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Churchill Downs Inc (NASDAQ:CHDN)

Q3 2008 Earnings Call

November 6, 2008; 09:00 am ET

Executives

Bob Evans - President and Chief Executive Officer

Bill Mudd - Executive Vice President and Chief Financial Officer

William Carstanjen - Chief Development Officer and Executive.

Kevin Flanery - Senior Vice President, National Public Affairs

Analysts

Steve Altebrando - Sidoti & Co.

Ryan Worst - Brean Murray.

Steve Wieczynski - Stifel Nicolaus

Operator

Good day ladies and gentlemen and welcome the third quarter 2008 Churchill Downs Incorporated earnings conference call. My name is [Tulisha] and I will be your operator for today. At this time, all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the call over to your host for today Mr. Kevin Flanery, Senior Vice President of Churchill Downs Incorporated.

Kevin Flanery

Thank you, Tulisha. Good morning and welcome to this Churchill Downs Incorporated conference call to review the company’s results for the third quarter of 2008.

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 as well as any other financial and statistical information about the periods to be presented in this conference call, including any information required by Regulation G, is available at the section of the company’s website titled ‘Company News,’ location at www.churchilldownsincorporated.com.

Let me also note that a news release was issued advising of the acceptability 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 facts. 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 operation to differ materially from the forward-looking statements made in this call.

The information being provided today is as 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.

Members of our executive team are here and will be available to answer questions after some formal remarks. We’ll begin now with our President and Chief Executive Officer, Bob Evans; Bob.

Bob Evans

Thanks Kevin. Good morning everyone. Thank you for joining us today for this discussion of our third quarter financial performance. I will begin by making a few comments about our results and then I’ll turn it over to our Chief Financial Officer, Bill Mudd, who will take you through the numbers in more detail and we’ll then be happy to take your questions.

I am very pleased with our third quarter results and here are the highlights. On a continuing operations basis, we reported 11% higher EBITDA and more than double the net earnings compared to the third quarter of 2007 on about 4% less revenue. I ensured our online ADW and Gaming businesses offset weakness in our racing business and our conservative approach to managing our balance sheet has left us in a strong financial position with the resources available to pursue growth opportunities that may present themselves.

As its been our practice of late, I would like to focus on the five things we think you should know about the company at this point in time. Number one, the economy is having a very pronounced negative impact on all gaming businesses including U.S. thoroughbred racing. According to the National Thoroughbred Racing Association Handle or the amount wagered on U.S. Thoroughbred Racing was on a year-over-year, per day basis, down about 2.2% in the first quarter, down 3.7% in the second quarter and down 8.7% in the third quarter.

We have three tracks running during the third quarter; Churchill Downs only conducted five days of racing down from six days during 2007’s third quarter. Handle was down at Churchill 20%, but that was largely caused by the horsemen’s dispute as well as the one less race day.

Calder’s handle was down 27%, the disputes with Florida Horsemen and with Florida Breeders over how much of future slot revenue they would receive in purses were resolved during the quarter, but clearly there have been aftereffects on handle from their decision that have still not been overcome.

In addition, Calder’s signal was not available to any national events deposit wagering businesses during the quarter. Arlington Park, which raced through September 21 in the third quarter saw handle up about 6% outperforming the industry. So far in the fourth quarter, according to the respective press releases, Keeneland’s Fall Meet all sources wagering was down about 17.3% on track handle for Oak Trees, Santa Anita Meet was down 14% and the average per race wagering on the Breeder’s Cup Championship races, there were 14 this year versus 11 last year, was down about 17%.

Fair Grounds opens for live racing on November 14, the slot and video poker operation there will allow us to alter the highest daily overnight purses in Fair Grounds history, so we hope we will do better than the industry trend in the fourth quarter and going forward.

Number two, the current economic and industry situation is demonstrating just how important Advance Deposit Wagering or ADW is to U.S Thoroughbred Racing. The conventional wisdom seems to be that ADW is bad for racing. Supposedly, all ADW handle is stolen from other channels particularly the on-track channel and ADW wagering under compensates the tracks and horsemen who put on the race that generates that handle, well we see it quite differently.

According to the 2008 Jockey Club Fact Book, over the five-year period between 1997 and 2002, on-track handle declined an average of $135 million a year. ADW started to generate significant handle in 2002 and since then, over the last five years through 2007 on-track handle has dropped about $72 million year-on average, roughly half the rate of decline as in the prior five-year pre-ADW period.

We conclude that on-track handle was declining long before ADW arrived and that the rate of decline is actually slowed by roughly half since ADW started in earnest around 2002. So if ADW handle isn’t coming from on-track, where is it coming from?

Well, some will say that ADW is stealing from off-track betting or the OTB channel, well if you are a track or horsemen who put on the race that produces that handle, you should be very pleased. On average, only about 3.5% of interstate OTB handle is returned to the horsemen and tracks that put on the race. The horsemen and tracks then split that, which means each receives about 1.75% on average. When the exact same wager is made through, say the TwinSpires.com ADW channel, the horsemen and tracks that put on the race share in about 9.1% of the amount handle, split roughly 4.5% each.

The decline in on-track handle has slowed market lease since ADW really took off starting in 2002 and any handle that ADW steals from the OTB channel, produces over 2.5 times more for the horsemen and track that put on that race. Total industry handle on a per-race day basis was off 8.7% in the third quarter. Although the total ADW industry numbers haven’t been released yet, we believe ADW handle was probably up in Q3. We know that TwinSpires.com’s handle was up 62% even though TwinSpires.com did not have access to either Churchill or Calder races during the third quarter.

TwinSpires.com’s new account sign-ups in the quarter were double the 2007 level and average daily wagering on TwinSpires.com increased by more than 53%. It seems increasingly clear to us that during the third quarter, a time of growing unemployment, high gas prices and declining consumer confidence, customers increasingly chose the more convenient and far lower cost way to wager ADW.

We should all be listening carefully to the two wakeup calls that the ADW business is delivering so loudly. First, the industry and our company’s results in the third quarter suggests that ADW is increasingly a new positive for racing and that in fact may very well be offsetting what would otherwise be an even more precipitous decline in total handle.

Second, there are many races on which customers can bet and if your track races aren’t available, no problem, plenty of others are. As Calder’s results show, if you shut off your track signal, don’t be surprised if customers have moved on to other racing even after you have turned that signal back on.

Number three, we will continue to look for ways to expand our gaming operations. Our video poker and temporary slot operations in Louisiana are doing quite well. Video poker performance improved during the third quarter over 2007 and the net win per unit on our 250 slot machines averaged $239 in the third quarter.

Since we only started our slot operation in Louisiana last September, year-to-year comparisons aren’t yet meaningful. We look forward to the grand opening of our permanent slot facility in New Orleans on Friday November 14 with approximately 600 machines. Just last week, we appointed Austin Miller, formerly a Harrah’s executive as the President of our operations in New Orleans.

Austin joined us originally in May 2007 and has been responsible for leading our gaming success there so far. We also announced that Eric Halstrom, a fifteen-year racing industry veteran, who most recently served as the Vice President of Racing in Simulcast Operations at Canterbury Park in Minnesota will join us to run our racing operations at the Fair Grounds.

At Calder, we are in the process of finalizing our plans and securing the required regulatory approvals for construction of a slot facility. With the election this week now over and as we move into 2009, we will again engage in the legislative process in both Illinois and Kentucky to try to secure alternative naming rights at our tracks there. With Maryland voters just approving slots there this week Kentucky is now the only one of the three states to conduct racing storied Triple Crown without legislation allowing slot machines.

Number four; racing. As I mentioned earlier, US Thoroughbred racing is like many industries, particularly those that depend on the consumer’s discretionary income going through a very difficult period. I read a Wall Street Journal article recently about the US gaming industry where Harrah’s which was acquired last year by private equity funds is struggling and firms like Las Vegas Sands and MGM Mirage are creating 80% to 90% below their 52 week highs.

Historically, the gaming industry and the U.S. Thoroughbred racing industry were considered largely recession-proof, so these are very unusual times. As a result, we are paying very close attention to our expense structure and we are being quite conservative in committing capital as we do our 2009 planning for our racing business.

Number five, we will continue to proactively manage our costs and improve our margins. We have reduced employment, we have outsourced some functions, and we’ve continued implementing a new purchasing process across the company and the results show. Our EBITDA margins in the third quarter improved by 150 basis points over the third quarter of 2007. Now we aren’t managing to a particular EBITDA target or EBITDA margin target each quarter, if there are good gross based reasons to spend money, we spend it, but on a trended basis, we will continue to work and improve our cost management and margin performance.

Let me now turn this over to our CFO, Bill Mudd, who will give you a bit more insight on our reported financial results and then we will be back to take your questions. Bill.

Bill Mudd

Thank you, Bob and good morning everyone. I’ll be reviewing the information as set forth in the tables of the press release that can be found under the ‘Company News’ section that Kevin referred to earlier, which is located on our website www.churchilldownsincorporated.com. Following my comments, we will open the call for questions and answers in which Bob and I will respond to your questions.

As a reminder from our previous calls, the discontinued operations section of our financial statements and tables contain the operations of Hoosier Park, Ellis Park, and Hollywood Park. My comments will focus on the performance from continuing operations for the three months ended September 30.

Let’s begin by reviewing the segment information, which is contained in the schedule title supplemental information by operating unit in the press release. As Bob mentioned in his comments, the National Thoroughbred Racing Association has reported that handle was down 8.7% year-over-year on a per race day basis in the third quarter. We also felt the impact of that industry decline across our tracks. Churchill Downs racetrack, net revenues from external customers declined 23% on a 20% reduction in handle.

In addition to the industry headwinds, Churchill finished the Spring Meet with five live race days in the quarter versus six last year. It was not able to distribute the signal to the national ADW providers due to ongoing dispute with horsemen. Arlington Park ran 58 live race days during the third quarter, an increase of one day over the prior year.

Net revenues from external customers decreased on 4% on a handle decline of 6%, while on-track results decline much like the rest of the industry, Arlington saw an increase in export handle through online account wagering with various horsemen disputes making other content unavailable for ADW businesses, we believe Arlington was the beneficiary of limited competition in this channel.

It appears that customers wager on whatever product is available. Regardless, we are happy with the result in Arlington outperformed the industry.

Our Calder operation recorded a 26% decline in net revenues from external customers on a handle decline of 27%. Calder ran 56 live racing days, two days to here than the prior year. As a reminder, the Florida horsemen did not consent to sending the Calder signal outside of the state of Florida over a dispute regarding first contributions from the future slot facility.

While this dispute was resolved in early July, we continue to feel the effects of the signal dispute both on track as well as in the export market. Our online business grew net revenues from external customers 46% to $13.1 million on handle growth 62%. This is the first quarter for which full year comparisons are relevant, or quarter comparisons are relevant.

Since we launched TwinSpires.com in the second quarter of 2007 and acquired the America-Tab and BRIS family company in early June last year. The increase in revenues is the result of an increase in wagering content and an increase in the number of new customer accounts.

Gaming revenues increased primarily as a result of our temporary slot facility at our Fair Grounds property. Our video poker business also improved as a result of opening of a new facility in Boogie, Louisiana, increases in machine count of select locations and the installation of new jackpot chips.

When you consider that our slot operation was closed for seven days and our OTB and video poker facilities were closed up to 15 days for hurricanes Gustav and Ike, we are very pleased with these results. At this time, we do not anticipate filing any insurance claims for business interruption or damage. In total, our quarterly net revenues from continuing operations were down slightly to $99.6 million in the quarter.

Dropping down to the bottom of the segment data, I’ll highlight some of the EBITDA changes by segment for the quarter. EBITDA from continuing operations in total increased $1.1 million or 11%. Our racing operations EBITDA declined by $3 million, while this is primarily a result of the external revenue decline, this is also driven by $1.1 million of severance expense related to actions we took to address our cost structure.

Our online business, EBITDA increased $1.4 million driven primarily by increased wagering content, an increase in customers and an increase in average daily wagering activity of existing customers. Our gaming EBITDA increased primarily due to our temporary slot facility at Fair Grounds, which opened in September 2007.

Now let’s look at the condensed consolidated statements of net earnings. Third quarter operating profit of $4.3 million is down slightly versus $4.6 million. Operating expenses decreased by $3 million or 3%. This does include an increase of $1 million and depreciation and amortization primarily related to capital spending for our temporary slot operation and technology investments in our ADW platform. Excluding this increase, our operating expenses decreased at a greater rate than our revenues.

SG&A expenses decreased by $1 million as a result of prior spending on professional services to establish our ADW business and open the temporary slot facility at Fair Grounds, additionally current year severance expense was more than offset by good cost management in the racing segment and lower equity award compensation.

Interest expense decreased as free cash flow generated over last year was used to pay down debt. Equity loses and unconsolidated investments improved primarily as a result of a prior year write-off for empire racing, but also include better performance of HRTV and Tracknet media. Net earnings from continuing operations more than doubled to $2.3 million or $0.17 per diluted common share.

Now if I could turn your attention to the condensed consolidated balance sheet, I will briefly review a few variances. Accounts receivable decreased primarily due to the collection of Kentucky Derby and Churchill Downs racetrack Spring Meet related receivables in addition to simulcast receivable collections. Income taxes receivable declined as a result of year-to-date earnings, which have generated approximately $22.8 million of tax expense, partly offset by 2008 estimated tax payments made.

Net additions to property and equipment, balances are primarily due to the CapEx spending at Fair Grounds for the permanent slot facility, in addition spending was incurred related to technology investments for enhancements at TwinSpires.com such as TwinSpires TV. Goodwill increased $7 million as a result of the accrual of earn-out payments related to the acquisition of America-Tab and BRIS.

During the second quarter, we reached the handle objectives of the acquired ADW business, thus triggering a payment of $3.5 million which we made in July. We anticipate that wagering levels requiring the remaining payout when we reach prior to the end of the agreement.

Accounts payable and accrued expenses increased consistent with the commencement of the race meet at Arlington Park, which concluded late in the third quarter. In addition, payables related to TwinSpires increased consistent with the growth of the business during the year.

Deferred revenue decrease slightly since December as a result of the Derby and other Spring Meet revenues recognized during the year, and long-term debt decreased to result the payments under our bank revolver using cash generated from our various collection activities, and EBITDA generation. That concludes my remarks. I will now turn it over to Bob for your questions; Bob.

Bob Evans

Thanks, Bill. I’d like to ask the operator Tulisha if you could put through any questions that might be out there that would be great.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ryan Worst - Brean Murray.

Ryan Worst - Brean Murray

I’m sorry if I missed this, but what was CapEx in the quarter and also what was the severance expense in the quarter?

Bill Mudd

Yes, the severance expense was $1.1 million in the quarter and the CapEx in the quarter, on a year-to-date basis; you got both periods, but about $13 million in the third discreetly.

Ryan Worst - Brean Murray

13 million?

Bill Mudd

Right.

Ryan Worst - Brean Murray

Then as far as the payments go to the acquired ADW’s, how much more do you owe on that?

Bill Mudd

About $3.5 million.

Ryan Worst - Brean Murray

Is that the last payment that you guys have?

Bill Mudd

We accrued $7 million into goodwill in the second quarter, we paid $3.5 of that out in July and there is 3.5 to go, which will be paid sometime between now and the end of the agreement.

Ryan Worst - Brean Murray

Okay and then when you are talking about your increase in handle, does that include the separate platforms last year, so you are 62% over the combined platforms?

Bill Mudd

Yes, last year had the acquired businesses. I would say that, content and states that we are in and things like that changes over here, so it is a tough comparison, but it does contain the operations of both for the full period.

Ryan Worst - Brean Murray

So did you say wagering was like $64 million through TwinSpires this quarter?

Bill Mudd

The handle on TwinSpires online was 56.

Ryan Worst - Brean Murray

56 okay, and then maybe you or Bob could comment on, what the content picture looks like for TwinSpires relative to last year in the third quarter and then in the fourth quarter or not only content but states you are accepting wagers in?

Bill Mudd

Maybe Bill Carstanjen is the best guy to answer that question, since he deals with it day-in and day-out.

William Carstanjen

I think it is hard to tell exactly what the content picture will be in the fourth quarter, hopefully it will be consistent with what we had last year, but those are the sort of decisions that you have made right before meets open, so they haven’t been made yet, but certainly we are optimistic and hopeful. We will work as hard as we can to get as much content as possible and that is in everybody’s interest.

Ryan Worst - Brean Murray

How does the environment look for open content and getting additional content from like TVG or providing your content to other ADW players?

Bill Mudd

We have said from the beginning when we got into the business that we want to see a world of open content sharing between the major ADW platforms, but we will still work hard to achieve that and I think that day is coming and when it comes exactly I am not sure, but we remain hopeful. It’s something we thought we did on this and it hasn’t, but his contracts or as it tried to come off their exclusive contracts with TVG. Generally, we felt pretty good about getting access to those tracks.

Ryan Worst - Brean Murray.

Okay and then one question concerning New Orleans, when you guys talk about that net win number. What goes into that, are you deducting promotional expenditures to get to that net win?

Bob Evans

Yes, it is less promotional expenditures and less taxes.

Ryan Worst - Brean Murray.

In terms of Calder racetrack, how much of the deterioration was related to the contract dispute that is now over would you say?

Bob Evans

Its hard to be definitive about that, so I have got to be a little bit careful here because my lawyer is looking at me, but we clearly say its down more than the industry and its still down kind of in the range of in certain places where we were during the conflict. We haven’t seen it come back as much as we like, so I think it is pretty good portion. Now clearly the industry is down too, so that is affecting it as well. The split is hard to determine.

Ryan Worst - Brean Murray.

Throughout the dispute, you were not able to export the signal to other states and now you can right?

Bob Evans

Correct.

Operator

Your next question comes from Steve Wieczynski - Stifel Nicolaus.

Steve Wieczynski - Stifel Nicolaus

Would you mention some of the CapEx forecast for next year yet?

Bill Mudd

Well, first we don’t talk about forward-looking statements, but no we haven’t talked about anything about CapEx for next year.

Steve Wieczynski - Stifel Nicolaus

Any update, Bob in terms of what you are going to do with Calder and slots there?

Bob Evans

Yes I know there is a number of people that are interested in the specifics there, we have got a plan, that plan is making its way through the permitting and other sort of regulatory process, so once we have got it confirmed we’ll be the first guys to announce it, but we just aren’t ready to do that yet.

Steve Wieczynski - Stifel Nicolaus

Do you have any idea about the timing on it, is it quarter away or is it six months away?

Bob Evans

It is a good question. We are dependent on various regulatory agencies to sign off on things, so we will get it done as quickly as we can, we want to move forward quickly, but we just need them to do it. So I’m not going to try to predict what they are going to do.

Operator

(Operator instructions) Your next question comes from Steve Altebrando - Sidoti & Co.

Steve Altebrando – Sidoti & Co.

Can you give us some color about what’s remaining CapEx wise on the permanent New Orleans facility?

Bob Evans

Yes we have provided that number in the past, so I will be happy to provide kind of what is remaining. Between the temporary facility and the permanent facility, the number that we provided was around $32 million total. There is about $9 million to that to go. A good portion of that will be paid in the fourth quarter, but it will probably finish up in the first quarter of next year.

Steve Altebrando – Sidoti & Co.

Then in terms of Florida and I know it was just brought up, but I think it is kind of been out in the press that you guys have a contractor or is that accurate?

Bob Evans

Bill Carstanjen, can you do that one.

William Carstanjen

Sure. We have hired architects and contractors to help us do this; it is part of the process of getting our plans ready. So it’s just part of the process and actually necessary to have those folks lined up as we move through the permitting process as well.

Steve Altebrando – Sidoti & Co.

Okay and then lastly Bob, if you could talk about, you mentioned earlier in your prepared comments about, the flexibility of your balance. If you can give just kind of a sense of what you look at as a priority, are you thinking of expanding more on the ADW segment, are you thinking more of a regional track with slots potential, if you could kind of just give a sense of how you view that?

Bob Evans

I’d love to but I got a whole bunch of people looking at me saying no, no, no. So, I’m going to unfortunately give you the standard answer that we are not going to speculate about what we might do going forward, so it would be an interesting discussion to have, but unfortunately we are not going to have it.

Steve Altebrando – Sidoti & Co.

I mean, are you thinking kind of, buckling down right now and not expanding or are you looking around. I mean can you give us just a little bit of the sense of the game plan?

Bob Evans

As I said in my comments, that we’ve been pretty conservative with our balance sheet and that has left us in a strong financial position. We have got the resources to pursue growth opportunities and you can find whatever meaning you chose to find in that.

Operator

(Operator Instructions) There are no additional questions at this time. I would now like to turn to call over to Mr. Bob Evans for any closing remarks.

Bob Evans

Thanks Tulisha. Thanks everybody for joining us, I appreciate the time this morning and talk to you in a few more months.

Operator

This concludes your presentation. You may now disconnect and have a great day.

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