and provide working capital during the pendency of the completed Chapter 11 case, Bally added.

Scudder says the DIP facility also will allow Bally to refinance the debt on the senior notes and extend it by another one to two years beyond 2011. In the noteholders' restructuring support agreement, the senior notes due 2011 will be modified to reflect an increase in interest rate to 12 3/8 percent from July 16, 2007. That increase may be too high, Scudder says.

“If a company's got to offer 12 and 13 percent today, that just shows you how bad their credit rating is and how suspect potential payback is,” Scudder says. “No matter how you cut it, with potential new debt at the 12-13 percent rate, you better have sales supporting net earnings or you're going to be right back in the same boat two years from now, not being able to pay interest on your debt.”

Family Feud

At press time, Liberation Investment Group, Bally's second-largest shareholder, proposed an alternate Chapter 11 plan that would give shareholders 10 percent of the reorganized equity and rights to participate in the rights offering for an additional 10 percent of the equity. The alternate plan would also pay the senior subordinated noteholders $60 million in cash in lieu of reorganized equity.

Andrew Glenn, an attorney representing Liberation, wrote in a July 4 letter to Bally that this plan “undeniably is superior to the Bally plan.” Bally said in a July 6 press release that it would provide due diligence access to these shareholders but added that there were no assurances that an agreement would be reached. For more on this developing story, go to www.fitnessbusinesspro.com.

Prior to submitting the alternate restructuring plan, Liberation threatened to sue Bally. In a June 6 letter to Bally, Glenn wrote that Bally's pre-packaged plan was “draconian” in nature because it cancels all existing equity.

Liberation claims that Tennenbaum Capital Partners, the largest holder of Bally's senior subordinated debt, sold all of its Bally stock as it was negotiating with Bally in February.

“It turns out that this is more than a coincidence,” Glenn wrote. “We have been informed that it was [Bally's] own financial advisor, Jefferies & Company, that handled Tennenbaum's sale.”

The letter also questions why Bally plans to give bonuses to its top officials, including Kornstein, if the restructuring plan clears bankruptcy court by Sept. 30 and questions Bally's claim that the bonuses are in the best interests of Bally “and its shareholders.” Glenn writes that the people in control of Bally now treat the interests of shareholders as “little more than a joke” and adds that the pre-packaged plan “clearly is not in the interest of shareholders.”

Glenn concludes that Liberation's Manny Pearlman and Gregg Frankel should be appointed to Bally's board of directors. It was Pearlman who led a charge to oust then-Bally CEO Paul Toback at the January 2006 Bally shareholder meeting, but Pearlman did not garner enough votes. At the same meeting, Pardus Capital Management, which is Bally's largest shareholder, fought to get Kornstein on the board and was successful. Pearlman also supported Kornstein at the time.

Pearlman did not return calls for this story, and Glenn did not respond to an interview request. Karim Samii, the head of Pardus Capital Management, also did not respond to an interview request. Bally spokesperson Matt Messinger did not make Kornstein or former acting CEO Barry Elson, who resigned in May but remains on the Bally board, available for comment.

Caro says that Liberation has a right to sue Bally if it feels there's been an injustice. “When someone is going to end up with zero value, they obviously want to contest that,” Caro says.

Scudder says that Pearlman and Liberation don't have much of a case. “The stock is worth virtually nothing,” he says.

On July 5, Bally's stock was at 44 cents on the Pink Sheets exchange and had previously reached a low of 27 cents. The New York Stock Exchange delisted the stock in May.

Closing Time

Most analysts agree that Bally will sell its underperforming clubs during the restructuring plan. Bally has 375 operating clubs, and Scudder estimates that Bally could close up to 200 of them. Even if Bally retains 150 clubs that carry $500 million of gross revenue, management must find a way to grow the company substantially over the next couple of years to actually come out of reorganizational bankruptcy well enough to pay the interest due on the debt, Scudder says.

“The reorganizational plan even looks somewhat suspect,” he says. “They're gaining some time, but are they gaining any significant advantage? What they haven't said is how they plan to substantially grow the revenues of the company under reorganization. I would say that this company's got a 50/50 chance of even coming out of a reorganizational bankruptcy over the next 24 months and looking good.”

Jim Booker, a Bally investor for more than 20 years and a landlord of a Bally club in Clearwater, FL, says that Bally will pull through, even though he agrees that the company will have to sell some clubs. Bally already sold 16 of its Toronto, Canada, clubs this year for net cash proceeds of $18 million.

“For the company to survive, Bally is going to have to make certain moves that let them become a little more flexible with their debt,” Booker says. “I think the new management has some good ideas on what the go-forth plan is, and they're kind of making up for some past bad moves. They're out to keep some good, productive clubs and keep the company.”

Booker compares Bally's situation to that of Kmart, which filed for Chapter 11 in 2002.

“Kmart was a great company that became poorly managed,” Booker says. “And that's kind of what you've got here with Bally. It's a great company that started off well, continued to do very well, and some people along the way didn't make some of the better choices.”

Kmart could be the company Bally models itself after during its restructuring process. In 2002, Kmart, with $17 billion in assets, became the largest retailer to file for bankruptcy. At the time, Kmart had 2,114 stores. After an 18-month bankruptcy period, Kmart dropped 600 stores and cut an estimated 54,000 jobs.

Kmart has bounced back, thanks in part to a merger with Sears Roebuck and Company and a large investor. Scudder says the advantage that Kmart had was that large investor, along with a marketing plan.

“Kmart still had a fairly good sales record going on at the time, even though they were obviously in trouble as a company,” Scudder says. “Comparing Bally to Kmart is not a fair comparison because Kmart is so much bigger in terms of sales. Bally is probably down to $800 million a year in sales from close to $1 billion a couple of years ago. So why would somebody want to be behind it waiting for it to fall and then rescue it, with sales and net continuing to drop and [with] a dwindling bunch of assets?”

However, a couple of private-equity firms may be waiting in the wings for Bally. The New York Post reported in early June that J.H. Whitney & Co. and Texas Pacific Group have explored a possible buyout of Bally before it goes into bankruptcy. A spokesperson at Texas Pacific Group declined to comment, and representatives at J.H. Whitney did not respond to an interview request.

What's in a Name?

After Bally's proposed reorganization plays out, will Bally be known as Bally anymore? It depends on whom you ask. Scudder thinks the company needs to change its name. Booker thinks the name should be left alone. Caro thinks the name could be altered somewhat, perhaps changing it to “The New Bally” or “Bally Fitness,” with the word “Total” removed.

“There are firms that specialize in name and corporate identity that are experts in this,” Caro says. “There are lots of ways to build on the past but not necessarily keep the same story and sometimes let the world know that there's a different story available.”

Count Geoff Dyer, CEO and founder of Lifestyle Family Fitness in St. Petersburg, FL, among those who say Bally, despite its troubles, will keep its name.

“The good news is Bally can probably come out of this bankruptcy and keep their best clubs and re-brand them and reinvest in them and start over,” Dyer says. “The unfortunate thing is the other clubs that are underperforming or too far gone will all have to be let go or recycled in the marketplace. I'm sure that [Bally] will come out of the bankruptcy with 200 of the best clubs, and I'm sure that they'll probably do well with the right reinvestment. I don't see the brand going away. It's too well known.”