Churchill Downs 2006 Third-Quarter Conference Call Transcript

Operator: Good day everyone and welcome this Churchill Downs Incorporated Third Quarter Earnings conference call. Today’s call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Vice President of Communications Julie Koenig Loignon. Please go ahead, ma’am.

Julie Koenig Loignon: Thank you and good morning. Welcome to this Churchill Downs Incorporated conference call to review the Company’s results for the third quarter and first nine months 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 site titled Company news, located at Churchilldownsincorporated.com. Let me also note that a new release was issued advising 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 are otherwise 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 Evans: Thanks Julie. Good morning everyone. I’d like to welcome you to today’s conference call. Thanks for joining us. We’re planning an event for investors in the early part of next year at which we’ll outline our strategy for growing the business, and I look forward to meeting many of you in person then.

As has been the case in our previous quarterly conference calls, I’ll give you some highlights of the quarter and discuss some of our near-term priorities and then our CFO, Mike Miller, will take you through the specifics of our financial performance. So following that, we’ll try to answer any questions you might have.

I joined CDI in mid-August and in the last three months I’ve spent a lot of time getting to know the team, our industry partners and the issues we need to address to promote future growth and profitability. Perhaps the most important thing I can tell you at this point is that I believe there are ways to profitably grow this business; however, we’re going to have to think differently about what we do.

Let me give you three examples: First, we need to use technology to engage our existing and new customers differently than we have in the past. Think about how you personally today use technology to choose and use the travel, financial services, healthcare and media and entertainment products and services – to name but a few – that you buy.

I can guarantee you that the Generation X and Y consumers that hold the most potential to create growth in the racing business use technology in nearly every facet of their daily economic lives, and we need to use technology to introduce our products into the way they live – not require them to modify the way they live in order to enjoy our products.

Second, we need to reinvent the existing products we sell. Every racing day in the United States there are about 300 horse races presented in a simulcast and Internet wagering markets that now account for roughly 90 percent of all money wagered. During the core afternoon period, there’s roughly one race per minute. How can we reinvent the 20 to 30 of those 300 races that occur at Churchill Downs Incorporated tracks so that they are the winners in this highly competitive market space?

Now you’re probably thinking that there’s not much new about a horse race, but I’d ask you to consider how cleverly poker, blackjack and even ballroom dancing have been reinvented in their TV, online and in-person forms such that they each now have over 30 million fans.

Third, we need new products. Obviously alternative gaming, slots and video poker machines are one such opportunity, but there are others as well. If you think of us as being in the entertainment industry rather than the horse racing business, then a host of new product ideas begins to emerge.

Technology will be increasingly important to all that we do. We have hired a terrific individual to lead our technology initiatives, and we are building or a core technology team in Silicon Valley, California. Why Silicon Valley? Because that’s where we can build a team of people on the cutting edge of technology innovation, and because we’ll benefit from the perspective of those outside the traditional racing business. As I said earlier, we’ll be meeting with you early next year to fill you in on the details of this strategy.

As for our third-quarter results, I’m pleased with the revenue growth we enjoyed last quarter, up 4.6 percent year over year. I am not pleased with our overall cost structure, and we have already begun working on that. We remain encouraged by the performance of our Louisiana operations. Our simulcast and video poker business continues to outperform pre-hurricane levels and netted 7.6 million of top-line growth year over year.

We tried something new at Calder Race Course this quarter that produced positive results. From July 31 to Aug. 27, we conducted live racing on only three days a week – Fridays, Saturdays and Sundays – rather than the traditional five days per week in an attempt to increase field sizes, handle and purses. We met all three goals during the test period, with average field sizes reaching 9.0 horses.

By offering bigger fields, we increased overall wagering on our simulcast signal both in state and at simulcast outlets around the country during that period. Our August gains helped boost Calder’s meet and daily averages for inter-track and interstate wagers.

We are pleased with the initial results from this shortened mid-summer schedule, and we are looking at ways to duplicate, and hopefully improve upon, our 2006 results next year.

Churchill Downs had a truly unique opportunity to host The Rolling Stones in concert in September. We cannot disclose the financial terms for our agreement with the concert promoter, but the event positively impacted our results for the quarter and for the first nine months of the year. And more important, it gave us an opportunity to introduce a new kind of customer to Churchill Downs and created yet another historic moment under the Twin Spires.

During the quarter, we reached an agreement to sell Ellis Park to Kentucky businessman Ron Geary and in doing so have found a great owner/operator for Ellis Park, which was no longer a core strategic asset for us. We closed the sale on Sept. 29. Through the sales agreement, we retained the Ellis Park signal for our Churchill Downs Simulcast Network.

In an otherwise positive quarter, Arlington Park struggled. During the middle part of Arlington’s May through September meet, we experienced a high level of injuries to horses racing at Arlington Park. We believe the unusual number of on-track injuries affected trainers’ decisions to race their horses at Arlington, which in turn, negatively impacted the field size. The breakdowns received a lot of media attention as well, and we believe the combination of lower field sizes and negative publicity contributed to the significantly lower attendance and wagering for the meet.

Now while no one cause has been determined for the higher number of injuries, experts have ruled out the racing surface itself as a contributing factor. In fact, three separate analyses of the track surface were conducted by outside consulting firms and independent experts, and the studies found no causal factors linking the condition of the track surface to the injuries.

We are committed to ensuring the safety of the racing surface on an ongoing basis and for the 2007 meet, which begins next May. And we are looking at a number of initiatives we believe will improve the performance of Arlington Park next year.

And finally a bit of recent news: I’m sure most of you know that Churchill Downs racetrack hosted the Breeders Cup World Championships Nov. 4, the sixth time Churchill Downs has hosted this prestigious event and the first time since the recent renovation of our Louisville facility.

I’m happy to report that we set Breeders Cup records for on-track, off-track and all-sources wagering, and we had the third highest attendance in Breeders Cup history. The five highest Breeders Cup attendance levels were all achieved here at Churchill Downs.

In a couple of weeks we’ll be reopening Fair Grounds Race Course on Thanksgiving Day, its traditional opening. Our team there has done an unbelievable job of recovering from the extensive damage caused by Hurricane Katrina.

To give you a sense about how eager New Orleans is to have racing back, we sold out of reserve seating for our Thanksgiving Day opener within an hour of opening our phone lines to take reservations. And on the day the track reopened for training, Nov. 2, that story made front-page news.

Once Fair Grounds has reopened, we will switch our focus on Louisiana to creating a slot machine gaming facility and on determining the best time and way to introduce alternative gaming at the track.

Now let me turn things over to Mike who will take you through the numbers, and then we’ll try to respond to your questions. Mike.

Mike Miller: Thanks Bob and good morning everyone. I will briefly go over the financial statements for the quarter, and then as Bob stated, we’ll entertain your questions. I plan only to address the quarter’s results but can take any questions you may have about the year-to-date results during the Q-and-A session.

Let’s begin by first reviewing the segment information. As Bob stated, revenues from continuing operations increased approximately 4.6 percent, thanks to strong performances at Churchill Downs and at our Louisiana Operations. At Churchill Downs, we benefited from The Rolling Stones concert, as well as from racing during the quarter that had previously been run at Ellis Park. In 2007, that extra week will return to Ellis Park as part of the agreement to sell that unit.

The decline in revenues at Arlington Park was both at the pari-mutuel line as well as in ancillary revenues from admissions, food and beverage, parking etc., which all appear to be related to the quality of our racing product.

We are well into our planning cycle for 2007, and we’ll address the operating issues including field sizes, as well as our overall approach to marketing with a view to recapturing the patrons and handle lost during the 2006 meet.

As Bob stated, I’m also pleased to state the business continues to be brisk in Louisiana, both on the pari-mutuel level as well as the video poker side. During the quarter we deployed more new video poker machines consistent with our strategy when we acquired Fair Grounds, and our complement of machines is now comprised of approximately 75 percent new technology, compared with an average age of between eight and 10 years for the machines that we inherited at the time of acquisition. We are also now determining the best way to get our 700-machine slot operation up and running.

At the EBITDA line, performance for all units except Arlington and Calder closely tracked revenue trends. At Arlington the decline in EBITDA exceeded the revenue variance primarily as a result of purse payments during the quarter exceeding the purses generated from the wagering handle.

As we had discussed on previous occasions, these overpayments can be carried forward in future periods and recovered by the way of purse reductions. We will be planning our racing program for 2007 to allow us to recover as much of this overpayment as possible, but it may require more than the 2007 racing season to get fully caught up.

At Calder, we enjoyed a $1.8 million insurance recovery gain, which accounts for Calder’s EBITDA increase. Turning now to the statement of net earnings, the EBITDA from continuing operations generally reconciled to operating income after including the $5.1 million charge for the quarter for depreciation and amortization.

Below the operating income level, we actually had a slight increase in interest expense as a result of virtually all our interest expense in 2005 being allocated to discontinued operations. The turnaround in the miscellaneous category is due to both option income and minority-interest income in 2005 – both related to our ownership in Hoosier Park.

Our effective income tax rate is approximately five percent over the prior year, due to a change in the estimate of our reserve for prior year’s taxes. Going forward, we would expect our (tax) rate to more closely approximate that for the third quarter of 2005. As a reminder, the discontinued operations category includes the impact of both the operating results as well as the sale of both Hollywood Park in 2005 and Ellis Park in 2005 and 2006.

Our overall fully diluted EPS for continuing operations declined from 23 cents to 20 cents due primarily to the poor operating performance of Arlington. It will likely be early in 2007 before we are able to fully address the pertinent issues there with a view to returning its performance to historic levels.

Now turning attention to the balance sheet, 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, restricted cash increased as a result of the purses being generated in Louisiana, which will be dispersed during the upcoming live meet beginning on Thanksgiving Day.

Much of the increase in other current assets is due to significantly higher prepaid insurance premiums as a result of the renewal of our property and casualty coverage at a much higher cost. On the insurance front, we have nearly finalized our negotiations with our carriers relative to the property damage portion of our hurricane and tornado losses. We have also submitted our business interruption claim and are looking forward to settling that piece as well, hopefully by early 2007.

The decrease in dividends payable reflects the payment in January, and the decrease in deferred revenue results from the recognition of Kentucky Derby-related revenues during the second quarter.

At Sept. 30, 2006, there was nothing outstanding under our $200 million revolver. The balance of our long-term debt represents the convertible note issued in 2004 in connection with a share repurchase and approximately $5 million due to our partner in Hoosier Park as a result of a participation agreement in Hoosier’s debt.

Finally, as stated in prior calls, the unearned compensation charge of $3 million has been moved and is now included with common stock in accordance with the relevant accounting literature.

In summary, we enjoyed yet another strong operating quarter, and we continue to benefit from the diversification that the Fair Grounds acquisition has afforded us. Additionally, our balance sheet provides us with access to affordable capital as we look forward to positioning the Company for growth under Bob’s leadership.

That concludes my remarks. I will now turn it back over to the operator for your questions.

Operator: If anyone would like to ask any questions today, they may signal us by pressing the “*” key, followed by the digit 1 on your touch-tone telephone. Do keep in mind that if you have been using your speakerphone, please make sure the mute function has been released to allow the signal to reach our equipment. Once again to ask a question, press “*1”. We will pause for just a moment.

We’ll take the first question from Ryan Worst with Brean Murray.

Ryan Worst: Thanks. Good morning.

Mike Miller: Hello.

Ryan Worst: Just a couple questions. Mike, do you have any details on your insurance claims and what you expect in proceeds and what you have received so far?

Mike Miller: I think we stated it in the past as to the total amount that we’ve received to date – and it’s included in the 10-Q. $18 million in New Orleans, $4 million in Florida, and $8 million for Ellis Park.

Ryan Worst: OK and what about outstanding claims yet to be recovered?

Mike Miller: We’re not in a position to disclose that right now. We have submitted our business interruption claim and we’re just at the – at the beginnings of the negotiation process on that.

Ryan Worst: Okay. And then, Bob, you spoke a little bit about alternative gaming in New Orleans at the Fair Grounds. When do you think that can be up and running and kind of – you know what are the issues there?

Bob Evans: Well the issue is primarily New Orleans and the devastation that’s occurred, and when will the sufficient population be back to take advantage of anything we might do? So we’re looking at that pretty closely, looking at a couple of different alternatives and how we might build out the existing facility or new facility to support the slot machines, and we’ll probably make a decision on that over the next couple of months. And I would expect within a year or so after that, maybe less, we’ll be in business.

Ryan Worst: Do you – do you think that there’s a market there now that could support some level of slot machines?

Bob Evans: Do I think that? Yes. Do I have any data yet confirming that? No.

Ryan Worst: OK. And then what about in Florida, any thought to when you guys could – or when you will hold a local vote there for Miami-Dade County?

Bob Evans: It would be possible to do in 2007, but there’s no other local election scheduled for that timeframe, so we’re still trying to figure out whether it makes sense to do it in ’07 or a later year.

Ryan Worst: Are there – there’s no vote in November in ‘07?

Bob Evans: Not at the moment.

Ryan Worst: Okay. Okay. And then also regarding technology, it seems like you guys are building an infrastructure. I mean what are your options there? Are you still looking at potentially acquiring something, or is it that you’re going to build up your own account-wagering platform?

Bob Evans: We don’t have an acquisition program active where we’re out trying to find a particular target to buy. Opportunistically, if we encounter something, we’ll consider it. I would like to put off any discussion on what we’re going to do specifically in the technology area until shortly after the first of the year. But I can say that we are considering every possible alternative that I’ve heard mentioned around the Company, plus a few more.

So I think we have a pretty aggressive plan. Just for competitive reasons, I don’t want to tip off everybody else to what we’re doing for a while. So give me a couple of months here and then we’ll be glad to get back with everybody and share our full strategy.

Ryan Worst: Well what are you building initially in Silicon Valley? I mean I guess without specifics on the objective but how – what about cost-wise and how big your operation is there?

Bob Evans: Small team of six or eight to begin with, and then once we’ve figured out exactly what we’re going to do, that may get larger if we build it ourselves or outsource it or acquire something. But we haven’t made any of those decisions yet.

Ryan Worst: OK great. Thank you.

Bob Evans: You’re welcome.

Operator: We will now move to a question from Tim Rice with Rice Voelker.

Tim Rice: Good morning. I’m a little confused about your hesitancy with the Fair Grounds slot facility, given the fact that Harrah’s land-based casino here continues to report record win at their operation and if you see sufficient demand to operate a race meet.

I’m just confused as to why you wouldn’t think that that would justify accelerating the slot facility.

Bob Evans: Well Tim, I answered the question earlier. Do I think there’s demand? Yes, I do. Do I have any confirming data at this point? No, I don’t. And there’s still a question as to the – sort of the construction process. Do we do a stand-alone facility? Do we use the existing facility of some capacity? So we’ve got some architects working on that. And, as I said, we’ll make a decision here in a very short period of time.

Tim Rice: But you don’t think that Harrah’s Casino having record handle 10 minutes away is confirming data?

Bob Evans: I told you that I think there is demand. I also said that I don’t have any confirming data and even if I did, we still have some architectural and construction questions that we have to resolve.

I have this interest of being in the slot business in New Orleans ASAP.

Tim Rice: OK. And one other quick question: what’s your view about converting the surface at Churchill to Polytrack?

Bob Evans: Well with the Breeders’ Cup here last weekend I’ve probably been asked this question somewhere in the neighborhood of 10,000 at this point, and I can give you a 20-minute answer. I’ll give you a one-minute answer, which is that all the initial evidence suggests it’s a very positive thing to do. But my father who worked for Monsanto Chemical was involved when Astroturf was introduced in 1965, and here we are 41 years later still debating whether natural grass or artificial turf is best for baseball, football, etc.

So while I think that’s the direction the industry is going to go, and I think you’ll probably see us do it at at least one track to get our feet wet, I don’t think the final jury has returned on just what the right answer is here. And you know, my guess is 40 years from now we’ll still be debating this issue within the horse racing business.

But all the early evidence at Keeneland and Woodbine is very positive, and I think you’ll see CDI and the rest of the industry move in that direction in an orderly manner.

Tim Rice: Great. Thanks very much.

Bob Evans: You’re welcome.

Operator: We will now move to our next question that will come from Jen Ganzi with Gabelli and Co.

Jen Ganzi: Hi. Just a few more quick questions on the Fair Grounds. Do you have any and idea of what sort of margins or tax rates would be for the machines once you got them?

Mike Miller: Well the tax rates are – they’re statutory and I don’t have them at the tip of my finger here, but that’s something that can be readily determined. Margins are not something that we’re ready to talk about at this juncture.

Jen Ganzi: Okay. And this – just for clarification, how many video poker machines do you have now and how many do you see yourselves having in the long term?

Mike Miller: We have approximately 700 video poker machines today. We will continually explore the possibility of expanding that, but right now that’s about the complement. That’s down from what we acquired since we have a couple of OTBs that were destroyed in the hurricane that still haven’t returned to surface yet.

Jen Ganzi: Okay. How many more machines would be when those return?

Mike Miller: Well, we’re trying to make a determination if and where they’ll return. So I’m not ready to give you a number there on that one.

Jen Ganzi: OK. Thanks.

Operator: Moving now to a question from Steve Altebrando from Sidoti & Company.

Steve Altebrando: Thank you. With the sale of Ellis Park, should we consider the depreciation in the quarter as a run rate going forward?

Mike Miller: I’ll see if I can answer that. Yes. I think that’s a fair statement given our level of capital expenditure and the fact that Ellis is included in discontinued operations. I think that should closely approximate the run rate, yes.

Steve Altebrando: Okay. Can you give any specifics in terms of how you’re going to try to turn Arlington around, whether it is on the cost side or plans to drive revenue?

Bob Evans: No. We’re early in that process and that’s going to be unfolding over the next weeks and short months so we can be ready for the May opening, but no specifics at this time.

Steve Altebrando: Okay. Were there any one-time expenses in Louisiana in the quarter? I’m still a little bit confused. It looks like sequentially video poker revenue was roughly the same, yet its margin was down pretty significantly. I realize that – yes, it looked like pari-mutuel wagering was down, but that’s typically lower margin business...

Mike Miller: Yes. We are learning about the market in Louisiana, and both pari-mutuel and video poker go through highs and lows very predictably down there. In the summer months the revenues slow down for both pari-mutuel and video poker and also in the previous quarter. In the second quarter, we enjoyed (revenues from) the New Orleans Jazz and Heritage Festival, which is a very high-margin product that maybe skewed the results for the second quarter as compared to the third quarter.

Steve Altebrando: Okay. Thanks. And could you just remind me quickly, is it the build-out period for the slots parlor roughly a year after you decide?

Bob Evans: Well it depends on how we’d ultimately choose to do it, whether it’s a stand-alone or whether we retrofit interior space, etc. So I don’t have a specific build out period yet.

Steve Altebrando: Okay. Thank you very much.

Operator: And now I’d like to remind everyone if you have a question, “*1” one at this time. And we’ll pause for another moment.

With no further questions. I will turn the call back over to Mr. Evans for closing remarks.

Bob Evans: Thanks for joining us today. As I said we’re going to host an event in the early part of next year for investors, and I look forward to meeting as many of you as possible in person then. Thanks very much.

Operator: And that does conclude our conference for today. We do thank you for your participation. Everyone have a wonderful day.