CHICAGO — Rough waves and gale force winds in the form of missed deadlines and a federal investigation are whipping around Bally Total Fitness. The crew has tossed some executives and accountants overboard while others have jumped ship. As the Blackstone Group tries to steer the vessel back on course, some investors nervously wait for the captain, Bally CEO Paul Toback, to announce what lies ahead.

Bally, the nation's largest operator of commercial health clubs, is sailing on uncharted waters, and analysts, investors and the fitness industry are waiting for numbers from Bally as the Securities and Exchange Commission (SEC) continues its investigation of the company. The Chicago-based fitness operator missed the July 31 deadline for filing financials for 2002 through 2004 and has requested a 90-day extension from its lenders. As of press time, the company hadn't received an extension from debtholders and extended its consent date for solicitation of waivers from July 26 to July 28. If 50 percent of the lenders don't grant Bally an extension, then Bally will be in technical default on some of its $757 million debt.

In a July 13 conference call, Bally attributed the filing delay to the complexity of the accounting issues and the fact that several of its key executives — its chief financial officer, treasurer, controller and assistant controller — were hired in recent months. Its accounting firm, Ernst and Young, was also replaced with KPMG LLP in November 2004. Toback said that Bally, which is working with the Blackstone Group on a turnaround strategy, has made progress toward completing the audit but needs more time.

“It's more important to get the accounting right than to do it hastily or haphazardly,” he said.

In the past six months, the audit committee and the new finance team uncovered more than two dozen errors in Bally's past accounting, Toback said. Last November, the company was aware of three primary errors — it recognized revenue more quickly than it should have, it made an error in the recording of $22 million of repayment obligations and it neglected to remove the installment contract receivables and the corresponding amount of deferred revenue from the balance sheet. After 14 months of work including hiring new auditors and investigating the complex accounting issues, Toback said his company is close to being able to release the audited financials. However, some analysts are growing tired of waiting for results.

“For the past year, we haven't been able to gauge how well or poorly they are doing because we don't have enough financial information to make a decision,” said John Maxwell, managing director of fixed income research for Merrill Lynch in New York City. “It's a concern because people have been waiting for well over a year to get audited financials. It's making some people nervous.”

Change of Leadership

After the announcement of the missed deadline, one of the company's largest shareholders — Liberation Investment Group, which owns 12 percent of the company's outstanding shares — called for a change in leadership, prompting a volley of letters between the group and Bally's board of directors. Emanuel Pearlman, chairman and CEO of Liberation Investment Group in Los Angeles, sent a letter to the board on July 13 urging them to oust Toback, immediately commence a search for a new CEO and appoint Pearlman to the board. In the letter, he stated that he was surprised and disappointed by Bally's inability to meet generous, self-imposed deadlines, which were accepted by the public debtholders.

“In our estimation, last week's announcements are further evidence that Bally's management team continues to flounder in its efforts to set the company on a path to maximize shareholder value, and as a result, we believe the capital markets have now lost any and all confidence in current management,” he said. “We believe that Bally Total Fitness desperately needs new leadership at this time in order to restore investor credibility and move the company forward.”

Pearlman went on to say that the company's significantly depressed stock price has been sending a clear, strong message for some time now that Bally is not heading in the right direction. In the past five years, the value of Bally's stock has plunged 88 percent, and as of press time, it was holding steady at $3.57 a share. In response to Pearlman's letter, the board issued a letter expressing its support for Toback and the management team and unanimously declining Pearlman's appointment to the board.

“We have every confidence that Mr. Toback and his team are on the right track and have the right plan to restore Bally to financial success,” said the letter from the directors. “Any efforts to destabilize the company, particularly during a critical debt consent solicitation process, are damaging to our ability to return Bally to profitability.”

The board's letter noted that Pearlman served as an advisor to former CEO Lee Hillman during the years in which the financials must be restated. During that time, the stock price fell from a high in the $20-range to a low in the $6-range, and the company took on unprecedented levels of new debt and expensive acquisitions, without an operating plan or a capital market plan to increase shareholder value, according to the letter.

“Our shareholders have already experienced your approach to creating value, and we think your historical actions — and the millions of dollars your ideas have cost the company and shareholders to date — speak for themselves,” the board said.

In a follow-up letter to the SEC, Gregg Frankel, president of Liberation, took issue with the tone of the board's letter. He also said that Pearlman served as an outside advisor to Bally on a limited number of specific transactions during the time in question and was personally retained by Toback during the first six months of 2003. He then said that during the two years that need to be restated, Toback signed the financial statements. The board members followed up with a letter that reiterated their support of Toback and his turnaround plan.

Pearlman isn't the only one who thinks it's time for a change. A large shareholder and a small bondholder who responded to Club Industry's Fitness Business Pro's online survey and wished to remain nameless, agreed.

“As long-term shareholders, we have lost confidence in the CEO, and find it absurd that to date, every issue at the company was blamed on someone else,” they said. “The CEO has yet to take responsibility for anything, and that is unacceptable given that he has been the CEO for two years and COO for another two. Operating issues and to some extent accounting issues are his responsibility.”

In a July 27 interview, Toback said that as CEO of the company, he took responsibility for everything under his leadership; however, he said he wasn't responsible for the company's accounting policies, which are the subject of the investigation, until he became CEO. He also said Bally's need to keep quiet while it is auditing financials from 2000 through 2004 has hurt the company's ability to communicate effectively with shareholders.

“People need to withhold judgment on the performance until they see the numbers,” Toback said. “We are moving through a company transformation and an audit process at an amazing pace given the amount of work to do.”

What's Ahead for Bally

To improve the company's financial position, Toback and his team are evaluating non-core assets and may close underperforming clubs. Bally currently owns Crunch, Gorilla Sports, Pinnacle Fitness and Sports Clubs of Canada, but the company announced this summer that it was shopping around Crunch. Toback said the company may consider selling some of its other assets to maximize value for shareholders. Part of Bally's strategy to leverage its debt centers around the sale of Crunch, which it bought for about $90 million in a cash/stock transaction in December 2001. Toback said by selling Crunch, Bally would be able to focus on its core business — mid-market health clubs in major cities.

If a sale occurs, Toback said Bally would need to use the majority of the proceeds to repay its debt. But if Bally can't get the right price for Crunch, the company plans to continue running the 21 clubs.

While selling Crunch may satisfy short-term debt holders, it won't make Bally's debt go away, said consultant Michael Scott Scudder.

“They may be able to get the debt holders off their back for awhile and buy themselves six months, but it's hard to increase sales in a mature company such as Bally,” he said. “Unless they can rapidly increase sales and decrease expenses, they'll have this tremendous burden of debt to get out from under.”

Whether or not Bally can decrease its debt through asset sales, the SEC investigation still looms, causing investors and analysts to question what lies ahead.