Rising Share Price for Churchill Downs Implies More Value

 |  Includes: CHDN, ISCA, UBET
by: Jeffrey Walkenhorst, CFA

Since news of Churchill Downs' (CHDN, $36.50) proposed acquisition of (UBET, $2.95) on 11/11/09, shares of both companies have moved higher. As a reminder, the proposed deal is 2/3 CHDN stock and 1/3 cash. We included a summary table of potential upside/downside values to Youbet shareholders in our post about the merger. If the deal were to close tomorrow, we estimate that shareholders would receive combined cash and CHDN shares worth approximately $3.15, or +7% from current levels. Here's the one month relative stock performance from as of 12/06/09:

On Churchill's conference call the morning after the announcement, one of the analysts asked: "I do wonder about the timing of the transaction and the use of stock considering that you guys are basically trading at what seems to be an all-time low valuation?" (transcript here). Management didn't directly answer this question, yet the the ensuing dialogue essentially highlighted where Churchill sees value in Youbet for the combined company.

We subsequently looked at Churchill Downs's historical, ten-year average and median TTM (trailing 12 months) multiples of cash flow ((EBITDA)), operating income (EBIT), and earnings multiples . Based on our review, CHDN was, in fact, trading at all time low valuation at the time of the transaction, with multiples at only 60-70% of historic median multiples. Thus, if we subscribe to reversion to the mean over time (we do) and also believe that Churchill Downs is solid, durable franchise (we do), then it's reasonable to expect CHDN to once again trade at historical multiples (at some point).

On this basis, we estimate that CHDN is worth $45-50 per share, which puts UBET's value at approximately $3.70-4.00 per share assuming deal terms remain unchanged. We don't think this view is lost on Churchill or Youbet management, which likely explains why the latter company's board (and JB Pritzker's New World Opportunity Partners as well as investor Lloyd Miller III) agreed to the transaction. Also, we note that the less liquid shares of Churchill Downs tend to move quickly and were in the high $30s just a few weeks prior to the announcement. Finally, Churchill Downs currently pays a $0.50 per share annual dividend, which appears sustainable even after expected dilution from issuing new shares to Youbet shareholders (i.e. Churchill will benefit from Youbet's free cash flow generation).

In a way, Churchill Downs reminds us of International Speedway Corp. (NASDAQ:ISCA), which owns many NASCAR "speedways" and is a favorite of many "value" investors. The margin (and free cash flow) profile is higher for International Speedway, yet both companies own and operate irreplaceable brands/assets.

Although we've slightly reduced our Youbet position to reallocate into other names and continue to do so, we presently retain the lion's share and expect that the implied UBET value may keep nudging higher.

Disclosure: Long UBET