Churchill Downs Incorporated 2006 Fourth-Quarter and Year-end Conference Call Transcript

Operator

Good day, ladies and gentlemen and welcome to the fourth quarter 2006 Churchill Downs Incorporated earnings conference call.

I would now like to turn the call over on to Ms. Julie Koenig Loignon, vice president of communications for Churchill Downs Incorporated.

Julie Koenig Loignon
Churchill Downs Incorporated Vice President of Communications

Good morning and welcome to this Churchill Downs Incorporated conference call to review the Company's results for the fourth quarter and full year of 2006. The results were released yesterday afternoon in a news release that has been covered by the financial media. A copy of this release announcing results and any other financial and statistical information about the period to be presented in this conference call, including any information required by Regulation G, is available at the section of the Company's Web site titled “Company News,” located at Churchilldownsincorporated.com. Let me also note that a news release was issued advising of the accessibility of this conference call on a listen-only basis via phone and over the Internet.

As we begin, let me express that some statements made during this call will be forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, expectations, or beliefs about future events or results or otherwise are not statements of historical fact. The actual performance of the Company may differ materially from what is projected in such forward-looking statements. Investors should refer to statements included in reports filed by the Company with the Securities and Exchange Commission for a discussion of additional information concerning factors that could cause our actual results of operations to differ materially from the forward-looking statements made in this call. The information being provided today is of this date only and Churchill Downs Incorporated expressly disclaims any obligation to release publicly any updates or revisions to these forward-looking statements to reflect any changes in expectations.

I will now turn the call over to Bob Evans, President and Chief Executive Officer. Bob?

Bob Evans
Churchill Downs Incorporated President and Chief Executive Officer

Thanks, Julie. Good morning, everyone. Thank you for joining us today. If you have had the chance to review our financials, then you can understand why we are encouraged by our 2006 performance. Revenues from continuing operations were up 5.7 percent year-over-year and up 13.6 percent on a Q4-over-Q4 basis. Profitability also improved.

Now, I know that any measure of profitability that we've released includes the insurance gains. I was going to take those out for you, but then I learned I would be creating a non-GAAP measure, and I can't do that. Let me simply observe that our EBITDA information is available in our supplemental information by operating unit statements, and the insurance gains are available in the consolidated statements of net earnings. You can do whatever math with those you so choose. Finally, we continued to increase the strength of our balance sheet, building our cash balance and reducing our long-term debt. Mike Anderson, our principal financial officer, will be going through the financials with you in just a few moments and we will both be happy to address any specific questions you have about our 2006 fourth quarter and year-end results during the Q&A portion of today's call.

Before we get to that, I would like to take a few minutes to outline our plans for the year ahead, which we believe will be a year of transformation and progress for our Company on many fronts. First, we announced last week that Churchill Downs is entering the account-wagering business with the launch of our own platform, www.twinspires.com later this year. I'm very excited about what our site will offer. I don't want to tip our hand right now on all the bells and whistles; after all we're entering a very competitive segment of the pari-mutuel industry, so why give our ideas away? We will let our customers know by April 1, whether www.twinspires.com will be up and ready to take wagers in time for this year's Kentucky Oaks and Kentucky Derby.

Twinspires.com is important to us for several reasons. First, it should be a very significant contributor to the future revenue and EBITDA growth of the Company. Second, we believe the online interactive channel will be extremely important to us in attracting to our business new customers who have not played horse racing before. Third, we believe customers will continue the shift toward placing more and more of their bets via the Internet even when they are at the track, and this holds significant long-term cost reduction potential for us. Fourth, we will increasingly know just who our customers are and what they want from us. And fifth, we believe the www.twinspires.com platform can serve as a distribution channel for other products, games and services, both wagering and non-wagering, inside and outside the United States in those places where such activities are legal.

We've also taken a 50-percent ownership position in HRTV and will co-own the national cable and satellite horse racing network with Magna Entertainment. Over the next 12 months, racing from all Churchill Downs-owned tracks will join the HRTV lineup as their respective TVG contracts expire. The first will be Churchill Downs this spring with the start of the track's 133rd Spring Meet on April 28. Now admittedly, I'm not happy about disrupting the viewing and wagering habits of some of our customers, but we believe the changes we are making will enable us to offer them significantly new products and services going forward and we appreciate their patience and understanding. And I appreciate the supportive feedback I have received from customers all over the country. I think people get what we're trying to do.

Last week we also announced the formation of TrackNet Media Group LLC, a venture we've launched with Magna Entertainment, through which we will exchange racing content with each other and buy content from and sell content to third parties. Track Net Media will sell racing content from Churchill- and Magna-owned tracks to other racetracks, OTBs, casino race books, and account-wagering platforms. Additionally, TrackNet Media will acquire racing content from third parties for distribution at Churchill- and Magna-owned tracks and OTBs and through our respective account-wagering platforms. TrackNet Media Group assures both Churchill and Magna will have access to much of the best racing content in the United States.

TrackNet Media will operate under a shared services model that will afford both Churchill and Magna a number of operational efficiencies and will manage simulcast sales and purchasing functions previously handled by both of our companies. The staff that previously supported our Churchill Downs Simulcast Network operations, known as CDSN, will move to TrackNet Media. Host fees acquired through TrackNet Media will pass through to the horsemen and racetracks that create the racing content. One of TrackNet Media's primary focuses will be enhanced wagering integrity and security, and TrackNet's management team will dedicate resources to monitor those entities that have access to our signals and our wagering pools to ensure their appropriate use -- and to ensure our horsemen and tracks receive the compensation they are due.

Shifting now to our live racing operations, during the course of 2006 we sold Ellis Park and negotiated the sale of our majority interest in Hoosier Park in Anderson, Ind., a transaction that should close this month. We now own and operate four core racetracks in key racing states and we see opportunities for growth in each one of those markets. Our focus in 2007 at our tracks and OTBs will continue to be on operational excellence, offering superior customer service, and on the implementation of an ongoing cost-out process to help us identify additional efficiencies throughout our operations and continue to manage our expense structure.

I was in Louisiana this past weekend at Fair Grounds Race Course for the Louisiana Derby. It was a great success, setting new handle records for the event, and I want to thank the team there for their exceptional and tireless work in getting the facility ready since Hurricane Katrina hit. This summer, we plan to begin construction of a permanent slot machine gaming facility, next to the track's grandstand, that will house up to 700 slot machines. We are also seeking approval from New Orleans city officials to operate a temporary slot machine gaming facility with about 200 machines in the existing OTB building, while the permanent facility is under construction. If we receive the necessary approvals, we hope to open the temporary facility this October, with the permanent facility being open for business in November 2008. The temporary operation would allow us to begin the flow of new revenues to state and local governments, to horsemen's purses, and to our Louisiana operations as early as this fall.

At Arlington Park, we are currently installing a synthetic racing surface known as Polytrack, the first synthetic surface to be installed at a Churchill Downs-owned racetrack. We believe this investment is positively viewed by the racing community and should help us recruit more horses to Arlington Park. When coupled with an improved racing program and a more effective marketing program for the track, we believe we can increase the overall quality of Arlington's live racing product in 2007 and reverse the negative EBITDA reported from our Illinois operations in 2006. We will also have the opportunity to monitor the Polytrack surface at Arlington over time and in various weather extremes and thereby have the in-house data and experience we desire to determine whether synthetic surfaces make sense for our other racetracks.

In Illinois, there also appears to be the prospect for legislation that would allow slots at racetracks. This legislation is in its early stages, having just been introduced, and we will continue to monitor its progress. In Florida, we hope to define our plans for another local referendum on racetrack slots in Miami-Dade County in the very near future. We continue to work with our pari-mutuel partners in the county to determine the optimal timeframe for another local vote. Florida's legislature is considering several other constitutional initiatives during 2007, which may result in a statewide referendum in the fall of this year. Simultaneously we are preparing a strategy to seek passage in Miami-Dade County regardless of the timing.

In 2007 we anticipate a higher level of capital expenditures due to three nonrecurring items. The first is the Polytrack installation at Arlington Park. The second is the construction of new back stretch dormitories at both Arlington Park and Fair Grounds. And third, the construction of a permanent, and we hope the start-up of a temporary slot machine gaming operation in our existing facility at Fair Grounds that will begin generating revenue yet, in 2007, about one year in advance of the expected opening of the permanent facility in late 2008.

With the launch of Track Net Media and our new account-wagering platform, www.twinspires.com, we are now focusing on a growth agenda with the following goals. First, increase our market share. There are about 52,000 Thoroughbred races in the U.S. each year, all of which compete for the betters dollars in the hyper-competitive simulcast and account-wagering markets that now account for about 90 percent of all wagers. We expect to compete differently and aggressively in the market to capture a larger share of the handle. Second, introducing new, innovative products and wagers to engage current and potential racing fans. Third, using our account-wagering platform, www.twinspires.com, to grow our export and import handle. Fourth, improving revenue realization for our racing signals for both horseman and Churchill Downs in both the account-wagering and rebate markets. Fifth, implementing slot machine gaming at Fair Grounds over the next 18 months. And finally, increasing the monetization of our intangible assets by leveraging our brands, media rights, licensing programs, and sponsorship opportunities.

Through these initiatives, as well as others we will share with you over time, we are looking to create a company capable of achieving and sustaining organic growth that is not dependent on acquisitions -- although we will still evaluate acquisition opportunities that fit with our strategic plans. Ultimately, to be successful we need a world class team. You'll recall that we reduced the size of our corporate staff by 24 positions in December. We plan to add back six of those positions and use that opportunity to bring some significant new capabilities to our organization. We now have recruited five of those six positions and we have added some outstanding new people who will be focused on the growth initiatives I just described.

Finally, we have engaged the executive search firm Heidrick and Struggles to conduct the search for our new CFO. I expect that process could take up to several months as we seek another world class addition to the team. Meanwhile I would like to thank Mike Anderson and the entire finance team who have done a fabulous job of getting things done over the last couple of months during the always hectic 10-K and proxy season. In the coming months we look forward to sharing with you our progress on our immediate goals, including the launch of our account-wagering platform, www.twinspires.com, as well as more details on our longer-term objectives. We've moved our contemplated investor day meeting from March/April to mid-May to enable us to more fully prepare for that event. At this point, I'll turn things over to our principal financial officer, Mike Anderson, who will review our 2006 fourth quarter and year end financials with you. Mike?

Mike Anderson
Churchill Downs Incorporated Principal Financial Officer/Vice President of Corporate Finance and Treasurer

Thank you, Bob, and good morning, everyone. I will be reviewing the information as set forth in the tables to the press release that can be found under the Company's section that Julie referred to earlier, which is at our Web site with www.churchilldownsincorporated.com. Following my comments, we will open the call for a Q&A in which Bob and I will be able to address your questions. Let's begin by first reviewing the segment information which is contained on the schedule titled supplemental information by unit in that release.

At the net revenues line, Churchill Downs racetrack improved year-over-year benefiting from a strong Kentucky Derby week performance in the second quarter and finished off the year on a positive note with hosting the Breeder's Cup for a record sixth time during the fourth quarter. The decline in net revenues at Arlington Park was related to both the pari-mutuel business and ancillary revenues from admissions, food and beverage, and other on-track revenues during Arlington’s live meet, which all appear to have been impacted by the quality of our racing product and lower attendance levels.

As Bob just mentioned in his comments, we believe that the installation of the Polytrack surface should help us recruit more horses and generally improve our overall racing program. That, along with more effective marketing and not paying more out in purses than is earned through wagering, we believe we can reverse some of the negative trends we saw in 2006.

In Louisiana, business continues to remain strong, both with our pari-mutuel operations as well as with the video poker business. Even with 51 fewer live racing days at the Fair Grounds in 2006 we were able to increase our total net revenues from this operation. We did return to live racing in New Orleans in late November, after a one-year hiatus when Hurricane Katrina forced us to run a short meet at Louisiana Downs last winter. And looking forward, as Bob just mentioned, we have recently announced that we will begin construction on our stand-alone slot facility this summer, as well as our intention to seek permission from the city of New Orleans for a temporary slot facility to open at our existing on site OTB later this year.

Now, down at the EBITDA level, performance for all of our units except Arlington generally follows the revenue trends. At Arlington Park, however, the decline in EBITDA exceeded the revenue variance, primarily as a result of purse payments exceeding the purses generated from the wagering handle. We've discussed this in previous quarters, that these overpayments can be carried forward to future periods and recovered by way of purse reductions, and we are currently planning our 2007 racing program to allow us to recover as much of this overpayment as possible. But it will require more than just the 2007 racing season to get fully caught up. For both Calder and Louisiana, their EBITDA performance was impacted additionally by insurance recoveries, net of impairment losses.

Now turning to the consolidated statements in net earnings, again, as Bob mentioned, we grew total net revenues from continuing operations by 5.7 percent, or roughly $20 million for the full year, and 13.6 percent for the fourth quarter. Our gross profit for the year of $75.1 million improved nearly $9 million over 2005 levels. Again, this was due primarily to the strong performances of Churchill Downs racetrack and our Louisiana Operations. Also keep in mind that our operations absorbed increased property insurance expenses, which followed the hurricane season of 2005, specifically at Calder and in Louisiana.

Below the gross profit level, please note the insurance recoveries, net of losses, which are recorded of $19.2 million in 2006, versus $2.2 million in 2005, which relate to the net insurance proceeds received for both Louisiana and the Florida operations. Our effective income tax rate from continuing operations decreased from approximately 44 percent to 39 percent, and this is due primarily to a reduction in our nondeductible legislative costs in 2006. Further down the page under discontinued operations, again, as a reminder, you will see the impact of the operating losses from Hoosier Park, Ellis Park and Hollywood Park, as well as a gain on sale of Hollywood in 2005, the gain from Ellis Park in 2006. As Bob mentioned previously, the sale of Hoosier Park is pending and is expected to close by the end of the first quarter 2007. Our fully diluted earnings per share from continuing operations for the year increased from $1.04 to $2.22.

Now, turning your attention to the consolidated balance sheets in the release, and as is often the case, the fluctuations in our working capital accounts are largely a function of the timing of settlements related to our live race meets. In addition to that, restricted cash and purses payable increased as a result of the purses being generated in Louisiana that are being distributed during the current live meet, which is now running at the Fair Grounds. Income taxes receivable was up in 2006, primarily as a result of the $8 million capital tax benefit generated from the Ellis Park sale during the third quarter.

During 2007, we will be able to apply this capital loss back against prior year capital gains that we generated in prior years. At Dec. 31, 2006, we have no outstanding borrowings under our $200 million bank revolver. The entire balance of our long-term debt represents the convertible note issued in 2004 in connection with a share repurchase. And also on the balance sheet, please note that both assets and liabilities held for sale relate to our pending sale of Hoosier Park. Again, expected to close by the end of the first quarter. Just in closing, briefly, we enjoyed a positive performance overall in 2006, excluding the downturn in business at Arlington, but as mentioned earlier we have several things in place there to try and reverse those trends. We also continue to improve our already strong balance sheet with more cash and no bank debt to enable us to effectively deploy our capital towards the growth initiatives that Bob discussed earlier. With that, now I'll turn it back over to the operator to field some questions.

Operator

Your first question comes from the line of Steve Altebrando from Sidoti and Company. Please proceed.

Steve Altebrando
Sidoti & Company Analyst

Hi, good morning.

Bob Evans

Good morning.

Steve Altebrando

As far as Hoosier, the Hoosier sale, is there a buyback option if alternative gaming should be passed similar to what you had at Hollywood Park?

Bob Evans

This is Bob. Hi, Steve. No, there's not.

Steve Altebrando

Okay. Are you hopeful to strike deals with all the ADW providers before the Kentucky Derby? Do you see any risk of a shortfall there, being that it's only a couple months from here?

Bob Evans

Well, this is Bob again. There's always a risk every year about this time. We go out and sign up the content contracts for the year, and you never know for sure who is going to take the signal in or at what price. But I'm pretty optimistic that we'll end up fine on that front.

Steve Altebrando

Okay. I just wanted to get, I guess just your thought process as far as taking in equity stake in the HRTV. I'm not sure if it was an option, just a formal content agreement instead. I know Magna indicated the sort of loss that the channel is generating, and I guess, do you expect that to widen as you add more content, or to subside as you'll be really increasing penetration of the channel?

Bob Evans

Well, I mean the reason we did it is we wanted to be sure that we had a channel through which we could deliver the television representation of our races. After TVG broke off discussions with us, HRTV was the obvious choice. So that's really why. I think we understand the financial performance of HRTV pretty well. I think we can certainly manage our share of those economics minus or plus, as we go forward. So I don't think that will be a big issue for us.

Steve Altebrando

Okay. Then just last couple of things. Any capital expenditure estimate for Fair Grounds? I know you have mentioned in the past I think it was around $20 million and the capital expenditure for the back stretch improvements you guys mentioned?

Mike Anderson

I think our total investments in New Orleans is approximately $30 million and that includes the, both the temporary build out, as well as the build out at the new stand-alone facility. And the dormitory, I'm not sure if we've received any bids on the dormitory yet, so I can't comment on that.

Steve Altebrando

Thanks, guys.

Bob Evans

You're welcome.

Operator

Your next question comes from the line of Ryan Worst from Brean Murray. Please proceed.

Ryan Worst
Brean Murray Carret & Co. Analyst

Thanks, good morning.

Bob Evans

Good morning.

Ryan Worst

Sorry if I -- I just missed this, Mike, but did you say $30 million for the build out of both the temporary facility and permanent facility at the Fair Grounds?

Mike Anderson

Yes. Keep in mind we're still negotiating with general contractors and we don't have final costs yet. That's just an estimate.

Ryan Worst

Okay, and what are still the hurdles to get approvals for a temporary facility?

Mike Anderson

We're still talking with the City of New Orleans. We have to get the officials with the city to approve our temporary build out of the OTB currently.

Ryan Worst

Okay. And then could you provide some color on Calder? I expected a little better results there. It looked like revenues were fine. Are you seeing an impact from the slot facility at Gulf Stream Park?

Mike Anderson

Our Tropical Meet, which runs through the end of the year -- through the end of December and early January -- we did incur, and this, you can see this in our meet-end release that we issued, we did suffer an unusual amount of rain during the month of December, which caused a lot of our turf races to be taken off, thereby reducing wagering overall. So we did have a relatively sluggish Tropical Meet, which caused some of the downturn in the fourth quarter.

Ryan Worst

Thanks. Just one more follow-up. The insurance recovery, sorry if I missed this, but that was all in the EBITDA line of the Fair Grounds?

Mike Anderson

That is correct.

Ryan Worst

Okay, thanks.

Operator

And there are no further questions at this time. We actually do have a follow-up question from the line of Steve Altebrando from Sidoti and Company. Please proceed.

Steve Altebrando

Thanks. Just a couple follow-ups. The insurance benefits pretty much done for now? Is that -- are they complete?

Mike Anderson 

We continue to negotiate in Louisiana on our business interruption piece of that. The majority of the property claims are settled full and final in Louisiana and Florida. But we do still have some business interruption that we are negotiating with the insurance companies now.

Steve Altebrando

Okay, and any estimated tax rate going forward?

Bob Evans

Again, it's going to be predicated based a lot now on our nondeductible expenses, so to the extent that we have any type of nondeductible legislative costs or lobbying costs, then certainly that's going to increase our rate. But the effective rate for the 2006 continuing operations, I would contend barring any changes in those nondeductible expenses would be a good go-forward rate.

Steve Altebrando

As far as HRTV, is that going to be consolidated or is it going to be below the operating line?

Bob Evans

That will be treated as an equity investment, not consolidated.

Steve Altebrando

Okay, and I guess what's the start-up costs of the wagering site?

Mike Anderson

We haven't disclosed that and don't plan to.

Steve Altebrando

Okay. And then I guess really the last question probably, if you could just take me through, I guess a little bit of the economics as far as how the simulcast revenue's going to be impacted in the near term here? I assume somewhere about maybe 15 percent of your simulcast revenue is done, is through ADW would that be roughly correct?

Bob Evans 

Yes, I think that's a reasonable guess.

Steve Altebrando

Okay, and then, so -- I mean just looking at I guess your hold on that type of -- on that type of revenue, is it safe to assume that your hold should roughly double there? I know you're no longer going to be doing business with TVG, which I guess will lower your distribution, but is it safe to assume your hold is likely going to double in that 15 percent segment

Bob Evans 

By hold, you mean the effective amount that we retain?

Steve Altebrando

Exactly.

Bob Evans

I don't really think that we're going to see a whole lot of change in that any time soon. So, yes, I think if you want to think about the issue, it's -- assuming the current state continues in which TVG does not elect to take wagers on our content, then those betters will have to find their path to another ADW or some other channel through which they can wager. We're reasonably confident most will do that, but if not, I suppose we could see some slippage.

Steve Altebrando

But as far as, now that TVG won't be involved taking their cut, depending on what it was, depending on the state it varies, but assuming it was somewhere around four percent, now somebody going through an other ADW, where is that four percent going, if you understand the question?

Bob Evans

Yes. I don't want to go too deep into this. Let me just say that you're kind of on the right path, which is -- there may be some reduction in handle as a result of the situation, but that won't necessarily translate into the same reduction in revenue. We would expect the reduction in revenue to be less for the reason that you just described.

Steve Altebrando

Okay, great. And I guess this really is the last one. Polytrack, I was reading a little on their Web site. It mentioned about -- it needs be either replaced or refurbished every five years. That's not a case where it's an $11 million investment every five years, is it?

Bob Evans

No, it is not.

Steve Altebrando

Okay, and any difference in maintenance costs? I'm just looking at that type of return you can get for that capital spending.

Bob Evans

The tracks that have done it before have generally reduced their annual maintenance cost by about 50 percent, which is a couple hundred-thousand dollar reduction.

Steve Altebrando

Okay. That's all I have thanks, guys.

Bob Evans

Thank you.

Operator

Your next question is a follow-up question from the line of Ryan Worst from Brean Murray. Please proceed.

Ryan Worst

Yes, thanks. Just on the legislative front, would you guys receive a benefit if Indiana does go ahead and legalize slots at the race tracks there?

Bob Evans

Yes, at some point depending on when those slot machines might actually be put into service.

Ryan Worst

So there's an earn-out there, or is it just the one-time payment and any -- could you provide any guidance as to what we should be looking for?

Bob Evans

It's a payment that occurs over time, but doesn't exist in the form of an earn-out. It's just based on the number of machines.

Ryan Worst

Okay.

Operator

There are no further questions at this time. I would now like to turn the call back over to Mr. Bob Evans, president and chief executive officer.

Bob Evans

Well, thanks, everybody. Apparently between the announcements of last week and this week, we've exhausted you all on the question front. So we appreciate that. Steve and Ryan, thanks very much for your thoughtful questions. We appreciate your interest in the Company, and we hope to see you at the Oaks and Derby in slightly less than eight weeks. Thanks very much.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.