Sunday, November 16, 2008

Churchill Downs Inc. v. Magna -- By the Numbers

I'm not particularly a fan of Churchill Downs Inc.; their take-no-prisoners war with the owners and trainers over the division of online wagering revenue hurts horsemen and chases away potential bettors.

But, in contrast to the other major players in racing, one has to give Churchill credit for knowing how to run a business.  Compared to NYRA, just emerging from bankruptcy, and Magna, whose every financial report brings it closer to collapse, Churchill has a solid balance sheet, enough cash on hand so that not only can it be sure of opening the doors every day, but, mirabile dictu, there's even a profit for the shareholders. However, the way that Churchill earns its profit makes an important statement about the state of racing today.  Increasingly, Churchill's profits are coming not from live racing but from internet wagering and slot machines.

To see how profits are shifting, we need to loook at some numbers from Churchill's latest quarterly financial report, filed with the US Securities and Exchange Commission on November 5th. Along the way, I'll make some comparisons with Magna, whose quarterly report, about which I've already commented in some detail, was filed two days later.

Churchill owns and operates four major tracks: Churchill Downs itself, Calder, the Fair Grounds, and Arlington Park. That gives the company a solid, though by no means overwhelming, presence through the spring, summer and fall, but Churchill takes a bit of a back seat to Magna in the winter, when the latter has the prime meets at Gulfstream and Santa Anita. In addition, Churchill operates 21 OTB locations in Kentucky, Illinois and Louisiana, and slots and video poker in Louisiana. Over the past few years, Churchill has sold Hollywood Park and two minor-league tracks, Hoosier Park in Indiana and Ellis Park in western Kentucky. And, most important for its future, Churchill operates Twin Spires, Inc., an advance deposit wagering (ADW) system that has absorbed BrisBet, WinTicket and TSNBet, along with the handicapping-data operations of Bloodstock Research (BRIS) and TSN.  It appears that the accountants, lawyers and marketers in charge of Churchill (only four of the company's 12 directors, and none of its principal executive officers are what one would call racing people) have decided that their future lies in these internet businesses. One suspects that corporate management regards its live racing operations as nothing more than a necessary evil -- something that exists only to supply "product" to the online world.

Let's start with Churchill's balance sheet.  In contrast to Magna, which hadliabilities equal to 78% of its total assets as of September 30th, Churchill's total debt was equal to only one-third of total assets.  That's a pretty healthy ratio for any company. In fact, over the past 12 months, Churchill actually paid down some $31 million of long-term debt.

Churchill's total assets as of the end of last quarter were $609 million. As is true of most balance sheets, however, not all of that is real stuff that could be sold. Included in the $609 million  is some $115 million in "goodwill," which basically represents the excess of what they paid to acquire other companies over the fair market value of those companies' assets.  That goodwill is about evenly divided between race track properties and the online operations of BRIS and TSN.  By way of comparison, Magna's balance sheet reports $110 million in "racing licenses," which are pretty much comparable to goodwill, in the sense that, if a track ceases to be a going concern, its license isn't worth much.

With regard to earnings, it was a tough quarter for Churchill, as it was for the entire US racing industry.  But, unlike Magna, Churchill did report a quarterly profit -- and a bigger profit than a year ago -- $2.5 million, compared to $818,000 in the same quarter of 2007.  For the nine months to September 30th, Churchill's corporate profit was $32.6 million, well up from the previous year's $21.9 million.

The 2008 profit figures, by the way, represent improving profit margins compared to revenue.  Net revenue for the third quarter of 2008, in fact, was slightly lower than for the same period in 2007, but Churchill nonetheless managed to triple its profit.  For the nine months to September 30th, revenue increased only 8%, but profits jumped by 50%.  Churchill has found a way to wring more profitability out of essentially flat revenue.

Thanks to what little remains of government regulation, we can see where the profits are coming from and what's driving Churchill's profitability.  Churchill, presumably at the direction of its outside accountants, has divided its financial report by business segments: (1) racing, (2) online businesses (i.e., Twin Spires), and (3) gaming (slot machines and video poker).  While all those segments were profitable this year, the growth is all in the online business and in gaming.  Here are the details:

Net earnings from racing were $4.7 million in the third quarter of 2008, down from $7.7 million in the same period last year.  Churchill, like most other racing entities, began to feel the country's economic crisis seriously in that quarter. For the first nine months of 2008, racing earnings were $61.1 million, up from $51.6 million in the same period in 2007. But the trend in racing earnings is downward. 

In contrast, Churchill's online operations recorded a profit of $2.1 million this year, up from $724,000 last year.  More striking, online profits for the first nine months of 2008 were $4.4 million, compared to a loss of $1.5 million in the same period last year.  And gaming operations produced a $4.4 million profit in 2008's third quarter, compared to $1.9 million in 2007, with gaming profits for the first nine months of 2008 at $13.8 million, more than an 80% increase over the same period in 2007.  Now that the permanent slot machine facility is in place at the Fair Grounds, with video poker terminals in Louisiana and slots at Calder still to come, it looks like gaming is the biggest growth sector in the Churchill portfolio. (For those who might be checking my figures, yes, there is a  difference between the sum of the sector profits and Churchill's overall corporate profit for the quarter; that reflects one-time charges for discontinued operations and for expenses at the corporate level.)

A look at actual handle, both at the race tracks and online, confirms the shift away from racing as the primary profit center for Churchill.  In the third quarter this year, handle at all four of Churchill's tracks declined compared to the same quarter last year: Churchill Downs dropped 20%, Arlington 6%, Calder 27% and the Fair Grounds (betting on simulcasts) 19%.  In contrast, online handle through Twin Spires was 62% higher than in 2007.  The overall handle decline was 12%, even more than the 10% nation-wide drop, but the online platform was definitely a bright spot.

When you combine the growth in Churchill's online betting with the fact that Churchill as a corporation retains a much larger share ofr the online revenues than it does from money bet at the track, one can see why it's so adamantly opposed to giving horsemen afair share of the online revenue.  Overall, the corporation returns 9.1% of its online handle to the originating racetracks.  If we assume that money is split 50-50 between purses and the track, then the contribution to purses from Churchill's online betting is about 4.5%.  Assuming a blended takeout rate of about 20-21%, the national average, that leaves a lot of money on the table for Twin Spires.

Owners and trainers at Churchill's tracks, represented by the Thoroughbred Horsemen's Group (THG) are seeking an equal three-way split of online wagering takeout.  That would raise the percentage that Twin Spires pays into purses from 4.5% to, say, 7%, an increase of roughly 55%.  Not enough to make racing a profitable proposition for most ownersand trainers, but every little bit helps.

In many contexts, the idea of a progressive tax is accepted as being patriotic and civic-minded.  As your income increases, it's reasonable to pay an increasing share of the growth in taxes, or in payments to the people who make yor profits possible. If Churchill took such a view, it would be saying, thanks for letting us keep expenses low when we were starting out in our online business, but now that we're up and running and making a profit, sure, we can pay a fair share to the horsemen.  But Churchill's management seems to share the view of Sarah Palin, that a progressive tax system is somehow unpatriotic. So far, they're not willing to share one more cent of their rapidly increasing online revenues.If their position prevails, and if total handle declines or even stays flat, while the share of that handle represented by online betting continues to grow, then Churchill's profits will continue to climb at the same time that purses decline. Given the shaky economics of owning and training race horses, that's simply unacceptable.

I've seen lots of comments on horseplayer blogs to the effect that it's all the fault of the greedy horsemen for cutting off simulcast signals where they don't have an agreement for a fair division of the revenue.  Well, we can't go on strike, since we're not "employees" of the tracks. And we can't do much else in the way of collective action lest the tracks and the ADWs sue us for antitrust violations -- something Churchill is already doing in Florida and Kentucky.  But federal law does give us (except in New York) the right to shut off the signal.  So if that's the only weapon we have, then that's the one we'll use.  Churchill, as we've seen, could afford to pay a little more into purses. Unlike Magna, the can't claim that giving the horsemen a fair deal would bankrupt them.  Oops, sorry, Magna's already bankrupt, fair deal or not. But even Magna, in its sorry state, is willing to negotiate about online revenue.  Maybe if all those non-racing people on Churchill's Board of Directors and in its executive suite spent a little more time with horses and a little less with their spreadsheets, they'd see their way to doing the right thing. 

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