With horse racing’s Triple Crown just wrapped up over the weekend, is it time to buy Churchill Downs with the expectation of an earnings bump? Not so much. Rarely is a stock totally untradeable but it looks that way with Churchill Downs. It’s a shame because the company itself is quite well run, except for its debt load.
First the good news. The trend that Churchill has been following for the last 3 years, taking focus away from racing and towards casino and games is continuing and the company is turning itself into a primarily casino/online gaming company rather than primarily a horseracing outfit. Casino gross margins went up from 40.7% to 41.8% year over last quarter, and this after only averaging about 26% from 2012 to 2015. Casino plus Big Fish Games now account for over 72% of revenues. Essentially, Churchill is only really a racing company for one quarter a year. Other than that they lose money every quarter on horseracing proper. TwinSpires, basically online horseracing, helps the horseracing segment as a whole break even and even made a small profit of $5.4 million last quarter. The path to growth in an old segment, once again, is going digital and especially mobile, as we’ve seen again and again with the failures and successes of various UK bookies.
That said, one potential shot in the arm for Churchill Downs and other mobile gamers would be Google Android supporting gambling apps on their phones so users can take advantage of TwinSpires mobile. Right now it’s only available on iPhones but if Alphabet ever changes its policy it could be big for Churchill. TwinSpires has been doing very well even without Android, with handle up 10.6% in the first quarter after being up 11% in the fourth quarter. As discussed in their last earnings call, the industry was up 3.1% so TwinSpires is growing faster than competition by 7.5 points.
In the meantime, the company keeps slowly expanding its casino and Big Fish operations. $25 million is being sunk into a hotel in Maine, a big expenditure for a company like this. Big Fish expenses revolve around user acquisition, a highly statistically-driven enterprise that costs a lot at first for a big return later. When a user is first acquired through marketing spend, it can take years for the ROI to establish itself as the user plays games. Once the cost of a new acquisition outweighs average user value, the campaign is stopped and moved on to another promising game that needs more users.
While this is a perfectly good business model, the share price movement of Churchill Downs stock indicates that the market does not really understand the dynamics here. The fact that the company refuses to ever give any guidance to its shareholders as to future earnings only exacerbates the trading situation. Wall Street estimates and whether a company hits or misses them has a profound effect on short term movements for certain, which can also induce trend changes and bring the stock in entirely new directions. We just saw this with the recent earnings release in late April that brought the stock down 11% in a week. Earnings estimates were way off due to accounting issues from acquisitions that only a professional CPA skilled in the GAAP handbook would have understood in advance. On top of this, the stock looks wildly inflated still and earnings are erratic and come in big chunks, fits and starts by the nature of the business. The dividend is paltry and liquidity fairly low so it’s not even an income hold.
But wait…there’s more! CHDN shares seem to operate in their own universe, as the stock was barely dented by last August’s monetary contraction that resulted in Black Monday August 24th with the Dow tanking over 1,000 points in a day. But then it fell dramatically when Wall Street estimates—based on zero guidance from Churchill Downs as is their custum—didn’t take accounting issues into account, no pun intended.
Another reason to leave this stock well alone is that Churchill’s debt load is below $1 billion now, and in an absolute sense it’s not that bad in itself. The problem is debt keeps going up because it is rolled over to pay interest due, and they won’t be able to do that for much longer. Rolling over debt is the white legitimate version of a Ponzi scheme, OK for the short term while rates are low but inherently dangerous. Inflation is picking up, trending higher since last January, now over 1% which isn’t much historically but this time there is little to nothing to stop it. Once it gets past 3%, probably by the end of the year considering the US economy is at full employment and has been for some time, interest rates will start going up naturally without the Federal Reserve’s help. It looks like the eggs are being laid for increasing inflation and increasing interest rates and the eggs could hatch at around the same time that Churchill has to repay principle on its debt-financed acquisitions, $393 million of which is due by 2019, and the rest by 2021.
By then, rolling debt over any further could prove impossible or at least extremely difficult. Big Fish will have to fully mature by then in order to meet the payments, and whether that will happen in time is impossible to predict.
So the story with Churchill Downs is that it is a growing company with a good business model that seems to know what it’s doing. But the stock movements make no sense, and to bring horse racing back into the equation, trading it would be like racing with a wild horse. It can’t be shorted because it’s doing too many things right, can’t be held short term because liquidity is low and movement is unpredictable and doesn’t follow general market beta trends, and can’t be held long term for debt reasons and a very small dividend that just isn’t worth the capital. A put/call spread might do it in the options market but that kind of position takes nerves of steel to manage.
