Running hard at Churchill Downs (Corporate Dealmaker)

Running hard at Churchill Downs

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More than 100,000 spectators packed the grandstands and infield at Churchill Downs on May 5 to watch as Street Sense followed in the hoofprints of Aristides, who won the first Kentucky Derby in 1875. The Derby is by a long shot the biggest day of the year for the Louisville race track.

But in the buildup to the 133rd running of the Derby, the Run for the Roses wasn't the only race on the minds of executives at Churchill Downs. CDI -- which owns four racetracks in as many states and has additional holdings in off-track betting and other racing-related businesses -- is also in the homestretch of a four-horse race to win control of the New York state racing franchise that oversees Aqueduct Race Track, Saratoga Race Course and Belmont Park, home to the Belmont Stakes, the third jewel in the Triple Crown. The New York franchise owner is bankrupt, and the franchise's status as a troubled acquisition target reflects an even tougher contest -- one that confronts not just CDI but the entire sport of kings. It's the contest for audience and market share in a world utterly unlike the one inhabited by Aristides, or for that matter Gato del Sol, who won the Derby in 1982.

"When you compare horse racing to what it was 25 years ago, it's been in the blink of an eye, and we're in this entirely different place," says Bill Carstanjen, executive vice president and chief development officer for CDI. Back then, horse racing still enjoyed a near monopoly on legal gambling; today, it competes with casinos in 38 states, lotteries and an increasing array of online gambling offerings. Back then, the move to off-track betting -- a precursor of the fights over digitized content now racking the entire entertainment industry -- had begun to bite, but the racetracks had yet to see how badly they were handling the transition. Today, electronic distribution is crucial, and the business model problems are far more complex -- and urgent. Triple Crown races draw huge crowds, but on many days grandstands across the country are nearly empty.

"People may think of horse racing as this old-fashioned game," says Carstanjen, a former General Electric Co. deal lawyer who joined CDI two years ago. "But this is about media rights, digital rights, distribution platforms and leveraging technology, whether it be Internet or mobile devices."

Combine these challenges with a strong tradition of local regulation (including tight restrictions on when tracks can run races), and you start to see how you end up with a situation like the one in New York. The New York Racing Association, the current franchise holder, entered bankruptcy last fall, embroiled in a dispute with then-Gov. George Pataki over a plan to cure its financial problems by bringing video lottery terminals to Aqueduct. Now, after multiple twists, the contest to succeed NYRA looks likely to be settled by June. CDI is part of the bid group Empire Racing, which also includes the New York Thoroughbred Horsemen's Association and Magna Entertainment Corp., the largest operator of tracks in North America. Empire is one of two front-runners, along with Excelsior Racing Associates, a group that includes casino mogul Steve Wynn. Other bid groups are Capital Play Ltd. from Australia and the New York Racing Association (see box, page 32).

For CDI, the bid for a piece of the New York franchise is part of a bigger bet on the shape of its industry. Led since last July by chief executive Robert L. Evans, a technology entrepreneur and horse breeder who most recently was president of buyout shop Symphony Technology Group LLC, CDI has been picking up the pace in multiple ways. Evans has already reorganized the corporate work force, reducing employees by 30%, and he also formed a Northern California innovation group to develop and test new technologies to distribute content. The company is completely rethinking its content licensing models, adding slot machines at its New Orleans track, and aligning itself with industry leader Magna Entertainment by forming an expansive joint venture called TrackNet Media Group LLC and becoming a partner in Magna's HorseRacing TV cable channel.

At the same time, CDI has tightened its focus by selling tracks and leveraging its marquee race, the Derby. It has sold three tracks since late 2005, most recently Hoosier Park and its affiliated OTBs in Indiana, which it unloaded to privately held Centaur Inc. in March for an undisclosed amount. Besides Churchill Downs in Louisville and its New Orleans track, Fair Grounds Race Course, it now operates Arlington Park outside Chicago and Miami's Calder Race Course.

CDI's contraction reflects overall trends. The total number of races run in the U.S. has dropped by about 20,000 over the past decade to roughly 52,000, and the amount wagered on horse racing has remained flat at around $15.5 billion since 2000. That contrasts sharply with the growth in casino gambling in the U.S. Take gross revenue -- the amount wagered minus the winnings returned to players. In 2005, commercial casinos netted $31.8 billion in revenue and Indian casinos $22.6 billion, according to the American Gaming Association. Pari-mutual wagering, which includes horse, greyhound racing and other short-duration sports, brought in just $3.7 billion.

Considering the industry context, CDI's results have been good. With a market capitalization of $600 million, publicly traded CDI posted net revenue of $376 million in 2006, up 5.71% from 2005. It was even able to spend $121 million over the last five years on facility upgrades and customer service initiatives to improve the at-the-track experience. "We'll never move away from the track experience," Carstanjen says. "But we have this new reality where the betting activity on our product and other people's products isn't happening here."

Like many a new reality, though, this one was a long time in the making. The country's first off-track-betting parlor opened in New York in 1971, and a stampede of others soon followed. For the track owners, it would turn out to be a disaster. No longer did bettors have to schlep to the track to watch races and place bets. They could just mosey over to the nearest OTB, and plenty did just that. Track attendance plummeted, particularly among serious gamblers, the most coveted of fans. One prominent victim was Roosevelt Raceway on Long Island, a premier harness track that was closed in 1988.

The New York OTBs were owned and operated by local political jurisdictions that paid a cut of the profits back to the tracks. This set up a revenue distribution model in which the entity providing the signal pulled down more than the entity generating the content. Understandably, the precedent set in New York soured owners on the idea of off-track betting, so much that the industry mobilized to fight OTB bills as they came before state legislatures. It was a losing battle.

The track owners never really seriously tried to embrace the idea. They never thought to go to states and say, 'We should do this and pay taxes back to the local jurisdiction,' " says Tim Capps, an industry veteran and executive-in-residence in the equine business program at the University of Louisville. "Instead they fought it all the way and got it stuffed down their throat. They were cut in for a piece of the revenue, but it turned out to be not nearly enough to make up for all the losses."

Today, more than 80% of bets are placed somewhere beyond the track, and the revenue split hasn't improved much. "If you look back historically, a dollar bet at the racetrack would generate something in the range of 15 cents for the racetrack to split with its horsemen," says Scott Daruty, former chief U.S. counsel for MEC and now CEO of the TrackNet joint venture. "When someone bets away from the track, either at another track, over the Internet or in a Las Vegas casino, the average is about 3 cents to the track to split with the horsemen. When we first had the ability to send a signal off by simulcasting, that was found money. That 3% was great. Today, it's not found money. That's 80% of our business."

Many tracks now simulcast races and operate OTB facilities. CDI, for example, simulcasts races from other tracks in the clubhouse at Churchill Downs and operates an OTB about five miles away. Still, those operations don't come close to equaling the revenue CDI could generate from the hundreds of other venues that broadcast its races worldwide. Not only has simulcasting taken money away from tracks, it has also created a big marketing challenge for CDI and other track owners as they try to lure casual fans out for a day at the track. "Imagine walking into Yankee Stadium and everybody is hanging out in the mezzanine watching TVs and marking programs, and there are only 1,500 people in the seats watching the Yankees," Capps says. "That's the kind of thing you're seeing."

Attracting the casual fan to CDI tracks is certainly part of the company's strategy. But the more pressing issue is overhauling its content distribution model -- and, significantly, convincing other track owners to follow suit. Back in 1997, just as Internet wagering was beginning to take hold, CDI signed an exclusive licensing agreement with TVG, the Television Games Network. Under terms of that deal, TVG became the exclusive distributor of CDI racing content over its satellite channel. It also takes bets through an online service in the 16 states where the practice is legal. The vast majority of track owners signed similar deals with TVG.

At the time, track owners were simply looking for a vehicle to tap more fans and collect more bets, and the exclusive agreement with TVG worked fine. But the relationship between CDI and TVG has long since soured. In November, CDI sued TVG for breach of contract for attempting to sublicense Churchill Downs races to overseas distributors. The lawsuit came as the two companies were attempting to renegotiate licensing agreements. TVG broke off talks in February.

"The fact is, despite the massive growth in gambling in this country, horse racing has remained flat at about $15 billion," Carstanjen says. "It appears to us that when someone has [exclusive access to] content, they begin to compete on the basis of owning our content and not providing the best customer experience. Clearly what we're doing as an industry isn't leading to growth. We're looking for something different."

That something different is encompassed in CDI's joint venture with Magna Entertainment, which owns or operates a dozen tracks, including Baltimore's Pimlico Race Course, home of the Preakness, and Santa Anita Park in Arcadia, Calif. The main objective of TrackNet is to make as much content as possible available on the maximum number of platforms.

The joint venture will sell CDI and MEC content to third-party distributors domestically and internationally, and offer racing content from both companies and as many other tracks as possible through licensing agreements as well as across multiple media platforms including HorseRacing TV. Content will also be available on MEC's XpressBet.com and CDI's twinspires.com, the companies' competing account wagering platforms.

"Different people are going to make different choices; that's what the free market is all about," says TrackNet's Daruty. "Wherever they choose to bet, they'll have all the content. [The account wagering sites] are going to compete by designing better Web sites, by running better promotions, by doing more marketing, by doing all the things that you as a racetrack owner want your distribution partners doing to bring more fans to the business." By serving as a clearinghouse for CDI and MEC content and selling that content to third-party distributors, TrackNet will also be well positioned to combat the increasing piracy problem. One focus of the JV is to develop in-house expertise, technology and procedures to monitor content distribution and flag unusual activity. So far the horse racing industry has done little to address piracy, despite recognizing its pervasiveness, so any technology or procedures TrackNet comes up with could benefit all content providers.

While many of CDI's most sweeping business objectives are wrapped up in TrackNet, it is also pursuing initiatives to provide a more immediate jolt to revenues. For one, it's moving forward with plans to build a slot gaming facility next to Fair Grounds Race Course. The move reflects what is happening at many tracks nationwide that are looking to add other forms of gaming to get people to their tracks and increase revenue.

"Horse owners, trainers, breeders and track owners are embracing slots somewhat reluctantly in the sense that they understand intuitively that they are changing the brand," Capps says. "It will change the culture, and it will change the mentality. It's not going to be about this great sport, with these beautiful animals and wonderful athletes in this nice outdoor setting. Those will still be there, but the business will be one where you're trying to generate as much revenue as possible to support the breeding infrastructure, the ownership infrastructure." The hope, adds Capps, is that money will be reinvested in the tracks themselves and the marketing necessary to get people back to the tracks.

Attendance wasn't a problem on May 5, of course. As always on the first Saturday in May at Churchill Downs, the stands were filled with ladies in elegant hats, including Britain's Queen Elizabeth II, and legions of other fans who saw Street Sense surge to victory from 19 lengths back. The mint juleps flowed and the tulips bloomed.

Alas, the Derby itself only lasted about two minutes. The challenge for CDI and the rest of the industry is how to get that mood to linger for another century or so.

Trading one fast track for another

Bill Carstanjen had an exciting ride during his five years as an M&A lawyer and general counsel at General Electric Co. He worked on the GE-Honeywell megadeal (ultimately blocked by European regulators), helped build the specialty materials and water divisions, and negotiated the purchase of pipeline assets from a bankrupt Enron estate. "I got to parachute into all these GE businesses and then work with them on whatever big deals they needed support for," he says.

So what would compel a rising young executive at one of the most respected and acquisitive corporations on the planet to trade it all in for the corporate development job at Churchill Downs Inc., which posted net revenue of $376.7 million last year? Surely, Carstanjen must be one of those horseracing hobbyists who loves nothing more than a day at the track and who's maybe even invested in a horse or two?

Nope. Other than a few visits to Arlington Park in Chicago, his wife's hometown, Carstanjen, 39, was most definitely not a horse person. Instead Carstanjen, who initially told a recruiter he wasn't interested in the job, did a little research and found the challenges facing Churchill Downs and the industry as a whole too intriguing not to tackle.

"I learned it was an exciting industry that hadn't really grown into its frame. The model was still being developed of how horse racing was supposed to work," he says. "As fantastic a company as GE is, it's such a huge business. This felt like a chance to practice the skills I'd picked up. ... This is a dynamic industry. It's a great playground to be in." - Suzanne Stevens

Heading down the home stretch in New York

What are the odds that Churchill Downs Inc. will be a winner when New York Gov. Eliot Spitzer decides who will run the Aqueduct, Saratoga and Belmont racetracks for the next 20 years? Not bad at all. Empire Racing, the bid group that includes CDI, is clearly one of the front-runners, perhaps even a nose ahead of rival Excelsior Racing Associates. But a dark horse could still emerge before Spitzer makes the final call, expected in June.

Rounding out the field are the bankrupt New York Racing Association Inc., which has held the rights to the state's racing franchise since 1955, and Australia's Capital Play Ltd. All four bidders made their proposals to a Spitzer-appointed panel during hearings on April 10 and 11. The panel was expected to recommend an operator within a month, with the governor choosing a winner shortly thereafter.

A previous state panel created by former New York Gov. George Pataki, recommended Excelsior's bid last year, but when Pataki did not choose a successor before the end of his term, the bidders went back to the starting gates. This time Excelsior stumbled, losing a key participant. In late March, Jennifer Steinbrenner, daughter of New York Yankees owner George Steinbrenner, filed divorce papers to end her 23-year marriage with Steve Swindal, heir to the Yankee empire and face of the Excelsior group. Shortly thereafter, Steinbrenner announced that his family and other Yankee officials were withdrawing from Excelsior. In stepped Las Vegas casino magnate Steve Wynn and an investment group that includes Steven Roth, chairman of Vornado Realty Trust, Richard D. Bronson, head of the Bronson Cos., and casino developer Richard Fields. That group proposed a $1.875 billion package, with $1 billion for renovations and construction at the three racetracks and $850 million in franchise fees to the state. Excelsior told the panel that it would also build a high-end hotel at Belmont, and attempt to construct thousands of video lottery terminals at Aqueduct and Belmont.

But the construction of the VLTs has been a contentious issue between the racetracks' current operator and the state for some time. NYRA filed for Chapter 11 protection last November when it was unable to resolve a dispute with the Pataki administration over a proposal to build 4,500 VLTs at Aqueduct. NYRA said in papers filed with the bankruptcy court that the New York legislature approved the project, which was scheduled to begin earlier this year, but that Pataki personally blocked it. The cash-strapped operator had said the VLTs, if ever built, would bring in an estimated $657 million annually at Aqueduct alone.

The Empire bid group teams CDI with Magna Entertainment Corp., the largest operator of tracks in North America, and the New York Thoroughbred Horsemen's Association. Empire's proposal included $1.9 billion in investments to the tracks and payments to the state, plus the construction of a new "Empire Equine Economic Zone" that's designed to encourage the development of horse businesses. It would also unify the management of the three Triple Crown races--the Kentucky Derby, the Preakness and the Belmont Stakes.

Capital Play, meanwhile, promised to use its $1.8 billion investment to transform the three racetracks into a hip destination for young people with an elaborate New York City marketing campaign. The company also promised to pick up $110 million in NYRA debt and $50 million in annual lease payments for the duration of the 20-year franchise. The winner will take charge of the New York tracks on Jan. 1, 2008. Then, of course, the going will really get tough. -- John Blakeley

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