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Saturday, March 6, 2010

Churchill / Youbet Deal Gets Closer; Unfortunately, Fundamentals Remain Poor

Churchill Downs (CHDN) reported results last week that fell short of Wall Street expectations. Churchill's management mentioned on the company's conference call that the environment remains challenging with no signs of near-term improvement. Based on Churchill's results and outlook, we're not expecting too much when Youbet.com (UBET) reports next week. In addition, we remind readers that the December and March quarters are seasonally weak for horse racing.

In our view, ongoing sector weakness isn't entirely surprising since the consumer remains weak and monthly handle figures reported by Equibase are decidedly disappointing. The month of February was released on Thursday (click to enlarge):

However, we are somewhat surprised by the Y/Y decline as we expected to see at least some improvement on what should be an easy Y/Y comparison. Also, Las Vegas / Nevada gaming results for the month of January were only down 4.8% Y/Y (source here). We can conclude that consumers and the average horse bettor remain stretched.

Importantly, Churchill's management also emphasized that the proposed Youbet.com (UBET) transaction is progressing and that the Internet business is a critical component of Churchill's go-forward growth strategy. We briefly highlighted the importance of a strong online presence in our update last month. In addition, Youbet.com officially announced April 6th as the special meeting date for shareholders to vote on the transaction. While approval from the Department of Justice remains a necessary for the deal to proceed, news of the April vote is encouraging and, in our view, shows confidence from both companies that DoJ approval should be forthcoming.

Since we're still long Youbet.com shares, we remain focused on the implied value to Youbet.com shareholders. Fortunately, even amidst unfavorable fundamentals, we see valuation support for Churchill Downs. Why? As noted in our December post, the application of historic median cash flow and earnings multiples suggests a fair value of $45-50 per share if we believe reversion to the mean can happen at some point. Despite economic and industry challenges, we're fairly certain that Churchill Downs will remain a major player well into the future. We think the company owns/operates a durable franchise. Of course, a return to growth may be necessary to attract more Market interest in the company and push shares back into the $40s.

If the deal were to close Monday, the implied value to Youbet.com shareholders is around $3.20 per share based on the current share price of Churchill Downs. Recall our summary table from our initial post regarding the transaction (click to enlarge):

* Please note that the 2010 consensus earnings estimate for Churchill Downs is now $1.54 (per Yahoo! Finance), down from $2.00 last fall.

The valuation difference today offers merger arbitrage players an excellent opportunity to potentially make a quick 10% absolute return over the next month or two (even better on an annualized basis) assuming the transaction closes. Investors continue to discount the risk the deal will fall apart.

We see two potential near-term positive catalysts for both CHDN and UBET, in no particular order: (1) Youbet.com shareholder approval and (2) DoJ approval. On the flip side, if these events fail to materialize, we would expect downside. Still, we think the odds favor consummation of the transaction.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2010 Jeffrey Walkenhorst
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