Tug of War

Given the current health craze, one would expect Bally Total Fitness to be the category-killer of the fitness industry. Yet despite sporting 440 clubs, 3.6 million members and $1 billion in annual sales, the company has been saddled with accounting problems and massive debt since its 1996 IPO. For the past three years, Bally has been led by Chairman and CEO Paul Toback — and for the past several months, some Bally shareholders have demanded the ouster of Toback, leading to a proxy contest to do just that at the annual shareholder meeting on Jan. 26.

Bally recently announced that revenues are up, costs are down and the company is turning itself around, so why is Liberation Investments, Bally's second largest shareholder, trying to push Toback out as CEO? As the CEO of Bally, Toback has presided over a 60 percent stock decline, failed (until recently) to file financial reports since early 2004, been unable to stem membership attrition, hasn't yet steered the company to an annual profit, lost several key personnel and managed a company facing investigations by the Securities and Exchange Commission (SEC) and Justice Department.

Toback had another explanation for the calls for his departure. He alleged that Emanuel Pearlman, managing director of Liberation Investments, was a close personal friend of Lee Hillman, former CEO of Bally, and that Hillman invested in Pearlman's Liberation Investments.

“This is an incestuous group of angry, disgruntled employees who are trying to take us back to the failed practices of the past,” he said. “Shareholders can make the choice to move the company forward on a positive track or go back to more debt, deals that have no value to the company or no operational plan in place.”

Pearlman denied that he and Hillman were working together to take over Bally. He said Hillman invested $100,000 in his $60 million fund and was a personal friend, but said his fund was not started just to buy Bally stock.

“That has been a lot of noise the company wants to make to hide behind the realization that shareholders are not satisfied with current management,” he said.

Figuring It Out

Shareholders may have a reason to be upset with Bally's past performance. Since 2001, the fitness chain has had 900,000 people join annually, yet the company has lost an equal number over the same period. Complaints of poor club maintenance and allegedly deceptive sales practices stretch back a decade. Despite reprimands for these practices by the Federal Trade Commission, the New York Attorney General and Oregon's Justice Department, those complaints continue under Toback.

This inability to retain members has only deepened Bally's financial crisis, one driven by more than $743 million in debt, requiring $70 million in annual interest payments. In a July 13 press release, Bally provided results from the first five months of 2005, a time frame that does not permit a comparison with the standard six-month reporting periods that Bally had released in the past. The five-month period results showed positive free cash flow ($6.3 million), but the six-month period would have included an interest payment of $16.5 million. Based on Bally's free cash flow run-rate, the free cash flow would have been negative. When asked during a Dec. 1, 2005, conference call how much the most recent interest payments were, Toback said the company didn't disclose those details, despite having done so in every previous financial report.

In 2003, as in previous years, Bally spent $50 million on membership processing and collection centers. Despite the company's poor performance in 2003, five officers were granted raises (Toback's salary and bonus rose to $775,000), as well as 680,000 stock options redeemable at $6 and $7 per share, and 2.65 million shares of restricted stock.

Until recently, Bally struggled with accounting issues, changing accounting methods three times, which triggered an investigation by the SEC. After undergoing a comprehensive restatement audit and postponing its SEC filings several times — requiring millions of dollars in consent fees to be paid to bondholders — Bally filed financial statements on Nov. 30, 2005, for the first time since early 2004. The restatements show that the company lost more than $450 million since 2000, $135 million of that since Toback became CEO.

Toback joined Bally in 1997 as a corporate development officer, later moving into the COO position. Despite his lack of experience in the fitness industry (see “The Players” sidebar on p. 22), Toback was award the CEO position by Bally board members in December 2002 (at a $300,000 salary and an equal amount in bonuses — today, he makes $975,000). Seeing millions in wealth evaporate after the failed merger between Bally and scandal-plagued Healthsouth, the board pushed out Hillman in favor of Toback. The reason for the failure surfaced during the accounting fraud trial of former Healthsouth CEO Richard Scrushy, when former Healthsouth CFO Weston Smith testified that the Bally deal fell through because of “problems we found during due diligence.”

Toback's Record as CEO

In the years he's served as CEO, Toback asserts that he has accomplished his three primary goals — an operational turnaround, restoring credibility to financial statements and addressing capital structure. According to a Dec. 1, 2005, report by Donald Trott of Jefferies and Co., Bally has improved its operating model.

“During the past 21 months, senior executive leadership has strengthened Bally's management team, revamped the company's accounting, overhauled its business model and embarked on new strategic initiatives in the wake of the imploding condition the company was in when CEO Paul Toback took the helm,” Trott said in the report.

Under Toback's leadership, Bally revamped its membership structure from three-year contracts to build-your-own memberships, which has helped the chain to appeal to a wider variety of customers. The company also launched a new advertising campaign called “Meet Your Potential” and rolled out its plans for continued growth through franchising. Bally added 152 clubs between 1997 and 2002, but Toback slowed Bally's growth to focus on the existing operations when he took over as the CEO. He's now pursuing an expansion strategy, and his company has hired a franchise expert from Midas to sell clubs to franchisees. Toback said he was happy to stand on his record of accomplishment at Bally.

“Bally was a company that was significantly laden with debt, and we've made significant progress on all fronts,” he said. “We posted a positive net income for the first nine months of 2005, restated financials, changed our accounting methodology and hired a new finance team. The results speak for themselves.”

While CEO, however, Toback has seen the departure of several significant employees — most of whom he hired — including Martin Pazzani, a marketing guru who resigned after 18 months; marketing executives Patrick Peduto and Jeff Gooding; and the entire public relations department. An executive from Kraft Foods was promoted to run the company's diet program and was fired soon thereafter. A subsequent hire from Jenny Craig quit six months later. In August 2005, board member Marilyn Seymann resigned after three months on the job and board member Stephen Swid left. In early September 2005, Anita Augustine and Ben Amante, the vice presidents of training and franchising, quit.

Toback said that many of these employees left for personal reasons, and in Pazzani's case, Bally accepted his resignation. Bally is not experiencing any major turnover or problem in staffing, Toback said.

Stock Sale

Despite the turmoil, Bally is working with JP Morgan and the Blackstone Group to explore a possible sale of its assets. Toback stressed during the Dec. 1 conference call that he owned 2.1 percent of the company and that his interests were therefore aligned with shareholders. One day later, Toback sold 420,000 shares of company stock (which is more than 75 percent of his shares), while other directors sold almost 800,000 shares — the same shares whose restrictions had been removed days earlier.

Senior management had not had the ability to sell stock since May 2004 because the company was in a quiet period, Toback said, and he liquidated some of his stock based on personal circumstances. Company insiders still own 5 percent of Bally's outstanding shares compared to 7 percent before the recent stock sales, he said.

In a Dec. 7, 2005, SEC filing, Pearlman expressed displeasure that the board granted Toback almost $1.8 million in restricted stock, options to purchase 230,000 shares and then removed the restrictions on the stock grants and accelerated the vesting date of the options to Nov. 28, 2005. These actions eliminated Bally's incentives (set forth in the 1996 Incentive Plan) for key employees to remain with Bally because they enabled them to “immediately cash in on what was meant to be deferred equity compensation,” said Pearlman. However, Toback said that when Bally's two largest shareholders crossed the 10 percent line in terms of stock ownership, it triggered the vesting of all the restricted stock that the management owned for a decade.

Toback asserted that despite the sale of a majority of his stock, he was confident Bally had a strong future or he wouldn't still be with the company. However, the sale of stock may be sending the wrong message to shareholders, said Rick Caro, president of consulting company Management Vision.

“The issue of the stock sale by senior management couldn't have been perceived as a more untimely event,” Caro said.

Future of Bally

What's next for Bally? Several separate private investment groups have amassed a 51 percent stake in the company and have likely done so because they see hidden value in Bally's assets. Bally, which announced a $1.6 million loss in the third quarter, is finalizing the sale of Crunch Fitness, which Bally purchased in 2001 for $90 million and is selling for $45 million.

“Bally paid $5 million per club,” Toback said, explaining the difference in the 2001 purchase price and the 2005 sale price. “There were no other competitive bidders, and we overspent on it.”

However, $45 million is below what KDP Investment Advisors, a Vermont-based research firm, valued Crunch.

Bally is also placing the entire company on the auction block, but a sale may be difficult because the company has a high debt-to-equity ratio, said Consultant Michael Scott Scudder.

“I wonder how much time there will be before the death bell tolls for Bally,” Scudder said. “These guys are really treading water at this point.”

Caro hopes Bally can soon return to its core focus — running a proper club company.

“I hope with restated financials and with a clarification soon from the SEC, Bally can avoid having to deal with other issues that have taken up time and money and distracted everyone — shareholders as well as management — from proper focus,” he said.

Toback couldn't agree more. He said Bally is in the midst of a complete turnaround, and shareholders like Pearlman are a distraction to the company's forward progress and plans for the future.

In the meantime, lenders will be able to decide the future of Toback and the Bally board at the January meeting.

The Players

Paul Toback
CEO
Bally Total Fitness
42 years old

• 1984 — Graduated from Stanford University with a degree in political science

• 1987 — Earned a JD degree from the University of Chicago

• 1993 — Was director of administration for Chicago Mayor Richard Daley

• 1993-1995 — Served as executive assistant to chief of staff for President Clinton

• 1995 — Served as COO of Globetrotter Engineering

• 1997 — Joined Bally as corporate development officer for Bally Total Fitness

• 2001 — Became COO at Bally

• 2002 — Bally board appointed him CEO after Hillman left the company

Emanuel R. Pearlman
manager of Liberation Investments
(12 percent shareholder in Bally)
45 years old

• 1985 — Graduated Harvard Business School with an MBA

• 1987 — Protégé of corporate raider Arthur Goldberg (assisted Goldberg in takeover of Di Giorgio Corp.)

• 1990 — Served as consultant to Goldberg after he took over Bally Manufacturing Corp.

• 1990s — Continued to work with Bally Total Fitness after Goldberg spun it off from Bally Manufacturing Corp.

• 2001 — Worked with then Bally CEO Lee Hillman on acquisitions of Crunch Fitness and Sports Clubs of Canada.

• 2002 — Continued as consultant to Bally after Hillman's departure from the company.

• 2003 — Departed Bally, partially due to a dispute with Toback over compensation.

• 2003 — Started Liberation Investment Group backed by investors (including $100,000 from Hillman).

• 2003 — As shareholder in Canadian retailer Intertan Inc., helped force its sale.

• 2004 — Proposed the ouster of Toback from CEO position and proposed himself for a board position at Bally.

• 2005 — Called again for ouster of Toback.

Source: Chicago's Crain Business

Bally Board of Directors
(as of Jan. 5, 2006)

Paul A. Toback — Chairman of the board

Barry M. Deutsch — Chief financial officer of Ovation Pharmaceuticals Inc., a specialty pharmaceutical company.

Eric Langshur — Founder and CEO of TLContact Inc., a privately held company that delivers patient communication and education services to the healthcare industry.

J. Kenneth Looloian — Retired senior vice president and chief financial officer of New Jersey Bell Telephone Co. and Bellcore (now Telecordia Technologies). Consultant to Di Giorgio Corp. since 1990.

James F. McAnally, M.D. — Private practitioner who specializes in hypertension and kidney disease. Dr. McAnally is also the medical director of nephrology services at Trinitas Hospital in Elizabeth, NJ.

John W. Rogers Jr. — Chairman and CEO of Ariel Capital Management, LLC/ Ariel Mutual Funds, an institutional money management firm that he founded in 1983. Rogers also serves as a director on the boards of Aon Corp., Bank One Corp., Exelon Corp. and McDonald's Corp.

Steven Rogers — Professor of finance and management at the Kellogg Graduate School of Management at Northwestern University, Evanston, IL. He is also a director at AMCORE Financial Inc., Duquesne Light Holdings Inc., S.C. Johnson & Son Inc. and SUPERVALU Inc.

Note: J. Kenneth Looloian is not standing for re-election. New nominees are Eric Langshur, Charles Burdick and Barry Elson.

Inside Liberation Investments' Proxy Fight

Bally is now enaged in a proxy fight with its two largest shareholders — Pardus Capital Management and Liberation Investments. In a proxy fight, one party tries to persuade other parties that an executive or director should be replaced, and if they agree, then sign proxy statements to allow the company to vote on their behalf.

Emanuel Pearlman, managing director of Liberation, said he was pleased that shareholders would vote on his proposal to oust Bally CEO Paul Toback at the Jan. 26 shareholders meeting, which begins at 8:30 a.m. at the Renaissance Chicago O'Hare Hotel in Chicago. Stephen Jenkins, a lawyer for Liberation, said Liberation must win more than 75 percent of the vote to oust Toback.

In response to Liberation's proposal, Bally sued the shareholder, which owns 12.1 percent of Bally's stock, in an effort to get Liberation's proposal declared illegal and invalid. Bally claimed that Liberation hid its ties with former Bally CEO Lee Hillman in its filings with the Securities and Exchange Commission. The state judge said he would rule on the case after the shareholder meeting.

Shareholders have four choices when it comes to voting on the proposals. They can cast their vote themselves by sending in their proxy card in the mail, vote via the Web or a telephone or deliver their proxy card in person to the annual meeting.

If they choose to do so, they can instead give their proxy vote to Bally, Pardus or Liberation. Lenders can only vote on one of the three proxies and can't split their vote, said Brad Wilkes, managing director of the Chicago office of Citigate Sard Verbinnen, an investor and media relations firm working with Bally.

Michael Scott Scudder, president of consulting company Fit Focus, said both sides in a proxy battle often try to discredit one another in order to influence the opinion of the stockholders. He doesn't see the proxy fight going away anytime soon.

“Pearlman and his cohorts seem bound and determined to take this all the way to the shareholder meeting in late January,” he said. “Bally management will do everything it can to block any actions by Pearlman's group. The last thing you want with a troubled company that hasn't been able to earn money for years is a fiasco at the shareholder meeting, but it looks as though that's what's coming.”

Inside Pardus Capital's Battle for the Board

Pardus Capital Management, Bally's largest shareholder with 14.4 percent of the shares, also launched a proxy fight against Bally, this one to change the composition of Bally's nine-member board.

The Corporate Library, an independent research group based in Portland, ME, recently downgraded the effectiveness of Bally's Board of Directors from “B” to “D.” In several filings with the Securities and Exchange Commission, Pardus stated the “ongoing pursuit of…strategic transactions that are designed to entrench current management…are not in the best interests of the company's stockholders…”

The Bally board includes several people from Bally CEO Paul Toback's past (view the flow chart, "The Bally Web," that appeared in the January 2006 issue). Barry Deutsch has known Toback since childhood; Eric Langshur runs a company whose board of advisors include Chicago Mayor Richard Daley's former chief of staff (Toback formerly worked for Daley); and John W. Rogers is a longtime Mayor Daley fundraiser. Bally's compensation committee includes the same three men, who voted to increase Toback's salary to its current level.

The New York Stock Exchange requires board members to be independent. Toback said the Bally board is made up of smart people with a broad range of expertise and advice. While he said he had known Deutsch for a long time, he said Deutsch was selected to the board because of his 20 years of experience as an investment banker.

Pardus nominated 54-year-old Charles Burdick, former CEO of London-based HIT Entertainment PLC; 64-year-old Barry Elson, acting CEO of Telewest Global Inc.; and 53-year-old Don Kornstein, founder and managing partner of Alpine Advisors LLC. Bally tried to avoid a proxy fight by nominating two out of the three — Burdick and Elson. Bally alleged that Kornstein was working with Manny Pearlman, managing director of Liberation Investments, and former Bally CEO Lee Hillman to take control of Bally and refused to nominate him. Pearlman denied working with Pardus.

“We're willing and responsive to our shareholders, but at the same time, we understand what the game is — they want selfish control of the company,” Toback said. “It's a game of trying to steal Bally for their own opportunistic reasons that don't include increasing shareholder value.”