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Bally ache Will the accounting pains ever end?

CHICAGO — Bally Total Fitness is facing more turmoil in a year in which the company has already seen its share. The latest chapter involves postponement of the release of Bally's second quarter 2004 financial results, filing of its Form 10Q quarterly report with the Securities and Exchange Commission (SEC) and a possible restatement of financials.

The company is already facing an investigation by the SEC and a possible class action lawsuit. Earlier in the year, the company changed accounting firms and had its chief financial officer resign.

The company will not say when it expects the second quarter results to be released, but it did say that when the results are reported, the company expects to record a liability that has accumulated to approximately $5 million as of June 30, 2004 related to repayment obligations due in 2015 or later on membership contracts sold by a subsidiary before Bally acquired it in the late 1980s, the company said in a press release. The effect on prior income statements is the addition of non-cash annual interest charges of between $231,000 and $472,000 in each of the years 1996 through 2003. In addition, the company is considering changing the balance sheet presentation of its installment contract receivables, which would also change an equal amount of deferred revenue so as not to report these amounts on the balance sheet. It is possible that this or one or more of the accounting issues being examined by the company may require further restatement of prior period financial statements.

“The issue that is the most ongoing is the continuous restatement of their numbers,” said Andrew Zarnett, a Deutsch Bank analyst that follows the company. This wouldn't be the first time Bally had restated its financials.

“When you think that we're at the end of the tunnel and that the accounting will have been simplified and no more issues exist, there are more issues,” Zarnett said.

In April, the company announced that the SEC was investigating the company's restatement of its 2003 results. The restatements were to correct errors in a portion of its revenues relating to non-obligatory prepaid membership dues. The errors accelerated dues recognition for certain prepaying members. The restated amounts aggregated approximately $43 million during the seven-year restatement period.

The company has changed its accounting procedures three to four times in the last few years (including how it treats revenue, recognizes revenue, attributes the cost to acquire members and reports ancillary revenue), said Rick Caro, industry consultant with Management Vision in New York City. All of the changes have led to confusion on Wall Street, a group that has long been confused by Bally's business model of part health club and part finance company (Bally finances membership dues for members), Caro said.

“The problem with Bally is that under this revised accounting, the company has significant leverage,” said Zarnett. “They continue to experience competitive pressures in many of their markets. They are not that agile in competing in terms of customer propositions that they offer. That's what management is trying to address on a regular basis.”

In May, several suits were filed against Bally on behalf of purchasers of the securities of Bally between Aug. 3, 1999 and April 28, 2004. The complaints allege that the company issued false and misleading statements describing the company's improving financial performance. The suit alleges that the statements violated the Securities Exchange Act of 1934 because they failed to disclose and/or misrepresented that the company had violated generally accepted accounting principles and its own internal policies by prematurely recognizing revenue on certain non-obligatory prepaid membership dues; that the company lacked adequate internal controls and was therefore unable to ascertain the true financial condition of the company; and as a result, the value of the company's reported revenues during the class period was materially overstated.

During the turmoil the company stock price has dropped. Stock sat at about $10 per share last year in August. On Aug. 18 of this year, it closed at $4.09 per share, which is actually an increase from about $3 per share in May when the SEC investigation was announced.

“We are working to resolve these matters as quickly as possible and we remain intensely focused on executing our business strategy of growing revenue and lowering costs,” said Paul Toback, chairman, president and CEO of Bally in a press release from the company.

Bally has several options for digging out of the situation, but it all depends on their strategic plan, what controls they want to maintain, what relationships they have with their debt institutions and what findings come out of the government investigation, said Caro.

“There is a whole host of opportunities for what they could do in the future in terms of identifying new capital, dealing with debt requirements, dealing with perhaps reviewing all of their sites and trying to free themselves up from less successful sites or less clustered sites,” said Caro.

Zarnett said that Bally must drive stronger incremental membership and higher EBITDA as well as reduce debt burden.

“That could take place in getting a partial or full sale of the company, which is probably a strong resolution because they need to have lower debt,” Zarnett said. Besides a sale of all or some of their clubs, the company could sell off their receivables, franchise out some of their clubs or move from a public to a private company, said Caro.

Another option would be to file Chapter 11.

“No one wishes them ill will, but if they are going through a tough time, they ought to go through it,” said Caro. “If they need to file Chapter 11, then they should do it.”

Bankruptcy filing wouldn't be the end of the world, Caro said. “I have watched clubs that have gone through Chapter 11, and they have come out stronger,” he said. Club members might not even notice a change in their memberships since the clubs themselves would probably stay open under someone's control.

However, Zarnett didn't think that bankruptcy was imminent for Bally. “That depends on other factors,” he said.

When contacted for comments about issues reported in this story, a Bally spokesperson said that the company is in a “quiet period” until the company announces earnings and, therefore, could not comment at this time.

Timeline of the Troubled Times at Bally

February 2004:

17 — New York State attorney general announces an agreement with the company that will “significantly reform its sales and advertising practices.”

March 2004:

30 — Ernst & Young resigns as Bally's accounting and audit firm.

April 2004:

2 — Bally files an amended annual report for 2003, which includes restated financials and discloses that the company modified its existing internal controls structure.

28 — SEC begins investigation in company's restatement regarding the timing of recognition of certain pre-paid dues.

28 — Bally CFO, John W. Dwyer, resigns but is retained as consultant.

29 — Senior vp of finance, William G. Fanelli, named interim CFO.

May 2004:

10 — Q1 financials show a 2 percent rise in revenues to $244.7 million.

18 — Bally hires KPMG LLP as its new independent auditor to replace Ernst & Young LLP.

27 — Law firms file a class action suit against Bally on behalf of all purchasers of common stock between August 3, 1999 and April 28, 2004.

June 2004:

1 — Liberation Investments and Amalgamated Bank Longfellow 600 Index Fund announce their intention to submit governance proposals at Bally's July stockholder meeting. Chief among the proposals is the separation of the offices of CEO and chairman of the board.

July 2004:

12 — Bally reaches an agreement with the two investment fund groups, who then pull the governance proposals from the shareholder meeting.

29 — Shareholder meeting.

August 2004:

9 — Bally postpones the release of Q2 financial results. Announces possible restatement of past financials.

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