Description

Magna Entertainment Corp.

Summary

At the current price, Magna Entertainment common stock represents an interesting investment opportunity. 

Because of the hard assets in the form of racetracks and the surrounding land, I believe your downside is limited.  I think the only way to really lose money here is if the controlling investor issues itself some cheap equity to finance the build out of the slot machines at a track and you get diluted (and sue).  Otherwise, the stock price is currently at about 55% of what it is potentially worth on the current use of the assets, with the potential for gaming licenses creating an additional upside.

The current net asset value per share is approximately $4.31 to $9.67 with several “free” calls that could be conservatively worth an incremental $1.00 to $5.00 per share. 

Company History

In November of 1999, Magna International Inc., its original parent and a diversified automotive parts supplier, completed a reorganization under which Magna Inc’s non-automotive businesses and certain real estate assets were transferred to Magna Entertainment.  As a result of the spin out, Magna Entertainment ended up with two classes of stock, one subordinate, Class A, and one super-voting, with 20 votes per share, Class B. 

MI Developments, the real estate spinout of Magna International, owns all of the Class B stock and 4.3 million of the Class A subordinate stock (96% of the votes), which it received when it was spun out of Magna International in 2003.   

Business

Magna Entertainment Corp. is the largest owner and operator of horse racetracks in the U.S. and one of the world’s leading suppliers, via simulcasting, of live racing content to the inter-track, off-track and account wagering markets.  They operate 11 thoroughbred, 1 standardbred or harness track, and 1 thorough and standardbred track.  The Company was incorporated in Delaware but maintains principal offices in Ontario, Canada.  They own and operate horse tracks in California, Florida, Maryland, Texas, Oklahoma, Pennsylvania, Ohio, Michigan, Oregon and Austria.

In addition to the racetracks, and land around them (the Company owns all the land with the exception of Great Lakes Downs, Lone Star Park, Remington Park and Portland Meadows in which it owns a minority interest) there are a few other businesses/assets as well. 

The Company owns XpressBet, a US account wagering business which allows customers to place wagers by telephone and over the internet at over 100 horsetracks in North America and tracks in South Africa, Dubai and Australia.  MagnaBet is the European version of this business. 

The Company also owns and operates HorseRacing TV (HRTV), a television network focused on horse racing which is currently distributed to 12 million cable and satellite TV subscribers and was initially launched on Racetrack Television Network (“RTN” which they own a minority stake in).  In 2004, they launched RaceONTV in Euproe to distribute North American racing content from its racetracks and other US racetracks.  The Company also owns AmTote International, a provider of totalisator services to the pari-mutuel industry.

Lastly, there are various tracts of real estate scattered across the country/world including training farms, a golf course and raw land.      

General Industry

Pari-mutuel wagering is a form of wagering where bets are commingled into a pool, called the mutel pool, and the payoff to winning customer is determined both by the total dollar amount of wagers and the allocation of those dollars among various bets.  The customers bet against each other, not against the operator, and therefore the operator bears no risk of loss with respect to any wagering conducted.  The operator retains a pre-determined percentage of the total amount wagered, called the takeout, on each event and the remaining balance is distributed to the customers.  Of the percentage retained, a portion is paid to the horse owners in the form of purses or winnings.  Wagering on horse racing is the largest form of pari-mutuel wagering and is authorized in 40 states.

According to the Juckey Club, pari-mutuel wagering on thoroughbred horse racing in the U.S. increased from $10.4 billion in 1995 to $15.2 billion in 2003 before receding to $14.6 billion in 2005.  The increase from 1995 is primarily related to off-track and inter-track wagering which has grown 47% from $8.7 billion in 1996 to $12.8 billion in 2005.

Organizational and Capital Structure

The company is organized as a holding company.  It can be thought of as a leveraged holding company who’s assets are the leveraged equity of operating subsidiaries.  As of June 30, 2006, there was $21.9 million of secured bank debt, $255.4 million of secured loans due to MI Developments (related party transaction at a spread of 255 bps to MI’s revolver cost), $225 million of Convertible Subordinated Notes and $215.2 million of project level debt for a total of $717.5 million.

Valuation/Financials

MECA is an asset rich, cash flow poor business currently.  LTM EBITDA is negative $18.1 million and I estimate maintenance capex to be about $22.0 million.  So, as a bunch of horse tracks, the business does not currently make any money (it should not lose money going forward either as the spending to add slot machines should make for a cash flow break even enterprise next year). 

On their current uses, I group the assets into three categories.  The current race tracks and their excess land, the non-core real estate, the options on gaming.

The current tracks including Santa Anita Park, Gulfstream Park, Laurel Park, Pimlico, Golden Gate Fields, Lone Star Park, The Meadows (which has been sold), Thistledown, Remington Park, Portland Meadows, Great Lakes Downs are worth between $1.0 billion and $1.5 billion based on their cash flows and real estate value.  I cannot find any information on Magna Racino, which is the racetrack in Austria and have placed no value on the 650 acres the Company owns there when I quote the $1.0 billion to $1.5 billion figures. 

The non-core real estate, which includes various land tracts, the golf courses and the training facilities are worth between $185 million and $240 million.  Again, I am giving no value to the media assets nor the Amtote business in these figures and leave them as upside as well.

These two groups of assets gets me to an enterprise value of $1.2 billion to $1.7 billion.  This enterprise value, after backing out all of the debt, nets me $4.31 to $9.13 per fully diluted share. 

The real story here is options on gaming licenses for slot machines at the various tracks.  Slot machines can generate between $200 and $500 per unit per day in revenue depending on the state and can do upwards of 25%-30% EBITDA margins.  The addition of 500 slot machines can create (pre license fee) $75 to $150 million of incremental value.  As evident by the Meadows Track in Pittsburgh, PA which the Company recently sold, the track garnered a sale price of $175 million simply with the addition of gaming license versus the $53.0 million purchase price that MECA paid for it a few years ago.

The residents of the State of Ohio, where the Thistledown track is located, are facing a slot machine proposal on the upcoming November ballot.  The legislation would permit 31,500 slot machines across nine locations in the state.  The state of Maryland (Laurel Park and Pimlico tracks) has been discussing for years the addition of slot machines at racetracks and the associated tax revenue they would generate.  California apparently will never legalize slot machines on horse tracks but are discussing ways to compensate the horse tracks for allowing incremental slot machines near their locations. 

I don’t believe anyone actually knows the likelihood of getting slot machines legalized at any of the tracks, but using a range of probabilities for each state and the incremental value based on the current net revenue per day and conservative EBITDA margins, I get to an incremental $1.00 to $5.00 per share for the options on slots.       

Current Events/Recapitalization Plan

The Company is trying to sell $150 million in assets, including the golf courses which have a book value of about $80 million and some of the land around Laurel Park, Maryland, plus the $175 million from the sale of The Meadows to pay down debt.  This $175 million will go to pay down the revolver and the Bridge Loan.  Management has stated it wants to knock debt down by $500 million and be debt-free by spring 2007. 

Additionally, in February 2006, the Company formed PariMax, Inc. to oversee the development of its various platforms such as XpressBet, HRTV, MagnaBet, RaceONTV, and AmTote.  Given the genesis of the Company, it seems likely to me that the Company is preparing this collection of assets (on which I place no value currently) for a spin-off to unlock value. 

Management

Frank Stronach is interim chief executive officer as they are looking for a new CEO.  Herein lies the biggest investment risk with respect to MECA.  It seems there are two distinct camps.  The first camp thinks that Frank Stronach loves horses and desperately wants to be in insider, so he keeps overpaying to own these tracks.  The conclusion of this camp is that profitability or returns on capital will always take a back seat to ego and stature. 

The second camp says that Frank Stronach has been and will continue to be a great investor, has a track record of buying assets cheap and has been very successful.  I think the truth is probably a combination of the two. 

Investment Risk

I view the major risk here to any sort of permanent impairment of capital coming from a related party transaction that dilutes the current shareholders in the form of issuing cheap equity to a related party to finance the expansion of one of the racetracks upon the issuance of a gaming license.  Because the current Greenlight lawsuit has brought a microscope to the relationship between MI Developments and MECA, I don’t view this as likely.  However it is still worth considering as a possibility as the Magna International 10-K states, “In anticipation of the spin-off of Magna Entertainment, we entered into a Forbearance Agreement in 1999 which restricted our ability to make debt or equity investments in, or give financial assistance to Magna Entertainment. This agreement also restricts our ability to invest in any business or assets determined in good faith by our independent directors to be non-automotive related and not ancillary or incidental to our automotive related business. This agreement will expire in accordance with its terms on May 31, 2006 and will not be extended”

Catalyst

Ohio passes legislation in November allowing slot machines at Thistledowns

Other states follow suit

Return on investment at Gulfstream Park leads to return to profitability

Catalyst