CHURCHILL — DOWN OR UP?

Churchill Downs, Inc. is traded on Nasdaq under the symbol CHDN. For purposes of reporting EBITDA (earnings before interest, taxes, depreciation, and amortization), the company groups its businesses into five segments-racing operations, on-line business, gaming, other investments, and corporate. An entertainment division was added in 2009.

Churchill Downs, Inc. owns four Thoroughbred racetracks: Churchill Downs in Louisville, Kentucky; Arlington Park near Chicago; Fair Grounds Race Course and Slots in New Orleans; and Calder Race Course in Miami Gardens, Florida. In 2008, Calder obtained voter approval to install up to 2,000 slot machines and management recently signed a facilitating agreement with the Florida Horsemen’s Benevolent and Protective Association. In addition to the racetracks, the company has 21 off-track betting (OTB) facilities in Illinois, Kentucky and Louisiana. It also owns: Video Services in Louisiana, which operates about 700 video poker machines; TwinSpires.com (a telephone and Internet advanced deposit wagering company); and Bloodstock Research and Information Systems (provides data for handicapping and for horsemen). The company has a partial interest in Horse Racing TV and TrackNet Media, which sells digital horse racing content.

Churchill Downs, Inc. management has identified risks that may impinge on the company’s future profitability. Three main risks are:

•Significant competition from bricks-and-mortar operations in the United States and Canada and from web-based businesses everywhere, many of which are capitalized beyond Churchill Downs’ capability.

•The decline in popularity of horse racing.

•Extensive government regulation.

Churchill Downs, Inc. is atypical of publicly-traded American corporations in the way it is organized at the very top. Unlike most U. S. firms, at Churchill Downs the offices of chairman of the board of directors and chief executive are held by separate people. Only a small percentage of U. S.-based companies follow this division of authority, such as Ford Motor Company.  It is characteristic of European companies.

Churchill Downs has a 13-person board of directors, comprised of two inside directors (the chairman and CEO) and 11 outside directors. The board consists of people with a plethora of diverse and relevant experience working in and running companies. They come from backgrounds in heavy industry, technology, sports, finance, and other fields. Importantly, the board members are major shareholders themselves in Churchill Downs, so decisions made for shareholders affect their own pocketbooks. Overall, the board is meritorious in terms of business skills and knowledge, and in having a personal financial stake in the company. Notably, as well, several members, including the chairman (Carl F. Pollard) and the CEO (Robert L. Evans), are active participants in the Thoroughbred industry as farm owners, breeders, buyers/sellers at the bloodstock auctions, and sportsmen with racing stables. This blend of business experience and knowledge  with Thoroughbred-industry involvement provides dual insight at the top of the Churchill Downs organization. Lastly, there has been very little turnover of board members, which provides for continuity and institutional memory.

The quality of the management team at Churchill Downs or any other publicly-traded company can best be determined by the results it produces, especially  in relation to companies in the same industry. The number 1 measure of quality of management is stock price because it depends on investor expectations about future earnings.

Churchill Downs’ stock price is down by 43.2% in the past 52 weeks.  By comparison, the Dow-Jones Industrial average is off 46.3%.  Churchill Downs’ stock has traded in a range of $24.11-$52.98 during the previous year and it has a current price-to-earnings (trailing twelve months) ratio of 15.88. The company’s market capitalization is  $410.73 million. Churchill Downs’ PEG ratio (the P/E ratio divided by the projected 5-year growth rate of earnings per share) is 2.11. A lower PEG ratio tends to indicate that a stock is undervalued and a higher PEG ratio suggests that it is overvalued. The peer group for Churchill Downs is the gaming industry, with such firms as MGM Mirage, Penn National Gaming, and Las Vegas Sands Corporation. This group has an average P/E ratio of 8.88 and an average PEG ratio of .44. Thus, by comparing Churchill Downs’ premium P/E ratio and high PEG ratio to the industry averages, the conclusion is either that (a) Churchill Downs has superior growth and earnings prospects or (b) its stock is overvalued. Were Churchill Downs to be looked upon as an average stock in its industry classification, its share price would be about $16.78 instead of yesterday’s close of $30.10.  A  factor that is likely to have supported the company’s relatively lofty P/E ratio, vis-à-vis its peers, is that 31% of its stock is held by insiders and, during the past six months, insiders have purchased  more shares than they have sold by a ratio of almost seven-to-one.

The question going forward is whether Churchill Downs, Inc. warrants its share price and exceptional P/E ratio? Has the market correctly valued the company? According to Nasdaq, one indicator of whether a stock is accurately valued is short interest or “The total number of shares of a security that have been sold short by customers and securities firms that have not been repurchased to settle outstanding short positions in the market…A related measure is Days to Cover–calculated as the aggregate short interest for the month divided by the average daily share volume traded between short interest settlement dates…Many investors believe that rising short interest positions in a stock is a bearish indicator. They use the Days to Cover statistic as a way to judge rising or falling sentiment in a stock from month-to-month, and use the statistic as a way to compare investor sentiment between stocks.” Looking at the latest short-interest statistics for Churchill Downs, both the total number of shares sold short and the Days to Cover have declined sharply.  This indicates that more and more short sellers are unwilling to bet that the stock will move lower anytime soon.

In the past several years, Churchill Downs earnings have been on a significant downward trend-with earnings per share of: $5.86 in 2005 (including the sale of Hollywood Park), $2.21 in 2006, and $1.14 in 2007. For the first three quarters of 2008, net revenues increased by 7%, earnings were up by 48.6%, and earnings per share increased by 47.4% (the next earnings report is scheduled for March 5, 2009).  The reasons for the spike in 2008 earnings are twofold and extraordinary. Churchill Downs received a $17.2 million cash settlement for damage done to its Fair Grounds racetrack in New Orleans by Hurricane Katrina and the company’s online business increased owing to its acquisition of ATAB and BRIS, which were consolidated under TwinSpires.

The company’s capital structure is about 34% debt and 66% equity, so it is leveraged but not dangerously so.  It is arguable whether Churchill Downs would, could, or should opt to increase its debt load significantly in the present economic climate in order to acquire one or more of the Magna Entertainment racetracks once that company files for bankruptcy.  

Churchill Downs’ financial performance has been mediocre in the last several years and the economic downturn and the company’s disputes with horsemen’s groups in 2008 over advanced deposit wagering earnings exacerbated the problem.  The market has placed a premium on Churchill Downs stock,  plausibly for several reasons. First, management has settled some of the deleterious disputes that kept most ADW  companies from taking wagers on Churchill Downs tracks. Even so, the company’s antitrust suit against several horsemen’s groups remains. Second, investors are anticipating the effects of the slot machines that will be installed at Calder and the possibility of legalization of alternative gaming in Kentucky in the next few years. Realistically, the legalization of slot machines in Kentucky in 2009 is not expected. Third, Churchill Downs is broadening its focus “from horse racing tracks to casino gambling, online betting, and concerts.” In January 2009, the company created an entertainment subsidiary and assigned Steven P. Sexton, formerly president of Churchill Downs racetrack, to lead it. Fourth, the board of directors and the CEO are recognized by investors for their skill sets.

It appears from the outside looking in that the CEO is gradually but surely repositioning the company as a gambling and entertainment company rather than as a horse-racing entity, undoubtedly in response to its warning that horse racing’s popularity is ebbing. The company’s  individual racetracks are headed up by executives who are not from traditional racetrack-management backgrounds. Significantly, the new chief operating officer of Churchill Downs, Inc., William C. Carstanjen, an attorney from General Electric, Inc., has been with the company only since 2005 and had no prior racing background. He is now the second-ranking executive in the corporation. Mr. Carstanjen’s elevation may, in large part, be due to the board’s intent to put someone in upper management with the acumen to operate in the heavily regulated arena of alternative gaming.

Mr. Carstanjen’s promotion is a black-box risk for investors.  His job as chief operating officer is to “keep the railroad running,” so to speak by overseeing day-to-day operations, but is he also being groomed to eventually become chief executive officer?  If so, the risk escalates because there is nothing in his educational background and work history to suggest he has the capability to become a creative “big picture” strategic thinker in an ever-increasing technology-oriented entertainment/gambling enterprise. Only time will tell.

Investors will likely give upper management’s initiatives a chance to work and may cut management some slack because of prevailing economic conditions. If the actions look to be yielding improved profitability, then Churchill Downs stock should continue to command an unusually high price. On the other hand, if the plans falter, look for the stock price to regress toward the mean for its industry group.

Note:  Financial information used was as of the close of Nasdaq on Friday, February 27, 2009. 

Postscript:  To provide a benchmark for evaluating the results of  any company covered by Horse Racing Business, consider that one of  the world’s most renowned investors, Warren Buffett of Berkshire-Hathaway, reported this week that his company had its worst performance in 44 years with profits down by 62%.

Disclosure: Bill Shanklin is not currently a shareholder in Churchill Downs, Inc., but has owned the company’s stock in the past.

Copyright © 2009 Horse Racing Business.

Comments

  1. Any earnings review should include some context.

    You wrote:
    “In the past several years, Churchill Downs earnings have been on a significant downward trend-with earnings per share of: $5.86 in 2005, $2.21 in 2006, and $1.14 in 2007. ”

    A better metric would be comparing core earnings, as the overall results in 2005 benefitted from a huge one-time item — the $260 million sales of Hollywood Park — while the results of 2007 were decimated by hurricanes in Florida and Louisiana that cost numerous race days at Calder and Fairgrounds.

    One other note: Churchill has always traded at a premium to its peers due to its lack of debt, consistent cash flow, industry-leading brand and world-renown marquee event.

  2. The other comparison that one of us should do is to look at the actual results from racing for the big three — Magna, Churchill, and the financially impenetrable NYRA — and see if there are significant differences. That comparison is made a lot more difficult by (a) NYRA’s status as, effectively, a not-for-profit corporation, whose financial reports, when available, aren’t comparable to those of SEC-reporting companies, and (b) Churchill and Magna’s involvement on both on-track racing and providing simulcast signals and, at the same time, operating online/telephone wagering networks.

    Although he may own some horses, Robert L. Evans isn’t a career racing guy any more than Carstanjen is. Evans came to Churchill only a few years ago from a career in technology companies. Is that better than being a lawyer? Perhaps, but it certainly is consistent with Churchill’s aggressive moves to reposition itself as a wagering site rather than a bunch of race tracks.

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