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.  o

 

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, 2005, was approximately $69.6 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, 2005. As of May 31, 2006, 41,310,827 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
2005 ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 

 

Forward-looking statements in this Form 10-K including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations, intentions, and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These factors include, among others, the following:

 

 

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. This Annual Report on Form 10-K is being sent to stockholders in lieu of an Annual Report. Information contained on our website is not intended to be part of this Annual Report on Form 10-K.

 

The Company’s Chief Executive Officer, Paul A. Toback, certified to the New York Stock Exchange (the “NYSE”) on December 29, 2005 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, 2004 and are also filed as exhibits to this Annual Report on Form 10-K.

 

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

 

General

 

Bally Total Fitness Holding Corporation is the largest publicly traded commercial operator of fitness centers in North America in terms of members, revenues and square footage of its facilities. As of December 31, 2005, we operated 409 fitness centers primarily under the Bally Total Fitness branded servicemark. Our fitness centers are concentrated in major metropolitan areas in 29 states, the District of Columbia and Canada, with more than 350 fitness centers located in the top 25 metropolitan areas in the United States and Toronto, Canada. We operate fitness centers in over 45 major metropolitan areas representing 61% of the United States population and over 16% of the Canadian population and have approximately 3.6 million members. We have approximately 21,600 employees, including approximately 10,100 full-time employees and over 5,400 personal trainers.

 

The Company was incorporated in Delaware in 1983. Since its inception, the Company’s business, its markets, the services it offers and the way it conducts its 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 and Canada. The Company believes the aging of America has also increased the size of its potential market. For many years our target market was the 18- to 34-year old middle-income segment of the population. In 2003, we expanded that 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.

 

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 nutritional products and, beginning in 2003, a nutrition and weight management program.

 

Since becoming a public company in 1996, Bally has raised significant capital used to acquire new clubs, remodel existing clubs and purchase additional or replacement equipment. Between 1997 and 2002, the Company focused on growth through the acquisition and internal development of new clubs. During that period, the Company bought or opened 152 new fitness centers.

 

Beginning with a change of management 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. The first phase of our new business plan focused on operating efficiencies, enrolling more new members and improving our membership retention, as well as increasing the training for our employees. Our principal strategies for achieving success on these initiatives included introducing month-to-month plan memberships, developing a new marketing strategy, making customer service a priority and optimizing our product and service offerings.

 

The second phase of our new business plan is 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. We have also focused on cross-training employees to serve in a variety of positions in our fitness centers so we can achieve optimal staffing profiles to more efficiently service the fitness needs of our current and prospective members. We believe the combination of increased accountability and cross-trained employees will improve customer service and, ultimately, member acquisition and retention. Our principal strategies in this phase of our plan include creating a simpler, more friendly process for joining Bally that provides customers with flexibility and options, properly aligning the compensation incentives for key employees to promote profitability, continuing to improve customer service, growing our product and service offerings, leveraging consumer health trends, enhancing our new marketing strategy, improving operating efficiencies and optimizing our club portfolio.

 

As the third phase of our business plan, management intends to address the Company’s capital structure in order to reduce leverage and debt service requirements, allowing it to invest more of its operating cash flow in improvements into its fitness centers. We have also begun to explore divesting non-core assets, including, but not limited to, the sale of fitness centers. In connection with these goals, on January 20, 2006, the Company announced

it had completed the sale of its Crunch Fitness business and four other high-end fitness centers in San Francisco, including the Gorilla Sports brand.

 

Financial Information About Segments

 

Not applicable.

 

Business Strategy

 

Our mission is to improve the health and quality of life of our members through cost efficient and customized fitness, nutrition and weight management programs. We strive to be a proactive “total” fitness and wellness resource, assisting our customers in achieving results by providing personalized fitness and nutrition plans and knowledgeable and informative fitness coaches and personal trainers.

 

As noted above, in 2003 we developed and began to implement a business plan to increase our membership origination and membership retention. Our principal strategies in this new plan include growing the number of new members by creating a simpler, more friendly process for joining Bally that provides customers with flexibility and options, properly aligning the compensation incentives for key employees to promote profitability, continuing to improve customer service, growing our product and service offerings, leveraging consumer health trends, creating a new marketing strategy to drive traffic and to promote our brand, improving operating efficiencies and optimizing our club portfolio. A description of each of our business strategies is outlined below:

 

Grow the Number of New Members by Creating a Simple, Friendly Process for Customers to Join Bally.  Since its inception, Bally has relied on multi-year membership contracts with its customers. These contracts provide the Company with a predictable revenue stream and provide our customers a guaranteed rate during their commitment period, followed historically by a lower, non-obligatory dues payment thereafter. As competition increased over the past decade and consumer shopping behaviors changed, our market research indicated that some customers wanted an alternative to the multi-year membership contract. In response, we added “month-to-month” memberships to all our markets in 2003. Beginning in late 2004 and through December 2005, we implemented the Build Your Own Membership (“BYOM”^sm) program, which simplifies the enrollment process and enables members to choose the membership type, amenities and pricing structure they prefer. Under BYOM, club members choose one of two basic membership plans that include a modest enrollment fee at the time of joining. They can select either a multi-year contract with a lower enrollment fee and a reduced monthly rate, or a month-to-month membership, which allows members to join on a month-to-month basis at a slightly higher enrollment fee and monthly rate. Prospective members also have the option to purchase non-renewable paid-in-full memberships at a savings compared to monthly programs. With any membership, members can add amenities such as national access to their base membership for additional monthly fees. In addition, members may add family and friends to their membership packages in several different ways. We believe that BYOM, in addition to our strong brand identity and the convenience of multiple locations, constitutes a distinct competitive advantage that will help to increase membership sales, decrease membership cancellations and improve retention rates and generate increased revenues from fitness services and retail products.

 

Align Management and Key Employees’ Incentives on Improving Profitability.  Our new field level compensation system aligns the goals of our field management with those of senior management and the Company. This system adds a profitability component to the compensation structure of all senior fitness center and area supervisory personnel, replacing a compensation system that was almost exclusively sales-based. We have designed a new sales commission program that is significantly simpler than our old system and rewards the employee for maximizing the value of each membership by focusing on key retention variables such as amount of enrollment fee (full vs. discounted), billing method (electronic funds transfer vs. statement), and contract type (obligatory value plan vs. non-obligatory month-to-month). We believe that, upon full implementation, the transparency and structure of this compensation system will enable Bally to more effectively attract and retain a quality sales force committed to inspiring new members to start a fitness and nutrition program and also provide a higher level of ongoing customer service. We believe a higher level of customer service should, in turn, increase member retention and new member referrals from existing customers.

Improve Customer Service and Member Retention.  Our market analysis and survey data indicates customers are more inclined to join and stay members of our fitness centers when our employees focus on meeting the customers’ unique health and fitness goals and customizing each individual’s fitness and nutrition program. Beyond the more customer-friendly sales process described above, other service initiatives include the use of new sales support tools, including a Personal Fitness Assessment (a series of questions and tests) given to new customers in order to customize their program. In addition, there are new initiatives to fully engage new members by better exposing them to our personal training, nutrition, weight loss and weight management services during the initial membership orientation phase. In support of these service initiatives, we implemented a new employee-training program for club personnel designed to ensure that all Bally employees who interact with customers have the appropriate health, fitness and nutrition as well as customer service expertise. As part of these new service initiatives all Bally sales people have been or will be retrained as, or replaced by, fitness coaches who now handle both the membership enrollment process and new member follow-up.

 

Optimize Our Product and Service Offerings.  We are increasingly using our clubs for the delivery of value-added products and services such as personal training, Bally-branded nutritional products, fitness-related merchandise and our online or in-club nutrition and weight management program. Integrating these ancillary products and services into our core fitness center operations positions Bally as a primary source for all of our members’ wellness needs. Our Bally-branded nutrition products are now sold in approximately 4,000 select retail, grocery and drug store outlets such as Rite Aid and Ralph’s. Our licensed portable exercise equipment is currently sold in over 13,000 retail outlets such as Ross Stores, K-Mart, Sears, Lady Foot-Locker and Value City Department Stores.

 

Leverage Consumer Health Trends and Target High Potential, Underserved Segments.  Current health and population trends such as the obesity epidemic and the aging of America make clear the need for more of the population to participate in fitness. In response, we are introducing specialized fitness programs targeting underserved consumer markets, such as aging “Baby Boomers,” senior citizens, women, multi-cultural households and families with children. We are committed to the continuing development and integration of new and innovative products and services that target the specific wants and needs of these key segments. Finally, we believe a significant opportunity exists to offer fee-based specialty programs with a special attraction to a niche of consumers, such as martial arts programs, and we have begun to include such programs in a number of our fitness centers. Multiple markets and fitness center locations allow us to “test-market” and refine new products and services in order to enhance the likelihood that only profitable and popular programs are implemented nationally.

 

Implement New Marketing Strategy.  For years the Company relied heavily on aspirational television advertising that featured young, fit people. As part of our new business plan, we have expanded our creative strategy as well as our targeting strategy. Based on extensive research and testing we have produced new advertisements featuring testimonial “Before and After” stories showcasing people of all ages, sizes and ethnicities who have achieved impressive results from participating in Bally programs.

 

Improve Operating Efficiencies.  After a period of rapid fitness center expansion, we have focused and continue to focus on enhancing operating efficiencies. In particular, we began various productivity initiatives, including consolidating back-office functions, streamlining management, reducing corporate benefits, pursuing rent reduction opportunities and revitalizing or pursuing exit alternatives for underperforming clubs. In addition, we are exploring alternative, value enhancing advertising strategies.

 

Optimize Club Portfolio.  On January 20, 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. We may also consider the sale of certain other non-core assets and real estate to the extent that such sales would reduce leverage, improve operating efficiencies or reduce operating costs. On November 30, 2005 we announced that we had retained J.P. Morgan Securities Inc. and The Blackstone Group L.P. to explore strategic alternatives, including potential equity transactions or the sale of businesses or assets. On March 14, 2006, we announced that the Strategic Alternatives Committee of the Board of Directors had authorized J.P. Morgan Securities Inc. and The Blackstone Group L.P. to engage in discussions with interested parties in connection with the strategic alternatives process.

Membership Plans

 

As noted above, our new sales strategy was developed to modernize our approach to sales and improve customer satisfaction, with the goal of improving our ability to sell memberships, reducing cancellations and improving member retention. BYOM enables members to choose a type of membership (paid-in-full, month-to-month or value plan memberships) and desired amenity package. Clearly presenting membership type and amenities enables the member to select the combination of services and monthly payment best suited for their individual circumstances. Under BYOM, 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, child care/kids club access, racquet sports, martial arts, nutrition 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 for members who choose a month-to-month or value plan membership. For month-to-month members the entire membership fee is typically collected at 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 $110 per membership, and value plan enrollment fees currently average approximately $63 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 $50 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 family 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 2005, family add-on members to value plan memberships were added as nonobligatory members (they can discontinue their membership at any point upon prior notice) while the primary sponsoring member makes payments on an obligatory basis. Single membership monthly payments range from approximately $34 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 $15 to $19 per month during 2005.

 

In the past, 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 payments generally ranging from $12 to $19 for the majority of members who were no longer in their obligatory period. Under the new business model, our value plan membership agreements generally do not provide for significantly discounted payments after a member’s obligatory period ends. 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 greater 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 under BYOM 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 92% of month-to-month members and over 65% of value plan members pay electronically. Approximately 70% of all our members pay electronically. 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, specialty exercise programs, fitness apparel, drinks, Bally-branded nutritional products and our nutrition and weight management program into our core fitness center operations, we have positioned the Bally Total Fitness brand as the primary source for all of our members’ wellness and weight loss needs.

 

 

 

Members

 

We define a member as a person whose membership fees are not delinquent by more than 90 days. Our membership was approximately 3.610 million as of December 31, 2005 and 3.675 million members at December 31, 2004.

 

Sales and Marketing

 

To support our market position as a low-cost provider of quality health and fitness services, we devote substantial resources to marketing and promoting our fitness centers and services. We believe strong marketing support is critical to attracting and retaining members at both existing and new fitness centers. The majority of our fitness centers use the branded mark “Bally Total Fitness,” including 10 upscale fitness centers known as “Bally Sports Clubs.” 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 61% of the United States population and 16% of the Canadian population with more than 350 of our fitness centers located in the top 25 metropolitan areas in the United States and Toronto, Canada. 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 2005.

 

Historically, we advertised primarily on television and, to a lesser extent, through direct mail, newspapers, telephone directories, radio, outdoor signage and other promotional activities. In late 2003, we fundamentally reshaped our entire marketing approach and organization, modernizing our creative approach and expanding our marketing message to reach multiple customer segments in the 18- to 54-year old demographic, rather than relying exclusively on our traditional 18- to 34-year old target audience. 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, which we believe is a distinct 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. Advertisements focus on Bally’s unique total fitness approach (fitness, nutrition and quality of life), the results it creates, special promotional offers and the frequent use of “Before and After” customer testimonials. We believe providing members a comprehensive, customized solution to their fitness and nutrition

needs, and flexible membership and payment plans, as well as our strong brand identity, effective national marketing programs and the convenience of multiple locations, constitutes additional distinct competitive advantages.

 

Our marketing efforts also include corporate memberships and in-club marketing programs. 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. Recently, we have placed greater emphasis on the internet component of our marketing strategy by including our website address in most of our television and print marketing materials. We also use the internet as a way to sell Bally goods and services, as well as month-to-month memberships. Our members also use our website to review account status and pay dues.

 

In 2005, we continued to benefit from new and existing strategic marketing alliances heightening public awareness of our fitness centers and the Bally Total Fitness brand. Strategic alliances during 2005 included Yum! Brands, Sports Display, Inc., Muzak^®, Discovery Health^tm Channel, Gatorade^®, Kellogg Company, Hilton Hotels^tm, Coca-Cola Enterprises, Inc. and NBC/Mark Burnett Productions (The Apprentice). These alliances provide the Company with an incremental source of revenue (through in-club advertising sales and sampling), as well as enhanced brand awareness through association with other strong brands.

 

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 fitness 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 million to construct, exclusive of purchased real estate. We generally invest approximately $500,000 in exercise equipment in a model fitness center. We have developed a new version of our fitness center model that is designed to be more inviting with an updated color scheme, higher-end finishes and a greater use of technology, with cost and durability comparable to our existing designs. These new fitness centers reflect all of our experience in club development and management over the past 40 years and include innovations such as juice bar/retail/front desk combinations for staffing efficiencies.

 

Fitness center operations.  Our overall goal is to maximize our members’ experience 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 and helpful personnel committed to providing a high level of customer service, creating an environment that meets the needs of our members. Our new approach to fitness center operations focuses on staffing our centers with well-trained health, fitness and nutrition professionals. This requires us to cross-train employees so they each have fitness and nutrition skills, as well as sales skills. Once fully implemented, our trained personnel will sell memberships as well as offer orientations to new members on the recommended use of exercise equipment and nutritional advice. Onsite personal trainers are and will continue to be available to assist in the development of a customized training regimen and have also been cross-trained to sell memberships. Our weight loss programs and nutrition products are available at all of our domestic fitness centers and are an 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 state-of-the-art 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. A member’s use of a fitness center may include group exercise programs or personal training instruction using Bally’s proprietary training methodology called “dynamic personal training”. Our unique personal training method focuses on a total body workout through the use of compound movements, small apparatus equipment, core conditioning, active recovery and partner-assisted stretching.

 

Franchises.  As of December 31, 2005 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., 17 fitness centers are operated in China — one under the joint venture and 16 as franchisees. As of the date of this filing, three additional franchise fitness centers are under construction in China.

 

Account Servicing

 

In addition to having member service representatives at most locations, we handle member services, collection and new member processing activities at our Norwalk, California national service center and some of our membership renewal processing at our Towson, Maryland center, providing efficiencies through centralization of these high volume activities.

 

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 or 194 days without 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. To credit score, we use a national bureau, which charges a nominal fee per account.

 

Competition

 

We are the largest publicly-traded commercial operator 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 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, country clubs, weight-reduction businesses, vitamin stores, juice and smoothie companies and the home-use fitness equipment industry. We also compete, to some degree, with entertainment and retail businesses for the discretionary income of 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 Curves International, Inc. However, 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 distinct competitive advantages in our markets. Future competitive factors may emerge which may hinder our ability to compete as effectively.

 

We believe competition has increased to some extent in certain markets from 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 programming and ability to secure prime real estate at economical rates. We believe with our locations, our strong brand identity and our flexible and affordable membership plans, we have the flexibility to respond to economic conditions and competition.

 

Our pursuit of new business initiatives, particularly the sale of weight management services, nutritional products and apparel, has us competing against large, established companies with more experience selling products on a retail basis. In some instances, our competitors in these business initiatives have substantially greater financial resources and we may not be able to compete effectively. However, the high volume of traffic to our fitness centers does provide a consistent stream of customers for our products and services.

 

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 the “The Sports Clubs of Canada^®”. We operated facilities under the “Crunch Fitness^sm” brand and the “Gorilla Sports^sm” brand until January 20, 2006, when we completed the sale of the Crunch Fitness business, including the Crunch Fitness and Gorilla Sports brands. We operated several fitness centers under the “Pinnacle Fitness^®” brand until May 1, 2006, when we converted those clubs to “Bally” clubs. 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, while advertising expenditures are typically lower during the fourth quarter. This seasonality of membership also impacts the timing of revenue generation from our products and services business.

 

Employees

 

At December 31, 2005, we had approximately 21,600 employees, including approximately 11,500 part-time employees. The distribution of our employees is summarized as follows:

 

 

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. Periodically, however, our sales personnel become somewhat more difficult to replace due, in part, to increased competition for skilled retail sales personnel in our industry and with other industries. We believe, however, that implementation of the BYOM and new club staffing programs will mitigate this difficulty by virtue of simplified enrollment programs and our ability to use other service staff in the membership enrollment process.

 

Government Regulation

 

Our operations and business practices are subject to regulation at federal, state, provincial 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 and provincial statutes and regulations affecting the fitness industry have been enacted or proposed in all of the states and provinces 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, state and provincial 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 and provincial laws governing the collection of debts. These laws and regulations are subject to varying interpretations by a large number of state, provincial 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 and provinces 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 or provincial 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 and provincial 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, therefore, 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

 

Sale of Crunch Fitness

 

On January 20, 2006, we completed the sale of the chain of health clubs operated under the “Crunch Fitness” brand along with certain additional health clubs located in San Francisco, California. Currently, two health clubs constituting part of the Crunch Fitness chain that could not be transferred to the purchaser at closing are being

managed by the purchaser as part of the acquired business until the parties secure consents necessary to complete the transfers. We received the $45 million purchase price at closing (less $2.25 million deposited in an escrow account to cover any required purchase price adjustments), plus $0.5 million in purchase price adjustments, as consideration for the transaction. In connection with the transaction, the Company sold property and equipment with a net book value of approximately $13 million and goodwill and intangibles with a net book value of approximately $27 million as of December 31, 2005. Deferred revenue and deferred rent associated with the sold health clubs was approximately $20.6 million and $15 million, respectively, at December 31, 2005. The Company expects to record a gain of approximately $38 million in the first quarter of 2006 as a result of the sale. After escrow, transaction costs and expenses, in accordance with our Amended and Restated Credit Agreement dated October 14, 2004 (the “Credit Agreement”), we retained $10 million of the sale proceeds and paid $30 million to reduce outstanding indebtedness under our term loan. On June 6, 2006, $1.8 million was released from the escrow account, all of which was used to reduce outstanding indebtedness under our term loan. The remaining funds held in the escrow account will be released upon satisfaction of the terms and conditions of the escrow agreement.

 

The Company and/or certain of its subsidiaries remain liable for the obligations (including rent) on certain leases transferred to the purchaser in the amount of $90.2 million and may remain liable for the obligations on three additional leases that have not yet transferred to purchaser in an additional amount of $8.5 million.

 

The amount of foregoing liabilities will reduce over time as obligations are paid by the purchaser under these leases. However, certain of the leases possess renewal options which, if exercised by purchaser, will again increase the amount of liability of the Company and/or certain of its subsidiaries under such lease existing as of the date of such exercise by purchaser but for no more than the obligations for a 5 year period under any such lease.

 

The Company’s exposure for these retained liabilities is mitigated by two letters of credit naming the Company as beneficiary, aggregating $3.2 million and having a term equal to the longer of three years or the time the purchaser has a Debt to EBITDA Ratio of less than 3 to 1.

 

The Company will record a liability on its balance sheet for the estimated fair value of these retained liabilities equal to $0.6 million based upon an analysis prepared by an independent third party valuation company.

 

Changes With Respect to the Board of Directors

 

On January 11, 2006, we announced the appointment of John W. Rogers, Jr. as Lead Independent Director of our Board of Directors.

 

On January 11, 2006, we announced the establishment of a special committee (the “Strategic Alternatives Committee”) comprised of four independent directors, led by the Lead Independent Director, to manage the strategic process with J.P. Morgan Securities Inc. and The Blackstone Group L.P., the Company’s outside financial advisors, in evaluating alternatives relative to the possible sale, recapitalization or other strategic transaction involving the Company.

 

We held our Annual Meeting of Stockholders on January 26, 2006, at which time J. Kenneth Looloian did not stand for re-election as a director of the Company. The vote at the Annual Meeting was certified by IVS Associates, Inc. on February 7, 2006, and Charles J. Burdick, Barry R. Elson and Don R. Kornstein were duly elected as directors of the Company. Eric Langshur was not re-elected. On February 9, 2006, Adam S. Metz resigned from the Board of Directors and Eric Langshur was unanimously reappointed by the Board of Directors. Mr. Langshur continues to serve as chairman of the Audit Committee.

 

On February 10, 2006, we expanded the Strategic Alternatives Committee to five members and announced that Don R. Kornstein would co-chair the Strategic Alternatives Committee with John W. Rogers, Jr., and that Barry M. Deutsch, Barry R. Elson and Steven S. Rogers would also serve on the Strategic Alternatives Committee.

 

Annual Meeting of Stockholders

 

On February 7, 2006, IVS Associates, Inc. certified the vote of the Annual Meeting of Stockholders held January 26, 2006 and confirmed that Charles J. Burdick, Barry R. Elson and Don R. Kornstein were elected as directors of the Company. In addition to the election of new directors, IVS Associates, Inc. certified that the

proposal to adopt the 2006 Omnibus Equity Compensation Plan was defeated, that the proposal to ratify the appointment of KPMG LLP as independent auditor was approved, that the stockholder proposal of Pardus Capital Management L.P. regarding bylaw amendments was approved, and that the stockholder proposals of Liberation Investments, L.P. did not receive the required approval of 75% of the outstanding common shares of the Company.

 

Credit Agreement Amendment and Noteholder Consent Solicitation

 

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 97/8% Senior Subordinated Notes (“Senior Subordinated Notes”) and 101/2% Senior Notes due 2011 (“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 excludes 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 through July 10, 2006, and for the quarter ended June 30, 2006 through September 11, 2006, with an option to elect to extend through 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, the Company 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 sales 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, the Company entered into the Fourth Amendment to the Credit Agreement 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. The Company paid the lenders under the Credit Agreement fees of $0.5 million in connection with the Fourth Amendment.

We are in the process of implementing new accounting processes and technologies designed to shorten the time required to prepare and file our financial statements. In addition, as described above, while we have secured additional time to file our second quarter financial statements with the SEC without causing a default under the indentures governing the Senior Notes and the Senior Subordinated Notes, and to file our third quarter financial statements with the SEC without causing a cross-default under our Credit Agreement, we cannot assure you that we will be able to make such filings within the extended time periods. Failure to do so will lead to further defaults under the indebtedness and the Credit Agreement and could require us to seek additional consents from our bondholders and lenders.

 

On March 31, 2006, the Company was not in compliance with two credit agreements with the same lender. These agreements represented debt of restricted subsidiaries in the amount of $3.1 million and debt of an unrestricted subsidiary in the amount of $1.7 million. On April 13, 2006, these agreements were amended and the Company was in compliance with the amended agreements.

 

Management Changes

 

On April 17, 2006, the Company announced that Carl J. Landeck, Senior Vice President and Chief Financial Officer was no longer an employee of the Company and that Ronald G. Eidell of Tatum, LLC had joined the Company as Senior Vice President, Finance, with responsibility for all accounting and finance functions.

Item 1A.  Risk Factors

 

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 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.

 

Our substantial leverage could adversely affect our financial health.

 

We have a substantial amount of debt. As of May 31, 2006, our total consolidated debt was approximately $735.2 million. Our substantial indebtedness could adversely affect our financial health by, among other things:

 

 

Our inability to comply with covenants under the Credit Agreement and indentures governing our Senior Notes and Senior Subordinated Notes could adversely impact our ability to operate our business.

 

The Credit Agreement and indentures governing our Senior Notes and Senior Subordinated Notes contain covenants that include, among others, financial reporting covenants; restrictions on incurring additional indebtedness; incurring liens; certain types of payments (including capital stock dividends and redemptions, and payments on existing indebtedness); capital expenditures; investments; and sale and leaseback transactions. The Company has failed to comply with its financial reporting covenants during 2004, 2005 and 2006, and has obtained waivers with respect to its non-compliance. Any breach of any of these covenants will result in a default and/or cross-default under the Credit Agreement or the indentures.

 

In addition, the Credit Agreement requires the Company to meet certain interest coverage and leverage tests, as such tests are defined in the Credit Agreement. If we are unable to comply with these covenants there would be a default under the Credit Agreement which could result in a cross-default under the indentures governing the Senior Notes and the Senior Subordinated Notes. Upon a default under the Credit Agreement, we will not have access to the revolving credit facility and likely will not have adequate liquidity to meet our operating needs. Changes in economic or business conditions, results of operations or other factors could also cause the Company to default under its debt instruments. A default, if not waived by Bally’s lenders, could result in acceleration of the Company’s debt.

 

We are uncertain of our ability to obtain additional financing for our future capital needs. If we are unable to obtain additional financing, we may not be able to continue to operate our business.

 

The Company requires substantial cash flows to fund its capital spending and working capital requirements. We maintain a substantial amount of debt, the terms of which require significant interest payments each year. We currently anticipate our cash flow and availability under our $100 million revolving credit facility pursuant to our Credit Agreement will be sufficient to meet our expected needs for working capital and other cash requirements through the first quarter of 2007. However, changes in terms or other requirements by vendors could negatively

impact cash flows and liquidity. We do not believe our cash flow and availability under the revolving credit facility will be sufficient to repay our $300 million Senior Subordinated Notes which are due in October 2007. In addition, the Credit Agreement will terminate in the event that the Senior Subordinated Notes have not been refinanced on or before April 15, 2007. As a result, we may need to raise additional funds through public or private equity or debt financings. We cannot assure you that any such funds will be available to us on favorable terms or at all. If such funds are unavailable to us, we may default on our Senior Subordinated Notes, our Senior Notes and our Credit Agreement, and may not be able to continue to operate our business. In addition, upon a default under our Credit Agreement, whether directly or as a result of a cross-default to other indebtedness, we will not be able to draw on the revolving credit facility and may not be able to continue to operate our business.

 

There can be no assurance that any strategic transaction will occur, or if one is undertaken, of its
potential terms or timing.

 

As we previously announced, we are currently exploring strategic alternatives to enhance stockholder value, and the Strategic Alternatives Committee of our Board of Directors has engaged J.P. Morgan Securities Inc. and The Blackstone Group L.P. to assist the Company in this process. The Strategic Alternatives Committee authorized J.P. Morgan Securities Inc. and The Blackstone Group L.P. to engage in discussions with interested parties in connection with the strategic alternative process. There can be no assurance that any transaction will occur, or if one is undertaken, of its potential terms or timing.

 

We are subject to risks associated with implementation of the new business initiatives.

 

We have devoted significant resources to the development and testing of new business initiatives, including our BYOM program and our new club staffing programs. However, there can be no assurance the results of our national roll-out of these programs will be successful. The introduction of BYOM could result in pricing contraction or variances in the average payment collected. Furthermore, the national roll-out required significant resources in the planning and implementation, as well as additional training for our club personnel, and may require additional such training in the future which may result in additional costs and distract personnel from other responsibilities. Accordingly, there can be no assurance that these programs will be effective in attracting and/or retaining members. Furthermore, some initiatives are long-term strategic initiatives and, accordingly, may not result in short-term operating efficiencies and, if unsuccessful, may result in additional operating costs.

 

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

 

The profitability of the Company’s fitness centers is dependent, in part, on the Company’s ability to originate and retain members. There are numerous factors that could affect the Company’s membership origination and retention at its fitness centers or that could lead to a decline in member origination and retention rates, including the ability 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. 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.

 

The positive results achieved from introducing the sale of products and services during recent years may not continue in the future.

 

We have introduced a number of business initiatives to capitalize on our brand identity, distribution infrastructure, significant member base and frequency of visitation. These initiatives primarily focus on selling ancillary products and services to our members within our fitness centers and include: providing personal training services; selling Bally-branded nutritional products; opening retail stores selling nutritional products, workout apparel and related accessories; and martial arts programs. We have generated significant revenue from products and services since implementing these initiatives. However, they may not continue to be successful in the future. The sale and marketing of nutritional products, workout apparel and related accessories and the provision of

rehabilitative and physical therapy services involve significant risk of competition. See Item 1 — Business — Competition.

 

We may not be able to continue to compete effectively in each of our markets in the future.

 

The fitness center industry is highly competitive. Within each market in which we operate, we 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, country clubs, weight reducing salons, vitamin stores and the home-use fitness equipment industry. We also compete, to some extent, with entertainment and retail businesses for the discretionary income of our target markets. In addition, we face greater regional competition with increasingly large and well-capitalized fitness companies such as 24 Hour Fitness Worldwide, Inc., L.A. Fitness, Inc., Town Sports International Holdings, Inc., Life Time Fitness, Inc. and Curves International, Inc. We may not be able to continue to compete effectively in each of our markets in the future. Additionally, competitive conditions may limit our ability to maintain or increase pricing of membership fees and may impact our ability to attract new members, retain existing members and retain or attract qualified personnel.

 

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.

 

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. If we are not able to achieve and maintain compliance, we may be liable for substantial fines and penalties and possibly lose our ability to accept credit cards for the payment of memberships and/or the sale of products and services. The inability to accept credit cards would have a material adverse impact on our business and results of operations.

 

Weaknesses in the Company’s internal controls and procedures could have a material adverse effect on the Company.

 

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, 2005, 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, set forth herein (See Note 2 of Notes to Consolidated Financial Statements, 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, 2005. See Item 9A — Controls and Procedures for a description of these material weaknesses.

 

Due to the existence of these material weaknesses, management concluded we did not maintain effective internal control over financial reporting as of December 31, 2005, 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 do not believe that all material weaknesses will be remediated by December 31, 2006.

 

We are developing a remediation plan and intend to implement remediation measures during 2006 and 2007, each designed to remediate the material weaknesses in our internal controls by December 31, 2007 (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.

 

Our ability to report our financial results on a timely basis in the future could be adversely affected by our weaknesses in internal controls.

 

If we are unable to substantially improve our internal controls, including the capability and efficiencies of our computer and information technology systems, our ability to report our financial results on a timely and accurate basis will continue to be adversely affected. If we are unable to timely file reports with the SEC, we may be required to seek further waivers of reporting covenants from our bondholders and lenders and pay additional consent fees to our bondholders and lenders. We cannot assure you that such waivers could be obtained. If we are unable to obtain a waiver, defaults would occur under our Senior Notes and Senior Subordinated Notes, with a potential cross-default under the Credit Agreement if the holders of the Senior Notes or Senior Subordinated Notes deliver a notice of default. Upon any such event, we may not be able to continue to operate our business. In addition, if we are unable to timely file, the Company could be considered for delisting by the New York Stock Exchange and our stockholders could find it difficult to buy or sell our common shares and the trading prices for our common shares could be adversely effected. Our ability to access the capital markets is also subject to our timely filing of periodic reports with the SEC, and our recent failure to file certain reports on a timely basis limits our ability to access the capital markets using a short-form registration.

 

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 Credit Agreement. 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 and current 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 maintain primary and excess directors and officers liability insurance policies. In November 2005 and April 2006, we and certain of our former and current officers and directors 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 intend to vigorously defend them. However, we cannot currently predict the impact or outcome of these litigations, 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 the Company is 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. The implementation of BYOM and the new club staffing program has required certain market specific adjustments and may require future adjustments to remain in compliance with federal, state and local 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.

 

If we do not retain our key personnel or fail to attract and retain other highly skilled employees our

business may suffer.

 

The success of our business is heavily dependent on the capabilities of our management team. If critical persons were to leave, it might be difficult to replace them and our business could be adversely affected. In addition, the Company has little equity compensation with which to induce or retain management. The Company’s 1996 Long-Term Incentive Plan expired on January 3, 2006, and as of the date of this filing, only 42,500 shares of common stock are available to be issued to new employees under the Company’s Inducement Award Equity Incentive Plan. Further, stockholders did not approve the proposed 2006 Omnibus Equity Compensation Plan at the Company’s Annual Meeting of Stockholders held in January 2006. We cannot assure you that we can attract and retain a sufficient number of qualified personnel to meet our business needs.

 

The continuing time, effort and expense relating to internal and external investigations and the
development and implementation of improved internal controls and procedures may have an adverse effect on our business.

 

In addition to the challenges of the various government investigations and extensive litigation we face, our current management team is expected to spend considerable time and effort dealing with the follow up to internal and external investigations involving our historical accounting and internal controls, and in further developing and implementing accounting policies and procedures, disclosure controls and procedures and corporate governance policies and procedures. The significant time and effort required for these matters may distract the management team and have an adverse effect on our business.

 

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 for our information systems and renewal processing facilities.

 

The following table sets forth information concerning fitness centers operated by the Company:

 

 

 

 

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 give us at least one five-year option to renew and often two or more such options.

 

Substantially all of our properties are subject to liens under the Credit Agreement or other mortgages.

 

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 Securities Exchange Act of 1934, as amended (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. The various defendants filed motions to dismiss the amended consolidated complaint on February 24, 2006, which motions are currently pending. It is not yet possible to determine the ultimate outcome of these actions.

 

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 and John Rogers, Jr., who are current directors and/or officers, and Lee Hillman, John Dwyer, J. Kenneth Looloian, Stephen Swid, George Aronoff, Martin Franklin and Liza Walsh, who are now 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. Bally 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. That motion is currently pending. It is not yet possible to determine the ultimate outcome of these actions.

 

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 current and 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. Bally 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. That motion is currently pending. 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 and are currently pending. It is not yet possible to determine the ultimate outcome of this action.

 

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 current 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. Under the current schedule, motions to dismiss on other grounds are to be filed on July 19, 2006. It is not yet possible to determine the ultimate outcome of this action.

 

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 our 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 requests 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, which motions are currently pending. 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 requests the Court to declare the Company’s excess policy for the year 2002-2003 void, voidable and/or subject to rescission. The Company and the individual defendants have not yet responded to the complaint. It is not yet possible to determine the ultimate outcome of these actions.

 

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.

 

On July 13, 2005, the Company commenced a solicitation of consents seeking an extension through October 31, 2005 of the waivers under the indentures governing its Senior Subordinated Notes and Senior Notes with respect to its inability to provide current financial statements. On August 24, 2005, certain beneficial owners of $155,829,000 in aggregate principal amount of the Senior Subordinated Notes consented to the extension of the waiver through November 30, 2005 providing the necessary consent to the waiver extension.

 

On August 25, 2005, the Company terminated the consent solicitation of the holders of the Senior Subordinated Notes. On August 30, 2005, the Company received the necessary consents from the holders of the Senior Notes to a waiver extension through November 30, 2005. On October 18, 2005, the Company commenced a follow-on consent solicitation to holders of the Senior Subordinated Notes, which closed on November 1, 2005. The vote totals for the consents are set forth on the following table:

 

 

Our common stock is 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.

 

 

As of May 31, 2006, there were 7,090 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 Credit Agreement 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 17, 2005, the Company entered into a consent agreement with its lenders under its Credit Agreement to permit the Company to enter into Rights Plan Transactions (as defined). On October 18, 2005, the Company’s 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, entitles 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 provides that the Rights become exercisable only after a triggering event, including a person or group acquiring 15% or more of the Company’s Common Stock. The Company’s Board of Directors is entitled to redeem the Rights for $0.001 per Right at any time prior to a person acquiring 15% or more of the outstanding Common Stock.

 

Should a person or group acquire more than 15% of the Company’s Common Stock, each Right will entitle its holder to purchase, at the Right’s then-current exercise price and in lieu of receiving shares of preferred stock, a number of shares of Common Stock of Bally having a market value at that time of twice the Right’s exercise price. In the same regard, the Rights of the acquiring person or group will become void and will not be exercisable. If Bally is acquired in a merger or other business combination transaction not approved by the Board of Directors, each Right will entitle its holder to purchase, at the Right’s then-current exercise price and in lieu of receiving shares of preferred stock, a number of the acquiring company’s common shares having a market value at that time of twice the Right’s exercise price.

The Rights Plan will terminate on July 15, 2006 unless the issuance of the Rights is ratified by Company stockholders prior to that time. We will not seek ratification of the Rights Plan by the Company’s stockholders.

 

Repurchases of Common Stock

 

The Company does not regularly repurchase shares nor does the Company have a share repurchase program. Furthermore, the terms of our Credit Agreement 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 — Securities Authorized for Issuance Under Equity Compensation Plans, which is incorporated herein by reference.

The following selected financial data reflects certain results of operations and certain balance sheet data for the years ended 2001 to 2005. 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. The financial information presented may not be indicative of our future performance.

 

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.

 

Executive Summary of Business

 

Bally is the largest publicly traded commercial operator of fitness centers in North America in terms of members, revenues and square footage of its facilities. As of December 31, 2005, we operated 409 fitness centers collectively serving approximately 3.610 million members. These 409 fitness centers occupied a total of 12.6 million square feet.

 

Our fitness centers are concentrated in major metropolitan areas in 29 states, the District of Columbia and Canada, with more than 350 fitness centers located in the top 25 metropolitan areas in the United States and Canada. As of December 31, 2005, we operated fitness centers in over 45 major metropolitan areas representing 61% of the United States population and over 16% of the Canadian population. Currently, approximately 50% of new joining members participate in a membership plan allowing multiple club access, varying from market to nationwide access to all like-branded fitness centers. Members electing multiple center access are required to make larger monthly payments than those who select a single club membership.

 

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.

 

Historically, Bally memberships in most markets required a two or three year commitment from the member with payments comprised of an initiation fee, interest and monthly dues. Since late 2003, we have expanded these offers to include “month-to-month” membership options that provide greater flexibility to members. Beginning in late 2004 and through December 2005, we implemented the Build Your Own Membership (“BYOM^sm”) program, which simplifies the enrollment process and enables members to choose the membership type, amenities and pricing structure they prefer.

 

We have three principal sources of revenue:

 

 

Currently, the majority of our members choose to purchase their membership under our multi-year value plan by paying an enrollment fee and by making monthly payments throughout the obligatory term of their membership. After the obligatory period of membership, our members enter the non-obligatory renewal period of membership and make monthly payments (“renewal payments”) to maintain membership privileges. Under sales methods in effect prior to December 2005, renewal payments were substantially discounted from the obligatory period monthly payment level. Following the nationwide implementation of our new BYOM pricing plan, in most markets renewal payments carry a smaller or no discount from the obligatory period monthly payment level. Our members may also choose to purchase a prepaid

membership for periods up to three years. Members choosing our month-to-month membership payment option make month-to-month non-obligatory payments after paying an enrollment fee. Ongoing membership dues for members in renewal periods may be paid monthly or annually or may be prepaid for multiple future periods.

 

Our membership services revenue is generally collected as cash on a basis that does not conform to its basis of revenue recognition, resulting in the deferral of significant amounts received early in the membership period that will be recognized in later periods. This recognition methodology is a consequence of our long history of offering membership programs with higher levels of monthly or total payments during the obligatory period of membership, generally for periods of up to three years, followed by discounted payments in the subsequent renewal phase of membership. Our revenue recognition objective is to recognize an even amount of membership revenue from our members throughout their entire term of membership, regardless of the payment pattern. As a result, we make estimates of membership term length on a composite group basis of all members joining in a period and set up separate amortization pools based on estimated total group membership term length averages. Estimated term lengths used to create the separate amortization term groups for revenue recognition are based on historical average membership terms experienced by our members.

 

Membership services revenue related to members who maintain their membership for periods beyond the obligatory term of membership is deferred as collected and recognized on a straight-line basis over the estimated term of total membership. Our historical evaluation of members has resulted in a determination that approximately 37% of originated monthly payment revenue from our members is subject to deferral to be recognized over their entire term of membership. As a result, we defer all collections received from members in this group, and recognize as membership service revenue these amounts based on five amortization pools with amortization periods of 39 months to 245 months, representing composite average membership terms of between 37 months and 360 months. Membership services revenues that have been prepaid in their entirety for the obligatory period of membership are recognized in a similar manner, except that the estimate of the group expected to remain a member for only the obligatory period of membership is amortized over the length of the contract, which is generally 36 months, but varies by state. Based on the historical attrition patterns of members who pay their membership in full upon origination, approximately 57% of such membership revenue relates to members who maintain their membership beyond the obligatory three-year period of membership, which is amortized using the same five amortization pools as described for monthly collections.

 

We evaluate the actual attrition patterns of all of our deferred revenue pools on a quarterly basis and make adjustments from our historical experience to take into account actual attrition by origination month groups. As we determine that our new estimated attrition is different than the initial estimate based on historical patterns, we recognize as a change in accounting estimate a charge or credit to membership services revenue in the period of evaluation to cumulatively adjust past recognition and ending deferred revenue. Under our deferred revenue methodology, an increase in membership attrition rates will result in an increase in revenue in the period of adjustment as it is determined that amounts previously deferred to future periods of membership no longer need to be deferred. Alternatively, a decrease in membership attrition rates can reduce membership services revenue as it is determined that amounts previously considered earned are required to be deferred for recognition in future periods.

 

Our membership mix impacts the amount of cash that we defer for later recognition as revenue, and the period of time over which we recognize that revenue. During 2005 we increased our sales of month-to-month memberships, nonobligatory add-on memberships, and nonrenewable paid in full contracts. The average deferral period for these memberships is substantially shorter than the average deferral period for members that select our multi-year plans that include memberships with discounted payments in the renewal phase of membership. As a result of these shorter deferral periods, cash is recognized as revenue more quickly for month-to-month, nonobligatory add-on, and nonrenewable paid in full memberships than for the multi-year plans.

Personal training and other services are provided at most of the Company’s fitness centers. Personal training services contracts are either paid-in-full at the point of origination, or are financed and collected generally over three months after an initial payment. Collections related to paid-in-full personal training services contracts are deferred and recognized as personal training services are rendered. Revenue related to personal training services contracts that have been financed is recognized at the later of cash receipt or the rendering of personal training services.

 

Membership services revenue comprised approximately 94% of our 2005 and 93% of our 2004 and 2003 revenue. Membership services revenue is recognized at the later of when membership services fees are collected or earned. Membership services fees collected but not yet earned are included as a deferred revenue liability on the balance sheet.

 

 

Our operating costs and expenses are comprised of the following:

 

 

We evaluate the results of our fitness centers on a two-tiered segment basis (comparable and non-comparable) depending on how long the fitness centers have been open at the measurement date. We include a fitness center in comparable fitness center revenues beginning on the first day of the 13th full calendar month of the fitness center’s operation, prior to which time we refer to the fitness center as a non-comparable fitness center and, therefore, an element of noncomparable revenue.

 

We measure performance using key operating statistics such as profitability per club, per area and per region. We also evaluate average revenue per member and fitness center operating expenses, with an emphasis on payroll and occupancy costs as a percentage of sales. We use fitness center cash contribution and cash revenue to evaluate overall performance and profitability on an individual fitness center basis. In addition, we focus on several membership statistics on a fitness center-level and system-wide basis. These metrics include new membership sales, growth of fitness center membership base and growth of system-wide members, fitness center number of workouts per month, fitness center membership sales mix among various membership types and membership retention.

 

Our primary sources of cash are enrollment fees, paid-in-full and monthly membership fees and dues payments made by our members and sales of products and services, primarily personal training. Because enrollment fees, membership fees and monthly membership dues are recognized over the later of when such payments are collected or earned, cash received from membership fees and monthly membership dues will often be received before such payments are recognized in the consolidated statement of operations.

 

Our primary capital expenditures relate to the construction of new fitness centers and upgrading and expanding our existing fitness centers. The construction and equipment costs for a new fitness center approximates $3.5 million, on average, which varies based on the costs of construction labor, as well as on the planned service offerings, size and configuration of the facility and on the market.

 

Most of our operating costs are relatively fixed, but compensation costs, including sales compensation costs, are variable based on membership origination and personal training sales trends. Because of the large pool of relatively fixed operating costs and the minimal incremental cost of carrying additional members, increased membership origination and better membership retention lead ultimately to increased profitability. Accordingly, we are focusing on member acquisition and member retention as key objectives.

 

We believe we are well positioned to benefit from continued growth in club membership, which, according to the IHRSA’s Industry Data Survey of the Health and Fitness Club Industry, increased 4.8% in 2004. Increased competition, however, including competition from very small fitness centers (less than 3,000 square feet), will require us to continue to reinvest in our facilities to remain competitive. Furthermore, price discounting by competitors, particularly in more competitive markets, may negatively impact our membership growth and/or our average revenue per member. Our principal strategies are to improve member origination and retention by enhancing customer service, promoting and improving our products and services and improving operating efficiencies. We believe the BYOM program provides a unique opportunity to combine a customized membership offering with this expanded service philosophy. See Item 1A — Risk Factors — “We may not be able to attract or retain a sufficient number of members to maintain or expand the business” and “We are subject to risks associated with implementation of the new business initiatives”.

 

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 1 in 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:  The Company’s principal sources of revenue include membership services, principally health club memberships and personal training services, and the sale of nutritional products. The Company recognizes 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, the Company relies upon a signed contract between the Company 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.

 

The Company receives membership fees and monthly dues from its members. Membership fees, which customers often finance, become customer obligations upon contract execution and after a “cooling off” period of three to fifteen 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. Contracts typically include a member’s right to renew the membership at a discount compared to the monthly payments made during the initial contractual term.

 

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 life is estimated at time of contract execution based on historical trends of actual attrition, and these estimates are updated quarterly to reflect actual membership retention. The Company’s estimates of membership life were up to 360 months during 2005, 2004, and 2003. As of December 31, 2005, the weighted average membership life for members that commit to a membership term of between 12 and 36 months is 39 months. Members with these terms that finance their initial membership fee have a weighted average membership life of 37 months, while those members that pay their membership fee in full at point of sale have a weighted average membership life of 56 months. Because of the discount in 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 Company 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 the change of estimate is made.

 

At December 31, 2005, 2004 and 2003, approximately 61% of members were in the non-obligatory renewal period of membership. Renewal members can cancel their membership at any time prior to their monthly or annual due date. Membership revenue from members in renewal include 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 4 and 41 months, with an average of 15 months.

 

Paid-in-full members who purchase nonrenewable memberships must repurchase the same 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 the Company’s 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. 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 the Company’s 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.

 

The Company enters 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 products. In these multiple element arrangements, health club services are typically the last delivered service. The Company accounts for these arrangements as single units of accounting because they do not have objective and reliable evidence of the fair value of health club services.

 

In November 2002, the Emerging Issues Task Force (“EITF”) issued a final consensus on Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“Issue 00-21”). In May 2003, the EITF issued additional interpretive guidance regarding the application of Issue 00-21. Issue 00-21, which provides guidance on how and when to recognize revenues on arrangements requiring delivery of more than one product or service, was effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. Effective July 1, 2003, the Company adopted Issue 00-21 on a prospective basis. Under 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 the Company’s control. As the Company does not have objective and reliable evidence of the fair value of health club services and treats these arrangements as single units of accounting, the adoption of Issue 00-21 did not have an impact on the Company’s financial statements.

 

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, 2005. 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 $1 million as of December 31, 2005.

 

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 future cash flows to the current carrying values of the related assets. We record impairment when the carrying values exceed the discounted 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 $10.1 million, $14.8 million and $19.6 million in 2005, 2004 and 2003, respectively. Changes may continue to occur as a result of investments in clubs in turnaround situations.

 

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. These charges amounted to $0 and $42.1 million in 2004 and 2003, respectively. No impairment of goodwill was identified at December 31, 2005.

 

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, the Company has recorded intangible assets totaling $9.4 million for trademarks, $4.7 million for leasehold rights and $0.3 million for membership relations at December 31, 2005. Balances at December 31, 2004 were $9.9 million for trademarks, $7.0 million for leasehold rights and $0.8 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 2005, 2004 and 2003 amounted to $1.2 million, $.4 million and $12.4 million, respectively.

 

Stock Option Plans:  We apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our stock option plans. Accordingly, because the exercise price of the option granted is equal to or greater than the market value of the underlying stock on the option grant date, no stock-based compensation expense is included in net earnings, other than expenses related to restricted stock awards. Note 1 of the Notes to Consolidated Financial Statements describes the effect on net earnings if compensation cost for all options had been determined based on the fair value at the grant date for awards, consistent with the methodology prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).

Results of Operations

 

The following table sets forth key operating data for the periods indicated (dollars in thousands except per member data):

 

 

 

Key Operating Data

 

 

 

 

Summary of revenue recognition method

 

The Company’s strategy is to grow the number of members by continued new member acquisition and improved retention. The Company also intends to grow its product and services revenue, as well as personal training.

 

The Company’s sources of membership revenue include health club memberships and personal training services. 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. The Company relies upon a signed contract between the Company 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.

 

The Company receives membership fees and monthly dues from its members. Membership fees, which customers often finance, become customer obligations upon contract execution and after a “cooling off” period of three to fifteen 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. Contracts generally include a member’s right to renew the membership at a discount compared to the payments made during the initial membership term.

 

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. The percent of add-on members has increased resulting from the popularity of this program, representing 26%, 25% and 22% of all members at December 31, 2005, 2004 and 2003, respectively.

 

Membership revenue is earned on a straight-line basis over the longer of the contractual term or the estimated membership term. Membership life is estimated at time of contract execution based on historical trends of actual attrition, and these estimates are updated quarterly to reflect actual membership retention. The Company’s estimates of membership life were up to 360 months during 2005, 2004 and 2003. As of December 31, 2005, the weighted average membership life for members that commit to a membership term of between 12 and 36 months is 39 months. Members with these terms that finance their initial membership fee have a weighted average membership life of 37 months, while those members that pay their membership fee in full at point of sale have a weighted average membership life of 56 months. Because of the discount in monthly payments made during the renewal term when compared to payments made in the initial contractual term, the estimate of membership term impacts the amount of revenue deferred in the obligatory period.

Cash collected for membership revenues is deferred and recognized on a straight-line basis over periods based on expected member attrition and cash collection patterns using historical trends, with the vast majority of membership revenues being recognized over six years or less. As a result, membership revenue recognized in the current period is largely attributable to the amortization of previously deferred cash receipts from prior periods. Decreasing attrition will result in more cash collected, but will also result in an increase in the amortization period. Increasing attrition, on the other hand, would decrease cash collected but accelerate the recognition of deferred revenue. We monitor actual retention and cash collection patterns and record any adjustments necessary to reflect the impact of changes in such patterns on a quarterly basis. Revenues recognized during a period reflect cash collected during prior periods and, to a lesser extent, cash collected in the current period. As a result, management considers both the cash collected for membership services as well as the revenue recognized in evaluating the Company’s results of operations.

 

Members in the non-obligatory renewal period of membership 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 member life. Member life is currently estimated at between 4 and 41 months, with an average of 15 months, for month-to-month members. Management believes that month-to-month memberships have become more appealing to those consumers who are willing to pay more, and do not want to be locked into a long-term obligation.

 

Personal training services are generally provided shortly after payment is received by the Company, which results in a relatively low and constant deferred revenue liability balance. As a result, personal training revenues recognized are relatively consistent with the level of cash received.

 

Comparison of the years ended December 31, 2005 and 2004

 

Total revenue for the year ended December 31, 2005 was $1,071.0 million compared to $1,048.0 million in 2004, an increase of $23.0 million (2%). The increase in total revenue resulted from the following:

 

 

Operating costs and expenses for the year ended December 31, 2005 were $995.4 million compared to $1,009.8 million during 2004, a decrease of $14.4 million (1%). This decrease resulted from the following:

 

 

We believe that membership revenue in 2006 will increase (after adjusting 2005 results for the effects of the sale of Crunch Fitness) primarily by enrolling new members and improving member retention as we implement BYOM, our new club staffing model and other initiatives designed to keep the member focused on fitness (See Item 1 — Business — Business Strategy). We generally expect changes in variable operating expenses in 2006 to track the changes in net revenue (also after adjusting 2005 results for the effects of the sale of Crunch Fitness). We are in the process of fully rolling out our new club staffing model to all our clubs, a program we expect to complete in 2006. Accordingly, expenses expected to be lower than 2005 levels include payroll and related costs, reflecting lower staffing levels on average than we experienced in 2005. Overall, approximately 70% of our expenses (primarily rent, utilities, maintenance and other occupancy related costs) are fixed in nature and do not vary with member or revenue levels. The balance of our expenses are variable and we have considerable ability to vary both the amount and timing of such expenses. We have changed the phasing and amount of planned expenses in the past and will likely do the same in 2006.

 

Comparison of the years ended December 31, 2004 and 2003

 

Total revenue for the year ended December 31, 2004 was $1,048.0 million compared to $1,002.9 million in 2003, an increase of $45.1 million (4%). The increase in total revenue resulted from the following:

 

 

 

Operating costs and expenses for the year ended December 31, 2004 were $1,009.8 million compared to $1,041.8 million during 2003, a decrease of $32.0 million (3%). This decrease resulted from the following:

 

 

Financial Condition

 

Our consolidated assets of $480.1 million as of December 31, 2005 reflect a decrease of $22.4 million from 2004. This decrease was primarily due to a $38.0 million decrease in property and equipment, resulting from a

decrease in capital expenditures in 2005 of $11.9 million compared to 2004 and asset impairment charges of $10.1 million. This decrease was offset in part by:

 

 

Liquidity and Capital Resources

 

The following table summarizes the Company’s liquidity for 2005 and 2004 (in millions):

 

 

The Company’s Credit Agreement provides for a $100 million revolving credit facility that expires in June 2008, and a $175 million term loan expiring in October 2009 (the term loan balance was $141 million at June 15, 2006 due to the previously mentioned repayment, pursuant to the sale of Crunch Fitness). The rate of interest on borrowings under the revolving credit is equal to the Eurodollar or reference rate (higher of the prime rate of the federal funds rate plus 0.50%) plus a margin that varies based on the total leverage of the Company. The interest on the term loan is equal to the Eurodollar rate or reference rate plus a fixed margin. The Credit Agreement is secured by substantially all of the Company’s real and personal property and contains restrictive covenants that include certain interest coverage and leverage tests (see subsequent discussion of Debt). Additionally, the Credit Agreement will terminate early in the event that the Senior Subordinated Notes have not been repaid or refinanced on or before April 15, 2007.

 

There was $35 million borrowed and $13.6 million in letters of credit issued under the revolving credit facility at December 31, 2005. The increased borrowing level during 2005 was due in part to payment of a judgment resulting from an arbitration award against the Company, various consent payments and other fees to lenders and increased professional fees.

 

As of December 31, 2005, we were in compliance with all covenants under the Credit Agreement.

 

The Company requires operating cash flow to fund its capital spending and working capital requirements. The Company maintains a substantial amount of debt, the terms of which require significant interest payments each year. The Company currently anticipates that cash flow and availability under the $100 million revolving credit facility under the Credit Agreement will be sufficient to meet its expected needs for working capital and other cash requirements through the first quarter of 2007. However, our cash flows and liquidity may be negatively impacted by various items, including changes in terms or other requirements by vendors, regulatory fines or penalties, settlements or adverse results in securities or other litigations, future consent payments to lenders or bondholders if required and unexpected capital requirements.

 

The Credit Agreement will terminate if the Senior Subordinated Notes are not repaid or refinanced on or before April 15, 2007. We do not believe our cash flow and availability under the $100 million revolving credit facility will be sufficient to meet our needs in 2007 when the Senior Subordinated Notes come due. Therefore, we may need to raise additional funds through private or public debt or equity financings. There is no assurance that funds will be available to the Company on favorable terms or at all. If such funds are unavailable to us, we may default on our Senior Notes, our Senior Subordinated Notes and our Credit Agreement. In addition, upon a default under our Credit Agreement, whether directly or as a result of a cross-default to other indebtedness, we will not be able to draw on the revolving credit facility and may not be able to continue to operate our business.

Interest Expense

 

Interest expense for the year ended December 31, 2005 increased $18.1 million to $85.3 million, principally due to higher interest rates ($10.9 million) as a result of the increase in general interest rate levels plus the full year impact of the replacement of the Company’s accounts receivable securitization with a higher rate term loan, and an increase in amortization of deferred financing fees ($5.1 million) resulting from the fees paid to obtain the waiver of financial reporting covenants under certain debt agreements (see subsequent discussion under Consent Solicitations).

 

Interest expense for the year ended December 31, 2004 increased $4.6 million to $67.2 million from the year ended December 31, 2003, principally due to a higher average effective interest rate in 2004 resulting from increases in general interest rate levels and the replacement of the Company’s accounts receivable securitization with a higher average rate term loan during 2004.

 

Of our total debt outstanding of $769.3 million at December 31, 2005, approximately 53% 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 2005 as a result of the rising interest rate environment and will continue to increase if interest rates continue to rise in 2006. Correspondingly, should rates decrease, we would benefit from the lower rates. Our interest expense will be favorably impacted by the $30 million reduction in our term loan from the application of the proceeds from the sale of Crunch Fitness. In March and April 2006, we paid fees to lenders and bondholders that will further increase amortization of deferred financing costs and interest expense.

 

Cash Flows

 

The following table summarizes the Company’s cash flows for 2005 and 2004 (in millions):

 

 

Operating Activities

 

Net cash provided by operating activities of $30.7 million decreased $5.4 million (15%) in 2005 from 2004. Cash received from memberships increased $7.9 million, offset by increased costs including insurance, occupancy costs, audit fees, professional fees associated with restructuring, restatements and securities matters and payment of a judgment resulting from an arbitration award against the Company.

 

Investing Activities and Capital Expenditures

 

Net cash used in investing activities totaled $36.2 million in 2005 compared to $50.2 million in 2004, a 28% reduction, due to a decrease in capital expenditures from $49.7 million in 2004 to $37.9 million in 2005. We opened a club in Huntington Park, California in March 2005. We opened a club in Carrollton (Dallas), Texas in April 2006. Three clubs currently in development are planned for opening in 2006 (two replace existing clubs), four are also planned to open in 2007 (three replace existing clubs) and two during 2008 (both replace existing clubs). During 2005 we spent approximately $10 million on new clubs and $25 million to maintain our existing clubs. During 2006 we expect to spend approximately $10 million on new clubs and $20-$25 million to maintain our existing facilities. These expenditures maintain our clubs at levels needed to attract and retain members.

Financing Activities

 

Net cash provided by financing activities totaled $3.4 million in 2005 compared to $19.2 million in 2004. Other than $0.25 million of capital leases, no new debt was issued during 2005. Debt related financing activities consisted of borrowings under the revolving credit facility and repayments of various debt and capital lease obligations. Debt issuance and refinancing costs of $11.3 million were related primarily to the fees associated with the consent solicitations, some of which were funded by the proceeds of $1.4 million from stock issuances in November 2005 (see subsequent discussion under Consent Solicitations).

 

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, 2005 (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 Credit Agreement 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 any in the future.

 

Debt

 

Credit Agreement

 

On October 14, 2004, we entered into a credit agreement with a group of financial institutions led by JPMorgan Chase Bank that provides for a five-year $175 million term loan in addition to the existing $100 million revolving credit facility that expires in June 2008. The proceeds of the term loan were used to refinance our $100 million Securitization Series 2001-1 which was to begin amortizing in November 2004, and to provide approximately $75 million of additional liquidity for general corporate purposes. The Credit Agreement is secured by substantially all of the Company’s real and personal property, including member obligations under installment contracts. The Credit Agreement contains restrictive covenants that include certain interest coverage and leverage ratios, 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; capital expenditures; investments; mergers, consolidations, sales and acquisitions; transactions with subsidiaries; conduct of business; sale and leaseback transactions; incurrence of judgments; changing fiscal year; and financial reporting, all subject to certain exceptions. The Credit Agreement will terminate on April 15, 2007 in the event that the Senior Subordinated Notes have not been refinanced on or before that date. As provided for in the Credit Agreement, all of our financial reporting to the lenders, including for the period ended December 31, 2005, will be prepared in accordance with U.S. generally accepted accounting principles. At December 31, 2005 there was $35 million borrowed and $13.6 million in letters of credit issued under the revolving credit facility. At May 31, 2006, there was $39.5 million borrowed and $14.1 million in letters of credit issued under the revolving credit facility and the outstanding balance on the term loan was $143.3 million, reflecting a $30 million mandatory repayment from the proceeds of the Crunch Fitness sale.

 

As of December 31, 2004, we believed that we may have violated certain financial ratios under our Credit Agreement. As of March 31, 2005, we entered into an amendment to the Credit Agreement that, among other things, excluded certain expenses incurred in connection with the SEC and Department of Justice investigations and other matters from the calculation of various financial covenants, waived certain events of default related to, among other things, delivery of financial information and leasehold mortgages, reduced permitted capital expenditures, and increased financial reporting requirements. In connection with the Consent Solicitations (see below), we entered into amendments and consents with our lenders under the Credit Agreement effective August 24, 2005 and March 24, 2006.

 

Consent Solicitations

 

As a result of the Audit Committee investigation into certain accounting issues and the retention of new independent auditors, we were unable to timely file our financial statements for the quarter ending June 30, 2004 with the SEC. Although the filing delay resulted in defaults of the financial reporting covenants under the indentures governing our Senior Subordinated Notes and Senior Notes, it did not become an event of default until delivery of a notice of default and expiration of a 30-day cure period. On October 29, 2004, we were advised by the trustee for both series of notes that it intended to send a notice of default no later than December 15, 2004 unless we obtained a waiver or remedied the default by that date. On December 7, 2004, we completed consent solicitations to amend the indentures governing the Senior Subordinated Notes and Senior Notes to waive through July 31, 2005 any default arising under the financial reporting covenants in the indentures from a failure to timely file consolidated financial statements with the SEC. In order to secure the waivers until July 31, 2005, we paid additional consent fees on June 3, 2005 and July 6, 2005. The fees paid to noteholders for these consents were $2.3 million in 2004 and $2.3 million in 2005.

 

On July 13, 2005, we commenced a consent solicitation to extend the waivers under the indentures. On August 4 and 5, 2005, we received notices of default under the indentures following the expiration of the waiver of the financial reporting covenant defaults on July 31, 2005. The notices commenced the 30-day cure period under the indentures and a 10-day period after which a cross-default would have occurred under our Credit Agreement.

Effective August 9, 2005, our lenders consented to extend the 10-day period until August 31, 2005. On August 24 and August 30, 2005, we received consents from holders of a majority of the Senior Subordinated Notes and Senior Notes, respectively, to extend the waivers until November 30, 2005. Effective August 24, 2005, we further amended the Credit Agreement to permit payment of consent fees to the holders of the Senior Notes and Senior Subordinated Notes, to exclude certain additional expenses from the computation of various financial covenants and to reduce the required interest coverage ratio for the period ending March 31, 2006 and limits revolver borrowings under the Credit Agreement if the Company’s unrestricted cash exceeds certain levels. On November 1, 2005, we completed a consent solicitation of those holders of our Senior Subordinated Notes who were not party to the August 24, 2005 consent agreement.

 

In connection with these consents, we paid $4.9 million in total fees to the noteholders, issued 1,903,200 shares of unregistered common stock and recorded $7.4 million in deferred finance charges. Additionally, we issued 232,000 shares of unregistered common stock to the solicitation agent as compensation, sold 409,314 shares of unregistered common stock to the solicitation agent to fund part of the cash portion of the fees to noteholders, and paid the lenders under the Credit Agreement $2.9 million for their consents and amendment.

 

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 through July 10, 2006, and for the quarter ended June 30, 2006 through September 11, 2006, with an option to elect to extend through 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, the Company 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 sales 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, the Company 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. The Company paid the lenders under the Credit Agreement fees of $0.5 million in connection with the Fourth Amendment.

 

We are in the process of implementing new accounting processes and technologies designed to shorten the time required to prepare and file our financial statements. In addition, as described above, while we have secured additional time to file our second quarter financial statements with the SEC without causing a default under the indentures governing the Senior Notes and the Senior Subordinated Notes, and to file our third quarter financial statements with the SEC without causing a cross-default under our Credit Agreement, we cannot assure you that we will be able to make such filings within the extended time periods. Failure to do so will lead to further defaults under the indebtedness and the Credit Agreement and could require us to seek additional consents from our bondholders and lenders.

 

Other

 

On October 17, 2005, we entered into a consent with the lenders under our Credit Agreement which permits us to enter into one or more stockholder rights plans subject to certain conditions. The Board adopted a stockholder rights plan on October 18, 2005, which will expire on July 15, 2006.

 

Other Secured Debt

 

As of December 31, 2005, our unrestricted Canadian subsidiary was not in compliance with the terms of its credit agreement. As a result, the outstanding amount of $2.4 million has been classified as current as of such date. On May 31, 2006 there was $0.8 million outstanding.

 

Off-Balance Sheet Arrangements

 

The Company does 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 the Company’s financial condition or results of operations. Pursuant to the sale of Crunch Fitness, the Company remained liable on certain leases and/or lease guarantees. See Note 19 of Notes to Consolidated Financial Statements, Subsequent Events, Sale of Crunch Fitness, for a discussion of such obligations.

 

Recently Issued Accounting Standards

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment” (“SFAS No. 123R”). SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values and eliminates the alternative method of accounting for employee share-based payments previously available under Accounting Principles Board Opinion No. 25 (“APB 25”). In April 2005, the FASB delayed the effective date of SFAS No. 123R to fiscal years beginning after June 15, 2005. As a result, the Company will adopt SFAS No. 123R on January 1, 2006. The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. The Company will use the modified prospective method of transition. Based on estimates, the future compensation cost to be recognized as a result of the adoption of SFAS No. 123R for fiscal 2006 will be approximately $1.7 million. In addition, for any new awards that may be granted during fiscal 2006, the Company will incur additional expense that cannot yet be quantified.

 

In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, which expresses views of the SEC staff regarding the interaction between SFAS No. 123R and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. The Company will consider the guidance of this SAB as it adopts SFAS No. 123R.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which replaced APB Opinion No. 20, Accounting Changes, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statement” (“SFAS No. 3”). Among other changes, SFAS No. 154

requires retrospective application of a voluntary change in accounting principle to prior period financial statements presented on the new accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires accounting for a change in method of depreciating or amortizing a long-lived non-financial asset as a change in accounting estimate (prospectively) affected by a change in accounting principle. Further, the Statement requires that corrections of errors in previously issued financial statements to be termed as a “restatement.” The new standard is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005. We do not expect the adoption of SFAS No. 154 to have a material impact on our consolidated financial statements.

 

In October 2005, the FASB issued FASB Staff Position No. FAS 13-1 (“FSP 13-1”) “Accounting for Rental Costs Incurred During a Construction Period”, to clarify the proper accounting for rental costs incurred on building or ground operating leases during a construction period. FSP 13-1 requires that rental costs incurred during a construction period be expensed. The statement is effective for the first reporting period beginning after December 15, 2005. The adoption of FSP 13-1 is not expected to have a material impact on the Company’s financial position or results of operations.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). This statement simplifies accounting for certain hybrid instruments currently governed by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), or SFAS No. 155, by allowing fair value remeasurement of hybrid instruments that contain an embedded derivative that otherwise would require bifurcation. This statement also eliminates the guidance in SFAS No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets,” which provides such beneficial interests are not subject to SFAS No. 133. This statement amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a Replacement of FASB Statement No. 125” (“SFAS No. 140”) by eliminating the restriction on passive derivative instruments that a qualifying special-purpose entity may hold. This statement is effective for financial instruments acquired or issued after the beginning of the fiscal year 2007. The Company does not expect the adoption of this statement to have a material impact on its financial condition, results of operations or cash flows.

 

We are exposed to market risk from changes in the interest rates on certain of our outstanding debt. The outstanding loan balance under our Credit Agreement bears interest at variable rates based on prevailing short-term interest rates in the United States and Europe. Based on 2005’s average outstanding balance of these variable rate obligations, a 100 basis point change in interest rates would have changed interest expense in 2005 by approximately $1.5 million. In September 2003, we entered into interest rate swap agreements whereby our fixed interest commitment on $200 million of outstanding principal on our Senior Subordinated Notes varies based on the LIBOR rate plus 6.01%. A 100 basis point change in the interest rate on the portion of the debt subject to the swap agreement would change interest expense on an annual basis by $2.0 million. For fixed rate debt, interest rate changes affect their fair market value, but do not impact earnings or cash flows. We presently do not use other financial derivative instruments to manage our interest costs.

 

We have operations in Canada, which are denominated in local currency. Accordingly, we are exposed to the risk of future currency exchange rate fluctuations, which is accounted for as an adjustment to stockholders’ equity until realized. Therefore, changes from reporting period to reporting period in the exchange rates between the Canadian currency and the U.S. dollar have had and will continue to have an impact on the accumulated other comprehensive income (loss) component of stockholders’ equity, and such effect may be material in any individual reporting period. In addition, exchange rate fluctuation will have an impact on the U.S. dollar value realized from the settlement of intercompany transactions.

 

The consolidated financial statements of the Company, including the notes to all such statements, and other information are included in this report beginning on page F-1.

 

On March 25, 2004, the Company was notified by Ernst & Young LLP (“E&Y”), our principal accountant, that it had resigned. E&Y’s resignation became effective on May 10, 2004 with the filing of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. On May 18, 2004, the Company engaged KPMG LLP (“KPMG”) as its principal accountants for the year ending December 31, 2004. The decision to engage KPMG was made by the Audit Committee of the Board of Directors. Subsequently, in November 2004, we engaged KPMG to audit its consolidated financial statements for 2003 and 2002.

 

During the two years ended December 31, 2003, and through March 25, 2004, there were no disagreements between us and E&Y on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to E&Y’s satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with its report. There were no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K.

 

E&Y’s reports on the Company’s consolidated financial statements as originally filed for the years ended December 31, 2003 and 2002 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty or audit scope.

 

 

Management of the Company, with the participation of the principal executive officer and the principal financial officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act), as of December 31, 2005. Based upon this evaluation, the principal executive officer and the principal financial officer have concluded that the Company’s disclosure controls and procedures were not effective as of December 31, 2005 due to the material weaknesses in internal control over financial reporting described below (Item 9A(b)).

 

 

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness represents a significant deficiency (as defined in the Public Company Accounting Oversight Board’s Auditing Standard No. 2), or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

 

Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 based on the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, Internal Control — Integrated Framework. Management has identified the following material weaknesses in the Company’s internal control over financial reporting as of December 31, 2005:

 

 

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected, and contributed to the development of other material weaknesses described below.

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

As a result of these deficiencies, there were misstatements in the Company’s consolidated financial statements that were corrected prior to the issuance of the 2005 consolidated financial statements. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

As a result of these deficiencies, there were misstatements in the Company’s consolidated financial statements that were corrected prior to the issuance of the 2005 consolidated financial statements. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

As a result of these deficiencies, there were misstatements in the Company’s consolidated financial statements that were corrected prior to the issuance of the 2005 consolidated financial statements. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

As a result of these deficiencies, there were misstatements in the Company’s consolidated financial statements that were corrected prior to the issuance of the 2005 consolidated financial statements. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

 

 

These deficiencies resulted in material misstatements in the Company’s interim consolidated financial statements for the periods ended March 31, 2005, June 30, 2005, and September 30, 2005, all of which have been restated, and in its preliminary 2005 annual consolidated financial statements, which were corrected prior to issuance. These deficiencies resulted in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements would not be prevented or detected.

 

As a result of the aforementioned material weaknesses, management has concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2005.

 

KPMG LLP, the Company’s independent registered public accounting firm, has issued an audit report on management’s assessment of the Company’s internal control over financial reporting, which is included herein (Item 9A(e)).

 

 

There were no changes in the Company’s internal control over financial reporting that occurred during the fourth quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

The Company is developing a formal remediation plan and intends to make notable progress on remediation during 2006 and to complete the remediation of the majority of these weaknesses by December 31, 2007. Further, remediation includes the verification through management testing that the revised control procedures are operating effectively, which may extend the remediation timeline if these tests indicate that control deficiencies remain.

 

The following are the more significant factors that impacted our inability to remediate these weaknesses as of December 31, 2005:

 

 

In order to remediate the aforementioned material weaknesses in internal control over financial reporting and improve the integrity of financial reporting processes, management has implemented or is in the process of implementing the following actions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Additionally, in an effort to improve internal control over financial reporting, the Company is now emphasizing the importance of establishing the appropriate environment in relation to accounting, financial reporting, and internal control over financial reporting. Management plans to formalize its 2006 remediation plan, including specific executive sponsorship for key deficiencies to help create and implement new policies and procedures where material weaknesses or significant deficiencies exist. The Audit Committee will be updated at least quarterly on remediation progress, with additional updates as deemed necessary.

It should be noted the Company’s management, including the principal executive officer and the principal financial officer, do not expect that the Company’s internal controls will necessarily prevent all error and all fraud, even after completion of the described remediation efforts. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.

 

Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving our stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.