CHURCHILL DOWNS PERFORMANCE REVIEW

Churchill Downs, Inc. (CDI) has several related lines of business: racetracks (Churchill Downs, Arlington Park, Calder Race Course, Fairgrounds Race Course, and 5% of Kentucky Downs); off-track betting facilities in Kentucky, Illinois, and Louisiana; online businesses (TwinSpires advance deposit wagering and Bloodstock Research data services); 50% of HRTV, a television channel; gaming (Calder Casino, Fair Grounds Slots, and Video Services video poker machines); and assorted other investments like a new entertainment subsidiary and a simulcast production company.

In addition, CDI is trying to acquire YouBet.com, an advance deposit wagering firm, but has encountered resistance. Following is an excerpt from the CDI 2009 10K:

“On November 17, 2009, a putative class action lawsuit, Wayne Witkowski v. Youbet.com, Inc., et al., was filed in the Superior Court of Los Angeles, California against Youbet, various of its directors, the Company and the Company’s wholly-owned subsidiaries, Tomahawk Merger Corp. (‘Merger Sub’) and Tomahawk Merger LLC (‘Merger LLC’). Subsequently, five additional lawsuits were also filed in the Los Angeles Superior Court, two of which name Youbet and its directors as defendants and three of which also name the Company as a defendant. All six lawsuits, which we refer to collectively as the Los Angeles litigation, are putative class actions brought on behalf of Youbet’s stockholders. Plaintiffs in the Los Angeles litigation have since moved to consolidate the Los Angeles litigation, to file a single consolidated complaint and to appoint lead counsel. That motion was granted on January 22, 2010.

The complaints in the Los Angeles litigation all allege that Youbet’s directors have breached their fiduciary duties, including alleged duties of loyalty, due care and candor, in connection with the proposed merger transaction.”

Total CDI handle was $2.7 billion in 2009, $2.9 billion in 2008, and $3.2 billion in 2007. This decline is consistent with the decreases experienced by other gambling companies during the recession.

For the year ended December 31, 2009 (the most recent financial results available), CDI reported net revenue of nearly $440 million; net earnings of $16.8 million, and diluted earnings per share of $1.21. It continued to maintain a per-share dividend of 50 cents. Net revenue increased by 2.2% from 2008 to 2009. Net earnings fell by 41% from 2008 to 2009 but this is an aberration because 2008 net earnings included $17.2 million from insurance recoveries stemming from damage caused by Hurricane Katrina. If 2008 net earnings are adjusted for the $17.2 million and then compared to 2009 net earnings, 2009 net earnings increased by 47% from 2008.

The CDI SEC 10K filing for 2009 states: “Our total net revenues increased $9.1 million primarily as a result of increased wagering through the Online Business and the full year’s effect of gaming revenues from the slot operations at Fair Grounds, which opened its permanent facility during November 2008. These increases were partially offset by declines in racetrack pari-mutuel revenues and other operating revenues derived from corporate hospitality and admissions revenues generated by Kentucky Derby week. In addition, Racing Operations conducted nine fewer live race days in 2009 compared to 2008. ”

In January 2010, CDI launched Calder Casino next to Calder Race Course with 1,200-plus slot machines in a 104,000 square-foot facility that also has three dining operations. This is part of the diversification initiative that CDI began in 2007. Because of a downward trend in pari-mutuel wagering in the United States, top management is attempting to compensate by venturing into non-pari-mutuel lines of business, such as the slots facilities and the new entertainment subsidiary.

At the conclusion of 2009, CDI had a debt-to-equity ratio of .78 and 44% of the company was financed with debt. One area of concern is that the current ratio (current assets/current liabilities) was a weak .57, meaning that CDI may be slow in meeting its current obligations to creditors.

CDI has been unable to install slots at its flagship racetrack in Louisville, Kentucky, owing to the lack of facilitating legislation in the Kentucky legislature. The governor would sign such legislation if it were to reach his desk. However, based on a contentious situation in the Kentucky Senate, that does not look promising in the foreseeable future. Moreover, Instant Racing (previously run races presented on a slots-like machine) legislation is defunct in the current term of the Kentucky legislature, although there is the possibility that the governor has the power to authorize Instant Racing under Kentucky’s existing pari-mutuel law and will exercise it.

During the past 52 weeks, CDI stock (listed on Nasdaq under the symbol CHDN) has traded in the range of $28.20-$40.68. It closed on March 26, 2010, at $37.74 per share with a 31.74-to-1 price-to-earnings ratio. This is a hefty premium to gambling stocks in general, which trade at an average price-to-earnings multiple of about 17-to-1. The short interest on CDI has been decreasing, which is a favorable sign in terms of the likely direction of the stock.

The outlook for CDI should improve along with the U. S. economy; CDI’s performance will move inversely with the unemployment rate in the United States. The stagnation in pari-mutuel handle should be offset and then some by the company’s alternative gaming operations. Even if the YouBet.com acquisition were to fall through, CDI still looks poised for growth in revenues and profits. Whether these prospects are worth the premium price-to-earnings ratio is the issue that each investor must evaluate.

Bill Shanklin is not currently a shareholder in Churchill Downs, Inc.

Copyright © 2010 Horse Racing Business

BLACK SWANS

In the Old World, all swans were thought to be white. Indeed, it was considered to be a fact, as empirically confirmed. No European had ever seen anything but a white swan.

Explorers to Australia found black swans. One sighting was all it took to discredit all of the evidence that came before. This illustrates the shortcomings of learning by trial and observation and of  inductive reasoning: the empirical evidence we use to reach conclusions and to forecast the future may be precisely wrong, especially in such a fast-paced world as the 21st century is proving to be.

Most commonly, we assume that tomorrow will be a continuation of today. Econometric models to forecast interest rates, GDP, unemployment, and the like, give the impression that they are scientific. High powered computers are only as good as the data they process and the assumptions in the underlying mathematical model. If the assumptions are wrong—notably that the future is an extrapolation of the recent past—the output will be worthless. The Long-Term Capital Management hedge fund crashed in the late 1990s, in spite of the fact that two of its board members were mathematical whizzes and Nobel laureates in economic sciences. The model on which the hedge fund was built was faulty under extreme and unusual conditions.

A parable is used to demonstrate the danger of using the past to predict. A turkey is born on a farm in the United States into relative comfort and is fed, watered, and cared for daily. He is pampered, by the standard for turkeys. Day-after-day and month-after-month, the caretaking routine continues…until a day arrives, shortly before Thanksgiving, when he meets the executioner. For the turkey, this is a black-swan event, a fatal unknown seemingly coming out of nowhere to rudely overturn the comfortable assumptions of the past.

Nassim Nicholas Taleb is a former mathematical trader on Wall Street. His bestselling book is titled The Black Swan. On Wall Street, black swans can and do occur and wreak havoc. On a single day, October 19, 1987, or Black Monday, the Dow Jones Industrial Average fell 22.6% and the S & P 500 declined by 20.4%. Black swans are evident elsewhere. On September 11, 2001, terrorists hijacked airplanes and leveled the World Trade Center buildings in New York and attacked the Pentagon in Virginia.

Taleb makes the critical point that we often focus too much on the wrong things and leave ourselves vulnerable to the consequences of black swans (unknowns) and gray swans (mostly unknowns) that can devastate. For example, he uses the example of casinos. The major risks incurred by casinos do not originate with the gambling that goes on within the confines of their brick and mortar buildings. Through the use of statistical probability techniques and by diversifying across different tables, casinos can control gambling-related risks. Moreover, casinos can control for big bettors –“whales”—by laying off their bets to other casinos. Further, casinos have elaborate surveillance systems to minimize their risks from cheating. It is outside the gambling where the big-time risks lurk that can ravage them. The Mirage lost an estimated $100 million when Roy of Siegfried and Roy fame was maimed by a tiger. Roy had reared the tiger and slept with him at times, so the past did not foretell that the future would turn out as it did. Consequently, the Mirage had no insurance. In other cases cited by Taleb, a disgruntled construction worker tried to dynamite a casino and casino owner Steve Wynn’s daughter was kidnapped and held for ransom.

In businesses of all kinds, the managers can insure for catastrophes like fire, theft,  liability, and the death of a key executive. However,  as with the casinos, a black swan or a gray swan can come along and be much worse than any of the insured-for possibilities. The tourism industry was devastated in the aftermath of September 11, 2001, and many banks literally ceased operations in the wake of the financial meltdown of 2008.

Nothing can be done to absolutely inoculate a company (or a person) against a black-swan event, because an actuary cannot quantify the likelihood of an unknown unknown. One way for investors to guard against total devastation is to use a “barbell strategy.” Put the portion of their portfolio that they absolutely cannot afford to lose into the safest assets they can find, perhaps U. S. Treasury securities. (Even here, however, a black swan like a U. S. default on debt owing to massive spending, titantic budget deficits, and devaluation of the dollar could take place, expecially if China opted out of buying U. S. paper.) This amount will vary with a person’s age and propensity for risk. Then, the remaining amount can be placed into risky assets with the potential for extremely high returns. The risks in the risky part of the portfolio are spread in the same manner that venture capitalists invest. Instead of sinking everything into one high-risk enterprise, invest in many, so that if 80% fail, the 20% that succeed will likely more than compensate. 

 Another way to cope with  black swans is to ask the question, “If a horrible and totally unexpected and destructive event were to occur, how would my business deal with it?” Since, by definition, a black swan is unknown, all you can do is assume the worst and that business would be virtually at a standstill. At the least, you can speculate on some gray swans and ask how your business would react.

I have sometimes  inquired of small-company manufacturing owners how they would respond if their place burned down. That is not even a black swan, because insurance companies can estimate its probability across all businesses. Most respond only by saying that they are insured. But how long would customers be without supply, that is a key issue? Would they seek alternative suppliers and perhaps never return? The majority of business owners are like the casino executives, who focus on the risks inside the walls of the firm, but who neglect to devote even a modicum of attention to how to contend with devastating unknowns, including their own sudden demise.

People sometimes say not to worry about what you cannot control. This is bad advice. You cannot control the future, but you can hedge your risks and plan for repercussions.

The racing industry is fraught with risks…with gray swans lurking everywhere, and maybe some black swans.

Copyright © 2010 Horse Racing Business

HARD-ROCK MINING FOR CORPORATE SPONSORS

Owing to his behavior, Tiger Woods has lost sponsorship agreements with Accenture, Gatorade, Gillette, and Tag Heuer, with more companies likely to follow suit. Preceding Woods’ troubles, Buick had severed their ties with him because of the financial mess at General Motors.

However, sponsorship problems for professional golf were already underway when the Woods’ story broke to exacerbate the situation. The Ladies Professional Golf Association television ratings are very weak, making sponsorship unattractive to potential sponsors. Anytime that TV ratings decrease, it raises the cost-per-thousand of reaching viewers, unless the advertising rates are cut to compensate. The men’s PGA Tour is also beset with waning fan interest, which makes the sport less desirable for potential sponsors.

Two early PGA tournaments in 2010—the SBS and the Sony Open—experienced television ratings declines of 21% and 30%, respectively, from 2009. Torrey Pines in San Diego did not get a title sponsor, Farmers Insurance, until virtually the last moment, and even then cut the normal price in half to $3.5 million. (Previously, the tournament was called the Buick Open, but GM’s bankruptcy scuttled the deal.) Ticket sales and corporate hospitality agreements also declined from 2009.

The PGA has 46 tournaments on its agenda for 2010 and three of them lack a title sponsor. For 2011, 13 tournaments do not have sponsors yet.

Professional golf’s travails predate the Tiger Woods’ scandal. In the final round of Woods’ first win at the Masters in 1997, the TV audience surged to an unfathomable 50 million viewers. In 2009, the TV audience for the final rounds of PGA tournaments averaged 3.5 million viewers. Compounding the downturn is the fact that the number of people playing golf has been eroding: approximately 10.2% of Americans (over the age of six) took to the links for at least one round in 2008, as opposed to 12.1% in 1990.

What is happening in golf regarding corporate sponsorship is not confined to that sport. In fact, corporate expenditures for sports sponsorships in 2009 were off by $100 million compared to 2008, to $11.3 billion. Some of this can be attributed to the recession but other factors are at work, namely that companies are fearful of associating their names with athletes and/or specific sports. A number of incidents of gun-wielding NBA and NFL players, the ongoing steroid revelations in baseball, well-publicized sordid sexual affairs in golf and the NBA, and so on ad infinitum have made company executives wary. (Actually, a tarnished reputation can also work the other way around, as when the stadium for the Houston Astros Major League Baseball team was christened with the name Enron.)

For economic and other reasons, Barclays cut its naming-rights sum for the under-construction New Jersey Nets arena by half; Microsoft and Cub Cadet did not renew their alliances with NBA star LeBron James; Bank of America gave up its sponsorship of the U. S. Olympics; and Pepsi terminated its use of soccer-phenom David Beckham.

Horse racing is undoubtedly being affected by the same winds of change. The putrid television ratings for the Breeders’ Cup World Championships make the event a hard sell, even if one argues that the quality of the audience compensates to a degree for the relatively small number of viewers. Sponsors for the Triple Crown races have access to a much larger audience, but may be skeptical of the sport’s issues with medications and on-camera breakdowns.

The Triple Crown races in particular offer an attractive venue for corporate sponsorships because of the ability of companies to host customers and other constituencies at an event combining a premier sporting competition with a grand social outing. Some of the lifestyle-friendly racing meets—Del Mar, Keeneland, Monmouth, Santa Anita, and Saratoga—are also capable of crafting sponsorship packages that are very salable to companies. The Breeders’ Cup World Championships can be pitched to firms like NetJets, whose target audience is very small and very affluent.

Horse racing, like other sports, can expect increasingly to find a harder row to hoe in closing the deal with corporate sponsors, who are being more frugal in the current economic climate and more cautious about linking their names with sports and athletes that may embarrass them.

Copyright © 2010 Horse Racing Business

References and further reading: “PGA Tour Feels Absence of Tiger Woods from Golf” and “When Big Money Doesn’t Play Ball”