Bally Total Fitness BFT S
March 03, 2003 - 12:24am EST by
2003 2004
Price: 5.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 189 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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Recommendation: This report recommends Bally Total Fitness as a terminal short. As opposed to many short arguments for BFT, this writeup will not solely rely on BFT’s arcane accounting as the foundation of the argument. Based on a comprehensive scrutiny of all SEC documents since BFT went public in 1996, this report will question BFT’s potential to operate as a going concern due to its failure to sign up enough new members overcome a deterioration of its membership base. In contrast to managers who have been recent buyers of the stock, I believe these issues combined with a highly leveraged capital structure provide little room for error. At this point, short interest is approximately 30%. Surprisingly, BFT shares have been difficult, but not impossible to borrow because of the relatively large float of 31.2 million and large institutional ownership.

Profile: BFT operates over 425 fitness centers in North America. BFT fitness centers operate under Bally Total Fitness, Crunch, Pinnacle Fitness, Gorilla Sports, and The Sports Clubs of Canada. These fitness centers are concentrated in major metropolitan areas in 28 states and Canada—with a particularly heavy presence in California and the NY Metro area. After reaching a high of $34.87 per share in 2000, BFT has declined considerably and have vacillated between $5.50 and $8.50 per share since October 2002. Possible reasons for the decline include (1) opaque accounting. (2) a failure to generate positive free cash flows (3) depressed earnings results (4) a balance sheet that many investors perceive to be anemic. (5) exposure to the troubled sub-prime lending environment. In spite of this pessimism, many value investors and well-known institutions including Janus, Morgan Stanley, and Capital Research are large shareholders and believe BFT is a bargain at 3.4x EPS before special charges. Additionally, legendary investor John Neff cited BFT as one of his top picks in Barron’s Roundtable 2003.

Business Model: The gym business is inherently a high-churn business because many people sign up for gym memberships with high hopes, only to become frustrated and realize that reaping benefits takes time, dedication, and hard-work. This explains why BFT reserves 41% of its membership initiation fees for members who quit. One reason that BFT has such a high reserve is that the Company attempts to collect payments for services that have not been received by the customers. In any high-churn business, it is helpful to charge a high upfront fee and/or sign the customer to a binding long-term contract. Consequently, BFT intelligently charges members a large initiation fee ranging from $675 to $2750 with a 16% to 18% interest rate, depending on seasonality, type of plan selected, level of facilities, and overall market conditions—with an average of $1300. Because most of its sub-prime customers do not want to pay and/or cannot afford such a large down payment, BFT offers financing plans up to 36 months. But, fewer than 20% of members opt for shorter installment periods, wanting to avoid large monthly payments. And while BFT offers month-to-month plans to customers, only 5% of customers choose these plans because they are far more expensive. During the 36 month initiation phase, BFT members pay $36 per month, inclusive of financing charges, initiation and monthly dues.

For example, when 100 people sign up, only 59 people make it through the contract. At the end of the contract, 25% of the 59 people decide not to continue their membership dues, which are now only $9 per month. Therefore, only 44 people are paying $9 by the end of the fourth year. Finally, the remaining customers churn off as 11% per year.

Membership Data Analysis: In any high-churn business, continued profitability is absolutely dependent on a healthy inflow of new subscribers; the gym business is no exception. The pricing structure of BFT suggests that BFT’s revenue will plummet without signing up new members. Since new members in the initiation phase pay $36 per month, they are four times as valuable as post-initiation members who are only paying $9 per month. Because of BFT’s confusing accounting, an analysis of the membership data trends is most valuable in determining BFT’s health as a Company; revenue, EBITDA, EPS, and CFFO are largely unhelpful because their integrity depends on indecipherable accounting.

A close analysis of public filings demonstrates that BFT is signing up fewer new members per club every year from 1996 until 2002.

1996 1997 1998 1999 2000 2001 2002
Weighted Avg.
# of Stores 322 317 320 343 376 387 412

Num. of Members
Per Club 12,422 12,618 12,500 11,662 10,638 10,336 9,709

% Change 2% -1% -7% -10% -3% -6%

New Memberships
Per Year/Per Store 3,401 2,994 2,852 2,793 2,701 2,651 2,540

Growth -12% -5% -2% -3% -2% -4%

The issue is BFT has had about the same number of members for six consecutive years. In spite of a net increase of 90 new stores or 28%, every single 10-K since 1996 states that BFT has “approximately four million members.” While this disclosure is vague, it is likely that BFT has had no material membership growth. On the contrary, the IHRSA/American Sports Data report states 26.2 million Americans belonged to a health club in 1996, which has increased to 33.8 million in 2002—a 29% increase. The 2002 10-K has not been released, but it will most likely state that BFT has “approximately four million members” since management stated on the conference call that the number of stores increased 6% while new membership sales increased only 2%. In FY2003, BFT will open fewer stores and reduce capital spending by over 50% because it aims to be free cash flow positive for the first time. Without opening as many new stores, it seems likely that the total number of members will decrease.

There are two major concerns that could be making it more difficult for BFT to attract new members. First, the health club business is also becoming more competitive and commoditized, putting further strain on new membership generation. According to the same report, there were 13,504 health clubs in 1996 and 17807 health clubs in 2002—a 32% increase. Although BFT remains the largest health club chain, competitors such as Gold’s Gym, World Gym, LA Fitness, and 24 Hour Fitness have rapidly entered the market on the low-to-middle end, while the Sportsclub LA and Equinox chain have likely attracted high-end customers in its top markets In NYC, LA, SF, and Chicago. BFT’s declining membership base could be due to poor customer service and increased competition within a commodity business. In addition, many signs suggest that BFT is notorious for its poor customer service. For example, BFT is the only health club chain to appear in the New York Post several times for aggressive, misleading sales practices. In addition, there is a useful website at the address which is exclusively devoted to the gym chain.

Disclosure Inconsistencies: When putting together this report, it became clear that BFT management gradually stopped disclosing certain information.

(1) In the FY1996 10-K, BFT indicated 3000 new memberships were processed per day. In FY1997, BFT indicated 2600 new memberships were processed per day. In FY1998, BFT recorded 2500 new memberships per day. After FY1998, BFT stopped disclosing this information at an inopportune time for investors.

(2) Until FY1999, BFT disclosed the average initiation price. Since then, they have only cited percentage increases or decreases and given rough ranges such as $650 - $2750. The numbers can be backed out, but it is difficult.

(3) In FY1998, BFT commented that “total membership units sold during 1998 declined slightly compared to the prior year period.” When backing out the numbers, we find that the real number is -4% or a very material amount of $42.85 million of initiation fees.

Enigmatic Accounting: BFT’s accounting is a hybrid between a gym and a financing operation. After analyzing BFT for over six months, I have realized that I will never feel comfortable with the numbers. I simply cannot trace the line-items and figure out what is happening. For what it’s worth, two sell-side analysts who I talked to also admitted that they cannot understand the accounting. If any VIC member understands this accounting, please post on the message board. Nonetheless, many investors will try anyway, so this section will attempt to introduce the accounting concepts.

BFT recognizes revenue under a deferral accounting system. Its accounting practices work as follows: a member signs up for a gym membership and pays an initiation fee of between $650 and $2700—averaging around $1300. This initial membership fee is financed via an installment contract of 36 months with an average interest rate between 16% and 18%. However, based on historical records, BFT assumes that 41% of this initiation fee will not be collected. Revenue is recorded over an assumed contract weighted average life of 22 months. Intuitively, many investors might assume that BFT is accelerating revenues because costs are not being matched with expenses. However, this is not necessarily true when one realizes that the average BFT member breaks the contract after 22 months and is unlikely to pay future bills, so BFT correspondingly stops recording revenues at this point. One might assume that the 33% of $1300 * (1 - 41%) is added to balance sheet under the line-item current Installment Contracts Receivable (ICR) and the remaining 66% is added under the same long-term account. With the same logic, (12/22) of $1300 * (1 - 41%) would be added to the current Deferred Revenue account and the remanding 66% would be added as a long-term liability. Thus in the first month, $34.86 would be recorded as revenue but the gym-user would be billed $21.30. This process would continue until month 22 at which point $468 of cash would be collected but $767 of revenue would be recorded. In this scenario, revenue would be overstated. However, if we realize BFT bills its customers as if they will stay for 36 months and the 41% is not deducted, we find that $36.11 of cash will be billed and collected for 22 months before the member quits, which corresponds nicely with $34.86 being recorded as revenue. However, this exercise cannot be applied with any accuracy to the balance sheet. This is because there are contra line-items in the Membership Revenue footnotes, allowance for doubtful accounts, installment contracts receivable such as committed monthly dues, and several unearned finance charge accounts without any indication of the discount rate, and products and services such as personal training, supplements that deducted from the dues.

Adding to this confusion BFT has changed its accounting system two times in the last six years. Prior to 1997, BFT recorded 100% of the initiation fee as revenue immediately after signing up a member—with no amortization. The SEC quickly banned this aggressive accounting. In Q3 2001, BFT again changed its system from a gross to net presentation. Please refer to the Sept 30, 2001 10-Q for a more detailed description of this recent change.

At some point, accounts receivable and deferred revenues cancel should cancel each other out. However, the below table suggests that there the ratio of Installment Contracts Receivable to Deferred Revenue has been accelerating for the past six quarters since the most recent accounting change, including and excluding bulk receivable sales are added back. The first column is straight off the balance sheet. The second column assumes that the bulk receivable sales never happened and adds back $60 mm in Q3-FY2001 and $24 mm in Q4-FY2002.

01-Q3 01-Q4 02-Q1 02-Q2 02-Q3 02-Q4

AR/DR 1.41 1.52 1.56 1.66 1.70 1.61

Bulk Sales 1.57 1.52 1.56 1.66 1.70 1.68

In Q1 FY2001, this ratio was only 1.19, but it’s unclear whether the accounting change precludes such a comparison. It doesn’t make sense conceptually that accounts receivable should be so much higher than deferred revenues. Nonetheless, it is essential to note that this specific analysis is just another unexplained phenomenon in the accounting; there is nothing more to draw from this.

Recent Writedown: In Q4 FY2002, there was a suspicious $55 million accounts receivable write-down taken that requires more review. The CEO Paul Toback explained that “prior to 1997, the Company had potentially under reserves as accounts receivable…At the time the Company believed that the 41% reserve would contain enough excess to eliminate any prior shortfall.” BFT has used a historical allowance of 41% since 1997. Without knowing anything about the Company, many investors would think that BFT, like most companies who are trying to collect bills from sub-prime customers, has suffered the fate of the bad economy. They would think that BFT made their estimates using historical data from the boom years and made an honest mistake.

But, Mr. Toback is saying that it took BFT management until 2003 to realize that its allowance from 1997 was too low. In the meantime, BFT had been overstating earnings because the accounts receivable were improperly left on the books. The fact that it took CFO John Dwyer and/or BFT’s auditors six years to realize the reserve was inaccurate indicates incompetence and a lack of integrity. Their excuse on the conference call of “we now believe that given our new strategic direction that this new approach is more appropriate and more conservative” does not seem reassuring.

Moreover, Mr. Toback explained that an “examination showed that reserving 41% for bad debt has been the right reserve level over the past 5 years. And continuing to reserve at this level is the appropriate way to reserve on an ongoing basis.” One might assume that 41% seems very conservative intuitively compared to other businesses with high churn. But considering BFT estimated 41% in 1997 during a good economy, how can collecting bills from sub-prime customers be of equal difficulty when BFT’s target middle-income audience is losing jobs? Ford, Sears, Household, and Capital One target many of the same sub-prime customers that BFT does and all of these pure sub-prime lenders have faced adversity and had to increase bad debt reserves. Interestingly, famous short-seller Jim Chanos cited BFT as a short candidate in this week’s Barron’s because “the company is a sub-prime lending outfit masquerading as a gymnasium chain.”

Toback further explained “the only remaining group of receivables that lack sufficient history to know if the reserves will be appropriate is a pool of recoveries for previously written off accounts comprising about 5% of the net receivables balance. It’ll take another year or two to fully evaluate this asset but we don’t see any material exposure.” Now, BFT management is instructing shareholders to avoid worrying about future charges. But because BFT has escaped taking writedowns from receivables originated in the last six years, it should not be surprising to any observers if BFT takes more write-downs of its receivables in subsequent quarters.

Corporate Governance Issues: One might presume that management and auditors must be trusted to accurately measure reserves, but in light of the issues discussed above, an analysis of potential conflicts-of-interest is justifiable. Considering Mr. Toback is a former COO for several years and CFO John Dwyer has been an officer since 1994, recent managerial changes are not a valid excuse for the accounting oversight. What's more, former CEO Lee Hillman, who unexpectedly resigned in December, Mr. Dwyer, and another officer were all ex-partners at Ernst and Young—which happens to be BFT’s auditor. And so, one questions whether the auditors were acting in the best interests of shareholders during the past six years

Exiting the Finance Business: In May 2001, BFT management proclaimed its desire to sell the receivables and/or establish a forward-flow arrangement for future membership dues. At that point, BFT sold a $45 million batch of receivables that were supposedly a random-cross section at net book value to then-independent Household Financial. Management was upbeat about its plan to de-leverage the balance sheet. BFT’s ex-CEO stated that “We intend to pursue a broader strategy along this line, or other proposed structures, until the market affords us recognized value for more than a half a billion of net receivable assets currently on our books.” In September 2001, BFT sold an additional $60 million of receivables and another $24 million in October 2002. When asked about the terms on a recent conference call, more inconsistencies surfaced. Mr. Toback stated that they were at 90% of net book value initially, but could be 100% if Household collected the rest of the receivables. This is completely different than previous conference calls when BFT said the receivables were strictly sold at net book value.

Now, 21 months after BFT’s ex-CEO attempted to exit the finance business, the new CEO management insists that it is “also fully committed to exiting the finance business. While we have worked for this for some time, I’ve made this a top priority.” Again, it is difficult to believe this new promise because management has not earned our trust.

We know that receivables were previously sold at 90% of net book value to Household. Because the investment community has encouraged BFT to exit the financing business, it management would have already sold the receivables by now if an attractive offer was presented. It is pure speculation to project an exact value, but it seems that 90% of $539 million or $485 million is not a realistic valuation. For the past 21 months; management is clearly not receiving the price it wants. It is more likely that a larger discount would be necessary to motivate a financial institution to commit to purchase existing receivables. The concerns surrounding recent writedown of $55 million might make some financial institutions question the quality of the receivables going forward.

Private Equity Buyer: BFT might appear to be an ideal fit for a private equity firm because Equinox, LA Fitness, 24 Hour Fitness, and most of its competitors are owned by private equity firms. This is because many private equity firms perceive the health club business to be a solid, recurring-revenue operation with a predictable cost structure. Specifically, a November 2002 article in the Daily Deal mentioned that many private equity buyers were interested in BFT only if the balance sheet was de-leveraged through a receivables sale. However, no receivable sales have occurred and because of the accounting, it is possible that many private equity firms do not believe EBITDA and would not be interested.

Timing Issues: At present, BFT has an enterprise value of $912 million. $727 million or 80% of the value is debt. Below is a summary of each level.

(1) $33 million drawn on a $90 mm revolver.
(2) $155 million drawn on a $255 million securitization facility.
(3) $135 million term-loan
(4) $300 million of 9.78% Senior Sub Notes due 2007 (trading at 81-83, YTM ~ 15%)
(5) $104 million of capital leases and property mortgages
(6) $185 million of common equity.

1997 1998 1999 2000 2001 2002

Total Debt 432 487 691 691 665 726

Cash 61 64 23 13 9 12

Net Debt 370 423 668 678 655 713

Operating CF-36 -32 39 49 102 53

EBITDA 72 101 146 192 205 202

EBITDA 1.60 2.46 2.81 3.10 3.48 3.64
/Int. Exp.

Leverage 5.15 4.19 4.58 3.54 3.20 3.53

On the surface, a bull argument could be made that EBITDA is growing. Also, one might think that BFT’s current leverage of 3.5x FY2002 EBITDA is manageable and that BFT’s EBITDA to Interest Expense ratio implies little bankruptcy risk.

However, the above data shows that BFT’s EBITDA is not been a reliable proxy for measuring operating cash flow generation of the business—since EBITDA has been higher than OCF for six consecutive years. During these six years, BFT has had money tied up in working capital—again raising suspicion about BFT’s revenue recognition and whether or not receivable reserves are accurate.

Conclusion: Determining the timeframe of the downfall is impracticable; this is because BFT’s coverage ratios and “black-box” accounting might mislead some investors and commercial banks to believe BFT can continue as a profitable business. For that reason, there is a substantial chance that BFT can refinance most of its debt at considerably higher interest rates. For this reason, investors who decide to short BFT must be patient and wait for cataclysmic events. One has to accept that the low P/E is going will certainly attract some value investors. In the meantime, investors should carefully check the sub notes. If the sub notes decline into the 60s or 70s, going long the bonds and short the common could prove to be a profitable trade if done correctly.


(1) Continued weakness in earnings. Management has not given guidance and since new memberships sales have decreased, earnings will face pressure in FY2003.

(2)Further deterioration in membership base. Without opening up new stores, BFT will likely sign up fewer new members who are 4x as valuable as current members.

(3)Additional receivable write-downs.

(4)Repeated discrepancy between EBITDA and cash flows from operations.
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