Wednesday, January 3, 2018

No More Gummy Drops for Churchill

Last November, Churchill Downs Inc. (CDI), the slot-machine and bet-taking company that happens to host the Kentucky Derby, announced that it was selling its largest single asset, something called Big Fish Games. Superficially, as the story in the Lexington Herald-Leader and other media outlets suggested, it appears that the Churchill suits had made a nice short-term profit. They bought Big Fish, whose best known offering is something called Gummy Drop!, a game apparently played by millions on their phones, for $885 million less than four years ago. The sale of Big Fish, to a subsidiary of the Australian-based Aristocrat Leisure Ltd., is for an announced price of $990 million, which would represent a profit of $105 million, a 12% gain, over what CDI paid for Big Fish, not counting whatever profits Big Fish contributed to the CDI bottom line over the past few years. Lots of potential adjustments to the price, according to the contract, but still, CDI is making a nice bit of change.

The reality is a bit more complicated. For one thing, the sale of Big Fish seems to represent a sharp U-turn in CDI's corporate strategy. Just a few months ago, when I looked at CDI's annual report for 2016, it appeared that the suits (including pant suits; Churchill's CFO is a woman) in Churchill's executive suite were committed to a strategy that downplayed racing and that focussed on people mindlessly watching video screens, whether those screens were on their phones or on slot machines in CDI's casinos. Now, if one is to believe the press release announcing the sale, CDI "will refocus our strategy on our core assets and capabilities including growing the Kentucky Derby, expanding the casino segment, and other forms of real money gaming, and maximizing our thoroughbred racing operations." For a company that has a well deserved reputation in the industry for its cavalier treatment of bettors and horsemen, focusing on racing seems, well, odd.

In addition, Big Fish Games, if not responsible for all of CDI's profits, has certainly been a big element in leading the company's stock to ever greater heights in the market. In December, 2014, just before the acquisition, Churchill stock was selling at $93 a share.  Today, the price is nearly $240. That's an increase of more than 150% in just three years, way better than any of the major market averages. Must make the bean-counters in the CDI executive suite proud -- as well as seriously enhancing the value of their stock options. So why jettison a piece of the company that has been an integral part of the stock price run-up?

Theory No. 1: One possible reason is to take CDI at its word; maybe they really do want to refocus on racing. Well, actually they don't say racing. They say Kentucky Derby. I suspect they'd happily dump all their other racing dates, whether at Churchill Downs itself, the Fair Grounds or Arlington, just as they've already dumped Calder, if only they could keep two days for the Derby and the Kentucky Oaks.

What they actually said was that they were refocusing on the Derby, their in-house ADW, Twin Spires, and on casinos, with an afterthought of "maximizing our . . .  racing operations." Maximizing what, exactly? If it's profit, then a two-day Derby and Oaks season would be ideal; racing probably loses money for CDI over the balance of the calendar. And not having to deal with those irritating horse people would be a big plus.

So, on that theory, What CDI is really doing is focussing on Twin Spires and on its casinos around the country. Could be a good strategy; with online betting on all sports, not just racing, looking ever more likely, Twin Spires and its well developed betting technology would be in a good position to capture a significant share of that emerging market. As for casinos, well, they're showing some signs of market saturation, but it's still a highly lucrative sector for CDI, producing just over 25% of the company's net revenue in the nine months ending September 30, 2016. (CDI's annual figures for 2017 won't be available until sometime in February.)

Theory No. 2: The execs want to boost the stock price, and getting a bunch of cash that can be used to buy back shares (a tactic that normally increases the prices of the remaining outstanding shares) is a quick and effective way to do that. The CDI press release announcing the Big Fish sale says that up to $500 million of the cash they'll get in the sale can be used for stock repurchases. That's almost 14% of CDI's current market capitalization of $3.6 billion. Enough to move the share price and, not so incidentally, the value of the executives' stock options. Never underestimate the power of short-term personal gain.

Theory No. 3: The traditional corporate suits in Louisville finally realized that they would never domesticate the video-game millennials in Seattle. Before CDI bought the company in 2014, Big Fish had been around for a dozen years, part of the West Coast computer culture. All the photos I've seen of CDI execs seem to include white shirts and ties; not many of those in evidence at Big Fish. Sometimes it's just too difficult to keep the children in line. It wouldn't be the first time that a corporate merger foundered on the shoals of clashing cultures.

Theory No. 4: Get out while the getting's good. In 2017, for the first time since the CDI acquisition in 2014, Big Fish's net revenue declined (from $370 million for the first nine months of 2016 to $342 million for the corresponding period in 2017, a drop of 7.5%). The video game market is notoriously volatile, and Big Fish itself is no stranger to ups and downs; it suffered a severe retrenchment in 2013, perhaps precipitating the sale to CDI. Is the revenue decline in 2017 a sign of worse to come? If the CDI execs thought so, now would be a great time to divest.

I don't have an inside source in the CDI boardroom (or, for that matter, in any other racing industry corporate headquarters), so I don't know which of these theories is right, or if, perhaps, they all are in some degree. I lean toward Nos. 2 and 4, enhancing the CDI share price and getting out ahead of potential disaster. But, then, I'm oh so cynical when it comes to corporate motives.