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Though we've certainly had well more than our share of great calls (click here to check out our Best Ideas portfolio in June 2011), we've definitely been wrong on Churchill Downs (NASDAQ:CHDN)...so far. Our valuation was off the mark on this company (click here). But as they say in the research business, when the facts change, so should your thesis. This is one of the biggest benefits of being an independent equity research provider. We are completely free from bias. Let's walk through our updated report on the company.

Our Report on Churchill Downs

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Investment Considerations

Investment Highlights

• Churchill Downs is still home of the Kentucky Derby, but the firm continues to evolve. It now owns four racetracks, three casinos, the country's leading online wagering business (TwinSpires.com), a video poker business, and a variety of other assets.

• Churchill Downs has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 10.6% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 18.6%.

• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

• Churchill Downs is undergoing a transformation, as it looks to shed some of its horseracing assets in favor of casino gaming and entertainment businesses. Its future acquisition plans are fraught with overpayment and selection risk.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Churchill Downs's 3-year historical return on invested capital (without goodwill) is 7.9%, which is below the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of POOR, though we note we're expecting much better performance in the future.. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Churchill Downs's free cash flow margin has averaged about 5.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Churchill Downs, cash flow from operations increased about 136% from levels registered two years ago, while capital expenditures fell about 71% over the same time period.

Valuation Analysis

The estimated fair value of $62 per share represents a price-to-earnings (P/E) ratio of about 17.5 times last year's earnings and an implied EV/EBITDA multiple of about 8.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 17.4%. Our model reflects a 5-year projected average operating margin of 14%, which is above Churchill Downs' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Churchill Downs, we use a 10.2% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $62 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Churchill Downs. We think the firm is attractive below $43 per share (the green line), but quite expensive above $81 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Churchill Downs' fair value at this point in time to be about $62 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Churchill Downs's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $82 per share in Year 3 represents our existing fair value per share of $62 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Updating Our Valuation On Churchill Downs