SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1998 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ---- to---- Commission file number 0-1469 CHURCHILL DOWNS INCORPORATED (Exact name of registrant as specified in its charter) Kentucky 61-0156015 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 700 Central Avenue, Louisville, KY 40208 (Address of principal executive offices) (Zip Code) (502) 636-4400 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No____ The number of shares outstanding of registrant's common stock at November 1, 1998 was 7,525,041 shares.
CHURCHILL DOWNS INCORPORATED I N D E X PAGES PART I. FINANCIAL INFORMATION ITEM 1. Condensed Consolidated Financial Statements (Unaudited) Condensed Consolidated Balance Sheets, September 30, 1998, December 31, 1997 and September 30, 1997 3 Condensed Consolidated Statements of Earnings for the nine and three months ended September 30, 1998 and 1997 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 1998 and 1997 5 Condensed Notes to Consolidated Financial Statements 6-9 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10-27 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk (Not Applicable) 28 PART II. OTHER INFORMATION AND SIGNATURES ITEM 1. Legal Proceedings (Not applicable) 28 ITEM 2. Changes in Securities and Use of Proceeds (Not applicable) 28 ITEM 3. Defaults Upon Senior Securities (Not applicable) 28 ITEM 4. Submission of Matters to a Vote of Security Holders (Not applicable)28 ITEM 5. Other Information 28 ITEM 6. Exhibits and Reports on Form 8-K 28 Signatures 29 Exhibit Index 30 Exhibits 31 -2-
CHURCHILL DOWNS INCORPORATED CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) <TABLE> September 30, December 31, September 30, ASSETS 1998 1997 1997 ---- ---- ---- Current assets: <S> <C> <C> <C> Cash and cash equivalents $ 8,130,380 $ 9,280,233 $11,030,692 Accounts receivable 10,925,891 7,086,889 11,627,361 Other current assets 564,286 540,489 548,464 ------------- ------------ ------------ Total current assets 19,620,557 16,907,611 23,206,517 Other assets 13,839,250 5,778,430 5,803,188 Plant and equipment 128,803,415 104,554,196 104,059,771 Less accumulated depreciation (44,853,970) (41,391,429) (40,227,530) ------------- ------------ ------------ 83,949,445 63,162,767 63,832,241 ------------- ------------ ------------ $117,409,252 $85,848,808 $92,841,946 ============= ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 10,213,879 $ 5,732,783 $10,532,273 Accrued expenses 8,695,124 7,937,575 6,096,346 Dividends payable - 3,658,468 - Income taxes payable 2,310,085 186,642 2,605,534 Deferred revenue 5,647,027 7,344,830 7,778,630 Long-term debt, current portion 128,404 79,805 79,805 ------------- ------------ ------------ Total current liabilities 26,994,519 24,940,103 27,092,588 Long-term debt, due after one year 9,543,201 2,633,164 2,827,191 Outstanding mutuel tickets (payable after one year) 2,204,634 1,625,846 2,702,221 Deferred compensation 921,498 880,098 884,000 Deferred income taxes 8,000,643 2,377,100 2,316,600 Stockholders' equity: Preferred stock, no par value; authorized, 250,000 shares; issued, none - - - Common stock, no par value; authorized, 20,000,000 shares, issued 7,525,041 shares, September 30,1998, 7,316,934 shares, December 31 and September 30, 1997 8,926,975 3,614,567 3,613,697 Retained earnings 61,141,469 49,842,930 53,470,649 Deferred compensation costs (258,687) - - Note receivable for common stock (65,000) (65,000) (65,000) ------------- ------------ ------------ 69,744,757 53,392,497 57,019,346 ------------- ------------ ------------ $117,409,252 $85,848,808 $92,841,946 ============= ============ ============ The accompanying notes are an integral part of the condensed consolidated financial statements. </TABLE> -3-
CHURCHILL DOWNS INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS for the nine and three months ended September 30, 1998 and 1997 (Unaudited) <TABLE> Nine Months Ended Three Months Ended September 30, September 30, 1998 1997 1998 1997 ---- ---- ---- ---- <S> <C> <C> <C> <C> Net revenues $116,058,759 $90,488,275 $33,299,256 $16,827,607 Operating expenses 88,884,904 69,391,492 30,548,256 17,803,197 ------------- ------------ ------------ ------------ Gross earnings (loss) 27,173,855 21,096,783 2,751,000 (975,590) Selling, general and administrative expenses 8,739,883 6,421,807 3,767,288 2,029,680 ------------- ------------ ------------ ------------ Operating income (loss) 18,433,972 14,674,976 (1,016,288) (3,005,270) ------------- ------------ ------------ ------------ Other income (expense): Interest income 449,543 349,286 87,238 152,446 Interest expense (646,521) (255,930) (241,224) (107,220) Miscellaneous, net 261,545 289,479 95,359 90,835 ------------- ------------ ------------ ------------ 64,567 382,835 (58,627) 136,061 ------------- ------------ ------------ ------------ Earnings (loss) before income tax provision (benefit) 18,498,539 15,057,811 (1,074,915) (2,869,209) Federal and state income tax (provision) benefit (7,200,000) (5,940,000) 420,000 1,050,000 ------------- ------------ ------------ ------------ Net earnings (loss) $ 11,298,539 $9,117,811 $(654,915) $(1,819,209) ============= ============ ============ ============ Earnings (loss) per share: Basic $1.52 $1.25 $(.09) $(.25) Diluted $1.51 $1.25 $(.09) $(.25) Weighted average shares outstanding: Basic 7,438,159 7,310,405 7,522,309 7,314,101 Diluted 7,496,524 7,312,325 7,522,309 7,314,101 The accompanying notes are an integral part of the condensed consolidated financial statements. </TABLE> -4-
CHURCHILL DOWNS INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS for the nine months ended September 30, 1998 and 1997 (Unaudited) <TABLE> Nine Months Ended September 30, 1998 1997 Cash flows from operating activities: <S> <C> <C> Net earnings $11,298,539 $ 9,117,811 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 3,972,359 3,340,076 Deferred compensation 126,759 58,789 Increase (decrease) in cash resulting from changes in operating assets and liabilities: Accounts receivable 804,593 (1,383,807) Other current assets 102,204 130,757 Accounts payable 2,532,882 2,956,700 Accrued expenses (35,259) 294,016 Income taxes payable 2,123,443 95,026 Deferred revenue (5,454,981) (3,758,590) Other assets and liabilities 95,609 539,170 ------------ ------------ Net cash provided by operating activities 15,566,148 11,389,948 ------------ ------------ Cash flows from investing activities: Additions to plant and equipment, net (2,809,648) (4,034,359) Acquisition of RCA, net of cash acquired (17,232,849) - Purchase of minority-owned investment - (2,187,500) ------------ ------------ Net cash used in investing activities (20,042,497) (6,221,859) ------------ ------------ Cash flows from financing activities: Increase (decrease) in long-term debt, net (133,398) (92,195) Borrowings on bank line of credit 17,000,000 - Repayments of bank line of credit (10,000,000) - Dividends paid (3,658,468) (2,375,271) Common stock issued 118,362 120,655 ------------ ------------ Net cash provided by (used in) financing activities 3,326,496 (2,346,811) ------------ ------------ Net increase (decrease) in cash and cash equivalents (1,149,853) 2,821,278 Cash and cash equivalents, beginning of period 9,280,233 8,209,414 ------------ ------------ Cash and cash equivalents, end of period $ 8,130,380 $11,030,692 ============ ============ Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 451,377 $ 115,290 Income taxes $ 4,919,540 $ 5,823,674 Noncash transactions: Issuance of common stock related to the acquisition of RCA $ 4,850,000 - Invoicing for 1999 and 1998 Kentucky Derby and Oaks $ 2,765,865 $ 5,612,204 Invoicing for November 1998 Breeders' Cup races $ 956,895 - The accompanying notes are an integral part of the condensed consolidated financial statements. </TABLE> -5-
CHURCHILL DOWNS INCORPORATED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS for the nine months ended September 30, 1998 and 1997 (Unaudited) 1. The accompanying condensed consolidated financial statements are presented in accordance with the requirements of Form 10-Q and consequently do not include all of the disclosures normally required by generally accepted accounting principles or those normally made in Churchill Downs Incorporated's (the "Company") annual report on Form 10-K. The year end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Accordingly, the reader of this Form 10-Q may wish to refer to the Company's Form 10-K for the period ended December 31, 1997 for further information. The accompanying condensed consolidated financial statements have been prepared in accordance with the registrant's customary accounting practices and have not been audited. In the opinion of management, all adjustments necessary for a fair presentation of this information have been made and all such adjustments are of a normal recurring nature. 2. Because of the seasonal nature of the Company's business, revenues and operating results for any interim quarter are not indicative of the revenues and operating results for the year and are not necessarily comparable with results for the corresponding period of the previous year. The accompanying condensed consolidated financial statements reflect a disproportionate share of annual net earnings as the Company normally earns a substantial portion of its net earnings in the second quarter of each year during which the Kentucky Derby and Kentucky Oaks are run. The Kentucky Derby and Kentucky Oaks are run on the first weekend in May. The Company's second quarter acquisition of Ellis Park Race Course (Ellis Park) contributed positively to the Company's net revenues and net earnings by $15.5 and $1.7 million, respectively, for the third quarter. A substantial portion of Ellis Park's annual net earnings historically occur during the third quarter when the majority of its live race meet is conducted. 3. On September 15, 1998, the Company obtained a $100 million line of credit through a syndicate of banks headed by its principal lender which expires in September 2001. The new credit facility replaces a $50 million line of credit obtained during the second quarter of 1998. The interest rate on borrowings is based upon LIBOR plus 50 to 112.5 additional basis points which is determined by certain Company financial ratios. There was $7.0 million outstanding on the line of credit at September 30, 1998 and no borrowings outstanding at December 31, 1997 or September 30, 1997 under previous lines of credit. 4. Certain prior period financial statement amounts have been reclassified to conform to the current period presentation. -6-
CHURCHILL DOWNS INCORPORATED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS for the nine months ended September 30, 1998 and 1997 (continued) (Unaudited) 5. During the third quarter of 1998, the Company issued 8,107 shares of its common stock to employees under its Stock Purchase Plan for total proceeds of $118,362. 6. Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130). Currently, there are no amounts to be included in the computation of comprehensive income of the Company that are required to be disclosed under the provisions of SFAS 130. As such, total comprehensive income and net earnings are the same for the nine and three months ended September 30, 1998 and 1997, respectively. 7. In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" SFAS 131). The Company will adopt SFAS 131 during the fourth quarter of 1998 as required. 8. In February 1998, the FASB issued Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and other Post-retirement Benefits" (SFAS 132). This statement revises employers' disclosures about pensions and other post-retirement plans without changing the measurement or recognition of those plans. The Company is assessing the impact of the standard on its financial statements and will include SFAS 132 disclosures in its 1998 annual report. 9. On April 21, 1998, the Company acquired from TVI Corp., ("TVI") all of the outstanding stock of Racing Corporation of America ("RCA") for a purchase price of $22.6 million, which includes transaction costs of $.6 million. RCA owns and operates Ellis Park Race Course in Henderson, Kentucky, and the Kentucky Horse Center, a training facility located in Lexington, Kentucky. As part of the transaction, TVI received 200,000 shares of the Company's common stock valued at $4.9 million with the remaining balance of $17.1 million paid from cash on hand and a draw on the Company's bank line of credit. The purchase price of $22.6 million was allocated to the acquired assets and liabilities based on their fair values on the acquisition date with the excess of $7.7 million being recorded as goodwill which is being amortized over 40 years. The acquisition was accounted for by the Company under the purchase method of accounting and, accordingly, the results of operations of RCA subsequent to April 20, 1998 are included in the Company's consolidated results of operations. The purchase price allocation above is preliminary and may require adjustment in the Company's future financial statements based on the final determination of available elections related to the income tax treatment of certain assets acquired and liabilities assumed in the acquisition. -7-
CHURCHILL DOWNS INCORPORATED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS for the nine months ended September 30, 1998 and 1997 (continued) (Unaudited) 9. Following are the unaudited pro forma results of operations as if the April 21, 1998 transaction had occurred on January 1, 1997 (in thousands, except per share and share amounts): <TABLE> Nine Months Ended Nine Months Ended September 30, 1998 September 30,1997 <S> <C> <C> Net revenues $118,031 $107,200 Net earnings $10,121 $9,229 Net earnings per share data: Basic $1.35 $1.23 Diluted $1.34 $1.23 Weighted average shares outstanding: Basic 7,516,934 7,510,405 Diluted 7,575,299 7,512,325 </TABLE> This unaudited proforma financial information is not necessarily indicative of the operating results that would have occurred had the transaction been consummated as of January 1, 1997, nor is it necessarily indicative of future operating results. 10. In September 1998, the Company announced that it is negotiating a purchase of a majority ownership interest in Charlson Industries, Inc., a privately held company that provides video services to racetracks and off-track betting facilities. If the transaction occurs, the total cost of the Company's equity interest is not expected to exceed $7 million. -8-
CHURCHILL DOWNS INCORPORATED CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS for the nine months ended September 30, 1998 and 1997 (continued) (Unaudited) 11. The following is a reconciliation of the numerator and denominator of the basic and diluted per share computations: <TABLE> Nine months ended Three months ended September 30, September 30, 1998 1997 1998 1997 <S> <C> <C> <C> <C> Earnings (loss) (numerator) amounts used for basic and diluted per share computations: $11,298,539 $9,117,811 $ (654,915) $(1,819,209) ----------- ---------- ---------- ----------- Weighted average shares (denominator) of common stock outstanding per share: Basic 7,438,159 7,310,405 7,522,309 7,314,101 Plus dilutive effect of shares 58,365 1,920 - - ----------- ---------- ---------- ----------- Diluted 7,496,524 7,312,325 7,522,309 7,314,101 Basic net earnings (loss) per share $1.52 $1.25 $(.09) $(.25) Diluted net earnings (loss) per share $1.51 $1.25 $(.09) $(.25) </TABLE> Options to purchase 426,532 shares for the three months ended September 30, 1998 are excluded from the computation of earnings (loss) per common share-assuming dilution since their effect is antidilutive because of the net loss for the period. In addition, options to purchase 290,500 shares for the three months and nine months ended September 30, 1997 were not included in the computation of earnings (loss) per common share-assuming dilution because the options' exercise prices were greater than the average market price of the common shares. -9-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations This discussion and analysis includes a forecast of future results of operations. Such a forecast is a "forward-looking statement" under the federal securities laws. Actual results could differ materially from this forecast, and there can be no assurance that such forecast of future results will be achieved. Important factors that could cause actual results to differ materially from the presently estimated amounts include: the continued ability of the Company to effectively compete for the country's top horses and trainers necessary to field high-quality horse racing, the continued ability of the Company to grow its share of the interstate simulcast market, a substantial change in allocation of live racing days, the impact of competition from alternative gaming (including riverboat casinos and lotteries) and other sports and entertainment options in those markets in which the Company operates, a decrease in riverboat admissions revenue from the Company's Indiana operations, and the Company's success in its pursuit of strategic initiatives designed to attract new patrons and generate additional revenue for purses and capital investment. The Company primarily conducts pari-mutuel wagering on Thoroughbred and Standardbred horse racing at its facilities in Kentucky and Indiana. The Company owns and operates Churchill Downs racetrack in Louisville, Kentucky ("Churchill Downs"), which has conducted Thoroughbred racing continuously since 1875 and is internationally known as home of the Kentucky Derby. The Company also owns and operates Ellis Park Race Course, a Thoroughbred racetrack, in Henderson, Kentucky ("Ellis Park"), and the Kentucky Horse Center, a Thoroughbred training center, in Lexington, Kentucky. Additionally, Churchill Downs is majority owner and operator of Hoosier Park in Anderson, Indiana, which conducts Thoroughbred, Quarter Horse and Standardbred horse racing. The Company conducts simulcast receiving wagering on horse racing year-round at its four simulcast wagering facilities in Louisville, Kentucky, and in Merrillville, Fort Wayne and Indianapolis, Indiana, as well as at its three racetracks. Because of the seasonal nature of the Company's business, revenues and operating results for any interim quarter are not indicative of the revenues and operating results for the year and are not necessarily comparable with results for the corresponding period of the previous year. The Company normally earns a substantial portion of its net earnings in the second quarter of each year during which the Kentucky Derby and the Kentucky Oaks are run. The Kentucky Derby and the Kentucky Oaks are run on the first weekend in May. The Company's loss in the third quarter of 1998 is substantially less the loss in than the same period in 1997 due to the acquisition of Ellis Park. Closing for this purchase was in April 1998, but the track's annual live race meet was run primarily during the third quarter. The greatest portion of Ellis Park's earnings are attributable to its annual live race meet, which traditionally has run from the end of June through Labor Day. -10-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The Company's primary sources of income are commissions and fees earned from pari- mutuel wagering on live and simulcast horse races. Other sources of income include admissions and seating, riverboat admission tax supplement, concession commissions (primarily for the sale of food and beverages), sponsorship fees, and license, rights and broadcast fees. Churchill Downs and Ellis Park, which was acquired by the Company during the second quarter of 1998, as well as Kentucky's other racetracks are subject to the licensing and regulation of the Kentucky Racing Commission (KRC). The KRC consists of 11 members appointed by the governor of Kentucky. Licenses to conduct live Thoroughbred race meetings and to participate in simulcasting are approved annually by the KRC based upon applications submitted by the racetracks in Kentucky. Although to some extent Churchill Downs and Ellis Park compete with other racetracks in Kentucky for the awarding of racing dates, the KRC is required by state law to consider and seek to preserve each racetrack's usual and customary live racing dates. Generally, there is no substantial change from year to year in the racing dates awarded to each racetrack. Churchill Downs conducted live racing from April 25 through June 28, 1998, and has been granted a license to conduct live racing during the period November 1 through November 28, 1998, for a total of 71 racing days compared to 77 racing days in 1997. Ellis Park conducted live racing from June 29 through September 7, 1998, for a total of 61 racing days. The Company has received approval from the KRC to conduct live racing at Churchill Downs from April 24 through June 27, 1999 (Spring Meet) and from October 31 through November 27, 1999 (Fall Meet) for a total of 71 days. Ellis Park has been granted a total of 61 live racing days running from June 28 through September 6, 1999. The total number of days on which Churchill Downs and Ellis Park conduct live racing fluctuates annually according to the calendar year. A substantial change in the allocation of live racing days at Churchill Downs or Ellis Park could impact the Company's operations and earnings in future years. Churchill Downs hosted Breeders' Cup Day on November 7, 1998. Breeders' Cup Day is sponsored by Breeders' Cup Limited, a tax-exempt organization chartered to promote Thoroughbred racing and breeding. The Breeders' Cup Day races are held annually, featuring $12 million in purses, for the purpose of determining Thoroughbred champions in seven different events. Racetracks across the United States compete for the privilege of hosting the Breeders' Cup Day races each year, and the 1998 Breeders' Cup was the Company's fourth time hosting this event, the most of any racetrack. The Breeders' Cup Day races were held in California in November 1997. Although most of the income earned from this event goes to Breeder's Cup Limited, hosting the event in 1998 is expected to have a positive impact on the Company's 1998 results. In Indiana, licenses to conduct live Standardbred and Thoroughbred race meetings, including Quarter Horse races, and to participate in simulcasting are approved annually by the Indiana Horse Racing Commission (IHRC), which consists of five members appointed by the governor of Indiana. Licenses are approved annually by the IHRC based upon applications submitted by the Company. Currently, the Company is the only facility in Indiana licensed to conduct live Standardbred, Quarter -11-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Horse or Thoroughbred racing and to participate in simulcasting. Quarter Horse races are conducted during some Thoroughbred race days. Hoosier Park conducted live racing beginning April 17, 1998, and has received a license to conduct live racing through November 28, 1998, for a total of 152 racing days, including 94 days of Standardbred racing and 58 days of Thoroughbred racing (which also includes Quarter Horse races). In 1997, the Company conducted 142 days of live racing, including 85 days of Standardbred racing and 57 days of Thoroughbred racing. A substantial change in the allocation of live racing days at Hoosier Park could impact the Company's operations and earnings in future years. The Company employs approximately 480 full-time employees. Due to the seasonal nature of the Company's live racing business, the number of seasonal and part-time persons employed will vary throughout the year, with peak employment occurring Kentucky Derby week when the Company employs as many as 2,600 persons. Through September 30, 1998, average full-time and seasonal employment per pay period was approximately 900 individuals. The Company generally does not directly compete with other racetracks or simulcast facilities for patrons due to geographic separation of such facilities. However, the Company competes with other sports, entertainment and gaming options, including riverboat casinos and lotteries, for patrons for both live racing and simulcasting. The Company attempts to attract patrons by providing the highest quality racing products in attractive entertainment facilities with fairly priced, appealing concession services. Churchill Downs is the premier racetrack in Kentucky for both live racing and simulcasting, based upon total handle and attendance, and Hoosier Park is the only facility in Indiana providing live and simulcast racing. The development of riverboat gaming facilities began in Indiana pursuant to authorizing legislation passed by the state of Indiana in 1993. Illinois had previously authorized riverboat gaming. There are currently four riverboat casinos operating on the Ohio River along Kentucky's border -- two in the southeastern Indiana cities of Lawrenceburg and Rising Sun, one in southwestern Indiana in Evansville and one at Metropolis, Illinois. Direct competition with these riverboats has negatively impacted wagering at Churchill Downs and Ellis Park. However, both tracks have minimized this negative impact compared to the impact suffered by other racetracks including Turfway Park, in northern Kentucky, due primarily to an aggressive on-track marketing program, and further expansion of interstate simulcast receiving wagering. Two additional riverboats are anticipated to open along the Indiana shore of the Ohio River. In May 1996, the Indiana Gaming Commission (IGA) awarded a preliminary license to RDI/Caesars World to build a $275 million riverboat casino complex, featuring the world's largest riverboat casino, in Harrison County, Indiana, just 10 miles from Louisville. A construction permit was issued to RDI/Caesars World by the U.S. Army Corps of Engineers (Corps) in February 1998. However, the U.S. Environmental Protection Agency (EPA) has conducted a separate review of the Corps' decision -12-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) and issued a letter critical of some aspects of the Corps' decision-making process. It is not known what, if any, impact this letter will have on the process. In May 1998, three Indiana environmental groups filed a lawsuit in U.S. District Court for the Southern District of Indiana challenging the Corps' decision to issue a construction permit to RDI/Caesars World ("environmental litigation"). It is unlikely the lawsuit will be heard in court until next year, and the groups have not yet sought an injunction while the case is pending. RDI/Caesars World representatives have announced that a "shakedown" cruise is scheduled for mid-November, 1998, on the "Glory of Rome" riverboat and the riverboat casino will be open for customers soon after. The vessel must be inspected and cleared for cruises by the U.S. Coast Guard prior to its opening. The IGA voted in September 1998 to grant a license to open a fifth Indiana riverboat along the Ohio River in Switzerland County, about 70 miles from Louisville. The licenseholder, Hollywood Park-Boomtown, Inc. plans to build a $150 to $160 million riverboat casino, hotel and resort complex near Vevay, Indiana. Hollywood Park estimates the resort will open as early as the third quarter of 2000. The full impact of riverboat casinos on Kentucky racing cannot be accurately determined until all riverboats are open and the markets are fully matured. Studies project that Churchill Downs could experience a material adverse impact on its wagering and attendance in the Louisville market when the RDI/Caesars World riverboat is open and mature. These same studies projected similar declines in western and northern Kentucky but recent experience at Ellis Park and Turfway Park indicates the impact may not be as severe as these studies projected. In addition to those riverboats operating along the Ohio River, five riverboat casinos have opened along the Indiana shore of Lake Michigan near the Company's Sports Spectrum in Merrillville, Indiana. The Company's pari-mutuel wagering activities at the Merrillville facility have been adversely impacted by the opening of these Lake Michigan riverboats. Additionally, the Pokagon Band of the Potawatomi Indian Tribe has expressed an interest in establishing a land-based casino in northeastern Indiana. At this time, Indiana Governor Frank O'Bannon has publicly expressed his opposition to any further expansion of casino gaming in Indiana, and has enlisted the support of Indiana's congressional delegation in blocking a potential Indian casino. Currently, Indiana's U.S. Senators are co-sponsors of the Enzi Amendment to the fiscal year 1999 Department of Interior Appropriations Bill, which would prohibit the Secretary of the Interior from formally approving Indian gaming compacts that have not first been approved by the states themselves. The Company continues to anticipate that development of such an Indian casino will negatively impact pari-mutuel wagering activities at its Indiana facilities. However, the extent of the impact is unknown at this time due, in part, to the uncertain geographic distances between the Company's operations and the potential casino sites. The Company continues to pursue legislation to allow video lottery terminals at its racetrack facilities in Kentucky and Indiana. The integration of alternative gaming products is one of four core -13-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) business strategies developed by the Company to position itself to compete in this changing environment. Implementing these strategies, the Company has successfully grown its live racing product by strengthening its flagship operations, increasing its share of the interstate simulcast market, and geographically expanding its racing operations in Kentucky and into Indiana. Alternative gaming in the form of video lottery terminals and slot machines should enable the Company to more effectively compete with Indiana riverboat casinos and provide new revenue for purse money and capital investment. Currently, the Company is working with members of the Kentucky horse industry to establish a consensus for a plan to operate video lottery terminals exclusively at Kentucky's racetracks. The horse industry in Indiana presently receives $.65 per $3 admission to riverboats in the state to compensate for the effect of riverboat competition. Riverboat admissions revenue from the Company's Indiana operations increased $3.9 million for the nine months ended September 30, 1998 as a result of the opening of additional riverboats along Lake Michigan compared to the same period in 1997. The net increase in riverboat admissions revenue, after required purse and marketing expense increases of approximately $2.4 million, is $1.5 million. Legislation challenging the allocation of the $.65 subsidy was introduced in the 1998 session of the Indiana General Assembly, but the bill did not pass out of the Senate Finance Committee. A change in Hoosier Park's share of the tax would significantly impact funding for operating expenditures and would in all likelihood re-emphasize the need for the integration of alternative gaming products at the racetrack in order for it to effectively compete with riverboat casinos. The Company has partnered with ODS Technologies L.P. (ODS) in the development and operation of an in-home interactive wagering system in Jefferson County, Kentucky, since 1995. The second phase of the Company's relationship with ODS is the launching of the Television Games Network (TVG), originally projected for the fourth quarter of 1998. In June, an arbitration panel approved United Video Satellite Group, Inc.'s proposal to acquire all of the assets of ODS. United Video, which previously owned approximately 10% of ODS, has bought out the majority partners and assumed control over agreements between ODS and 12 racetracks, including Churchill Downs. At this time, the Company cannot assess any impact of this ruling on its in-home wagering operations. In September 1998, the Company announced that it is negotiating a purchase of a majority ownership interest in Charlson Industries, Inc., a privately held company that provides video services to racetracks and off-track betting facilities. If the transaction occurs, the total cost of the Company's equity interest is not expected to exceed $7 million. -14-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The Company owned and operated two live racing facilities and five simulcast wagering facilities during the entire nine month periods ended September 30, 1998 and 1997. Ellis Park, a third live racing facility acquired on April 21, 1998, was included in the Company's operations for a portion of the nine month period with the Company operating 61 live race days during the period as discussed separately below. The chart below summarizes the results of Churchill Downs, Hoosier Park and their respective simulcast wagering facilities: <TABLE> <CAPTION> Churchill Downs and the Louisville Hoosier Park and all four Indiana Simulcast Facility Simulcast Facilities Nine Months Nine Months Nine Months Nine Months Ended Ended Ended Ended September 30 September 30 Increase September 30 September 30 Increase 1998 1997 (Decrease) 1998 1997 (Decrease) ---- ---- ---------- ---- ---- ---------- On-Track <S> <C> <C> <C> <C> <C> <C> Number of Race Days 47 47 - 110 100 10 Attendance 692,725 687,533 1% 116,398 119,068 (2%) Handle $95,951,158 $95,093,015 1% $11,179,288 $11,621,736 (4%) Average daily attendance 14,739 14,628 1% 1,058 1,191 (11%) Average daily handle $2,041,514 $2,023,256 1% $101,630 $116,217 (13%) Per capita handle $138.51 $138.31 - $96.04 $97.61 (2%) Intrastate Simulcast Sending Number of Race Days 47 47 - Handle $27,424,738 $26,741,196 3% Average Daily Handle $583,505 $568,962 3% Receiving Number of Race Days 156 148 8 Handle $28,380,521 $37,523,088 (24%) Average Daily Handle $181,926 $253,534 (28%) Interstate simulcast Sending Number of Race Days 47 47 - 110 100 10 Handle $276,632,157 $255,947,702 8% $25,322,707 $15,690,932 61% Average Daily Handle $5,885,791 $5,445,696 8% $230,206 $156,909 47% Receiving* Number of Race Days 178 166 12 901 904 (3) Handle $72,028,977 $64,435,630 12% $99,984,111 $97,692,525 2% Average Daily Handle $404,657 $388,166 4% $110,970 $108,067 3% Totals $500,417,551 $479,740,631 4% $136,486,106 $125,005,193 9% </TABLE> * The Company's Indiana operations include four separate simulcast wagering facilities. -15-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Total handle at Churchill Downs and the Louisville simulcast facility increased $20.7 million (4%) for the nine months ended September 30, 1998 primarily as the result of a general increase in handle bet on Churchill Downs' live races through interstate simulcast sending including record handle bet on Kentucky Derby and Kentucky Oaks weekend. An increase in the number of interstate simulcast receiving wagering days at the Louisville simulcast facility also contributed to the overall handle increase for Churchill Downs. Total handle at Hoosier Park and the Indiana simulcast facilities increased $11.5 million (9%) for the nine months ended September 30, 1998 as a result of a 61% increase in interstate simulcast sending handle due to an increase in the number of interstate simulcast sending days combined with higher average daily handle of 47%. Hoosier Park's live race signal was sent to a record number of outlets during the first nine months of 1998. Ellis Park contributed a total of $150.4 million in handle to the Company since April 21, 1998, the acquisition date. Ellis Park conducted live racing for 61 days during the period June 29 through September 7, 1998 producing $21.0 million in live race handle. Intrastate and interstate simulcast sending handle on Ellis Park's live races were $22.7 and $94.0 million, respectively. Intrastate and interstate simulcast receiving handle were $5.0 and $7.7 million, respectively. Comparison of nine months ended September 30, 1998 to nine months ended September 30,1997 Net Revenues Net revenues during the nine months ended September 30, 1998 increased $25.6 million (28%). Pari-mutuel revenues increased $17.0 million (30%) due primarily to the acquisition of RCA which includes Ellis Park Race Course located in western Kentucky. Ellis Park, which was acquired by the Company during the second quarter, contributed $14.6 million in total pari- mutuel revenue for the nine month period ended September 30, 1998. Ellis Park conducted live racing from June 29 through September 7, 1998, for a total of 61 racing days. Additionally, interstate simulcast sending revenues were up as the result of a general increase in betting on Churchill Downs' live races including record wagering on Kentucky Derby and Kentucky Oaks weekend. Admission and seat revenue increased $1.0 million (9%) primarily due to higher admission prices on Kentucky Derby and Kentucky Oaks days and due to the record attendance on those two days. License, rights, broadcast and sponsorship revenues increased $1.3 million (21%) due to new corporate sponsorships received during the Spring Meet at Churchill Downs and an increase in the broadcast fees for the Kentucky Derby. Concession revenues increased $1.2 million (74%) primarily as a result of the acquisition of RCA during the second quarter of 1998. -16-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Other revenues grew $1.0 million (33%) primarily from additional stall rental revenues earned from RCA which was acquired during the second quarter of 1998. Riverboat admissions revenue from the Company's Indiana operations increased $3.9 million for the nine months ended September 30, 1998 compared to September 30, 1997 primarily as a result of increased admissions on riverboats bordering the state of Indiana and the opening of additional riverboats along Lake Michigan. The net increase in riverboat admissions revenue, after required purse and marketing expense increases of approximately $2.4 million, is $1.5 million. Following is a summary of Net Revenues: <TABLE> NET REVENUE SUMMARY Nine Months Nine Months Ended % to Ended % to 1998 vs 1997 September 30, Total September 30, Total $ % 1998 Revenue 1997 Revenue Change Change Pari-Mutuel Revenue: <S> <C> <C> <C> <C> <C> <C> On-track $20,183,932 18% $16,087,293 18% $4,096,639 25% Intrastate Sending 11,858,205 10 4,863,669 5 6,994,536 144 Interstate Sending 12,883,541 11 9,165,465 10 3,718,076 41 Intrastate Receiving 3,646,059 3 3,457,119 4 188,940 5 Interstate Receiving 25,689,534 22 23,728,719 26 1 ,960,815 8 ------------ ---- ----------- ---- ----------- ---- $74,261,271 64% $57,302,265 63% $16,959,006 30% Riverboat Admissions Revenue 13,016,460 11 9,137,345 10 3,879,115 42 Admission & Seat Revenue 11,979,850 10 11,016,414 12 963,436 9 License, Rights, Broadcast & 7,181,100 6 5,925,759 7 1,255,341 21 Sponsorship Revenue Concession Revenue 2,920,202 3 1,678,846 2 1,241,356 74 Program Revenue 2,486,682 2 2,256,058 2 230,624 10 Other 4,213,194 4 3,171,588 4 1,041,606 33 ------------ ---- ----------- ---- ----------- ---- $116,058,759 100% $90,488,275 100% $25,570,484 28% ============ ==== =========== ==== =========== ==== </TABLE> -17-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Operating Expenses Total operating expenses increased $19.5 million (28%) during the nine months ended September 30, 1998. Gross profit grew by $6.1 million (29%) during the same period. Purse expense increased $10.0 million (35%) with Ellis Park purses and riverboat purses contributing $7.0 million (70%) and $1.9 million (19%), respectively, to the total purse increase. In Kentucky and Indiana, purse expense varies directly with pari-mutuel revenues and is calculated as a percentage of the related revenue and may change from year to year pursuant to contract or statute. Accordingly, on-track, intrastate and interstate simulcast purses reflect changes in direct proportion to changes in pari-mutuel revenues for the same categories. The increases in all categories of purses expense , including riverboat purses, is directly related to the increases in the respective pari-mutuel net revenue category and riverboat admissions revenue. Wages and contract labor increased $2.7 million (20%) primarily due to the addition of RCA during the second quarter of 1998. Higher salary expenses resulting from increased business activity and general cost of living raises also account for a portion of the variance. Simulcast host fees and audio, video and signal distribution expenses were higher by $.5 million (8%) and $.4 million (26%), respectively, during the period primarily as a result of the acquisition of RCA during the second quarter of 1998. Advertising, marketing and publicity expenses grew $1.1 million (31%) primarily as a result of an increase in marketing expenses in Indiana of $.5 million which were reimbursed from the riverboat admissions subsidy. Racing relations and services, depreciation & amortization expense and insurance, taxes & license fees were higher by $.5 million (36%), $.6 million (19%) and $.8 million (46%) during the nine months ended September 30, 1998 and 1997, respectively, primarily due to the acquisition of RCA during the second quarter of 1998. Utilities expense grew $.6 million (35%) primarily due to warmer spring and summer months in 1998 at Churchill Downs and also due to the acquisition of RCA during the second quarter of 1998. Concessions expense of $.5 million in 1998 resulted from the second quarter RCA acquisition. Expenses are incurred by Ellis Park's in-house concession services. Other meeting expense increased $1.0 million (36%) primarily as a result of the acquisition of RCA during the second quarter of 1998. -18-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Following is a summary of Operating Expenses: <TABLE> OPERATING EXPENSE SUMMARY Nine Months Nine Months Ended % to Ended % to 1998 vs 1997 September 30, Total September 30, Total $ % 1998 Expenses 1997 Expenses Change Change ---- -------- ---- -------- ------ ------ Purses: <S> <C> <C> <C> <C> <C> <C> On-track $10,412,979 12% $ 8,452,993 12% $1,959,986 23% Intrastate Sending 5,685,536 7 2,282,013 4 3,403,523 149 Interstate Sending 6,558,991 7 4,669,537 7 1,889,454 40 Intrastate Receiving 1,549,853 2 1,464,810 2 85,043 6 Interstate Receiving 7,875,133 9 7,138,002 10 737,131 10 Riverboat 6,608,272 7 4,701,220 7 1,907,052 41 ----------- ---- ----------- ---- ----------- ---- $38,690,764 44% 28,708,575 42% $9,982,189 35% Wages and Contract Labor 16,303,255 18 13,569,389 19 2,733,866 20 Simulcast Host Fee 6,403,552 7 5,906,651 8 496,901 8 Advertising, Marketing 4,686,067 5 3,584,782 5 1,101,285 31 & Publicity Racing Relations 1,755,219 2 1,295,212 2 460,007 36 & Services Totalisator Expense 1,298,830 1 1,119,758 2 179,072 16 Audio/Video & Signal 2,018,164 2 1,606,604 2 411,560 26 Distribution Expense Program Expense 2,064,040 2 1,737,891 2 326,149 19 Depreciation & 3,972,359 5 3,340,076 5 632,283 19 Amortization Insurance, Taxes & 2,656,172 3 1,819,475 3 836,697 46 License Fees Maintenance 1,576,208 2 1,418,404 2 157,804 11 Utilities 2,476,700 3 1,832,697 3 644,003 35 Facility/Land Rent 630,105 1 611,078 1 19,027 3 Concessions Expense 482,167 1 - - 482,167 100 Other Meeting Expense 3,871,302 4 2,840,900 4 1,030,402 36 ----------- ---- ----------- ---- ----------- ---- $88,884,904 100% $69,391,492 100% $19,493,412 28% =========== ==== =========== ==== =========== ==== </TABLE> -19-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by $2.3 million (36%) during the nine month period ended September 30, 1998 primarily as a result of increased business activity, general cost of living raises for the Company's employees and the acquisition of RCA during the second quarter of 1998. SG&A expenses as a percentage of net revenues increased slightly for the nine months ended September 30, 1998 and 1997 to 7.5% from 7.1%, respectively. Other Income and Expense Interest income of $.4 million for the nine months ended September 30, 1998 was $.1 million over the same period in 1997 as a result of the interest earned on notes receivable from a minority-owned investment. Interest expense increased $.4 million during the nine months ended September 30, 1998 as a result of financing costs associated with the second quarter acquisition of RCA. The Company drew on its bank line of credit for $16 million of the acquisition costs and subsequently repaid $10 million during the second quarter of 1998. The Company drew an additional $1 million on the line of credit during the third quarter leaving an unpaid balance of $7 million at September 30, 1998. Income Tax Provision Income tax provision increased by $1.3 million for the nine months ended September 30, 1998 as the result of higher pre-tax earnings of $3.4 million. Comparison of three months ended September 30, 1998 to three months ended September 30, 1997 Net revenues for the three months ended September 30, 1998 of $33.3 million grew by $16.5 million compared to the same period in 1997 primarily as the result of revenues generated by RCA during the quarter. Net losses for the three months ended September 30, 1998 of $.7 million were lower by $1.2 million compared to the same three months in 1997. The Company's second quarter acquisition of RCA, which includes Ellis Park, contributed positively to the Company's net revenues and net earnings and accounted for the decreased net losses during the third quarter of 1998. A substantial portion of RCA's net revenues and net earnings historically occur during the third quarter when the majority of Ellis Park's race meet, this year running June 29 through September 7, was conducted. Comparison of three months ended September 30, 1998 to three months ended June 30, 1998 Net revenues for the three months ended September 30, 1998 of $33.3 million were lower than the net revenues for the three months ended June 30, 1998 by $34.1 million and the decrease from the net earnings for the three months ended June 30, 1998 of $13.5 million to the net loss for the three months -20-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) ended September 30, 1998 of $.7 million is primarily the result of live racing income generated at Churchill Downs during its 1998 Spring Meet which includes Kentucky Derby and Kentucky Oaks weekend. Live racing in Kentucky begins in the second quarter during which the Company earns a substantial portion of its net earnings for the year. Significant Changes in the Balance Sheet September 30, 1998 to December 31, 1997 The cash and cash equivalent balances at September 30, 1998 were $1.1 million lower than December 31, 1997 primarily due to cash used in acquiring RCA during the second quarter of 1998. Borrowings on the Company's line of credit for the acquisition were partially paid down by September 30, 1998. Accounts receivable at September 30, 1998 were $3.8 million higher than December 31, 1997 primarily due to the timing of advanced invoicing of corporate tents for the 1999 Kentucky Oaks and Derby days, an increase in the Indiana riverboat admissions tax receivable of $2.2 million and the advanced invoicing for 1998 Breeder's Cup tickets of $1.0 million. The 1998 Breeder's Cup was held at Churchill Downs during the fourth quarter. The increase was partially offset by decreases in intrastate and interstate simulcasting receivables. Other assets increased by $8.1 million primarily as the result of the goodwill of $7.7 million recorded for the acquisition of RCA during the second quarter of 1998. Plant and equipment increased by $24.2 million which includes $22.0 million for the acquisition of RCA during the second quarter. The increase was also due to routine capital spending throughout the Company. Accumulated depreciation increased $3.5 million from depreciation expense on the Company's plant and equipment. Accounts payable at September 30, 1998 were $4.5 million higher than December 31, 1997 primarily as a result of a $3.9 million increase in purses payable due to Churchill Downs and Hoosier Park horsemen. Live-meet payable balances for the Company's 1997 live race meets had substantially been paid prior to December 31, 1997. The increase is also due to the Company's acquisition of RCA during the second quarter of 1998. Accrued expenses increased by $.7 million at September 30, 1998 primarily as a result of expenses generated during the Company's 1998 live race meets. Dividends payable decreased by $3.7 million at September 30, 1998 due to the payment of dividends (declared in 1997) in the first quarter of 1998. Income taxes payable increased by $2.1 million at September 30, 1998 primarily representing the estimated income tax expense attributed to the income generated in the second quarter of 1998. -21-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Deferred revenue was $1.7 million lower at September 30, 1998 due to the significant amount of admission and seat revenue that was received in advance at December 31 and recognized as income in May 1998 for the Kentucky Derby and Kentucky Oaks. The decrease was partially offset by the advanced invoicing of corporate tents for the 1999 Kentucky Derby and Oaks days during the third quarter of 1998 and $1.0 million in Breeder's Cup invoicing during the second and third quarters of 1998. The 1998 Breeder's Cup was be held at Churchill Downs during the fourth quarter of 1998. Long-term debt increased $6.9 million primarily as a result of line of credit borrowings used for the acquisition of RCA during the second quarter of 1998. Outstanding mutuel tickets increased by $.6 million at September 30, 1998 primarily as a result of unclaimed mutuel tickets relating to Churchill Downs' 1998 Spring Meet. Deferred income taxes increased by $5.6 as a result of the RCA second quarter acquisition. Common stock increased by $5.3 million primarily as a result of $4.9 million of stock issued as part of the RCA acquisition during the second quarter. The Company also issued $.1 million of common stock under its stock purchase plan during the third quarter. Significant Changes in the Balance Sheet September 30, 1998 to September 30, 1997 Cash and cash equivalents decreased $2.9 million in 1998 primarily due to the cash used for the acquisition of RCA during the second quarter of 1998. Other assets increased by $8.0 million primarily as the result of the goodwill of $7.7 million recorded for the acquisition of RCA during the second quarter of 1998. Plant and equipment increased by $24.7 million which includes $22.0 million for the acquisition of RCA during the second quarter. The increase was also due to routine capital spending throughout the Company since September 30, 1997. Accumulated depreciation increased $4.6 million from depreciation expense on the Company's plant and equipment. Accrued expenses increased by $2.6 million due primarily to an increase of $1.5 million in the amount of outstanding mutuel tickets which are payable within one year. Effective with the new state legislation in July 1998, the Company must remit all uncashed outstanding mutuel tickets to the Commonwealth of Kentucky older than one year. Under previous law, tickets were remitted after two years. Accrued expenses also grew as the result of the acquisition of RCA. Deferred revenue decreased by $2.1 million primarily as a result of the timing of advanced invoicing for Kentucky Derby and Oaks tickets offset partially by the advanced invoicing for 1998 Breeder's Cup tickets of $1.0 million during 1998. -22-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Long-term debt increased $6.7 million primarily as a result of line of credit borrowings used for the acquisition of RCA during the second quarter of 1998. Deferred income taxes increased by $5.7 as a result of the assumption of deferred taxes in the RCA second quarter acquisition. Common stock increased by $5.3 million primarily as a result of $4.9 million of stock issued as part of the RCA acquisition during the second quarter. The Company also issued $.1 million of common stock under its stock purchase plan during the third quarter of 1998. Liquidity and Capital Resources The working capital deficiency for the nine months ended September 30, 1998 increased by $3.5 million to $7.4 million compared to the September 30, 1997 working capital deficiency as shown below: September 30 ------------ 1998 1997 ---- ---- Working capital deficiency $(7,373,962) $(3,886,071) Working capital ratio .73 to 1 .86 to 1 The working capital deficiency results from the nature and seasonality of the Company's business. During the nine months ended September 30, 1998, the working capital deficiency increased compared to the nine months ended September 30, 1997 primarily due to the use of cash and cash equivalents toward the purchase of RCA and the repayment of a portion of the Company's line of credit used to finance the acquisition during the second quarter of 1998. Cash flows provided by operations were $15.6 million and $11.4 million for the nine months ended September 30, 1998 and 1997, respectively. The increase of $4.2 in 1998 is primarily the result of an increase in net earnings of $2.2 million and the timing of income taxes payable of $2.0 million. Management believes cash flows from operations and available borrowings during the remainder of 1998 will be substantially in excess of the Company's disbursements for the year, including capital improvements. Cash flows used in investing activities were $20.0 million and $6.2 million for the nine months ended September 30, 1998 and 1997, respectively. The increase in cash used of $13.8 million during 1998 is primarily due to the Company's purchase of RCA during the second quarter of 1998 offset partially by the acquisition of 24% of Dueling Grounds racecourse (a.k.a. Kentucky Downs) during the third quarter of 1997. Routine capital spending throughout the Company accounted for a portion of the cash used in investing for 1998 and 1997. Cash flows provided by (used in) financing activities were $3.3 million and $(2.3) million for the -23-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) nine months ended September 30, 1998 and 1997, respectively. The Company borrowed $17 million and repaid $10 million on its line of credit during the nine month period primarily to finance the purchase of RCA, which was acquired during the second quarter of 1998. Cash dividends of $3.7 million were paid to shareholders in 1998 (declared in 1997) versus $2.4 million paid in 1997 (declared in 1996). The Company has a $100 million line of credit, of which $93 million is available at September 30, 1998, to meet working capital and other short-term requirements and potential future acquisitions. Impact of the Year 2000 Issue The "Year 2000 Issue" is the result of computer programs that were written using two digits rather than four to define the applicable year in date-dependent systems. If the Company's computer programs with date-sensitive functions are not Year 2000 compliant, they may be unable to distinguish the year 2000 from the year 1900. This could result in system failure or miscalculations leading to a disruption of business operations. A substantial portion of the Company's mission critical operations are dependent upon computer systems and applications. These systems are either directly owned and controlled by the Company or are provided under contract by third party technology service providers. To address the Year 2000 issue, the Company has categorized the Year 2000 Issue into four principal areas. A) Systems Owned By the Company The first area is related to systems owned by the Company which have been purchased or developed internally. These systems include application software and dedicated hardware that administrate the core operations of the Company. In addition, there are numerous applications that provide administrative support and management reporting functions. To address Year 2000 compliance across this broad category of systems, the Company has broken each system down into its most elemental pieces in order to study the hardware including any embedded chip technology/firmware, the operating systems and finally, the applications themselves. Hardware including any embedded chip technology/firmware that was not Year 2000 compliant has been identified and replaced as part of the routine turnover of technology capital. Hardware remaining to be replaced is scheduled for upgrading during the first half of 1999. By June, 1999 all hardware and embedded chip technology/firmware owned by the Company is expected to be Year 2000 compliant. All operating systems supporting specific applications have been checked by advancing the dates to determine if operating system-level functionality is impacted by the date change. As new operating system upgrades are made available and installed, periodic testing will continue to assure operating system-level functionality is maintained. In addition, the Company has contacted the developers of the operating systems in use by the Company and has received assurances as to their compatibility with the Year 2000 transition. -24-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Application software compliance with the Year 2000 has been certified through a combination of technical consultation with the software developers and testing. Applications developed with internal resources have been written with the Year 2000 compliance in mind using development tools that are Year 2000 compliant. The Company has received technical reports from third parties on Year 2000 compliance for financial reporting, payroll, operations control and reporting and internal communications applications. The Company requires Year 2000 compliance on any software upgrades. Based on the schedule outlined above, the Company expects to be Year 2000 compliant with systems that are owned by the Company by June 30, 1999. However, even though the Company's planned modifications to internally-owned hardware and software should adequately address Year 2000 issues, there can be no assurance that unforeseen difficulties will not arise. B) Technology Services Provided to the Company Under Contract By Third Parties The second area of concern is services provided to the company by third parties. Many of these services are mission critical to the Company and could materially impact the Company should the systems upon which the services are dependent be unable to function. The totalisator services provided by United Tote are the most critical to the Company's operations. Totalisator services include the calculation of amounts wagered and owed to winning ticket holders. United Tote has developed a plan to bring all systems provided to the Company into Year 2000 compliance. United Tote and the Company initiated this plan during the second quarter of 1998 by undertaking a comprehensive system hardware and software upgrade which is Year 2000 compliant. The systems were successfully installed in three phases with the last phase having been completed in October 1998. All on-track, intertrack wagering and hub operations are Year 2000 compliant. The Company will continue to work closely with United Tote to assure that future releases and upgrades are Year 2000 compliant by including this provision as a condition of contracting for future services. The video services provided by Spector Entertainment Group ("Spector") are also important to the Company's operations. Video services include the capture, production and distribution of the television signal for distribution to customers located on the Company's premises and to customers located at remote outlets throughout the nation. The Company is working closely with Spector to assure the software applications that provide the graphical enhancements and other distinguishing features to the televised signal are Year 2000 compliant. The existing software for the graphical enhancements to the television signal is not Year 2000 compliant. The Company and Spector are expected to upgrade this software by the second quarter of 1999. -25-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The Company purchases certain data and statistical information from Equibase for resale to the public. This information is an essential element of the Company's product and is included in printed material made available to the Company's customers to assist in their wagering decisions. Equibase has implemented a Year 2000 remediation plan to assure compliance of their systems. The Company has contacted and received assurances from Equibase that the critical database information needed for the Company's core operations is Year 2000 compliant. A variety of other smaller and less critical technology service providers are involved with the Company's product. The Company is working closely with each of the organizations and is receiving assurances that their services are not expected to be disrupted by the Year 2000 transition. Because of the nature of the Company's business and its dependence upon key technology services provided by third parties, the Company requires that all new software and technology services are Year 2000 compliant. This requirement extends to include patches, upgrades and fixes to existing technology services. In the event that any of the Company's third party service providers do not successfully and timely achieve Year 2000 compliance, and the Company is unable to replace them with alternate service providers, it could result in a delay by the Company in providing its core live racing and simulcasting products to the Company's customers and have a material adverse effect on the Company's business, financial condition and results of operations. C) Industry-wide Issues Because a significant portion of the Company's revenues are derived from customers at other racing organizations that are confronted with the same technological issues, including totalisator, video and statistical information services, the Company has been actively participating in an industry-wide assessment and remedial efforts to assure Year 2000 compliance. Company officials actively participate in industry trade organizations and committees to study these issues on a large scale including the telecommunications and banking industries. D) Feedback Control Systems A variety of the newer control and regulating systems are date sensitive. Environmental control systems, elevator/escalator systems, fire control and security systems utilize date-sensitive software/embedded chip technology for correct operation. Although the Company has systems which perform each of the above named functions, the Company is identifying if any of these systems employ technology which may not be Year 2000 compliant. The Company will work closely with these manufacturers to develop a remedial plan to assure year 2000 compliance if problems are identified. To date, the Company has incurred limited costs to remediate Year 2000 compliance issues. Because most of the Company's mission critical operations rely on third party providers and a substantial portion of the costs of the Year 2000 remediation is borne by the third party providers, the Company's management believes that any future costs to remediate Year 2000 compliance issues will not be material to the financial position or results of operations of the Company. -26-
CHURCHILL DOWNS INCORPORATED ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) The Company is currently evaluating its most reasonably likely worst case Year 2000 scenario and is also developing contingency plans to be implemented as part of its efforts to identify and correct Year 2000 issues affecting the systems owned by the Company as well as issues involving third party service providers. The Company intends to complete both its evaluation of a worst case Year 2000 scenario and contingency planning by June 30, 1999. Impact of Recent Accounting Pronouncements Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130). Currently, there are no amounts to be included in the computation of comprehensive income of the Company that are required to be disclosed under the provisions of SFAS 130. As such, total comprehensive income and net income are the same for the nine and three months ended September 30, 1998 and 1997, respectively. In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" (SFAS 131). The Company will adopt SFAS 131 during the fourth quarter of 1998 as required. In February 1998, the FASB issued Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and other Post-retirement Benefits" (SFAS 132). This statement revises employers' disclosures about pensions and other post-retirement plans without changing the measurement or recognition of those plans. The Company will include SFAS 132 disclosures in its 1998 annual report. -27-
CHURCHILL DOWNS INCORPORATED ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Not Applicable PART II. OTHER INFORMATION ITEM 1. Legal Proceedings Not Applicable ITEM 2. Changes in Securities and Use of Proceeds Not Applicable ITEM 3. Defaults Upon Senior Securities Not Applicable ITEM 4. Submission of Matters to a Vote of Security Holders Not Applicable ITEM 5. Other Information Not Applicable ITEM 6. Exhibits and Reports on Form 8-K. A. Exhibits See exhibit index on page 31. B. Reports on Form 8-K Churchill Downs Incorporated filed a Current Report on Form 8-K dated April 28, 1998 reporting, under Item 2, "Acquisition or disposition of assets", the acquisition of Racing Corporation of America pursuant to a Stock Purchase Agreement dated March 28, 1998 and an Agreement and Plan of Merger dated April 17, 1998 as amended by Form 8-K/A, dated July 1, 1998 and further amended by Form 8-K/A dated July 10, 1998. -28-
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized. CHURCHILL DOWNS INCORPORATED November 13, 1998 \s\Thomas H. Meeker Thomas H. Meeker President and Chief Executive Officer (Principal Executive Officer) November 13, 1998 \s\Robert L. Decker Robert L. Decker Senior Vice President, Finance (Chief Financial Officer) November 13, 1998 \s\Vicki L. Baumgardner Vicki L. Baumgardner Vice President, Finance/Treasurer (Principal Accounting Officer) -29-
<TABLE> EXHIBIT INDEX Numbers Description By Reference To <S> <C> (10)(b) $100 Million Revolving Credit Facility Credit Pages 31 to 98, Report on Form Agreement between Churchill Downs Incorporated, 10-Q for the fiscal quarter ended Churchill Downs Management Company, Churchill September 30, 1998 Downs Investment Company, Racing Corporation of America, Ellis Park Race Course, Inc., the banks party thereto and PNC Bank, National Association, as Agent, dated as of September 15, 1998 (27) Financial Data Schedule (FDS) for the quarter Page 99, Report on Form 10-Q for ended September 30, 1998 the fiscal quarter ended September 30, 1998 </TABLE> -30-