Churchill Downs: Still Off the Radar, Still a Great Business

Churchill Downs Investment Thesis

Churchill Downs Public Company (NASDAQ:CHDN), despite the stock’s excellent performance over both 5- and 10-year periods, it is still, unfortunately, one of those overlooked companies. And it looks like the underlying business is showing There is no indication that the pace will slow down.

Especially since the business metrics have improved significantly, and yet the multiple, as we’ll see later, is now lower than it was a few years ago. As a result, I think the stock is attractive right now, especially given the growth opportunities, excellent management team, and exceptional capital allocation history.

CHDN Q2 results

In my last article on Churchill Downs, published in April 2023, I described the company as an undiscovered gem with significant growth potential. That assessment has not changed, and the year-over-year results bear it out. Revenue per quarter rose 16% to a record $891 millionThis was $32 million more than expected, and earnings per share were $0.09 higher than analysts’ estimates.

In addition, we can see that gross profit and margins have also improved over the last 5 years. And this trend is likely to continue as the focus over the next 5 to 10 years will be on high margin, high growth HRM machines. In addition, there are rising fees for horse racing content and fees for each HRM machine with Exacta software, which also have high margins.

In addition, the acquisition of Exacta resulted in lower technology fees, which had and will have a positive impact on margins.

The gaming and HRM industries have extremely high barriers to entry, which vary by jurisdiction. New competitors would have to spend a lot of time and money to even enter the market. In Virginia, for example, Churchill Downs is the only provider that can offer HRM. A huge competitive advantage.

And many times you get approval for how many machines you can have in a state, and here Churchill Downs has sometimes gotten approval for more machines than originally expected. Another positive sign.

As the chart above shows, there is still a lot of potential for growth in the US for gaming as many states are not yet served. And in the Q1 earnings call, Churchill Downs suggested that international growth was also interesting, and a quarter later in the Q2 earnings call they said they had secured their first international deal with Malta and IGT.

Additionally, there are currently 5 projects in the pipeline that qualify as HRM and 1 project related to Kentucky Derby renovations. These projects are expected to drive organic growth and provide excellent returns on capital.

Churchill Down Capital Allocation

Return on equity, currently at 45% and with a 10-year median of just under 25%, shows that the investments over the last decade have produced positive results for shareholders. At this point, the management team should be commended because their M&A efforts have worked very well and they have also achieved organic growth, which has been reflected in the share price performance. So I think another competitive advantage of Churchill Downs is that the management is disciplined, capital-efficient and shareholder-friendly.

And that Churchill Downs is shareholder-friendly is evidenced by the fact that the company has increased its dividend for 13 straight years and has bought back $1.7 billion worth of stock since 2015. That’s almost 20% of its current market cap. In total, they’ve returned ~$2 billion to shareholders since 2015.

And these share buybacks were not diluted by excessive SBCs as is often the case today as the number of shares outstanding was steadily reduced which had a positive impact on EPS. In fact, EPS grew by 25.53% per year over the last 10 years. Strong numbers.

Churchill Down’s Balance Sheet

But one thing I’m not entirely happy with is the balance sheet, because the leverage is higher than I would normally prefer. But that’s partly because they’re in the gaming industry, which traditionally has a higher leverage ratio, and partly because they’ve done a lot of successful M&A with debt.

EBIT to interest is close to 2.4x, while most other companies in my portfolio are closer to >15x. That’s a big difference. And long-term debt is ~10x net income, while I usually prefer less than 4x. So the balance sheet is definitely riskier than I’d like, but I trust the management team to manage that risk wisely. Because they’ve shown over the last few decades that they can efficiently and effectively manage what I personally consider to be a relatively high debt load.

Quotation

Over the last 3 years, revenue has been growing at an average annual rate of approximately 21%, earnings per share (EPS) has been growing at an average annual rate of approximately 28%, and the TTM P/E is 25x, which translates into a PEG ratio of 1x, meaning that in my opinion the company is fairly valued.

And while the company has grown a lot and continues to have excellent growth prospects, the P/E ratio is below its long-term average of 29x. This leads me to conclude that the company is at least fairly valued, if not undervalued.

It is very likely that Churchill Downs will continue to reduce the number of shares outstanding, there is plenty of growth to organically increase EPS, but M&A activity is also likely if management sees an opportunity. Add to that the fact that the stock is currently trading below its long-term average, and I am bullish on the future.

Iterative expansion is possible, as well as long-term dividend and earnings per share growth, when the business has strong barriers to entry and a competitive advantage with the Kentucky Derby or Exacta brand.

Application

It is always important to look at the underlying business and not pay too much attention to short-term stock market volatility, because from April 2023 when Churchill Downs shares were trading at $145 to today when the share price is just under $138, the company appears to have remained largely unchanged if you look at the share price alone.

But as you can see above, a lot has changed since then. Earnings and revenues have improved significantly, but Churchill Downs is trading at a lower multiple. As a result, I think the stock is more attractive than it was a year ago.