This time of year is most exciting for horseracing fans, and 2014 could mark the first time in more than three decades that the sport will garner a Triple Crown winner, as California Chrome heads to the Belmont Stakes in a few weeks (having won at the Kentucky Derby and the Preakness). Though all eyes will be on the thoroughbred, let's walk through our assessment of Churchill Downs (NASDAQ:CHDN), the namesake of which is where all 3-year-old horses first start their Triple Crown journeys. We'll also run the company through the Valuentum style of investing.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Churchill Downs posts a Valuentum Buying Index score of 4, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technical. A score of 4 is not terrible, but we do note that it is below average. We generally prefer companies that register a 9 or 10 (a "we'd consider buying" rating) on the Valuentum Index and hold them in the Best Ideas portfolio until they register a 1 or 2 (a "we'd consider selling" rating). With that said, let's take a look at the firm's report.
Churchill Downs' Investment Considerations
- Churchill Downs scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 13.6% during the past three years. Though it is best know for its Twin Spires, we think the company has an Economic Castle.
- Churchill Downs is still home of the Kentucky Derby, but the firm continues to evolve. It now owns five racetracks, six casinos, the country's leading online wagering business (TwinSpires.com), and a variety of other assets.
- Churchill Downs has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 12.9% in coming years. Total debt-to-EBITDA was 2.4 last year, while debt-to-book capitalization stood at 34.4%. The company's registers a solid score on the Valuentum Dividend Cushion methodology.
- Though the Kentucky Derby is stronger than ever in terms of attendance, wagering, strategic partnerships and overall prominence, the company's growth through-diversification strategy should allow it to overcome the challenges of its traditional racing operations during economic troughs. We think California Chrome could reinvigorate the sport if it wins the Triple Crown in a few weeks.
- Churchill Downs is undergoing a transformation, as it considers shedding some of its horseracing assets in favor of casino and entertainment businesses. Though this makes sense, its future acquisition plans are fraught with overpayment and selection risk. Still, it has made some savvy moves thus far.
- The company registers a 4 on the Valuentum Buying Index. Though this is below average, we'll be watching developments closely to see if thoroughbred horseracing catches greater fan favor in the event that 2014 reveals a Triple Crown winner, the first in more than three decades. In any case, we won't be rushing to add shares to the Best Ideas portfolio given its current rating.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Churchill Downs' 3-year historical return on invested capital (without goodwill) is 13.6%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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' free cash flow margin has averaged about 15.5% 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 decreased about 14% from levels registered two years ago, while capital expenditures expanded about 106% over the same time period.
Our discounted cash flow model indicates that Churchill Downs's shares are worth between $68-$102 each. Shares are trading at roughly $85, or the midpoint of the range at this juncture. The fair value range is a relatively wide one, but we think it is appropriate given the firm's acquisition strategy and the upside potential related to a potential reinvigoration of the sport (and a stabilization of its racing operations). On a fundamental level, the margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $85 per share represents a price-to-earnings (P/E) ratio of about 27.7 times last year's earnings and an implied EV/EBITDA multiple of about 12 times last year's EBITDA. Though these multiples are rather high, they are supported by the firm's pace of future expansion, shift to higher-margin online operations, and its net debt position on the balance sheet. We also find that, on a forward-looking basis, the firm is priced more attractively than industry peers.
Our model reflects a compound annual revenue growth rate of 4.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 10%. We think the company's top-line expansion will largely be driven by strong online performance, offset in part by declines in its racing operations. Still, we note that its racing operations could be a source of upside potential (given California Chrome's run). Our model reflects a 5-year projected average operating margin of 15.8%, which is above Churchill Downs' trailing 3-year average. We expect levels of profitability to be enhanced by higher-margin online growth.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Churchill Downs, we use a 9.6% weighted average cost of capital to discount future free cash flows. We think the long-term growth assumptions and discount rate are consistent with universal assumptions in our framework and the risk profile of the equity.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Churchill Downs to peers MGM Resorts (NYSE:MGM) and Las Vegas Sands (NYSE:LVS). We think most of its peer group is burdened by significant debt loads, and from a relative standpoint, its price-to-earnings ratio and price-earnings-to-growth ratio are attractive. Still, we place greater emphasis on its cash-flow-derived intrinsic value estimate, which suggests that the equity is fairly priced.
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 $85 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 $68 per share (the green line), but quite expensive above $102 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 $85 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' 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 $113 per share in Year 3 represents our existing fair value per share of $85 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.