CHDN

Churchill Downs Inc. 10-Q Summary: Quarter Ended June 30, 2005

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended June 30, 2005, for Churchill Downs Incorporated, a leading operator of horse racing and simulcast wagering facilities. The reporting period includes the second quarter, which is historically the company's most significant revenue-generating period due to the Kentucky Derby and Kentucky Oaks. The company operates racetracks in Kentucky, Florida, Illinois, Indiana, and Louisiana, alongside a simulcast network. A major strategic development during this period was the agreement to sell the Hollywood Park Racetrack and Casino in California, reclassifying these assets as "held for sale."

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 16% ($23.0 million) for the quarter and 24% ($42.2 million) for the six months compared to the prior year. This growth was primarily driven by the acquisition of Louisiana Operations (Fair Grounds and Video Services, Inc.) in late 2004 and increased attendance at the renovated Churchill Downs facility.
• Profitability Decline: Despite revenue growth, net earnings from continuing operations decreased slightly for the quarter (1%) and significantly for the six months (12%). This was due to a 4% increase in the effective tax rate (from 40% to 44%) caused by non-deductible legislative initiative costs, and a 50% increase in SG&A expenses driven by corporate initiatives and Sarbanes-Oxley compliance.
• Discontinued Operations: Hollywood Park results are now reported as discontinued operations. For the six months ended June 30, 2005, discontinued operations reported a net loss of $2.5 million, compared to a net earnings of $1.3 million in the prior year, largely due to increased interest expense allocated to the segment.
• Segment Performance: Kentucky Operations revenues increased 10% for the quarter. Louisiana Operations contributed $14.8 million in new revenue for the quarter. Conversely, Arlington Park revenues decreased 11% year-over-year for the six-month period due to fewer days designated as the host track in Illinois.

Guidance, Outlook, and Risks

• Hollywood Park Sale: The company entered an agreement to sell Hollywood Park for $260 million, with closing expected in September 2005. Proceeds are contractually required to pay down existing debt facilities unless amendments are made. The company retains an option to reinvest if electronic gaming is authorized at the facility.
• Regulatory Risks:
  • Florida: Slot machine legislation in Miami-Dade County (Calder Race Course) failed in a referendum, though a court ruling in Broward County (Gulfstream Park) remains under appeal.
  • Indiana: New legislation (SEA 92) criminalizes internet gambling operators, potentially threatening in-home wagering revenue streams.
  • Louisiana: The company is pursuing licenses to install slot machines at Fair Grounds, pending local zoning and legal challenges regarding the New Orleans City Charter.
  • Illinois: Ongoing litigation and legislative uncertainty regarding the Rosemont casino license and purse recapture payments could materially impact Arlington Park.
• Internal Control Weakness: Management identified a material weakness in internal controls regarding third-party service organizations that process pari-mutuel wagering. While no misstatements were found, the inability to obtain evidence on these controls poses a risk to future financial reporting accuracy.
• Market Risk: The company has $219.5 million in variable-rate debt. A 1% increase in LIBOR would reduce annual pre-tax earnings by approximately $2.2 million, partially mitigated by interest rate swaps.

Investor Verification Checklist

• Hollywood Park Closing: Verify the final closing date and any adjustments to the $260 million purchase price.
• Debt Repayment: Confirm the allocation of Hollywood Park sale proceeds toward the $237.5 million long-term debt balance.
• Slot Machine Approvals: Monitor the status of slot machine licensing at Fair Grounds (Louisiana) and the outcome of the Broward County (Florida) court appeal.
• Internal Controls: Review subsequent filings for remediation of the material weakness regarding third-party wagering processors.
• Tax Rate Sustainability: Assess whether the 44% effective tax rate is sustainable or if it was driven by one-time non-deductible legislative costs.