Given the current health craze, one would think that Bally Total Fitness (NYSE: BFT ) should be the category killer of the fitness industry. It has 440 clubs, $1 billion in annual sales, and 4 million members! But despite having a national lifestyle movement pushing members into its clubs, Bally seems to be imploding in spectacular fashion -- consuming itself in a Hindenburg-esque conflagration of its own making.
It's a cautionary tale for ordinary investors. A story of boardroom bungles, allegations of overaggressive accounting, and ever-increasing amounts of debt. In short, it's a financial horror story to keep investors up at night.
So why spend several articles detailing the problems with Bally? Why not detail the success of Dell Computer (Nasdaq: DELL ) or the great turnaround story of Marvel Enterprises (NYSE: MVL ) ? Well, as they say in the movie business, you can learn more from a bad film than from a good one.
Every step of the way, Bally gave off clues that all was not well, and therein lie the lessons for all investors. These lessons will help you avoid a bad IPO, know when to sell a troubled stock, know when not to buy (even if the stock has fallen precipitously), and when to short a stock.
Remember, this is about your hard-earned cash. These lessons are critical -- perhaps the most important you'll ever learn.
Specifically, from this sorry fable, we shall learn to BEWARE OF the following:
- (1) The Ugly Stepsister Spinoff
- (2) Shareholder Dilution
- (3) The Abrupt Board Member Departure
- (4) The Personally Unvetted Board Member Replacement
- (5) The Board That Gives Itself Unwarranted Raises
- (6) The SEC Investigation
- (7) The Unasked Question
- (8) The Call for the CEO's Head
- (9) Management That Won't Admit Mistakes
- (10) Knowing How to Fix Things the Company Can't
- (11) The Unscrutinized Press Release
- (12) Overwhelmingly Bad Internet Scuttlebutt
- (13) The Fleeing Minions
- (14) The Press Release That Requires an Advanced Degree in Linguistics
Join me now as we begin our journey and learn the first two lessons Bally offered to investors: (1) Beware the Ugly Stepsister Spinoff, and (2) Beware of Shareholder Dilution.
It all started out so well ...
Bally Total Fitness went public in 1996, a spinoff from Bally's Entertainment -- the hotel and gaming concern. Bally HQ was in Chicago. It had, and still has, enormous and opulent offices with large executive washrooms done up in marble. You'd think, given such extravagance, that Bally's Entertainment would send Cinderella to the IPO Ball. Instead, it sent her ugly stepsister. When the fitness company went public, it carried well in excess of $300 million in debt in addition to sluggish revenue growth, a bottom line in the red, and negative free cash flow.
Sorry, but there's no way I'd be asking that ugly duckling to dance. I don't like the idea of sending a company public with that much debt and with such weak revenue growth. That would seem to me like running to the capital markets to bail out a mediocre concept, while everyone with stock options gets rich.
Even in 1998, when the company finally showed 12% revenue gain and a profit of $0.51 a share, debt increased from $400 million to $480 million as the company opened new clubs and bought out others. The number of shares outstanding ballooned from 15 million to 22 million, diluting shareholder earnings by almost 50%.
Those numbers should have tipped some people off. There can be merit in taking on tons of debt to become a "category killer," but it's risky. If your angle works, you conquer the marketplace and your cash flow ultimately extinguishes your debt. If you fail, you go down in flames.
As the clock struck midnight and the millennium ball drew to a close, Bally's intensive sales efforts seemed to be paying off. Revenue, as reported at the time, climbed more than 15% in 1999, despite only a 7% increase in new stores. Earnings tripled. The acquisition binge was in full swing.
Investors chose to overlook the negative side of the financials. They had bid up the stock from its IPO price of $7 a share to the low $30s. But two instructive flaws remained: Shares outstanding had popped to 27.5 million, and debt was now approaching $600 million. Why would anyone want to own a company that had now diluted shareholder value and increased its debt by almost 100%?
During 2000, it appeared at first glance that things were beginning to look better for the company. Revenues had increased 18%. Products and services, such as personal training, were doing extremely well. Earnings nearly doubled. Business boasted 4 million members and almost 400 clubs. Shares outstanding barely budged for the year.
But free cash flow was, well, negative by $55 million. The debt had piled up to $675 million. Around $63 million was vanishing from the company's bottom line because of interest payments. But it still seemed that if management could just get cash flowing positive, the company could still get back in shape.
CEO Lee Hillman looked like a genius. Although the stock had been volatile, it had ranged as high as the low $30s and ended the year at $24. But the growth-at-any-cost strategy still seemed to be working. Bally dominated the market and was the only fitness company with a coast-to-coast presence. This may have been the one point when a usually wise investor might have been roped in. But there were things bubbling below the surface that would have made folly of their reliance on these financials.
The time had come to cash out. The directors and board members had options they could exercise in the teens. A merger or buyout candidate needed to be found. But what kind of company might be interested in a fitness business? In the first of many strange twists, Bally's chosen suitor would be a company that would become embroiled in one of the major financial scandals of the early 21st century: HealthSouth.
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