UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number: 001-13997

Bally Total Fitness Holding Corporation

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(773) 380-3000

 

SEE TABLE OF ADDITIONAL REGISTRANTS

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes: o     No: þ

 

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes: o     No: þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes: o     No: þ

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  o          Accelerated Filer  þ          Non-Accelerated Filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes: o     No: þ

 

The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant as of June 30, 2006, was approximately $212 million, based on the closing price of the registrant’s common stock as reported by the New York Stock Exchange at that date. For purposes of this computation, affiliates of the registrant include the registrant’s executive officers and directors as of June 30, 2006. As of May 31, 2007, 41,257,012 shares of the registrant’s common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE: NONE

 

 

TABLE OF ADDITIONAL REGISTRANTS

 

 

The address for service of each of the additional registrants is c/o Bally Total Fitness Holding Corporation, 8700 West Bryn Mawr Avenue, 2nd Floor, Chicago, Illinois 60631, telephone (773) 380-3000. The primary industrial classification number for each of the additional registrants is 7991.

 

In this Annual Report on Form 10-K, references to “the Company,” “Bally,” “we,” “us,” and “our” mean Bally Total Fitness Holding Corporation and its consolidated subsidiaries.

BALLY TOTAL FITNESS HOLDING CORPORATION
2006 ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 

 

The information and discussion in this Annual Report on Form 10-K (the “Form 10-K”), should be considered in the context of the following overall trends and factors:

 

 

Forward-looking statements in this Form 10-K including, without limitation, statements relating to (i) our plans, strategies, objectives, expectations, intentions, and adequacy of resources, (ii) our expectation that our strategies will enable us to create economic value, and (iii) the anticipated future performance of our business are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934 (as amended, the “Act” or the “Exchange Act”).

 

Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. These statements are based on beliefs and assumptions by our management, and on information currently available to management. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update publicly any of them in light of new information or future events. In addition, these forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

A number of factors could cause actual results to differ materially from those contained in any forward-looking statement. These factors include, among others:

 

 

Our website address is www.ballyfitness.com. We make available free of charge on our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports, as soon as reasonably practicable after we electronically file or furnish such materials to the SEC. In addition, we also make available through our website our press releases, our Code of Business Conduct, Practices and Ethics, our Corporate Governance Guidelines, the Charters for the Audit Committee, Nominating and Corporate Governance Committee and Compensation Committee, as well as contact information for the Audit Committee, including an employee hotline and website. These materials are also available in print to any stockholder upon request. Information contained on our website is not intended to be part of this Form 10-K.

 

Barry R. Elson, our then Acting Chief Executive Officer, certified to the New York Stock Exchange (the “NYSE”) on December 22, 2006 pursuant to Section 303A.12 of the NYSE’s listing standards, that he was not aware of any violation by the Company of the NYSE’s corporate governance listing standards as of that date. In addition, the certifications required pursuant to Section 302 of the Sarbanes-Oxley Act were filed as exhibits to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 and are also filed as exhibits to this Form 10-K.

 

Our executive offices are at 8700 West Bryn Mawr Avenue, Chicago, Illinois, 60631; our telephone number is (773) 380-3000.

 

The information and discussion set forth below should be considered in the context of the following overall trends and factors:

 

 

General

 

Bally Total Fitness Holding Corporation is among the largest full-service commercial operators of fitness centers in North America in terms of members, revenues and square footage of its facilities. As of December 31, 2006, through our subsidiaries, we operated 375 fitness centers concentrated in 26 states and Canada. Additionally, as of December 31, 2006, 35 clubs were operated pursuant to franchise and joint venture agreements in the United States, Asia, Mexico, and the Caribbean. We operate fitness centers in over 45 major metropolitan areas representing 62% of the United States population and have approximately 3.5 million members. By clustering our fitness centers in major metropolitan areas, we are able to offer city-wide and national memberships, providing more value to members and differentiating ourselves from “mom and pop” competitors while achieving operating efficiencies.

 

We were incorporated in Delaware in 1983. Since inception, our business, markets, the services we offer and the way we conduct our business have changed significantly and are expected to continue to change and evolve. These changes are primarily the result of increasing awareness of the need for exercise, weight control, good nutrition and a healthy lifestyle among adults and children in the United States. We believe that through more targeted sales and marketing efforts of our service and product offerings we can capitalize on the opportunities in our markets, including the aging of America and generally higher awareness levels of fitness. For many years our

target market was the 18- to 34-year old middle-income segment of the population. In recent years, we expanded our target market to include 35- to 54-year olds. Currently, our members range in age from approximately 16 to 80, reflecting our many years in business and diverse membership base.

 

In order to better serve these diverse members and address the growing need for better health and fitness, in 1997 we began offering members additional products and services, including personal training, Bally-branded apparel, Bally-branded nutrition products and, beginning in 2003, a nutrition and weight management program which emphasizes effective and sustainable weight loss.

 

We became a public company in 1996 and have raised capital, which has been used to acquire new clubs, remodel existing clubs and purchase additional or replacement equipment. Between 1997 and 2002, we focused on growth through the acquisition and internal development of new clubs. During that period, we bought or opened 152 new fitness centers. During the period from 2002 through December 31, 2006, we have acquired or opened 23 clubs and sold or closed 58 clubs.

 

Beginning in 2003, we changed our focus and our business plan, scaling back our club expansion plans and focusing on improving operating margins and cash flows from our existing fitness centers. We first focused on operating efficiencies, enrolling more new members by expanding our membership offerings to include month-to-month and discounted add-on memberships and improving the retention of new members during their critical first 30 days of membership, as well as increasing the training for our employees consistent with the changes in our focus and business plans. The second phase of our business plan centered around implementation of our new club operating model, which calls for each fitness center to be run by a general manager accountable for the profitability of his or her fitness center and for cross-training employees to serve in a variety of positions in our fitness centers so we can achieve optimal staffing profiles. These changes to our business model, when combined with competitive conditions in key markets where well-financed competitors have expanded their operations, have adversely affected our operating results and cash collections. The third phase of our business plan, currently being pursued, is focused on addressing our capital structure in order to reduce leverage and debt service requirements and improve liquidity, which would allow us to invest more of our operating cash flow in fitness equipment for and improvements to our fitness centers. We have begun divesting non-core assets, by means that have included, but are not limited to, the sale of fitness centers. In January 2006, we completed the sale of our Crunch Fitness business and four other high-end fitness centers in San Francisco, including the Gorilla Sports brand. In the fourth quarter of 2006, we entered into three sale/leaseback transactions involving eight of our fitness centers. In June 2007, we completed the sale of substantially all of our Canadian operations. We continue to evaluate strategic alternatives to enhance our liquidity and make necessary investments in our ongoing business.

 

We reported a loss from continuing operations for each of the years 2002 through 2005, and had modest income from continuing operations in 2006. During the last five years, our primary markets have become more competitive, with well financed competitors entering and opening new fitness centers. At the same time, our ability to invest in our fitness centers has been constrained by our financial condition, particularly as it relates to liquidity. These conditions are expected to persist.

 

We have a substantial amount of debt. As of May 31, 2007, our total consolidated debt (excluding trade debt) was more than $811 million. We paid over $79 million in interest in 2006, an amount which would be higher in 2007 based on higher levels of outstanding debt. This substantial amount of debt service adversely affected our financial health and business operations by, among other things, limiting our ability to obtain additional financing to fund future working capital, capital expenditures, acquisitions of clubs and other general corporate requirements; continuing to require that we dedicate a substantial portion of any cash flows from operations and future business opportunities to debt service; and increasing our vulnerability to adverse economic conditions.

 

Planned Reorganization

 

Forbearance Arrangements

 

As a result of our deteriorating financial condition and pending debt requirements, in November 2005 we began considering strategic alternatives. To this end, the Company engaged JP Morgan Securities, Inc. and The Blackstone Group to assist the Company in commencing a process to identify and evaluate strategic alternatives,

including without limitation a sale of substantially all of the Company’s assets. This process, which was conducted under the direction of the Strategic Alternatives Committee of the Board, did not result in a strategic transaction. We subsequently retained Jefferies & Company in February 2007 as our financial advisors. In March 2007, certain holders of our Senior Notes and Senior Subordinated Notes formed an Ad Hoc Committee and we began discussions with them with respect to de-leveraging of our balance sheet. In April 2007 we were required to make an interest payment of $14.8 million on our Senior Subordinated Notes. We elected not to make this interest payment and an event of default occurred under the Indenture, dated as of December 16, 1998 between the Company and U.S. Bank National Association, as trustee (the “Senior Subordinated Notes Indenture”), which also triggered an event of default under the Indenture, dated as of July 2, 2003 between the Company and U.S. Bank National Association, as trustee (the “Senior Notes Indenture” and together with the Senior Subordinated Notes Indenture, the “Indentures”).

 

In April 2007, prior to the Senior Subordinated Note interest payment date, we entered into a Forbearance Agreement (the “Forbearance Agreement”) under the Amended and Restated Credit Agreement between the Company, JP Morgan Chase Bank, N.A., as Agent, Morgan Stanley Senior Funding, Inc., as Syndication Agent, and other Lenders dated October 16, 2006 (the “New Facility”). Under the Forbearance Agreement, the Agent and the Lenders agreed to forbear from exercising any remedies under the New Facility as a result of the cross-default arising as a result of our failure to make the required interest payment on the Senior Subordinated Notes, failure to provide audited financial statements for the fiscal year ended December 31, 2006 and certain other defaults. The Lenders also agreed not to exercise cross-default remedies as a result of defaults under our Senior Notes Indenture and Senior Subordinated Notes Indenture due to our failure to timely file our 2006 Annual report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 with the Securities and Exchange Commission. The Forbearance Agreement will terminate on the earlier of July 13, 2007 or the date on which a default occurs which is not a default covered by the Forbearance Agreement, any payment of principal or interest is made on the Senior Subordinated Notes, the commencement of any enforcement action under the indenture governing either the Senior Notes or Senior Subordinated Notes, including acceleration of the Senior Notes or Senior Subordinated Notes, or upon certain challenges to the validity or enforceability of the New Facility or the Forbearance Agreement. The Forbearance Agreement required that we enter into forbearance agreements with respect to defaults under our public indentures with holders of at least a majority of our Senior Notes and at least 75% of our Senior Subordinated Notes.

 

In May 2007, we entered into a Limited Waiver and Forbearance Agreement (the “Senior Notes Forbearance Agreement”) with holders representing over 80% of the aggregate principal amount outstanding of our Senior Notes. Pursuant to the Senior Notes Forbearance Agreement, holders of the Senior Notes waived the cross-default in connection with our failure to make the required interest payment on the Senior Subordinated Notes and certain other defaults under the Senior Notes Indenture and agreed to forbear from exercising any related remedies until July 13, 2007. Holders of the Senior Notes also consented to amend certain provisions of the Senior Notes Indenture in connection with the waiver of the defaults. We agreed to pay a one-time cash consent fee of $1.25 per $1,000 principal amount of Senior Notes to holders of the Senior Notes that executed the Senior Note Forbearance Agreement and consented to the related amendments to the Senior Notes Indenture.

 

In May 2007, we also entered into a Limited Waiver and Forbearance Agreement (the “Senior Subordinated Notes Forbearance Agreement”) with holders representing over 80% of the aggregate principal amount outstanding of our Senior Subordinated Notes. Pursuant to the Senior Subordinated Notes Forbearance Agreement, holders of the Senior Subordinated Notes waived the default in connection with our failure to make the April interest payment and certain other defaults under the Senior Subordinated Notes Indenture and agreed to forbear from exercising any related remedies until July 13, 2007. Holders of the Senior Subordinated Notes also consented to amend certain provisions of the Senior Subordinated Notes Indenture in connection with the waiver of the defaults. We did not pay a consent fee to holders of the Senior Subordinated Notes in connection with the Senior Subordinated Notes Forbearance Agreement.

 

Solicitation of Votes on the Plan of Reorganization

 

On June 27, 2007, we commenced a solicitation of votes on the Plan of Reorganization from holders of the Senior Notes and Senior Subordinated Notes. If we receive the requisite votes in favor of the Plan of Reorganization,

we intend to file a voluntary prepackaged petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court in the Southern District of New York (the “Bankruptcy Court”) in late July 2007. Prior to commencement of the consent solicitation, we entered into a Restructuring Support Agreement with holders of a majority of the Senior Notes and more than 80% of the Senior Subordinated Notes, in which the consenting noteholders agreed to vote in favor of the Plan of Reorganization, on the terms and conditions specified therein. Under certain circumstances, we may file for bankruptcy prior to the end of the solicitation period.

 

The Plan of Reorganization, which is described in greater detail below, would, if approved, confirmed and consummated, result in the cancellation and discharge of all claims relating to the Senior Subordinated Notes. Each holder of Senior Subordinated Notes would receive a pro rata share of new subordinated notes (the “New Subordinated Notes”) in the principal amount of approximately 24.8% of their claims, or $80 million, new junior subordinated notes (the “New Junior Subordinated Notes”) in the principal amount of approximately 21.7% of their claims, or $70 million, non-detachable rights to participate in a rights offering for new senior subordinated notes (the “Rights Offering Senior Subordinated Notes”) in the principal amount of approximately 27.9% of their claims, or $90 million, and shares of new common stock representing 100% of the equity in the reorganized company. All existing equity would be cancelled for no consideration.

 

General Structure of the Plan of Reorganization

 

The Plan of Reorganization, if consummated, will achieve a consensual de-leveraging of our balance sheet and permit us to become a private company upon emergence from bankruptcy. The Plan of Reorganization includes, among other things, the following key terms:

 

 

 

We expect to continue normal club operations during the restructuring process. If we file the Plan of Reorganization, we would seek to obtain the necessary relief from the Bankruptcy Court to pay the majority of our employee, trade and certain other creditors in full and on time in accordance with existing business terms. Upon effectiveness of the Plan of Reorganization, we would, among other things, amend our charter and by-laws and enter into a stockholders’ agreement and a registration rights agreement with holders of our common shares. In addition, our new Board of Directors will consider adopting a new management long-term incentive plan intended to provide incentives to certain employees to continue their efforts to foster and promote our long-term growth objectives.

 

If we do not receive the necessary votes in favor of the Plan of Reorganization during the solicitation period, we will evaluate other available options, including filing one or more traditional, non-prepackaged Chapter 11 cases.

 

Financial Information About Segments

 

Not applicable.

 

Business Strategy

 

We intend to help our members and prospective members achieve their health and wellness goals, and increase our revenue, earnings and cash flow, as well as our profitability, through a company-wide focus on the following items.

 

Increase membership through continued addition of new members and through improved retention of new and existing members.  We offer prospective members the ability to choose the membership type, amenities and pricing structure they prefer. Prospective members may choose between our multiyear value contract, a month-to-month membership or a paid-in-full annual or multiyear membership. These membership options are presented in a simplified sales process, giving prospective members important choices around membership term, enrollment fee level and monthly payment amount, as well as scope of membership (for example, one club, citywide or national). We believe our membership offerings align with the “consumer choice” mandate prevalent in the retail marketplace. We also believe the choices we offer are an important competitive differentiator in our market space. Our focus is on improving retention rates through new and more focused initiatives to fully engage new members in the full range of our wellness offerings (for example, nutrition programs and nutrition products, weight loss and weight management programs, personal training and group exercise).

 

Leverage our strong, national “Bally Total Fitness” brand.  Our “Bally Total Fitness” and “Bally Sports Club” brands continue to receive high awareness ratings and high marketing recognition from consumers. We believe that strong marketing support at the local, regional and national levels, with messages focused on our target (and in some cases, underserved) market segments is a key to attracting new and retaining present members. Continuing high-focused market research is the key, we believe, to understanding our present members and to identifying geographic markets and consumer segments that present our best opportunities to add new members. This market research and the resulting creative concepts, selectively tested in appropriate markets, helps maximize the effectiveness of our advertising.

Grow our ancillary revenues.  Our large, valuable membership base of approximately 3.5 million members affords us an opportunity to provide members other value-added products and services to help them achieve their health and wellness goals and increase our revenue per member. We offer a comprehensive and extensive list of products and services to members and, depending on the retail distribution channel, to nonmembers, at our fitness centers, retail stores and through other in-store and internet retail channels. These products and services include Bally-branded nutritional products; licensed personal exercise equipment; personal training; group specialty exercise classes; nutrition and weight management programs; Pilates classes; basic workout apparel, packaged drinks and other fitness-related convenience products sold in our retail locations; and our Bally Total Martial Arts (“TMA”) program, the nation’s largest, and offered in over 40 of our fitness centers. Our national presence with multiple fitness center locations in numerous population centers allows us to “test market” new products and services and delivery methods, providing important insights into the best, most profitable ones to offer before a regional or national rollout. Furthermore, we are pursing other ways to leverage our large member base with other national brands and consumer products with the goal of mutually benefiting our members and the owners of those brands and products, while further increasing our revenue.

 

Optimize results from and the investment in our national club portfolio footprint.  We have completed a fitness center portfolio review and have determined key markets where we have a leading share and where there is, we believe, considerable growth opportunity. At the same time, we have identified potential non-strategic locations. We are now determining actions from that review. In January 2006, we completed the sale of the chain of health clubs operated under the “Crunch Fitness” brand and certain additional high-end fitness centers in San Francisco, including the Gorilla Sports brand. In the fourth quarter of 2006, we entered into three sale/leaseback transactions involving eight of our fitness centers. We will consider additional sale/leaseback transactions as well as the sale of certain other non-core fitness centers and real estate, to the extent that such sales would reduce leverage, improve operating efficiencies or reduce operating costs. In June 2007, we completed the sale of substantially all of our Canadian operations.

 

Rationalize and optimize our operating cost structure, consistent with our revenue initiatives, club portfolio actions and improving member experience.  In order to improve our profitability, we will continue to focus on our national, regional and local cost structures, reducing expenses and improving effectiveness where and when appropriate. To this end, in 2006, we reduced our workforce; combined certain functions previously performed in more than one location; eliminated certain management layers; renegotiated rents downward, where possible; closed under-performing clubs; outsourced certain functions; and changed the scale or timing of certain expenditures compared to plans developed earlier in the year in order to improve profitability and conserve liquidity. We also notably improved productivity in certain key business functions, particularly as they relate to member services. Many of these actions were initiated in the second half of 2006 and have already yielded positive results. Actions taken in 2006 are continuing and will continue during 2007 and beyond, and will be expanded around similar or new management actions in order to improve our profitability and liquidity.

 

Membership Plans

 

As noted above, our sales strategy modernized our approach to sales and improved customer satisfaction both immediately after new member sign-up, and during the membership period, with the goal of improving our ability to sell memberships, reducing cancellations and improving member retention. Members have the ability to choose the type of membership (paid-in-full, month-to-month or value plan membership) they prefer. Clearly presenting membership type and amenities enables the member to select the combination of services and monthly payment best suited for their individual circumstances. A monthly paying member pays a modest enrollment fee at the time of joining and is given the option to select either a month-to-month plan membership with the flexibility to discontinue their membership at any point upon prior notice or a multi-year commitment value plan membership at a reduced monthly rate. Paid-in-full members pay their membership fees in full for a committed period of time (typically 12-36 months) upon joining. Members may also add amenities to personalize their membership. Amenity choices cover a range of options, including nationwide access to all our clubs, kids club access, martial arts, nutrition and weight management programs and personal training. Availability varies by club and requires the member to pay additional fees, either one-time or monthly. In addition, members may add family and friends to their membership in a variety of ways, including at a discount at the point of sale.

Enrollment fees represent cash received at time of enrollment for membership fees from members who choose a month-to-month or value plan membership. For month-to-month members, the entire membership fee is typically collected at the time of enrollment, while value plan member enrollment fees represent a down payment on the total membership fee. Under our month-to-month plan memberships, the enrollment fee for joining our Bally Total Fitness brand fitness centers, excluding limited special offers and corporate programs, generally ranges from approximately $0 to $249. Under our value plan memberships, the enrollment fee generally ranges from approximately $0 to $199. Month-to-month enrollment fees currently average approximately $120 per membership, and value plan enrollment fees currently average approximately $70 per membership. In addition, value plan members may choose to pay a higher or lower enrollment fee if they agree to pay a correspondingly lower or higher monthly payment amount. Generally, 30% of new value plan members choose to pay an enrollment fee of less than $49 by agreeing to ongoing higher monthly payment amounts.

 

Monthly payments vary by membership type selected, amenity levels and by whether additional members have been added to the membership. Due to the availability of discounted monthly payments on such add-on contracts, family and friends of primary joining members may be added at monthly rates generally lower than those available for the primary member. Generally during the first two months of 2006, add-on members to value plan memberships were added as nonobligatory members (who may discontinue their membership at any point upon prior notice) while the primary sponsoring member makes payments on an obligatory basis. During the rest of 2006, we sold both obligatory and non-obligatory add-ons to value plan members and believe this will improve the retention of add-on members since obligatory add-ons experience significantly better retention. Single membership monthly payments range from approximately $19 for one club membership plans with minimal amenities to $60 for all club memberships with higher amenity levels. Family add-on members have been added generally for $19 to $24 per month during 2006.

 

Prior to the fourth quarter of 2004, monthly payments were significantly lower after expiration of the obligatory period (which was generally 36 months). This practice led to member retention rates that were higher than the industry average, but also resulted in lower monthly renewal dues payments generally ranging from $12 to $19 for the majority of members who were no longer in their obligatory period. Beginning in late 2004, our value plan membership agreements generally have not provided for significantly discounted payments after a member’s obligatory period ends. However, some members who purchase their membership with higher enrollment fees and/or higher priced national access memberships do qualify for reduced renewal dues after their initial obligatory term. A similar change in renewal pricing has been implemented in our upscale Bally Sports Clubs locations. Bally Sports Clubs offer memberships similar to Bally Total Fitness brand clubs in terms of enrollment fee and monthly payments, but at higher prices, which generally are $20 per month higher than Bally Total Fitness clubs within the same market. The Sports Clubs membership payments vary depending on the membership program selected and are subject to increases after the obligatory period.

 

Members who choose the value plan membership may choose to send in payments by mail or sign up for an electronic payment option where the fixed monthly payment is automatically deducted from a checking, savings or credit card account. Over 93% of month-to-month members and over 67% of value plan members pay electronically. Approximately 70% of all our members pay by making recurring electronic payments. Our experience indicates that members who choose the electronic funds transfer method of payment are more likely to make payments than members who do not choose electronic funds transfer.

 

Products and Services

 

Our fitness center operations provide a unique platform for the delivery of value-added products and services to our fitness, wellness and weight loss-conscious members. By integrating personal training, nutrition products, and our weight management program into our core fitness center operations, we have positioned the Company as the total source for all of our members’ wellness and fitness needs.

 

 

 

Members

 

We define a member as a person whose membership fees or dues are not delinquent by more than 90 days. Our membership was approximately 3.485 million as of December 31, 2006, down approximately 1% from 3.530 million members at December 31, 2005.

Sales and Marketing

 

We devote substantial resources to marketing and promoting our fitness centers, products and services. We believe strong marketing support is important to attracting new members at both existing and new fitness centers as well as promoting our various product and service offerings to both new and current members. We also believe that our sales and marketing efforts compliment other in-club actions and programs to improve member retention. The majority of our fitness centers use the branded mark “Bally Total Fitness,” including 9 upscale fitness centers known as “Bally Sports Clubs.” We believe the nationwide use of the service mark enhances brand identity and increases advertising efficiencies.

 

We operate fitness centers in more than 45 major metropolitan areas representing approximately 62% of the United States population with 300 of our fitness centers located in the top 25 metropolitan areas in the United States. Most of these fitness centers are located near regional, urban and suburban shopping areas and business districts. This concentration of our fitness centers in major metropolitan areas increases the efficiency of our marketing and advertising programs and enhances brand identity and word-of-mouth marketing. In addition, given our broad distribution of fitness centers, we are not dependent upon one customer or group of customers to generate future revenue opportunities. Our highest-volume fitness center accounted for approximately 1% of our net revenues during 2006. Additionally, our market research indicates Bally successfully attracts new members from a diverse variety of market segments in both urban and suburban areas.

 

We advertise primarily on television and, to a lesser extent, through direct mail, newspapers, telephone directories, radio, outdoor signage, on-line advertising, and other promotional activities. Our advertising programs are both national and local. Our marketing approach and organization, as well as our creative approach is developed to reach multiple customer segments in the 18- to 54-year old demographic. Our national scope of operations also allows us to effectively use national television advertising at a lower cost compared to purchasing these spots on a local basis; we believe this is an important competitive advantage.

 

Our sales and marketing programs emphasize the benefits of health, physical fitness, nutrition and exercise by appealing to the public’s desire to lose weight, look and feel better, be healthier, experience an improved quality of life and live longer. We believe providing members a solution to their fitness and nutrition needs, along with flexible membership and payment plans, our strong brand identity and the convenience of multiple locations, constitute additional competitive advantages.

 

Our marketing efforts also include corporate memberships and in-club marketing programs. We sell corporate memberships directly to businesses, as well as directly to their employees through a combination of offsite sales activities and in-club corporate events. Open houses and other monthly in-club activities for members and their guests are used to foster member loyalty and introduce prospective members to our fitness centers. Referral incentive programs are designed to involve current members in the process of new member enrollments and enhance member loyalty. Direct mail and email reminders encourage renewal of existing memberships.

 

We also attract membership interest from visitors to our internet home page at www.ballyfitness.com and continue to explore ways to use the internet as a customer relationship management tool. Membership inquiries via the internet have become an important source of new members. All internet visitors are encouraged to download a free trial membership, as well as set an appointment for an initial visit. We also use the internet to sell Bally goods and services, as well as a one month trial and, from time to time, month-to-month memberships. Our members also use our website to review account status and pay dues.

 

We continue to leverage the Bally brand through strategic marketing alliances with key brands. Most recent alliances include Kraft, Unilever, Discovery Health Channel and Discovery Health Education, Rite-Aid, Gap Body, Foot Locker, Fitness Magazine and Real Age. These alliances heighten public awareness of the Company’s fitness centers and provide incremental revenue via endorsements and/or placement fees.

 

Fitness Centers and Operations

 

Site selection.  Our objective is to select highly-visible locations with high traffic volume, household density and proximity to other generators of retail traffic. Most of our fitness centers are located near regional, urban and suburban shopping areas and business districts of major cities. Since 2003, our strategy for new club development

has been to add clubs to our largest, most profitable markets to reinforce our competitive position in those markets, as well as to take advantage of existing marketing and operating synergies.

 

Fitness center model.  Our current fitness center model offers those fitness services our members use most frequently, such as well-equipped cardiovascular, strength and free weight training areas along with a wide variety of group exercise classes. These centers, typically 25,000 to 35,000 square feet, have recently averaged approximately 30,000 square feet and cost an average of $3.5 million to construct, exclusive of purchased real estate. We generally invest approximately $600,000 in exercise equipment in a model fitness center.

 

Fitness center operations.  Our overall goal is to maximize our members’ experiences by combining exercise instruction with nutrition guidance to assist our members in achieving all of their fitness and weight loss objectives. We believe the most effective way to retain members is by successfully assisting them in reaching their fitness goals and experiencing a higher quality of life. We strive to employ friendly, helpful and fitness informed personnel committed to providing a high level of customer service, creating an environment that meets the needs of our members. We staff our fitness centers with well-trained health, fitness and nutrition professionals. Onsite personal trainers are available to assist in the development of a customized training regimen. Our weight management programs and nutrition products are available at all of our domestic fitness centers and are becoming an increasingly important part of our total fitness offering.

 

Fitness centers vary in size, amenities and types of services provided. All of our fitness centers contain a wide variety of progressive resistance, cardiovascular and conditioning exercise equipment, as well as free weights and stretch areas with small apparatus equipment. Some fitness centers contain amenities such as saunas, steam rooms, whirlpools and swimming pools. Older facilities may contain tennis and/or racquetball courts. Most of our fitness centers also include one or more group exercise studios. Additionally, most of our clubs now have areas specifically designated for personal training.

 

Franchises.  As of December 31, 2006 pursuant to franchise agreements, five fitness clubs in upstate New York, one fitness club in Baton Rouge, Louisiana and one fitness club in Jacksonville, Florida are operating or will operate in the United States as Bally Total Fitness brand clubs. Internationally, six fitness clubs operate as Bally Total Fitness brand clubs pursuant to franchise agreements — one in the Bahamas, three in South Korea and two in Mexico. Pursuant to a joint venture agreement in which the Company holds a 35% interest with China Sports Industry Co., Ltd., 22 fitness centers are operated in China — one under a joint venture agreement and 21 as franchises.

 

Member Account Servicing

 

In addition to having member service representatives at most locations, member services, collection and new and renewal member processing activities are handled at our Norwalk, California national service center, providing continuing efficiencies and cost savings through centralization of these high volume activities. Our members can make monthly membership payments through electronic funds transfer, by mailing a payment to our national service center, by telephone to a customer service agent, via the internet and our interactive voice recognition system (IVR).

 

All collections for past-due accounts are initially handled internally by our national service center. We systematically pursue past-due accounts by utilizing a series of computer-generated correspondence and telephone contacts. Our power-dialer system assists in the efficient administration of our in-house collection efforts. Based on a set period of delinquency, members are contacted by our collectors. Past due members are generally denied entry to the fitness centers. Delinquent accounts are generally written off after 90 days (for those members who have not made any payments) or 194 days (for those members who have made at least one payment), depending on delinquency history. Accounts written off are reported to credit reporting bureaus and selected accounts are then sold to third-party collection services.

 

We prioritize our collection approach based on credit scores and club usage, among other criteria, at various levels of delinquency. By tailoring our membership collection approach to reflect a delinquent member’s likelihood of payment, we believe we can collect more of our membership receivables at a lower cost than using outside collection agencies. We use a national bureau for credit scores.

Competition

 

We operate in a fragmented but highly competitive market. Several of our competitors have access to capital which has fueled their expansion and growth, including entry into key markets served by us. In several cases, these competitors have a more favorable liquidity position than we do. Despite increasing levels of competition, at this time we remain among the largest commercial operators of fitness centers in North America in terms of members, revenues and square footage of our facilities. We are the largest operator, or among the largest operators, of fitness centers in every major market in which we operate fitness centers. Within each market, we primarily compete with other commercial fitness centers; physical fitness and recreational facilities established by local governments, hospitals, and businesses for their employees; the YMCA and similar organizations; and, to a certain extent, with racquet, tennis and other athletic clubs, weight-reduction businesses, and the home-use fitness equipment industry. We also compete, to some degree, with entertainment and retail businesses for the discretionary income of consumers in our target markets. In addition, we face regional competition with increasingly large fitness companies such as 24 Hour Fitness Worldwide, Inc., L.A. Fitness, Inc., Town Sports International Holdings, Inc. (NSDQ: CLUB), Life Time Fitness, Inc. (NYSE: LTM) and Gold’s Gym International, Inc. Other competition comes from new small footprint, lower cost competitors such as Fitness 19, Anytime Fitness and Planet Fitness. We believe our national brand identity, nationwide operating experience, membership options, significant advertising, ability to allocate advertising and administration costs over all of our fitness centers, customized fitness offerings, purchasing power and account processing and collection infrastructure gives us important competitive advantages in our markets.

 

Competition has increased in certain markets from national and regional competitors expanding their scope of operations, and due to the decrease in the barriers to entry into the market with financing available from, among others, financial institutions, landlords, equipment manufacturers, private equity sources and the public capital markets. We believe several competitive factors influence success in the fitness center business, including convenience, price, customer service, quality of operations, quality and innovative programming as well as the ability to secure prime real estate. We believe we benefit from our strong brand identity, our flexible and affordable membership plans, and our large membership base, although we have been adversely affected by our lack of capital and the aging of our facilities, which affects our ability to compete. We expect the persisting increase in competition from well-financed competitors to continue to have an adverse effect on our business. See Item 1A. — Risk Factors.

 

Trademarks and Trade Names

 

The majority of our fitness centers use the service mark “Bally Total Fitness^®.” Other facilities operate under the names “Bally Sports Clubs^sm” and, prior to the June 2007 sale of our Canadian operations, the “The Sports Clubs of Canada^®,” which trademark was assigned to Goodlife Fitness Centres, Inc., an Ontario, Canada corporation (“Goodlife”), in connection with the sale. The use of our trademarks and service marks enhances brand identity and increases advertising efficiencies.

 

Seasonality of Business

 

Historically, we have experienced greater membership originations in the first quarter and lower membership originations in the fourth quarter. Club use (as measured by club visits) by our members is historically higher in the first quarter and then tends to decrease ratably throughout the remaining quarters to a low in the fourth quarter. Member visits are an important driver of our product and service revenue.

 

Employees

 

At December 31, 2006, we had approximately 19,200 employees, 8,800 of which were full-time employees. We are not a party to a collective bargaining agreement with any of our employees. Although we experience high turnover of non-management personnel, historically we have not experienced difficulty in obtaining adequate replacement personnel.

Government Regulation

 

Our operations and business practices are subject to regulation at federal, state and local levels. The general rules and regulations of the Federal Trade Commission (the “FTC”) and of other federal, state, provincial and local consumer protection agencies apply to our franchising, advertising, sales and other trade practices. State statutes and regulations affecting the fitness industry have been enacted or proposed in all of the states in which we conduct business. Typically, these statutes and regulations prescribe certain forms and regulate the terms and provisions of membership contracts, including:

 

 

In addition, we are subject to numerous other types of federal and state regulations governing the sale, financing and collection of memberships, including, among others, the Truth-in-Lending Act and Regulation Z adopted thereunder, as well as state laws governing the collection of debts. These laws and regulations are subject to varying interpretations by a large number of state and federal enforcement agencies and the courts. We maintain internal review procedures in order to comply with these requirements and believe our activities are in substantial compliance with all applicable statutes, rules and regulations.

 

Under so-called “cooling-off” statutes in most states in which we operate, new members of fitness centers have the right to cancel their memberships for a period of three to fifteen days after the date the contract was entered into and are entitled to refunds of any payment made. The amount of time new members have to cancel their membership contract depends on the applicable state law. Further, our membership contracts provide that a member may cancel his or her membership at any time for qualified medical reasons or if the member relocates a certain distance away from any Bally fitness center. The specific procedures for cancellation in these circumstances vary according to differing state laws. In each instance, the canceling member is entitled to a refund of prepaid amounts only. Furthermore, where permitted by law, a cancellation fee is due upon cancellation, which may offset any refunds owed.

 

We are a party to some state and federal consent orders. The consent orders essentially require continued compliance with applicable laws and require us to refrain from activities not in compliance with those laws. From time to time, we make minor adjustments to our operating procedures to remain in compliance with those consent orders.

 

Our nutritional products, and the advertising thereof, are subject to regulation by one or more federal agencies, including the Food and Drug Administration (the “FDA”) and the FTC. For example, the FDA regulates the formulation, manufacture and labeling of vitamins and other nutritional supplements in the United States, while the FTC is principally charged with regulating marketing and advertising claims.

 

We are subject to state and federal labor laws governing our relationship with employees, such as minimum wage requirements, overtime and working conditions and citizenship requirements. Certain job categories are paid at rates related to the federal minimum wage. Accordingly, further increases in the minimum wage would increase labor costs. Our martial arts personnel are generally foreign nationals with expertise in their field and are subject to applicable immigration laws and other regulations.

 

Other

 

Because of the nature of its operations, the Company is not required to carry significant amounts of retail inventory either for delivery requirements to its fitness centers or to assure continuous availability of goods from suppliers.

Recent Developments

 

First Quarter 2007 Operating Trends

 

Operating trends evident in the business through year end 2006 continued in the quarter ended March 31, 2007. Membership cash collections declined 6 percent (approximately $12 million) compared to the 2006 quarter. We had approximately 79,000 fewer members at March 31, 2007 compared to the year earlier date, a 2% reduction. Further, in the first quarter of 2007, we added approximately 12% fewer new members than in the year earlier quarter. The negative effect of the lower volume was only partially mitigated by higher monthly payment amounts for new member additions in each membership group (value, month-to-month and paid-in-full). Lastly, operating expenses in the first quarter of 2007 were approximately 3% lower than the first quarter of 2006, reflecting management actions taken beginning in the fourth quarter of 2006 and continuing into 2007, and reduced expenses resulting from lower new member originations. These operating trends have continued through the second quarter of 2007.

 

NYSE Delisting

 

On May 2, 2007, the NYSE permanently suspended trading of our common stock and delisted the common stock in accordance with Section 12 of the Exchange Act and the rules promulgated thereunder as of June 8, 2007. Since May 2, 2007, our common stock has been quoted on the Pink Sheets Electronic Quotation Service.

 

Sale of Canada Clubs

 

On April 24, 2007, our subsidiaries Bally Matrix Fitness Centre Ltd., an Ontario, Canada corporation (“Matrix”), and BTF Canada Corporation, an Ontario, Canada corporation (“BTF,” and together with Matrix, the “Sellers”), entered into an Asset Purchase Agreement (the “Purchase Agreement”) pursuant to which, among other things, the Sellers transferred five health clubs and certain related assets located in greater metropolitan Toronto in Ontario, Canada, to Extreme Fitness, Inc., an Alberta, Canada unlimited liability corporation (“Extreme Fitness”). In addition, on April 20, 2007, the Sellers entered into an Asset Purchase Agreement with Goodlife to sell 10 additional health clubs located in greater metropolitan Toronto in Ontario, Canada. The Sellers closed on the agreements with Extreme Fitness and Goodlife on June 1, 2007, realizing net cash proceeds of approximately $18 million. The completion of the transactions resulted in the sale of substantially all of our Canadian operations.

 

Management Changes

 

Effective May 31, 2007, Barry R. Elson resigned as Acting Chief Executive Officer of the Company. Mr. Elson is facilitating a transition of his responsibilities by providing consulting services for a 90-day period through August 2007 and by continuing to serve as a member of our Board of Directors (the “Board”). The Board approved a $25,000 monthly stipend to Mr. Elson for such consulting services. Mr. Elson will not receive non-employee director fees during the period he is providing consulting services. We are continuing to search for a permanent Chief Executive Officer.

 

Effective May 4, 2007, the Board appointed Don R. Kornstein to serve as Chief Restructuring Officer responsible for the oversight and implementation of our restructuring efforts and exploration of strategic options for the Company. Mr. Kornstein reports directly to the Company’s Board, of which he is also a member. The Board approved a $50,000 monthly stipend to Mr. Kornstein in connection with such services, in addition to the $50,000 monthly stipend Mr. Kornstein currently receives for his service as interim Chairman of the Board. Mr. Kornstein will not receive non-employee director fees during the period he is receiving either of these monthly stipends.

 

Effective June 5, 2007, the Board of Directors appointed Michael A. Feder to serve as our Chief Operating Officer. Mr. Feder is responsible for oversight and management of our operations. Mr. Feder succeeds former Chief Operating Officer John H. Wildman, who remains employed by us as Senior Vice President, Sales and Interim Chief Marketing Officer. On June 5, 2007, we entered into an Agreement for Interim Management and Restructuring Services (the “APS Agreement”) with AP Services, LLC, an affiliate of AlixPartners, LLP (“AlixPartners”), pursuant to which Mr. Feder serves as our Chief Operating Officer.

On June 13, 2007, we entered into a Confidential Settlement Agreement and Mutual General Release with James A. McDonald, who had been employed by us as our Senior Vice President and Chief Marketing Officer since May 2, 2005, providing for the termination of Mr. McDonald’s employment with us effective June 29, 2007.

 

In addition to the factors discussed in Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, the following factors may affect our future results. If any of the following risks actually occur, our business, financial condition or operating results could be materially adversely affected. In such case, the trading price of our underlying common stock and public debt could decline and investors may lose part or all of their investment. Additional risks and uncertainties, not presently known to us or that we currently deem immaterial, may also impair our business operations. As a result, we cannot predict every risk factor, nor can we assess the impact of all of the risk factors on our business or the extent to which any factor, or combination of factors, may impact our financial condition and results of operations.

 

We may not be able to obtain confirmation of the Plan of Reorganization.

 

We may not receive the necessary votes in favor of the Plan of Reorganization during the consent solicitation period. Even if we receive the requisite consents from creditors, the Bankruptcy Court must confirm the Plan of Reorganization. A number of factors could result in the Bankruptcy Court not confirming the Plan of Reorganization. Even if the Bankruptcy Court determined that the balloting procedures and results were appropriate, the Bankruptcy Court could still decline to confirm the Plan of Reorganization if it found that any of the statutory requirements for confirmation had not been met, including that the terms of the Plan are fair and equitable to non-accepting classes.

 

We will not complete the solicitation of votes for the Plan of Reorganization prior to expiration of applicable forbearance agreements.

 

The Forbearance Agreement, the Senior Notes Forbearance Agreement and the Senior Subordinated Notes Forbearance Agreement terminate on July 13, 2007, while our prepackaged bankruptcy solicitation is not scheduled to expire until July 27, 2007. Upon termination of these forbearance agreements, events of default will occur under the indentures governing the Notes and under the New Facility. If such events of default occur, the lenders under the New Facility and the Trustee under the indentures or the requisite holders of Notes could accelerate the related obligations and exercise any available rights and remedies. While we hope to successfully complete the prepetition solicitation and obtain confirmation of the Plan of Reorganization before any enforcement action is taken by the Lenders or the Trustee or holders of Notes, there can be no assurance that this will occur on the timetable we project. In such event, we would be forced to consider commencing one or more traditional non-prepackaged reorganization cases under Chapter 11 of the Bankruptcy Code, which, as set forth below, would be more protracted and expensive than a prepackaged case.

 

If we do not receive confirmation of the Plan of Reorganization, we may be forced to incur the additional time and expense of more traditional bankruptcy proceedings.

 

We maintain a substantial amount of debt, the terms of which require significant interest payments each year. In 2007, we have substantial interest payments due on our Senior Notes in July and interest and principal on the Senior Subordinated Notes in October, and, in light of our current financial position, we did not make the $14.8 million interest payment due on the Senior Subordinated Notes in April 2007 and may not make other such payments. Moreover, access to the liquidity that might subsequently become available under the New Facility may be limited in the future if decreased revenues or increased expenses limit our ability to comply with the financial covenants under the New Facility, which we are required to meet monthly, as described below. In turn, any such events could negatively impact us, including our relations with members, vendors, and suppliers with whom we conduct or may seek to conduct business.

 

If the Plan of Reorganization is not confirmed and consummated, our capital structure will remain highly leveraged and we will be unable to service our debt obligations or to cure the current defaults thereunder.

Accordingly, we would be forced to evaluate other available options, including filing one or more traditional, non-prepackaged Chapter 11 cases, which would be more protracted and, as a result, more expensive than a prepackaged bankruptcy case.

 

Even if we receive confirmation of the Plan of Reorganization we cannot assure you that we will have sufficient liquidity to meet all known and unforeseen requirements.

 

We reported losses from continuing operations for each of the years 2002 through 2005, and modest income from continuing operations in 2006 of $5.6 million. We expect to continue to be affected by increased competition from well-financed competitors and our own limited ability to invest in capital improvements, including new fitness equipment, due to our constrained liquidity and overall financial condition.

 

We require substantial cash flows to fund capital spending and working capital requirements. Although our liquidity (cash, the unused portions of the Delayed Draw Term Loan and the Revolver) increased by $20.8 million, from $68.9 million to $89.7 million, during 2006, the increased liquidity at December 31, 2006 was primarily due to the $29.1 million unused Delayed Draw Term Loan, which was available at that date to fund capital expenditures and certain improvements. Excluding the effect of the Delayed Draw Term Loan, our liquidity declined $13.3 million in 2006, despite the net proceeds available from the sale of certain clubs and the sale/leaseback transactions in 2006, all of which contributed net proceeds of approximately $33 million after transaction costs, mandatory debt repayments and excluding funds held in escrow. Furthermore, we drew $20.5 million under the Revolver on February 14, 2007 and $19.0 million under the Delayed Draw Term Loan on March 12, 2007, a portion of which was used to finance an equipment purchase of approximately $15.0 million. On June 1, 2007, we received net proceeds of approximately $18 million from the sale of substantially all of our health clubs in Canada. As of June 15, 2007, availability under the facilities was $1.5 million and liquidity was approximately $61 million.

 

Our liquidity may be negatively affected by various items, including declines in membership revenues, which result in reduced levels of cash collections; changes in terms or other requirements by vendors, including our credit card payment processor; regulatory fines; penalties, settlements or adverse results in securities or other litigations; future consent payments to lenders or noteholders, if required; and unexpected capital requirements. We have been required to provide additional letters of credit and cash deposits to support certain vendors, which has reduced our available liquidity. Although management believes that we have adequate liquidity to pay our ordinary course trade and employee obligations, there can be no assurances that we will have sufficient liquidity to meet our debt or other obligations as and when they become due in the presence of the unfavorable scenarios described in this Form 10-K. If revenue and membership cash collection decreases compared to 2006 get larger, expenses increase or a default occurs under the New Facility (whether directly or as a result of a cross-default to other indebtedness) and we do not have or cannot obtain sufficient liquidity to address any such scenario, we would be unable to continue operating our business. Furthermore, pursuant to the New Facility, our depository accounts are subject to control agreements that give the lenders the right to dominion over our cash on deposit in control accounts if an event of default under the New Facility occurs and is continuing.

 

If we do not obtain confirmation of the Plan of Reorganization and we are unable to refinance or extend the maturity of our Senior Subordinated Notes and as a result our New Facility terminates, we will not have sufficient liquidity to meet our obligations.

 

As of May 31, 2007, we had $235 million of outstanding Senior Notes; $300 million of outstanding Senior Subordinated Notes; and $282.2 million in obligations outstanding under the New Facility, including $205.9 million under the term loan portion of the New Facility, $43.6 million under the Revolver (including $20.1 million in letters of credit utilization), and $33 million under the Delayed Draw Term Loan.

 

The Senior Subordinated Notes mature on October 15, 2007. The New Facility will terminate on October 1, 2007 in the event that the Senior Subordinated Notes have not been refinanced on or before October 1, 2007. Further, we have substantial interest payments due on the Senior Notes in July 2007 and interest and principal on the Senior Subordinated Notes in October 2007.

 

We will not have sufficient liquidity if we do not receive the necessary approvals of the Plan of Reorganization and we are unable to refinance or restructure the Senior Subordinated Notes and the New Facility terminates on

October 1, 2007 as a result. If this occurs, we will not have access to cash through the Revolver and the Delayed Draw Term Loan, and amounts outstanding under the New Facility will become immediately due and payable. If the lenders do not extend the maturity of the New Facility or we are unable to obtain additional liquidity, we will not have sufficient liquidity to operate our business and will be unable to satisfy the obligations under the New Facility when due. If such events were to occur, the trustee under the applicable indenture or the requisite holders of Notes could accelerate the related obligations and exercise any other available rights and remedies, and we would be unable to satisfy those obligations. In addition, we could determine not to make interest payments under one or both classes of Notes when due, and the resulting default would trigger cross-defaults under the other class of Notes as well as under the New Facility. If such a default were to occur, the lenders under the New Facility and the trustee under the applicable indenture or the requisite holders of Notes could accelerate the related obligations and exercise any other available rights and remedies, and we would be unable to satisfy those obligations. As described above, other events, such as reduced levels of cash collections, changes in vendor terms, penalties, or unexpected capital requirements, could also affect our ability to meet our obligations and continue operating our business.

 

Without the protection of the Bankruptcy Court, our inability to comply with covenants under the New Facility and indentures governing our Senior Notes and Senior Subordinated Notes could cause our lenders to accelerate our debt.

 

The New Facility requires us to meet certain minimum cash EBITDA and minimum liquidity tests on a monthly basis, as such tests are defined in the New Facility. If we are unable to comply with these covenants, a default would occur under the New Facility, which, if the indebtedness thereunder is accelerated, could also result in a cross-default under the Indentures. Upon a default under the New Facility, we would not have access to the Revolver and the Delayed Draw Term Loan, and the lenders would be entitled to exercise any available rights and remedies, including their right to exercise dominion over our cash on deposits in control accounts.

 

In addition, the New Facility and the Indentures contain covenants that include, among other things, timely financial reporting requirements and restrictions on incurring, making or entering into additional indebtedness, liens, certain types of payments (including common stock dividends and redemptions and payments on existing indebtedness), investments, asset sale and sale and leaseback transactions. We failed to comply with our reporting covenants during 2004, 2005, and the first two quarters of 2006. However, we obtained waivers of the reporting covenants for those periods and filed the required reports within the agreed extended period. As we did not file this Form 10-K by March 16, 2007, and as a result were unable to file our quarterly report on Form 10-Q for the first quarter of 2007, we have been in default under the financial reporting covenants under the Indentures. Pursuant to the New Facility, the cross-default period is 28 days from any financial reporting default notices received under the Indentures. In addition, a default occurred under the New Facility as a result of our failure to deliver certain financial information, including audited financial statements, to the lenders by April 2, 2007. On April 12 and May 14, 2007, we entered into forbearance agreements related to these and other defaults with our lenders under the New Facility and the requisite noteholders under the Indentures, respectively. Refer to Item 1 — Business — Planned Reorganization for a description of these agreements. There can be no assurances that we will be able to comply with the reporting covenants under the New Facility and the Indentures in the future. If we do not receive the necessary approvals of the Plan of Reorganization and we are unable to file our periodic reports on a timely basis, and we cannot obtain additional consents from our noteholders and lenders and an event of default or cross-default occurs under the Indentures, the lenders under the New Facility, the trustee under the applicable indenture or the requisite holders of Notes could accelerate the related obligations and exercise any other available rights and remedies. In such an event, we would be unable to satisfy those obligations.

 

Under the terms of our Plan of Reorganization, we expect our existing stockholders’ investment to be extinguished and intend to become a “private company.”

 

If our Plan of Reorganization is confirmed and implemented, existing common stock will be cancelled and current stockholders will receive no distribution or other consideration in exchange for their shares. In connection with the Plan of Reorganization, we intend to deregister our existing securities under the Exchange Act and become a “private company” upon our emergence from Chapter 11. After such time, our obligation to file reports and other information under the Exchange Act, such as Forms 10-K and 10-Q, will be terminated.

Our liquidity position imposes significant risks to our operations.

 

Our management has devoted significant time to addressing our liquidity needs and will continue to do so. We cannot predict whether we will receive the necessary consents to our Plan of Reorganization. If we do receive the requisite consents and file a Chapter 11 case, we cannot predict when the Plan of Reorganization would be confirmed by the Bankruptcy Court or when we would emerge from bankruptcy. If our bankruptcy is protracted, our ability to continue operating in bankruptcy as a going concern and to emerge from bankruptcy will depend upon management’s ability to balance time and effort dealing with the reorganization and business operations at the same time in a prolonged continuation of our Chapter 11 case.

 

In addition, the timing of our financial restructuring and Plan of Reorganization may affect our relationships with our creditors, members, suppliers and employees. We may not be able to obtain additional financing, either as debtor-in-possession or otherwise, on commercially favorable terms. While we expect to continue normal club operations during our financial restructuring, member perception of our continued viability may affect the rate of new memberships and membership renewals. Because of the public disclosure of our liquidity constraints, our ability to maintain normal credit terms with our suppliers may become impaired. We may also have difficulty maintaining our ability to attract, motivate and retain management and other key employees. Failure to maintain any of these important relationships could adversely affect our business, financial condition and results of operations.

 

We may not be able to attract or retain a sufficient number of members to maintain or expand the business.

 

During each of the last two fiscal years, our number of members declined. We had 3,593,000 members on December 31, 2004, 3,530,000 members on December 31, 2005, and 3,485,000 members on December 31, 2006. The profitability of the Company’s fitness centers is dependent, in large part, on the Company’s ability to originate and retain members. Numerous factors have affected the Company’s membership origination and retention at its fitness centers and that could lead to a further decline in member origination and retention rates in the future, including the inability of the Company to deliver quality service at a competitive cost, the presence of direct and indirect competition in the areas where the Company’s fitness centers are located, delayed reinvestment into aging clubs, and the public’s level of interest in fitness and general economic conditions. Additionally, our announcements regarding the Company’s plans to commence a Chapter 11 bankruptcy case may cause public perception of the Bally brand to deteriorate, and lead to further membership declines. As a result of these factors, there can be no assurance that the Company’s membership levels will be adequate to maintain the business or permit the expansion of its operations. See Item 1 — Business — Business Strategy.

 

We may not be able to continue to compete effectively in the future.

 

We expect the persisting increase in competition to continue to have an adverse effect on our business, liquidity, financial condition and results of operations. In addition, the constraints on our liquidity have limited our ability to invest our operating cash flow in improvements to our fitness centers and address the aging of our facilities, which may affect our ability to compete. Public perception of our declining liquidity, financial condition and results of operations, in particular with regard to our potential failure to meet our debt obligations, may result in additional decreases in cash membership revenues (particularly those associated with longer term membership contracts) and increases in member attrition. In addition, if liquidity problems persist, our suppliers could refuse to provide key products and services in the future. Continuing liquidity concerns could also negatively affect our relationship with employees by decreasing productivity and increasing turnover.

 

We may lose the ability to deduct net operating loss carryforwards.

 

Under federal income tax law, a corporation is generally permitted to deduct from taxable income in any year net operating losses carried forward from prior years. On September 28, 2005, we underwent an “ownership change” (a “Section 382 Ownership Change”) for purposes of Section 382 of the Internal Revenue Code of 1986, as amended (“Section 382”).

 

As a result of the Section 382 Ownership Change in 2005, the use of our federal tax loss carryforwards from periods preceding the 2005 Section 382 Ownership Change is subject to a significant annual limitation under Section 382. We have net operating loss carryforwards of approximately $790 million as of December 31, 2006, approximately $115 million of which are not currently subject to any annual limitation under Section 382. Our

ability to deduct net operating loss carryforwards could be subject to further limitation if we were to undergo an additional Section 382 Ownership Change. There can be no assurances that future restructuring actions by us (including through a reorganization under Chapter 11) or actions by third parties, including dispositions of existing shareholdings, will not trigger a Section 382 Ownership Change resulting in a significant limitation on our ability to deduct net operating loss carryforwards in the future.

 

In connection with confidentiality arrangements between us and each of Liberation Investment Group, LLC and Pardus European Special Opportunities Master Fund LP, we have provided each such stockholder with certain certifications, which enabled trading in our securities by such stockholders as of the close of business on March 15, 2007. Any significant trading activity in our common stock by these stockholders could trigger a Section 382 Ownership Change.

 

Non-compliance with Payment Card Industry Data Standards could adversely affect our business.

 

Similar to others in the retail industry, we are currently not fully compliant with new Payment Card Industry Data Security Standards. We are working cooperatively with our third party assessor, our payment processor and our primary credit card companies to become compliant with these standards and analogous state law requirements. In late 2007, we will become subject to monthly fines, which will continue to be assessed until we are fully compliant. Further, we face the possible loss of our ability to accept credit cards for the payment of memberships and/or the sale of products and services until we are fully compliant. The inability to accept credit cards would have a material adverse impact on our business and results of operations.

 

Weaknesses in our internal controls and procedures could have a material adverse effect on us.

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”). In making its assessment of internal control over financial reporting as of December 31, 2006, management used the criteria described in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. A material weakness is a control deficiency, or combination of control deficiencies that results in a more than remote likelihood a material misstatement of the annual or interim financial statements will not be prevented or detected. These material weaknesses contributed to the restatements of our consolidated financial statements for 2002 and 2003, the adjustment to accumulated deficit as of December 31, 2002, and the restatements of the 2005 condensed quarterly financial statements. We cannot assure you further restatements or adjustments may not be required in the future.

 

Management determined that 11 material weaknesses in our internal control over financial reporting existed as of December 31, 2006. See Item 9A — Controls and Procedures for a description of these material weaknesses and the plan for remediation.

 

Due to the existence of these material weaknesses, management concluded we did not maintain effective internal control over financial reporting as of December 31, 2006, based on the criteria in the “Internal Control — Integrated Framework.” Further, the material weaknesses identified resulted in an adverse opinion by our independent registered public accounting firm on the effectiveness of our internal control over financial reporting.

 

We have developed a remediation plan and have begun to implement remediation measures, each of which is designed to remediate the material weaknesses in our internal controls over the next two years (See Item 9A — Controls and Procedures). We cannot assure you as to when the remediation plan will be fully implemented, nor can we assure you that additional material weaknesses will not be identified by our management or independent accountants in the future. We have incurred and will continue to incur substantial expenses relating to the remediation of material weaknesses in our internal controls identified in our management assessment. These expenses may materially and adversely affect our financial condition, results of operations and cash flows. In addition, even after the remedial measures discussed in Item 9A — Controls and Procedures are fully implemented, our internal controls may not prevent all potential error and fraud, because any control system, no matter how well designed, can only provide reasonable and not absolute assurance that the objectives of the control system will be achieved.

Any adverse outcome of investigations currently being conducted by the SEC or the U.S. Attorney’s Office could have a material adverse impact on us, on the trading prices of our securities and on our ability to access the capital markets.

 

We are cooperating with investigations currently being conducted by the SEC and the U.S. Attorney’s Office. We cannot currently predict the outcome of either of these investigations, which could be material. Nor can we predict whether any additional investigation(s) will be commenced or, if so, the impact or outcome of any such additional investigation(s). Until these existing investigations and any additional investigations that may arise in connection with the historical conduct of the business are resolved, the trading prices of our securities may be adversely affected and it may be more difficult for us to raise additional capital or incur indebtedness or other obligations. If an unfavorable result occurs in any such investigation, we could be required to pay civil and/or criminal fines or penalties, or be subjected to other types of sanctions, which could have a material adverse effect on our operations. Fines, penalties or settlements could also result in a default under our New Facility. The trading prices for our securities or our ability to access the capital markets and our business and financial condition could be further materially adversely affected.

 

The impact of ongoing purported securities class action, derivative and insurance-related litigation may be material. We are also subject to the risk of additional litigation and regulatory action in connection with the restatement of our consolidated financial statements. The potential liability from any such litigation or regulatory action could adversely affect our business.

 

In 2004, we restated our consolidated financial statements for the fiscal year ended December 31, 2003 and 2002. In connection with these restatements, we and certain of our former officers and directors have been named as defendants in a number of lawsuits, including purported class action and stockholder derivative suits and suits by individuals from whom we purchased health club businesses with shares of our common stock. We cannot currently predict the impact or outcome of these litigations, which could be material. The continuation and outcome of these lawsuits and related ongoing investigations, as well as the initiation of similar suits and investigations, may have a material adverse impact on our results of operations and financial condition.

 

In addition, we were named as defendants in actions by several insurers to rescind and/or to obtain a declaration that no coverage is afforded by certain of our excess directors and officers liability insurance policies for the years in which the class action and derivative claims were made. We believe that these actions are without merit and have vigorously defended them and will continue to do so. The Court granted our motions to dismiss two such lawsuits in 2006 and denied a motion in a similar suit in 2007. Despite the dismissal of its case, we have not received any payments from RLI Insurance Company for invoices that we have tendered in respect of outstanding claims. Moreover, we cannot currently predict the impact or outcome of the remaining outstanding litigation, nor can we ensure that we will be able to maintain both our primary and excess directors and officers liability insurance policies, the loss of either of which could be material. The continuation and outcome of these lawsuits, as well as the initiation of similar suits, may have a material adverse impact on our results of operations and financial condition.

 

As a result of the restatements of our consolidated financial statements described herein, we could become subject to additional purported class action, derivative or other securities litigation. As of the date hereof, we are not aware of any additional litigation or investigation having been commenced against us related to these matters, but we cannot predict whether any such litigation or regulatory investigation will be commenced or, if it is, the outcome of any such litigation or investigation. The initiation of any additional securities litigation or investigations, together with the lawsuits and investigations described above, may also harm our business and financial condition.

 

Until the existing litigation and regulatory investigations, any additional litigation or regulatory investigation, and any claims or issues that may arise in connection with the historical conduct of the business are resolved, it may be more difficult for us to raise additional capital or incur indebtedness or other obligations. If an unfavorable result occurred in any such action, our business and financial condition could be further adversely affected.

 

For a further description of the nature and status of these legal proceedings, see Item 3 — Legal Proceedings.

We are subject to various other litigation risks, including class actions that could have a material adverse impact on us.

 

We are, and have been in the past, named as defendants in a number of purported class action lawsuits based on alleged violations of state and local consumer protection laws and regulations governing the sale, financing and collection of membership fees. To date, we have successfully defended or settled such lawsuits without a material adverse effect on our financial condition or results of operations. However, we cannot assure you that we will be able to successfully defend or settle all pending or future purported class action claims, and our failure to do so may have a material adverse effect on our financial condition.

 

From time to time we are party to various lawsuits, claims and other legal proceedings that arise in the ordinary course of business, including claims that may be asserted against us by members, their guests or our employees. We cannot assure you that we will be able to maintain our general liability insurance on acceptable terms in the future or that such insurance will provide adequate coverage against potential claims.

 

We are subject to extensive government regulation. Changes in these regulations could have a negative effect on our financial condition and operating results.

 

Our operations and business practices are subject to federal, state and local government regulations in the various jurisdictions where our fitness centers are located and where our nutritional products are sold, including:

 

 

We are also a party to several state and federal consent orders. These consent orders essentially require continued compliance with applicable laws and require us to refrain from activities not in compliance with such applicable laws. From time to time, we make minor adjustments to our operating procedures to remain in compliance with applicable laws and we believe our operations are in material compliance with all applicable statutes, rules and regulations. Our failure to comply with these statutes, rules and regulations may result in fines or penalties. Penalties may include regulatory or judicial orders enjoining or curtailing aspects of our operations. It is difficult to predict the future development of such laws or regulations, and although we are not aware of any material proposed changes, any changes in such laws could have a material adverse effect on our financial condition and results of operations.

 

Our success depends in significant part upon the continuing service of management and our ability to attract and retain a sufficient number of qualified personnel to meet our business needs.

 

Our success depends in significant part upon the continuing service and capabilities of our management team. The failure to retain management could have a material adverse effect on our business. Our success will be dependent on our continued ability to attract, retain and motivate highly skilled employees. On August 11, 2006, we announced the departure of Paul A. Toback as our Chairman, President and Chief Executive Officer, and the appointment of Don R. Kornstein as interim Chairman and Barry R. Elson as Acting Chief Executive Officer. Effective May 4, 2007, the Board appointed Mr. Kornstein to serve as Chief Restructuring Officer responsible for the oversight and implementation of our restructuring efforts and exploration of strategic options. Effective May 31, 2007, Mr. Elson resigned as Acting Chief Executive Officer. Mr. Elson will continue to serve in a consulting capacity through August 31, 2007. Messrs. Kornstein and Elson remain as members of the Board of Directors. The Board of Directors is currently conducting a search for a permanent Chief Executive Officer. We cannot assure you that we will be able to identify and hire a permanent Chief Executive Officer. Even if we are successful at finding and hiring a suitable Chief Executive Officer, leadership transitions can be inherently difficult to manage and may cause disruption to our business or some turnover in our workforce or management team.

We will continue to incur an indeterminable amount of expense for support of external investigations and the development and implementation of improved internal controls and procedures.

 

The external investigations into our business practices have extended over a number of years and we are uncertain when the investigations will be completed. For as long as the investigations are ongoing, we will continue to incur incremental legal and other expenses and our management personnel and staff will be required to devote time gathering information and responding to questions raised by persons conducting the investigations. In addition, remediating our inadequate internal controls has required substantial time and effort on the part of our personnel and will continue to do so. We cannot predict the ultimate cost of the time we will need to devote to the investigations into and remediation of our internal control procedures.

 

Our trademarks and trade names may be misappropriated or subject to claims of infringement.

 

We attempt to protect our trademarks and trade names through a combination of trademark and copyright laws, as well as licensing agreements and third-party nondisclosure agreements. Our failure to obtain or maintain adequate protection of our intellectual property rights for any reason could have a material adverse effect on our business, results of operations and financial condition.

 

None.

 

Our executive office is located in leased office space (approximately 70,000 square feet) in an office park in Chicago, Illinois. We also lease space in Norwalk, California for our national service center, and Towson, Maryland primarily for our information systems.

 

The following table sets forth information concerning the fitness centers we operate:

 

 

 

 

 

The leases for fitness centers we have entered into in the last five years generally provide for an initial term of 15 years. Most leases include at least one five-year option to renew and often include two or more such options.

 

Substantially all of our properties are subject to liens under the New Facility or other mortgages.

 

The table below lists the number of clubs we operated at December 31, 2006 in the top 25 U.S. markets (based on TV households, as ranked by Nielsen Media Research) and Toronto, Canada:

 

 

 

 

Putative Securities Class Actions

 

Between May and July 2004, ten putative securities class actions, now consolidated and designated In re Bally Total Fitness Securities Litigation were filed in the United States District Court for the Northern District of Illinois against the Company and certain of its former and current officers and directors. Each of these substantially similar lawsuits alleged that the defendants violated Sections 10(b) and/or 20(a) of the Exchange Act, as well as the associated Rule 10b-5, in connection with the Company’s proposed restatement.

 

On March 15, 2005, the Court appointed a lead plaintiff and on May 23, 2005 the Court appointed lead plaintiff’s counsel. By stipulation of the parties, the consolidated lawsuit was stayed pending restatement of the Company’s financial statements in November 2005. On December 30, 2005, plaintiffs filed an amended consolidated complaint, asserting claims on behalf of a putative class of persons who purchased Bally stock between August 3, 1999 and April 28, 2004, and adding the Company’s former outside audit firm, Ernst & Young LLP as an additional defendant. On July 12, 2006, the Court granted defendants’ motions to dismiss the amended consolidated complaint and dismissed the complaint in its entirety, without prejudice to plaintiffs filing an amended complaint on or before August 14, 2006. An amended complaint was filed on August 14, 2006. Defendants filed motions to dismiss the amended complaint on September 28, 2006. On February 20, 2007 the Court issued a Memorandum Opinion and Order dismissing claims against all defendants with prejudice. Plaintiffs filed a Notice of Appeal on March 23, 2007. On April 18, 2007, the Court granted Plaintiff’s unopposed Motion to Suspend Briefing, suspending briefing pending a ruling by the United States Supreme Court regarding the Seventh Circuit’s standard for pleading scienter in Makor Issues & Rights v. Tellabs and directing the parties to file position statements within 14 days of the issuance of the Supreme Court’s decision. The Supreme Court’s decision was issued on June 21, 2007. It is not yet possible to determine the ultimate outcome of this action.

 

Stockholder Derivative Lawsuits in Illinois State Court

 

On June 8, 2004, two stockholder derivative lawsuits were filed in the Circuit Court of Cook County, Illinois, by two Bally stockholders, David Schacter and James Berra, purportedly on behalf of the Company against Paul Toback, James McAnally, John Rogers, Jr., Lee Hillman, John Dwyer, J. Kenneth Looloian, Stephen Swid, George Aronoff, Martin Franklin and Liza Walsh, who are former officers and/or directors. These lawsuits allege claims for breaches of fiduciary duty against those individuals in connection with the Company’s restatement regarding the timing of recognition of prepaid dues. The two actions were consolidated on January 12, 2005. By stipulation of the parties, the consolidated lawsuit was stayed pending restatement of the Company’s financial statements in November 2005. An amended consolidated complaint was filed on February 27, 2006. The Company filed a motion to dismiss on May 20, 2006, directed solely to the issue of whether plaintiffs have adequately alleged demand futility as required by applicable Delaware law in order to establish standing to sue derivatively. Shortly before oral argument on that motion, the parties executed a Memorandum of Understanding memorializing a settlement in principle of all claims. On May 18, 2007, the Court entered a Preliminary Order provisionally approving the Stipulation of Settlement subject to notice and a hearing on June 19, 2007. On June 19, 2007, the Court entered a final order approving the parties’ settlement and dismissing the action with prejudice.

 

Stockholder Derivative Lawsuits in Illinois Federal Court

 

On April 5, 2005, a stockholder derivative lawsuit was filed in the United States District Court for the Northern District of Illinois, purportedly on behalf of the Company against certain former officers and directors of the Company by another of the Company’s stockholders, Albert Said. This lawsuit asserts claims for breaches of fiduciary duty in failing to supervise properly its financial and corporate affairs and accounting practices. Plaintiff also requests restitution and disgorgement of bonuses and trading proceeds under Delaware law and the Sarbanes-Oxley Act of 2002. By stipulation of the parties, the lawsuit was stayed pending restatement of the Company’s financial statements in November 2005. An amended consolidated complaint was filed on February 27, 2006. The Company filed a motion to dismiss on May 30, 2006, directed solely to the issues of whether the court has subject matter jurisdiction and whether plaintiffs have adequately alleged demand futility as required by applicable Delaware law in order to establish standing to sue derivatively. On March 27, 2007, the Court entered an order

indicating its intention to convert the Company’s motion to a motion for summary judgment and requiring the Company to file a new motion and brief, which the Company did on April 13, 2007. That motion is currently pending. On June 18, 2007, the Company and plaintiffs reached an agreement in principle to resolve the action. It is not yet possible to determine the ultimate outcome of this action.

 

Individual Securities Action in Illinois

 

On March 15, 2006, a lawsuit captioned Levine v. Bally Total Fitness Holding Corporation, et al., Case No. 06 C 1437 was filed in the United States District Court for the Northern District of Illinois against the Company, certain of its former officers and directors, and its former outside audit firm, Ernst & Young, LLP. Plaintiff’s complaint alleged violations of Sections 10(b), 18 and 20(a) of the Exchange Act, SEC Rule 10b-5, and the Illinois Consumer Fraud and Deceptive Practices Act, as well common law fraud in connection with the Company’s restatement. The Court found this action related to the consolidated securities class action discussed above, and transferred it to the judge before whom the class action cases were pending. After defendants filed motions to dismiss the complaint and after the Court granted motions to dismiss the class action cases, plaintiff moved for leave to amend its complaint. On July 19, 2006, the Court denied plaintiff’s motion and ordered completion of briefings on defendant’s motions to dismiss on statute of limitations issues. On September 29, 2006, the Court granted defendant’s motion to dismiss plaintiff’s Section 18 claim as untimely, denied the motion as to Sections 10(b) and 20(a), dismissed Ernst & Young, LLP as a defendant and granted plaintiff leave to amend his complaint. An amended complaint was filed on November 3, 2006. The Company filed a motion to dismiss the amended complaint on January 5, 2007. On April 2, 2007, the Court granted the Company’s motion and dismissed the case with prejudice. Plaintiff did not file a timely Notice of Appeal of this dismissal, but instead filed a new action in the Circuit Court of Cook County, Illinois, Case No. 07 L 4280, asserting only claims for common law fraud and under the Illinois Consumer Fraud and Deceptive Practices Act. The Company has not yet answered the complaint. It is not yet possible to determine the ultimate outcome of this action.

 

Lawsuit in Oregon

 

On September 17, 2004, a lawsuit captioned Jack Garrison and Deane Garrison v. Bally Total Fitness Holding Corporation, Lee S. Hillman and John W. Dwyer, CV 04 1331, was filed in the United States District Court for the District of Oregon. The plaintiffs alleged that the defendants violated certain provisions of the Oregon Securities Act, breached the contract of sale, and committed common-law fraud in connection with the acquisition of the plaintiffs’ business in exchange for shares of Bally stock.

 

On April 7, 2005, all defendants joined in a motion to dismiss two of the four counts of plaintiffs’ complaint, including plaintiffs’ claims of breach of contract and fraud. On November 28, 2005, the District Court granted the motion to dismiss plaintiffs’ claims for breach of contract and fraud against all parties. Motions for summary judgment were filed on April 21, 2006. On July 27, 2006, the presiding Magistrate Judge issued proposed Findings and Conclusions recommending that summary judgment be entered in favor of all defendants on all remaining claims. The parties thereafter reached agreement under which plaintiffs would dismiss their case without appealing the Magistrate Judge’s recommendation. The parties executed a final Settlement Agreement on October 16, 2006, and final judgment dismissing the action with prejudice was entered on November 26, 2006.

 

Lawsuit in Massachusetts

 

On March 11, 2005, plaintiffs filed a complaint in the matter of Fit Tech Inc., et al. v. Bally Total Fitness Holding Corporation, et al., Case No. 05-CV-10471 MEL, pending in the United States District Court for the District of Massachusetts. This action is related to an earlier action brought in 2003 by the same plaintiffs in the same court alleging breach of contract and violation of certain earn-out provisions of an agreement whereby the Company acquired certain fitness centers from plaintiffs in return for shares of Bally stock. The 2005 complaint asserted new claims against the Company for violation of state and federal securities laws on the basis of allegations that misrepresentations in Bally’s financial statements resulted in Bally’s stock price to be artificially inflated at the

time of the Fit-Tech transaction. Plaintiffs also asserted additional claims for breach of contract and common law claims. Certain employment disputes between the parties to this litigation are also subject to arbitration in Chicago.

 

Plaintiffs’ claims are brought against the Company and its former Chairman and CEO Paul Toback, as well as former Chairman and CEO Lee Hillman and former CFO John Dwyer. Plaintiffs have voluntarily dismissed all claims under the federal securities laws, leaving breach of contract, common law and state securities claims pending. On April 4, 2006, the Court granted motions to dismiss all claims against defendants Hillman and Dwyer for lack of jurisdiction. All remaining claims were dismissed with prejudice pursuant to a confidential stipulation of settlement, which was filed on November 3, 2006.

 

Securities and Exchange Commission Investigation

 

In April 2004, the Division of Enforcement of the SEC commenced an investigation in connection with the Company’s restatement. The Company continues to fully cooperate in the ongoing SEC investigation. It is not yet possible to determine the ultimate outcome of this investigation.

 

Department of Justice Investigation

 

In February 2005, the United States Justice Department commenced a criminal investigation in connection with the Company’s restatement. The investigation is being conducted by the United States Attorney for the Northern District of Illinois. The Company is fully cooperating with the investigation. It is not yet possible to determine the ultimate outcome of this investigation.

 

Demand Letters

 

On December 27, 2004, the Company received a stockholder demand that it bring actions or seek other remedies against parties potentially responsible for the Company’s accounting errors. The Board appointed a Special Demand Evaluation Committee consisting of three independent directors to evaluate that request. On June 21, 2005, the Company received a second, substantially similar, stockholder demand, which the Special Demand Evaluation Committee also evaluated along with the other stockholder demand. The Special Demand Evaluation Committee retained independent counsel, Sidley & Austin LLP, to assist it in evaluating the demands.

 

On March 10, 2006, the Company’s Board of Directors accepted the recommendation of its Special Demand Evaluation Committee that no further action be taken at this time against any current or former officers or directors of the Company regarding the matters raised in the two shareholder demand letters. The Committee’s recommendation, based on the report of its independent counsel and adopted by the Board of Directors, was based on consideration of a variety of factors, including (i) the nature and strength of the Company’s potential claims; (ii) defenses available to the officers and directors; (iii) potential damages and resources available to satisfy any damages award; (iv) the Company’s indemnification and advancement obligations under its charter, bylaws, and individual agreements; (v) potential expenses to the Company and potential counterclaims arising from the pursuit of potential civil claims; and (vi) business disruption and employee morale issues.

 

Insurance Lawsuits

 

On November 10, 2005, two of the Company’s excess directors and officers liability insurance providers filed a complaint captioned Travelers Indemnity Company and ACE American Insurance Company v. Bally Total Fitness Holding Corporation; Holiday Universal, Inc. n/k/a Bally Total Fitness of the Mid-Atlantic, Inc; George N. Aronoff; Paul Toback; John W. Dwyer; Lee S. Hillman; Stephen C. Swid; James McAnally; J. Kenneth Looloian; Liza M. Walsh; Annie P. Lewis, as Executor of the Estate of Aubrey C. Lewis, Deceased; Theodore Noncek; Geoff Scheitlin; John H. Wildman; John W. Rogers, Jr.; and Martin E. Franklin, Case No. 05C 6441, in the United States District Court for the Northern District of Illinois. The complaint alleged that financial information included in the

Company’s applications for directors and officers liability insurance in the 2002-2004 policy years was materially false and misleading. Plaintiff requested the Court to declare two of the Company’s excess policies for the year 2002-2003 void, voidable and/or subject to rescission, and to declare that the exclusions and/or conditions of a separate excess policy for the year 2003-2004 bar coverage with respect to certain of the Company’s claims. Firemans Fund, another excess carrier, was allowed to join in the case on January 4, 2006. Defendants filed motions to dismiss or stay the proceedings on February 10, 2006. The motion to dismiss was granted on September 11, 2006.

 

On April 6, 2006, an additional excess directors and officers liability insurance provider filed a complaint captioned RLI Insurance Company v. Bally Total Fitness Holding Corporation; Holiday Universal, Inc.; George N. Aronoff; Paul Toback; John H. Dwyer; Lee S. Hillman; Stephen C. Swid; James McAnally; J. Kenneth Looloian; Liza M. Walsh; Annie P. Lewis, as Executor of the Estate of Aubrey C. Lewis, Deceased; Theodore Noncek; Geoff Scheitlin; John H. Wildman; John W. Rogers, Jr.; and Martin E. Franklin, Case No. 06CH06892 in the circuit court of Cook County, Illinois, County Department Chancery Division. The complaint alleged that financial information included in the Company’s applications for directors and officers liability insurance in the 2002-2003 policy year was materially false and misleading. Plaintiff requested the Court to declare the Company’s excess policy for the year 2002-2003 void, voidable and/or subject to rescission. Defendants filed motions to dismiss or stay the proceedings on July 10, 2006, and a motion for advancement of defense costs and to compel interim funding on October 20, 2006. On November 16, 2006, the Court granted Defendants’ motion to dismiss.

 

On August 22, 2006, the Company’s primary directors and officers insurance provider for the policy years 2001-2002 and 2002-2003 filed a complaint captioned Great American Insurance Company v. Bally Total Fitness Holding Corporation, Case No. 06 C 4554 in the United States District Court for the Northern District of Illinois. The complaint alleged that financial information included in the Company’s applications for directors and officers liability insurance in the 2001-2002 and 2002-2003 policy years was materially false and misleading. Plaintiff requested the Court to declare the Company’s primary policies for those years void ab initio and rescinded, and to award plaintiff all sums that plaintiff has paid pursuant to an Interim Funding and Non-Waiver Agreement between the parties, which consists of the $10 million limit of the 2002-2003 primary policy and additional amounts paid pursuant to the 2001-2002 primary policy. The Company filed a motion to dismiss or stay the proceedings on October 12, 2006. On April 26, 2007, the Court denied Defendant’s motion. On June 8, 2007, plaintiff filed a motion for summary judgment, which motion remains pending. On June 11, 2007, the Company filed its answer and counterclaims to Great American’s complaint for rescission, as well as a third-party complaint against RLI Insurance Company and other third party defendants. It is not yet possible to determine the ultimate outcome of the insurance litigation.

 

Other

 

The Company is also involved in various other claims and lawsuits incidental to its business, including claims arising from accidents at its fitness centers. In the opinion of management, the Company is adequately insured against such claims and lawsuits, and any ultimate liability arising out of such claims and lawsuits should not have a material adverse effect on the financial condition or results of operations of the Company. In addition, from time to time, customer complaints are investigated by various governmental bodies. In the opinion of management, none of these other complaints or investigations currently pending should have a material adverse effect on our financial condition or results of operations.

 

In addition, we are, and have been in the past, named as defendants in a number of purported class action lawsuits based on alleged violations of state and local consumer protection laws and regulations governing the sale, financing and collection of membership fees. To date we have successfully defended or settled such lawsuits without a material adverse effect on our financial condition or results of operations. However, we cannot assure you that we will be able to successfully defend or settle all pending or future purported class action claims, and our failure to do so may have a material adverse effect on our financial condition or results of operations. See Item 1 — Business — Government Regulation and Item 1A — Risk Factors.

 

Annual Meeting of Stockholders held on December 19, 2006

 

At the Annual Meeting of Stockholders held December 19, 2006, Don R. Kornstein was reelected as a director of the Company. Eric Langshur, Barry R. Elson and Charles J. Burdick continued as directors of the Company after the meeting.

 

In addition, the Company’s proposal to adopt the 2007 Omnibus Equity Compensation Plan was approved and the proposal to ratify the appointment of KPMG LLP as independent auditor was approved.

 

The votes were as follows, with holders of 35,710,851 shares of Common Stock represented in person or by proxy out of 41,286,512 shares outstanding on the record date:

 

 

 

As of March 31, 2007, our common stock was traded on the NYSE under the symbol “BFT”. The following table sets forth, for the periods indicated, the high and low quarterly sales prices for a share of our common stock as reported on the NYSE through May 1, 2007, and on an over-the-counter basis thereafter.

 

 

As set forth above in “Recent Events,” the NYSE has delisted our common stock. Our common stock continues to be traded on an over-the-counter basis under the symbol “BFTH” and market maker quotations are displayed on the Pink Sheets Electronic Quotation Service.

 

As of May 31, 2007, there were 6,846 holders of record of our common stock.

 

We have not paid a cash dividend on our common stock since we became a public company in January 1996 and do not anticipate paying dividends in the foreseeable future. The terms of our New Facility restrict us from paying dividends without the consent of the lenders during the term of the agreement. In addition, the indentures for our Senior Notes and Senior Subordinated Notes generally limit dividends paid by us to the aggregate of 50% of consolidated net income, as defined, earned after January 1, 1998 and the net proceeds to us from any stock offerings and the exercise of stock options and warrants.

 

On October 18, 2005, our Board of Directors adopted a Stockholder Rights Plan (“Rights Plan”), authorized a new class of and issuance of up to 100,000 shares of Series B Junior Participating Preferred Stock, and declared a dividend of one preferred share purchase right (the “Right”) for each share of Common Stock held of record at the close of business on October 31, 2005. Each Right, if and when exercisable, entitled its holder to purchase one one-thousandth of a share of Series B Junior Participating Preferred Stock at a price of $13.00 per one one-thousandth of a Preferred Share subject to certain anti-dilution adjustments. The Rights Plan terminated pursuant to its terms on July 15, 2006.

 

Repurchases of Common Stock

 

We do not regularly repurchase shares nor do we have a share repurchase program. Furthermore, the terms of our New Facility generally do not allow us to repurchase common stock without lender approval. We do not expect to repurchase any of our common stock in the foreseeable future.

Securities Authorized for Issuance Under Equity Compensation Plans

 

The information required by Item 201(d) of Regulation S-K is provided under Item 12 — Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters — Securities Authorized for Issuance Under Equity Compensation Plans.

 

COMPARISON OF 65 MONTH CUMULATIVE TOTAL RETURN*

Among Bally Total Fitness Holding Corporation, The S&P 500 Index

And The Russell 2000 Consumer Discretionary Index

 

 

* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends.
Fiscal year ending December 31.

 

 

The information set forth below should be considered in the context of the following overall trends and factors:

 

 

The following selected financial data reflects certain results of operations and certain balance sheet data for the years ended 2002 to 2006. The data below should be read in conjunction with, and is qualified by reference to

Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto included elsewhere in this report.

 

Selected Financial Data

 

 

 

 

 

The following discussion of the financial condition and results of operations of Bally should be read in conjunction with Item 8 — Consolidated Financial Statements and Supplementary Data and Item 1A — Risk Factors.

 

The information and discussion set forth below should be considered in the context of the following overall trends and factors:

 

 

Accordingly, and in light of the severe financial difficulties facing the Company, Management’s Discussion and Analysis is presented in the following order:

 

Executive Summary of Business

Financial Condition

Cash Flows

Capital Requirements and Contractual Obligations

Dividend and Other Commitments

Debt

Off-Balance Sheet Arrangements

Critical Accounting Policies

Results of Operations

Recently Issued Accounting Standards

 

Executive Summary of Business

 

Bally is among the largest full-service commercial operators of fitness centers in North America in terms of members, revenues and square footage of its facilities. As of December 31, 2006, we operated 375 fitness centers collectively serving approximately 3.5 million members. These 375 fitness centers occupied a total of 11.8 million square feet.

 

Our fitness centers are concentrated in major metropolitan areas in 26 states and the District of Columbia, with 300 fitness centers located in the top 25 metropolitan areas in the United States. As of December 31, 2006, we operated fitness centers in over 45 major metropolitan areas representing 62% of the United States population. In 2006, approximately 69% of new joining members elected a membership plan allowing multiple club access, varying between market and nationwide access. Members electing multiple center access are required to make larger monthly payments than those who select a single club membership. At December 31, 2006, 86% of our members had multiple club access memberships.

 

Concentrating our clubs in major metropolitan areas has the additional benefits of (i) providing our members access to multiple locations to facilitate achieving their fitness goals; (ii) strengthening the Bally Total Fitness brand awareness; (iii) leveraging national advertising; (iv) enabling the Company to develop promotional partnerships with other national or regional companies; and (v) more cost effective regional management and control by leveraging our existing operations in those markets.

 

Financial Condition

 

We reported losses from continuing operations for each of the years 2002 through 2005. These losses are expected to persist despite a modest profit from continuing operations in 2006 of $5.6 million. Further, we expect to continue to be affected by increased competition from well-financed competitors and our own limited ability to invest in capital improvements, including new fitness equipment, due to our constrained liquidity and overall financial condition. We expect the persisting increase in competition to continue to have an adverse effect on our business, liquidity, financial condition and results of operations. In addition, the constraints on our liquidity have limited our ability to invest our operating cash flow in improvements to our fitness centers and address the aging of our facilities, which may affect our ability to compete. Public perception of our declining liquidity, financial condition and results of operations, in particular with regard to our potential failure to meet our debt obligations, may result in additional decreases in cash membership revenues (particularly those associated with longer term membership contracts) and increases in member attrition. In addition, if liquidity problems persist, our suppliers could refuse to provide key products and services in the future. Continuing liquidity concerns could also negatively affect our relationship with employees by decreasing productivity and increasing turnover.

 

The value of our consolidated assets has decreased substantially from $495.1 million as of December 31, 2005 to $396.8 million as of December 31, 2006. This decrease of $98.3 million was due primarily to:

 

 

 

As a result of our deteriorating financial condition and pending debt requirements, in November 2005 we began considering strategic alternatives. To this end, we engaged JP Morgan Securities, Inc. and The Blackstone Group to assist us in commencing a process to identify and evaluate strategic alternatives, including without limitation a sale of substantially all of our assets. This process, which was conducted under the direction of the Strategic Alternatives Committee of the Board, did not result in a strategic transaction. We subsequently retained Jefferies & Company in February 2007 as our financial advisors. In March 2007, certain holders of our Senior Notes and Senior Subordinated Notes formed an Ad Hoc Committee and we began discussions with them with respect to de-leveraging our balance sheet. In April 2007, we were required to make an interest payment of $14.8 million on our Senior Subordinated Notes. We elected not to make this interest payment and an event of default occurred under the Senior Subordinated Notes Indenture, which also triggered an event of default under the Senior Notes Indenture. In April and May 2007, we entered into forbearance agreements with the Lenders under our New Facility and the requisite noteholders under the Indentures relating to these and other defaults, which forbearance agreements expire on July 13, 2007.

 

On June 27, 2007, we commenced a solicitation of votes on the Plan of Reorganization from holders of the Senior Notes and Senior Subordinated Notes. If we receive the requisite votes in favor of the Plan of Reorganization, we intend to file a voluntary prepackaged petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the Bankruptcy Court in late July 2007. Prior to commencement of the consent solicitation, we entered into a Restructuring Support Agreement with holders of a majority of the Senior Notes and more than 80% of the Senior Subordinated Notes, in which the consenting noteholders agreed to vote in favor of the Plan of Reorganization, on the terms and conditions specified therein. Under certain circumstances, we may file for bankruptcy prior to the end of the solicitation period. The Plan of Reorganization includes, among other things, the following key terms:

 

 

 

We expect to continue normal club operations during the restructuring process. If we file the Plan of Reorganization, we would seek to obtain the necessary relief from the Bankruptcy Court to pay the majority of our employee, trade and certain other creditors in full and on time in accordance with existing business terms. Upon effectiveness of the Plan of Reorganization, we would, among other things, amend our charter and by-laws and enter into a stockholders’ agreement and a registration rights agreement with holders of our common shares. In addition, our new Board of Directors will consider adopting a new management long-term incentive plan intended to provide incentives to certain employees to continue their efforts to foster and promote our long-term growth objectives.

 

If we do not receive the necessary votes in favor of the Plan of Reorganization during the solicitation period, we will evaluate other available options, including filing one or more traditional, non-prepackaged Chapter 11 cases.

 

Liquidity and Capital Resources

 

Our liquidity (cash, the unused portions of the Delayed Draw Term Loan and the Revolver) increased by $20.8 million, from $68.9 million to $89.7 million, during 2006. The increased liquidity at December 31, 2006 was primarily due to the $29.1 million unused Delayed Draw Term Loan, which was available at that date to fund capital expenditures and certain improvements. Excluding the effect of the Delayed Draw Term Loan, our liquidity declined $13.3 million in 2006, despite the net proceeds available from the sale of certain clubs and the sale/leaseback transactions in 2006, all of which contributed net proceeds of approximately $33 million after transaction costs, mandatory debt repayments and excluding funds held in escrow. Furthermore, we drew $20.5 million under the Revolver on February 14, 2007 and $19.0 million under the Delayed Draw Term Loan on March 12, 2007, a portion of which was used to finance an equipment purchase of approximately $15.0 million. On June 1, 2007, we received proceeds of approximately $18 million from the sale of substantially all of our health clubs in Canada. As of June 15, 2007, availability under these facilities was $1.5 million and our liquidity was approximately $61 million, most of which represented cash on hand.

The following table summarizes the Company’s liquidity (in millions):

 

 

We maintain a substantial amount of debt, the terms of which require significant interest payments each year. In 2007, we have substantial interest payments due on our Senior Notes in July and on the Senior Subordinated Notes in October. In light of our current financial situation, we did not make the interest payment due on the Senior Subordinated Notes in April 2007 and may not make other such interest payments. Moreover, access to the liquidity that might subsequently become available under the New Facility may be limited if future decreased membership cash collections or increased expenses limit our ability to comply with the financial covenants under the New Facility, which we are required to meet monthly, as described below. In turn, any such events could negatively impact us, including our relations with members, vendors, and suppliers with whom we conduct or may seek to conduct business.

 

The New Facility requires us to meet certain minimum cash EBITDA and minimum liquidity tests on a monthly basis, as such tests are defined in the New Facility. If we are unable to comply with these covenants, a default would occur under the New Facility, which, if the indebtedness thereunder is accelerated, could also result in a cross-default under the Indentures. Upon a default under the New Facility, unless waived, we would not have access to the Revolver and the Delayed Draw Term Loan, and the lenders would be entitled to exercise any available rights and remedies, including their right to exercise dominion over our cash on deposit in control accounts.

 

In addition, the New Facility and the Indentures contain covenants that include, among other things, timely financial reporting requirements and restrictions on incurring, making or entering into additional indebtedness, liens, certain types of payments (including common stock dividends and redemptions and payments on existing indebtedness), investments, asset sales, and sale and leaseback transactions. We failed to comply with our reporting covenants during 2004, 2005, and the first two quarters of 2006. However, we obtained waivers of the reporting covenants for those periods and filed the required reports within the agreed extended period. As we did not file this Form 10-K by March 16, 2007, and as a result were unable to file our quarterly report on Form 10-Q for the first quarter of 2007, defaults occurred under the financial reporting covenants under the Indentures. Pursuant to the New Facility, the cross-default period is 28 days from any financial reporting default notices received under the Indentures. In addition, as discussed above, a default occurred under the New Facility as a result of our failure to deliver certain financial information, including audited financial statements, to the lenders by April 2, 2007. On April 12 and May 14, 2007, we entered into forbearance agreements related to these and other defaults with our lenders under the New Facility, and the requisite noteholders under the Indentures, respectively. There can be no assurances that we will be able to comply with the reporting covenants under the New Facility and the Indentures in the future. If we are unable to file our periodic reports on a timely basis and cannot obtain the requisite approvals of the Plan of Reorganization or additional consents from our noteholders and lenders and an event of default or cross-default occurs under the Indentures, the lenders under the New Facility, the Trustee under the applicable indenture or the requisite holders of Notes could accelerate the related obligations and exercise any other available rights and remedies. In such an event, we would be unable to satisfy those obligations.

Our operating cash flows will not be sufficient to meet our expected needs for working capital and other cash requirements through December 31, 2007. On April 16, 2007, we did not make an interest payment of $14.8 million on our Senior Subordinated Notes and, as a result, are in default under the applicable indenture, and as a result of cross-default provisions, under the other indenture and the New Facility. Additional interest payments are due on the Senior Notes in July 2007 and interest and principal on the Senior Subordinated Notes are due in October 2007. Failure to make any of these payments would permit the Trustee under the applicable indenture (or the requisite holders of Notes) and the lenders under the New Facility to declare the respective obligations immediately due and payable and to exercise any other available rights and remedies. As noted above, we entered into forbearance agreements related to the interest payment default and other defaults with our lenders under the New Facility and the requisite noteholders under the Indentures that expire on July 13, 2007. Upon termination of these forbearance agreements, events of default will occur under the indentures governing the Notes and under the New Facility. If such events of default occur, the lenders under the New Facility and the Trustee under the indentures or the requisite holders of Notes could accelerate the related obligations and exercise any available rights and remedies. While we hope to successfully complete the prepetition solicitation and obtain confirmation of the Plan of Reorganization before any enforcement action is taken by the lenders, the Trustee or holders of the Notes, there can be no assurance that this will occur on the timetable we project. In such event, we would be forced to consider commencing a non-prepackaged reorganization case under Chapter 11 of the Bankruptcy Code, which would be more protracted and expensive than a prepackaged case.

 

Our cash flows and liquidity may also be negatively affected by various items, including declines in membership cash collections, changes in terms or other requirements by vendors, including our credit card payment processor; regulatory fines; penalties, settlements or adverse results in securities or other litigations; future consent payments to lenders or noteholders, if required; and unexpected capital requirements. We have been required to provide additional letters of credit, and cash deposits to support vendors, which have reduced our available liquidity. Although management believes that we have adequate liquidity to pay our ordinary course trade and employee obligations, there can be no assurances that we will have sufficient liquidity to meet our debt or other obligations as and when they become due in the presence of the unfavorable scenarios described in this Form 10-K. If cash revenue decreases compared to 2006 get larger, expenses increase or a default occurs under the New Facility (whether directly or as a result of a cross-default to other indebtedness) and we do not have or cannot obtain sufficient liquidity to address any such scenario, we would be unable to continue operating our business. Furthermore, pursuant to the New Facility, our depository accounts are subject to control agreements that give the lenders the right to dominion over our cash on deposit in control accounts if an event of default under the New Facility occurs and is continuing.

 

Interest Expense

 

Interest expense for the year ended December 31, 2006 increased $16.5 million to $101.9 million as compared to the prior year, principally due to increased amortization of deferred financing costs as a result of consent fees paid in March and April 2006 to obtain waivers from noteholders and lenders of financial reporting requirements. Amortization of deferred financing costs was approximately $21.1 million for the year ended December 31, 2006, a $12.5 million increase over 2005. The balance of the increase is due to increases in general interest rate levels, partially offset by lower weighted average debt outstanding during the year.

 

Interest expense for the year ended December 31, 2005 increased $18.1 million to $85.3 million, principally due to higher interest rates ($11.2 million) as a result of the increase in general interest rate levels plus the full year impact of the replacement of our accounts receivable securitization with a higher rate term loan, and an increase in the amortization of deferred financing costs ($5.1 million) resulting from fees paid to obtain the wavier of financial reporting covenants under certain debt agreements.

 

Of our total debt outstanding of $761.3 million at December 31, 2006, approximately 54% bears interest at floating rates. This includes the effect of interest rate swap agreements, which effectively convert $200 million of Senior Subordinated Notes into variable rate obligations. Our interest expense increased during 2006 as a result of the rising interest rate environment and will continue to increase if interest rates continue to rise in 2007. Correspondingly, should rates decrease, we would benefit from the lower rates. Our interest expense was favorably impacted by the $37.4 million reduction in our old term loan from the application of the proceeds from the sale of

Crunch Fitness and other assets during 2006. However, our interest expense in 2007 will increase as a result of the higher level of debt under the New Facility.

 

Cash Flows

 

The following table summarizes the Company’s cash flows for 2006 and 2005 (in millions):

 

 

Operating Activities

 

Net cash used in operating activities totaled $4.3 million in 2006 compared to cash provided by operating activities of $30.7 million in 2005. This decrease in cash provided by operating activities largely resulted from a decrease of $25.4 million in cash received from memberships compared to the prior year. Increases in operating costs, principally occupancy and repair and maintenance costs, severance costs, and higher audit and professional fees, including costs associated with the proxy solicitation in January 2006, also negatively impacted net cash provided by operating activities in the current year period. Cash interest paid increased $3.4 million in 2006 compared to the prior year.

 

Investing Activities and Capital Expenditures

 

Net cash provided by investing activities totaled $28.1 million in 2006 compared to a use of $36.2 million in 2005. The 2006 period benefited from the sale of Crunch Fitness ($45.0 million), fourth quarter sale/leaseback transactions ($14.6 million inclusive of $1.0 million held in escrow pending certain repairs to the properties) and property and asset sales ($7.6 million). Capital expenditures increased $3.6 million to $39.6 million in 2006 from $36.0 million in 2005. We opened a club in Carrollton (Dallas), Texas in April 2006 and Los Angeles, California in September 2006. In 2005, we opened a club in Huntington Park, California. During 2006 we spent approximately $7 million on new clubs and $25 million on existing clubs. Three clubs currently in development are planned for opening in 2007. During 2007, we expect capital spending to be approximately $35 - $40 million.

 

Financing Activities

 

Net cash used in financing activities totaled $6.7 million in 2006 compared to $3.4 million provided by financing activities in 2005. In October 2006, the Company entered into the New Facility; proceeds were used to refinance amounts outstanding under the Amended and Restated Credit Agreement dated October 14, 2004 between the Company, JP Morgan Chase Bank, N.A., as Agent, and other Lenders (“the Credit Agreement”) and to fund transaction fees. During 2006, the Company applied $37.4 million of proceeds from the sale of Crunch Fitness and other assets to repay the term loan pursuant to the Credit Agreement. Proceeds of $11.5 million (less $2.5 million remaining in escrow at year end pending the Company obtaining certain permits for one of the properties ($1.8 million) and effecting certain repairs to the properties ($0.7 million)) from the interim financing of a sale/leaseback transaction and $5.6 million from the sale of Common Stock were received in 2006 and were used to fund: (i) the cash portion of the consent fees paid to holders of the Senior Subordinated Notes and the Senior Notes and related expenses; (ii) fees and expenses relating to the Credit Agreement amendment and waiver; (iii) additional working capital; and (iv) capital expenditures.

Capital Requirements and Contractual Obligations

 

Capital Requirements

 

We currently anticipate that future funding needs in the near term will principally relate to:

 

 

Future Contractual Obligations

 

The following table sets forth our best estimates as to the amounts and timing of contractual payments for our most significant contractual obligations as of December 31, 2006 (in millions). The information in the table reflects future unconditional payments and is based upon, among other things, the terms of the relevant agreements, appropriate classification of items under GAAP currently in effect and certain assumptions, such as future interest rates. Future events, including refinancing of our securities, could cause actual payments to differ significantly from these amounts.

 

 

 

 

Dividend and Other Commitments

 

We have remaining authorization to repurchase up to 820,400 shares of our common stock on the open market from time to time. The terms of our New Facility generally do not allow us to repurchase common stock or pay dividends without lender approval. We do not expect to repurchase any of our common stock in the foreseeable future. We have not paid any cash dividends on our common stock and do not anticipate making any cash dividend payments in the future.

Debt

 

New Facility and Credit Agreement

 

On October 16, 2006, we entered into the New Facility with a group of financial institutions led by JPMorgan. The New Facility provides for (i) a term loan in the amount of $205.9 million, (ii) a delayed-draw term loan facility in the amount of $34.1 million, and (iii) a revolving credit facility in the amount of $44.0 million. The proceeds from the New Facility were used to refinance the amounts outstanding under the existing Credit Agreement (discussed below), to pay transaction fees and expenses, and have been and will be used to fund capital expenditures and improvements to properties as defined in the New Facility and provide for additional liquidity. The termination date of the New Facility is the earlier of (i) 14 days prior to the maturity of the Senior Subordinated Notes (due October 15, 2007), including extensions or refinancing or (ii) October 1, 2010. The current termination date for the New Facility is October 1, 2007, and as such, amounts outstanding under the New Facility will become due and owing on October 1, 2007 and are included as current maturities of long-term debt on our Consolidated Balance Sheet at December 31, 2006. The New Facility is secured by substantially all of our real and personal property, including member obligations under installment contracts. Our obligations under the New Facility are guaranteed by most of our domestic subsidiaries. The New Facility required us to raise $20 million of additional liquidity by December 31, 2006 from permitted sale/leasebacks, permitted asset sales or issuances of capital stock. We closed a sale/leaseback transaction in October 2006 and two additional sale/leaseback transactions in December 2006, generating approximately $22.5 million of aggregate proceeds, in order to satisfy this requirement.

 

The New Facility contains restrictive covenants that include minimum monthly cash EBITDA, and minimum monthly liquidity requirements; and restrictions on use of funds, additional indebtedness, incurring liens, certain types of payments (including, without limitation, capital stock dividends and redemptions, payments on existing indebtedness and intercompany indebtedness), incurring or guaranteeing debt, investments, mergers, consolidations, asset sales and acquisitions, transactions with subsidiaries, conduct of business, sale and leaseback transactions, incurrence of judgments, and changing our fiscal year, all subject to certain exceptions. The New Facility also contains various financial reporting requirements, including an annual audit opinion, provided that the receipt of a “going concern” qualification or exception to such audit opinion does not violate the terms of the New Facility so long as we are otherwise in compliance with the New Facility. As discussed above, covenant non-compliance, absent a waiver by the lenders, causes us to be unable to access the revolving credit facility and the delayed draw term loan and, therefore, be unable to satisfy our obligations and operate our business. In addition, as a result of not satisfying a covenant, an event of default could occur under the New Facility and cross-defaults could occur under the Indentures and holders could accelerate the obligations under these instruments and we would be unable to satisfy those obligations.

 

On April 2, 2007, we failed to comply with certain financial reporting covenants under the New Facility. On April 12, 2007, we entered into a Forbearance Agreement with the lenders under the New Facility. Under this agreement the lenders agreed to forbear from exercising any remedies under the New Facility as a result of certain defaults arising from, among other things, our inability to meet financial reporting covenants including delivery of audited financial statements for the fiscal year ended December 31, 2006, and the cross default arising from the non-payment of interest due April 16, 2007 on the Senior Subordinated Notes. The Forbearance Agreement contains restrictions during its term on additional indebtedness, liens, investments, asset sales and sale/leasebacks. Furthermore, the agreement required that we enter into forbearance agreements with respect to defaults under our public indentures with the holders of at least a majority of the Senior Notes and at least 75% of the Senior Subordinated Notes. The Forbearance Agreement will terminate on the earlier of July 13, 2007 or the date on which (i) a default occurs which is not a default covered by the Forbearance Agreement, (ii) any payment of principal or interest is made on the Senior Subordinated Notes, (iii) the commencement of any enforcement action under the indenture governing either the Senior Notes or Senior Subordinated Notes, including acceleration of the Senior Notes or the Senior Subordinated Notes, or (iv) upon certain challenges to the validity or enforceability of the New Facility or the Forbearance Agreement.

 

At May 31, 2007, we had $23.5 million in outstanding borrowings and $20.1 million in letters of credit issued under the revolving credit facility. The term loan balance under the new facility was $205.9 million and there was $33.0 million borrowed on the delayed-draw term loan facility.

Until refinanced by the New Facility, we had in place a Credit Agreement with a group of financial institutions led by JPMorgan that provided for a five-year initial amount $175 million term loan maturing in October 2009 in addition to a $100 million revolving credit facility expiring in September 2008. The Credit Agreement was secured by substantially all of our real and personal property, including member obligations under installment contracts. The Credit Agreement contained restrictive covenants that included certain interest coverage and leverage ratios; restrictions on use of funds, additional indebtedness, incurring liens, certain types of payments (including, without limitation, capital stock dividends and redemptions, payments on existing indebtedness and intercompany indebtedness), incurring or guaranteeing debt, investments; mergers, consolidations, sales and acquisitions; transactions with subsidiaries, conduct of business, sale and leaseback transactions, incurrence of judgments, and changing our fiscal year; and requirements with respect to financial reporting, all subject to certain exceptions. Amounts outstanding under the Credit Agreement were repaid on October 16, 2006 using proceeds from the New Facility.

 

Consent Solicitations and Forbearance Agreements

 

On March 14, 2006, we announced that we would not meet the March 16, 2006 deadline for filing our Annual Report on Form 10-K for the year ended December 31, 2005 with the SEC. Although the delay in filing resulted in defaults of the financial reporting covenants under the indentures governing our Senior Subordinated Notes and Senior Notes, it did not constitute an event of default without delivery of a notice of default and expiration of a 30-day cure period. A cross-default under our Credit Agreement would have occurred 10 days after receipt of such notice. Additionally, a default would also have occurred under the Credit Agreement if we did not deliver audited financial statements for the year ended December 31, 2005 to the lenders thereunder by March 31, 2006.

 

On March 24, 2006, we announced that we would seek waivers of the defaults of the financial reporting covenants under the indentures governing the Senior Subordinated Notes and the Senior Notes through a consent solicitation, which was commenced on March 27, 2006. In connection with the consent solicitation, we entered into agreements with approximately 53% of the holders of the Senior Subordinated Notes to consent to the requested waivers.

 

On March 30, 2006, we entered into the Third Amendment and Waiver with the lenders under our Credit Agreement that modified the definition of “Consolidated Interest Expense,” modified permitted dispositions, clarified the definition of “Banking Day,” extended the time for delivering the audited financial statements for the year ended December 31, 2005 and the unaudited financial statements for the quarter ended March 31, 2006 until July 10, 2006, extended the time for delivering the unaudited financial statements for the quarter ending June 30, 2006 until September 11, 2006, with an option to elect to extend until October 11, 2006, permitted payment of the consent fees to the holders of the Senior Subordinated Notes and the Senior Notes and excluded fees and expenses incurred in connection with the consent solicitation from the computation of financial covenants.

 

On April 10, 2006, we completed the consent solicitations to amend the indentures governing the Senior Subordinated Notes and the Senior Notes to waive any default arising under the financial reporting covenants from a failure to timely file financial statements with the SEC for the year ended December 31, 2005 and the quarter ended March 31, 2006 until July 10, 2006, and for the quarter ended June 30, 2006 until September 11, 2006, with an option to elect to extend until October 11, 2006.

 

In connection with these consents, we issued 1,956,195 shares of unregistered common stock and paid $0.8 million in consent fees to the holders of the Senior Subordinated Notes and the Senior Notes, paid the lenders under the Credit Agreement $2.5 million in fees and recorded $22 million in deferred finance charges as of March 31, 2006. Additionally, on April 11, 2006, we entered into stock purchase agreements (the “Stock Purchase Agreements”) to sell 400,000 shares of unregistered common stock to each of Wattles Capital Management, LLC and investment funds affiliated with Ramius Capital Group, L.L.C. Proceeds of $5.6 million from the sale of Common Stock were used to fund: (i) the cash portion of the consent fees paid to holders of the Senior Subordinated Notes and Senior Notes and related expenses; (ii) fees and expenses relating to the Credit Agreement amendment and waiver; and (iii) additional working capital.

 

On June 23, 2006, we entered into the Fourth Amendment, which extends the 10-day period to 28 days after which a cross-default will occur upon receipt of any financial reporting covenant default notice under the indentures

governing the Senior Subordinated Notes or Senior Notes for the third quarter of 2006. We paid the lenders under the Credit Agreement fees of $0.5 million in connection with the Fourth Amendment.

 

On April 12, 2007, we entered into the Forbearance Agreement under our New Facility. Under the Forbearance Agreement, the Agent and the Lenders will forbear from exercising any remedies under the New Facility as a result of certain defaults. The Forbearance Agreement will terminate on July 13, 2007, unless earlier in accordance with its terms. The Forbearance Agreement required that we enter into forbearance agreements with respect to defaults under our public indentures with holders of at least a majority of our Senior Notes and at least 75% of our Senior Subordinated Notes. We paid the lenders under the New Facility fees of $587,000 in connection with the Forbearance Agreement.

 

On May 14, 2007, we entered into the Senior Notes Forbearance Agreement with holders representing over 80% of the aggregate principal amount outstanding of our Senior Notes. Pursuant to the Senior Notes Forbearance Agreement, holders of the Senior Notes waived certain defaults under the Senior Notes Indenture and agreed to forbear from exercising any related remedies until July 13, 2007. Holders of the Senior Notes also consented to amend certain provisions of the Senior Notes Indenture in connection with the waiver of the defaults. We paid a cash consent fee of $279,000 to holders of the Senior Notes that executed the Senior Note Forbearance Agreement and consented to the related amendments to the Senior Notes Indenture.

 

On May 14, 2007, we also entered into the Senior Subordinated Notes Forbearance Agreement with holders representing over 80% of the aggregate principal amount outstanding of our Senior Subordinated Notes. Pursuant to the Senior Subordinated Notes Forbearance Agreement, holders of the Senior Subordinated Notes waived certain defaults under the Senior Subordinated Notes Indenture and agreed to forbear from exercising any related remedies until July 13, 2007. Holders of the Senior Subordinated Notes also consented to amend certain provisions of the Senior Subordinated Notes Indenture in connection with the waiver of the defaults. We did not pay a consent fee to holders of the Senior Subordinated Notes in connection with the Senior Subordinated Notes Forbearance Agreement.

 

We are in the process of implementing new accounting processes and technologies designed to continue to shorten the time required to prepare and file our financial statements, along with improving controls over our accounting and the close process. We cannot assure you that we will be able to file our financial statements on time in the future. Failure to do so will lead to further defaults under the Indentures and the New Facility and could require us to seek additional consents from our bondholders and lenders.

 

Other Secured Debt

 

Our unrestricted Canadian subsidiary was not in compliance with the terms of its credit agreement at December 31, 2006. As a result, the outstanding amount of $0.2 million has been classified as current. The amount outstanding on the Canadian subsidiary’s credit agreement was repaid in full on January 31, 2007. As of March 31, and April 15, 2007, we have not been in compliance with the financial reporting covenants under two mortgage agreements and certain capital lease obligations. At May 31, 2007, the amount outstanding under these agreements was $5.4 million. Upon filing this Form 10-K, we will be in compliance with these agreements.

 

Off-Balance Sheet Arrangements

 

We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities that would be expected to have a material current or future effect on our financial condition or results of operations. Pursuant to the sale of Crunch Fitness, we remained liable on certain leases and/or lease guarantees. See Note 18 of Notes to Consolidated Financial Statements for a discussion of such obligations.

 

Critical Accounting Policies

 

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and include accounting policies we believe are appropriate to report accurately and fairly our operating results and financial position. We apply those accounting principles and policies in a consistent manner from

period-to-period. Our significant accounting policies are summarized in Note 2 of the Notes to Consolidated Financial Statements.

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make judgments, estimates and assumptions at a specific point in time that affect the reported amounts of certain assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities not readily obtainable from other sources. Actual results could differ from those estimates. We believe the following critical accounting policies are impacted significantly by judgments, estimates and assumptions used in the preparation of the Consolidated Financial Statements:

 

Revenue Recognition:  Our principal sources of revenue include membership services, principally health club memberships and personal training services, and the sale of nutritional products. We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” as amended by SEC Staff Accounting Bulletin No. 104, “Revenue Recognition.” As a general principle, revenue is recognized when the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and services have been rendered, (iii) the price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured. With respect to health club memberships and personal training, we rely upon a signed contract between us and the customer as the persuasive evidence of a sales arrangement. Delivery of health club services extends throughout the term of membership. Delivery of personal training services occurs when individual personal training sessions have been rendered.

 

We receive membership fees and monthly dues from our members. Membership fees, which customers often finance, become customer obligations upon contract execution and after a “cooling off” period of three to 15 calendar days depending on jurisdiction, while monthly dues become customer obligations on a month-to-month basis as services are provided. Membership fees and monthly dues are recognized at the later of when collected or earned.

 

Membership fees and monthly dues collected but not earned are included in deferred revenue. The majority of members commit to a membership term of between 12 and 36 months. The majority of these contracts are 36-month contracts. The Company’s contracts include a member’s right to renew the membership at a discount compared to the monthly payments made during the initial contractual term. In late 2004, we discontinued selling the right to a significantly discounted renewal period. Beginning in the fourth quarter of 2006, we reinstated this feature in certain markets and at discount levels modestly below the obligatory monthly amount.

 

Additional members may be added to the primary joining members’ contract. These additional members may be added as obligatory members that commit to the same membership term as the primary member, or nonobligatory members that can discontinue their membership at any time.

 

Membership revenue is earned on a straight-line basis over the longer of the contractual term or the estimated membership term. Membership term is estimated on an aggregate basis at time of contract execution based on historical trends of actual attrition, and these estimates are updated quarterly to reflect actual membership retention. Our estimates of membership life were up to 360 months during 2006, 2005, and 2004. The table below presents the current member duration distribution of our members that have continuously maintained membership and were members as of December 31, 2006, 2005 and 2004. Reactivation members include members that have experienced discontinuous periods of membership, having ceased membership to later return to membership status through our ongoing reactivation solicitations of expired members. Nonrenewable members are those which have a definite term of three years or less and do not have a right to renew their membership at the conclusion of the term.

 

 

As of December 31, 2006 and 2005, the weighted average membership life for members that commit to a membership term of between 12 and 36 months was 34 months and 38 months, respectively. Members with these terms that finance their initial membership fee have a weighted average membership life of 33 months and 36 months, respectively at December 31, 2006 and 2005, while those members that pay their membership fee in full at point of sale have a weighted average membership life of 48 months and 57 months at December 31, 2006 and 2005, respectively. As a result of our business practice of discounting monthly payments made during the renewal term when compared to monthly payments made in the initial contractual term, the estimate of membership term impacts the amount of revenue deferred in the initial contractual term. Changes in member behavior, competition, and our performance may cause actual attrition to differ significantly from estimated attrition. A resulting change in estimated attrition may have a material effect on reported revenues in the period in which it is first identified.

 

Beginning in the fourth quarter of 2004, we increased contractual renewal rates associated with our typical membership offering. Historically, when the member reaches renewal, our business practice is to reduce renewal rates in order to increase retention during the renewal period. Because we have included a discount in our membership contract and do not have a demonstrated history of collecting the contractual renewal rate, we use the current collections of members in renewal to estimate both ultimate collections and the portion attributable to the initial term.

 

To the extent that actual cash collected in renewal is different from the estimated amount, revenues in the period of the change in estimate may be materially impacted. If we are successful in collecting the contractual renewal rate, revenue deferred during the initial term is expected to decline. If we offer discounts to renewing members that are more significant than those that have been offered in the past, revenue required to be deferred during the initial contract term will increase. The potential effects of this change in estimate may be amplified if, for example, the collection of higher contractual renewal rates results in a decline in membership retention, which will reduce our estimate of total membership term, and further reduce the amount of deferred revenue recorded. Change in member behavior, competition and our performance may cause actual collected renewal rates to differ significantly from estimated renewal rates. A resulting change in estimated renewal rates may have a material effect on reported revenues in the period in which the change of estimate is made.

 

Members in their non-obligatory renewal period of membership totaled approximately 62% of total members at December 31, 2006 and 2005, and approximately 61% of total members at December 31, 2004. Renewal members can cancel their membership at any time prior to their monthly or annual due date. Membership revenue from members in renewal includes monthly dues paid to maintain their membership, as well as amounts paid during the obligatory period that have been deferred as described above, to be recognized over the estimated term of membership, including renewal periods.

 

Month-to-month members may cancel their membership prior to their monthly due date. Membership revenue for these members is earned on a straight-line basis over the estimated membership life. Membership life for month-to-month members is currently estimated at between 2 and 67 months, with an average of 15 months as of December 31, 2006, and were estimated between 4 and 41 months, with an average of 15 months as of December 31, 2005.

Paid-in-full members who purchase nonrenewable memberships must purchase a new membership plan to continue membership beyond the initial contractual term. Such membership fees are deferred and amortized over the contract term.

 

Personal training and other services are provided at most of our fitness centers. Revenue related to personal training services is recognized when the four criteria of recognition described above are met, which is generally upon rendering of services. Personal training services contracts are either paid-in-full at the point of origination, or are financed and collected over periods generally through three months after an initial payment. Collections of amounts related to paid-in-full personal training services contracts, are deferred and recognized as personal training services are rendered. Revenue related to personal training contracts that have been financed is recognized at the later of cash receipt or the rendering of personal training services.

 

Sales of nutritional products and other fitness-related products occur primarily through our in-club retail stores and are recognized upon delivery to the customer, generally at point of sale. Revenue recognized in the accompanying consolidated statement of operations as “miscellaneous” includes amounts earned as commissions in connection with a long-term licensing agreement related to the third-party sale of Bally branded fitness equipment. Such amounts are recognized prior to collection based on commission statements from the licensee. Other amounts included in miscellaneous revenue are recorded upon receipt and include franchising fees, facility rental fees, locker fees, late charges and other marketing fees pursuant to in-club promotion agreements.

 

We enter into contracts that include a combination of (i) health club services (which may include two or more members on a single contract), (ii) personal training services, and (iii) nutritional and weight management products. In these multiple element arrangements, health club services are typically the last delivered service. We account for these arrangements as single units of accounting because we do not have objective and reliable evidence of the fair value of health club services. Under Emerging Issues Task Force Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“Issue 00-21”) elements qualify for separation when the services have value on a stand-alone basis, fair value of the separate elements exists and, in arrangements that include a general right of refund relative to the delivered element, performance of the undelivered element is considered probable and substantially in our control. We do not have objective and reliable evidence of the fair value of health club services and as a result, treat these arrangements as single units of accounting.

 

Costs related to acquiring members and delivering membership services are expensed as incurred.

 

Self-Insurance Costs:  We retain risk related to workers’ compensation and general liability claims, supplemented by individual and aggregate stop-loss limits. Reported liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred, but not reported, for all claims through December 31, 2006 and are not reduced by amounts covered under our stop-loss coverage. Receivables are recorded for the excess coverage to be recovered from the insurance provider. Case reserves are established for reported claims using case basis evaluation of the underlying claim data and are updated as information becomes known. The liabilities for workers’ compensation claims are accounted for on a present value basis utilizing a risk-adjusted discount rate. The difference between the discounted and undiscounted workers’ compensation liabilities was approximately $0.9 million as of December 31, 2006.

 

The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the ultimate liability for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled, can impact ultimate costs. Although our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could affect future claim costs and currently recorded liabilities.

 

Valuation of Long-Lived Assets:  In accordance with SFAS No. 144, we monitor the carrying values of long-lived assets for potential impairment each quarter based on whether certain trigger events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a trigger event occurs, an impairment calculation is performed, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific fitness centers, to the respective carrying values. If impairment is identified for long-

lived assets to be held and used, we compare discounted estimated future cash flows to the current carrying values of the related assets. We record impairment when the carrying values exceed the discounted estimated future cash flows.

 

The factors most significantly affecting the impairment calculation are our estimates of future cash flows. Our cash flow projections carry several years into the future and include assumptions on variables such as growth in revenues, our cost of capital, inflation, the economy and market competition. Any changes in these variables could have an effect upon our valuation.

 

We perform impairment reviews at the club level as opposed to a review on an area or regional level basis. Use of a different level could produce significantly different results.

 

Generally, costs to reduce the carrying values of long-lived assets are reflected in the Consolidated Statements of Operations as “asset impairment charges.” These charges amounted to $38.3 million, $10.1 million and $11.5 million in 2006, 2005 and 2004, respectively. Impairment charges may continue in future years as a result of investments in clubs in turnaround situations or around new estimates of future operating cash flows.

 

Valuation of Goodwill:  Goodwill is reviewed for impairment during the fourth quarter of each year on December 31, and also upon the occurrence of trigger events. The reviews are performed at a reporting unit level defined as one level below our operating regions, effectively the individual markets in which we operate. Generally, estimated fair value is based on a projection of discounted future cash flows, and is compared to the carrying value of the reporting unit for purposes of identifying potential impairment. Projected future cash flows are based on management’s knowledge of the current operating environment and expectations for the future. If potential for impairment is identified, the fair value of an area is measured against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the area’s goodwill. Goodwill impairment is recognized for any excess of the carrying value of the area’s goodwill over the implied fair value. No impairment of goodwill was identified at December 31, 2006, 2005 or 2004.

 

The annual impairment review requires the extensive use of accounting judgment and financial estimates. Application of alternative assumptions and definitions, such as reviewing goodwill for impairment at a different organizational level, could produce significantly different results. Similar to our policy on impairment of long-lived assets, the cash flow projections used in our goodwill impairment reviews can be affected by several items such as inflation, the economy and market competition, which could have an effect upon these projections.

 

Valuation of Intangible Assets:  In addition to goodwill, we have recorded intangible assets totaling $6.8 million for trademarks and $0.7 million for leasehold rights at December 31, 2006. Balances at December 31, 2005 were $6.9 million for trademarks, $2.8 million for leasehold rights and $0.1 million for membership relations. Leasehold rights are amortized using the straight-line method over the respective lease periods without regard to any extension options. We test these assets annually for impairment. Impairment charges for intangible assets for the years ended December 31, 2006, 2005 and 2004 amounted to $1.5 million, $1.2 million and $0.2 million, respectively.

 

Stock-Based Compensation Plans:  On January 1, 2006, we adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”) to record compensation expense for our employee stock options and restricted stock. SFAS No. 123R is a revision of SFAS No. 123, “Accounting for Stock-based Compensation,” (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and its related implementation guidance. Prior to the adoption of SFAS No. 123R, we followed the intrinsic value method in accordance with APB 25, in accounting for our employee stock options. For information regarding share-based compensation, see Note 15 of the Notes to Consolidated Financial Statements.

 

Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements:  In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on the consideration of effects of the prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The SEC believe registrants must quantify errors using both a balance sheet (the iron curtain method)

and income statement (the rollover method) approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The Company adopted the provisions of SAB 108 in the quarter ended December 31, 2006. As a result of adopting SAB 108 and electing to use the one-time transitional adjustment, the Company made an adjustment to the opening balance of retained deficit of $1.3 million net of tax. See Note 23 of the Notes to Consolidated Financial Statements for further details.

 

Results of Operations

 

Key Operating Data

 

As a result of the sale of Crunch Fitness in 2006, we have presented the operating results of Crunch as a discontinued operation for all prior periods presented. The following table sets forth key operating data for the periods indicated (dollars in thousands except per member data):