Description

Championship Auto Racing Teams (“MPH”) is one of two premier US-based open-wheel racing leagues. The company currently trades close to its net cash value ($8.25/shr) as a result of a recent spate of bad news, in addition to huge hype surrounding the recent running of the Indianapolis 500 – the flagship event of MPH’s primary competitor, the Indy Racing League (IRL). Historically, MPH has demonstrated earning power in excess of $1/shr. While it is highly unlikely to see these levels again for a number of reasons, it still runs a racing franchise that is extremely popular with fans and, therefore, sponsors. Ultimately, fan support will drive the success of the business, as both commercial sponsors and equipment sponsors/manufacturers choose to participate in a racing league on the basis of the exposure it provides for their product. I believe that the business is worth $4.50/shr (15 multiple on normalized $0.30/shr ex-interest income) + $7.25/shr cash (assuming $14mm aggregate burn during 2002-3) = $11.75/shr. This implies roughly 35% appreciation potential from current levels.

MPH runs a series of 20 races annually. The twenty races are run in seven different countries, and on both ovals and road courses. This profile differs considerably from competitor IRL, which runs a race series based primarily on North American oval tracks. These differences are meaningful for two reasons: 1) open-wheel racing has huge international appeal which makes a more internationally-based series a better sell to sponsors and 2) open-wheel race fans (international fans in particular) generally prefer road-based courses.

Some history: IRL, MPH’s competitor, was formed several years back following a major rift among US open-wheel racing participants. Tony George, whose family has long-owned the Indianapolis Motor Speedway, led the formation of IRL in search of what he claimed would be a more competitive racing series. His concerns stemmed from what he saw as a domination of the sport by cash-rich racing teams that were able to outspend opponents in pursuit of the best technology. Under this reality, the rich teams won races and got richer, while the poor teams slumped into inevitable decline. By dictating specs for the IRL racing teams based on non-turbocharged engines and a simpler chassis layout, he claimed to be creating a league in which there would be much more equipment parity between teams and races would be decided based on driver skill as opposed to the depth of the team owner’s pockets. By virtue of his position as owner of the venue for the world’s premiere open-wheel race, the Indy 500, he was able to exert a substantial amount of influence over team owners, and the IRL was formed. Initially, the formation of the IRL led to a huge split between IRL teams and MPH teams. Attendance at the Indy 500 dropped off markedly as many of the drivers with large racing fan followings chose to race for MPH. MPH attracted the richest teams, the best drivers (in most cases), a large fan following, and an admirable list of sponsors.

Fast forward to the present: Year-by-year, the IRL has been gaining converts at MPH’s expense. Under the leadership of former CEO Joseph Heitzler, MPH has suffered a string of driver and supplier defections. Most recently, these have included the defection of the Penske racing teams to IRL, as well as the departure of engine supplier Honda, which is also moving over to the IRL. Doomsayers are now predicting a continuing rash of racing team and supplier defections, leading to the inevitable demise of MPH. This scenario is overblown for a number of reasons:

1) MPH is still wildly popular with fans. Admittedly, the competing IRL’s Indy 500 is an enormously popular event – it is the world’s largest sporting event with attendance on race day in excess of 400,000 fans. However, this masks the underlying reality of overall fan attendance at the respective league events. MPH road races routinely attract in excess of 200,000 spectators, while the IRL oval races (with the exception of the Indy 500) routinely attract embarrassingly low attendance of less than 10,000. Sponsors who have lined up behind the IRL have done so solely to participate in its marquee event, the Indy 500. Sponsors at MPH events, on the other hand, get their audience delivered consistently, race after race.

2) Many drivers prefer the MPH format – a mixture of road races and ovals – to IRL’s primarily ovals format. Moreover, the drivers much prefer to run in MPH’s well-attended events than to IRL’s empty stands. To some extent MPH drivers can have their cake and eat it too, since they can run in MPH’s circuit all year, and then head down to run in the Indy 500 during the month of May (and thereby cherry-pick IRL’s only good event). Admittedly, team decisions are made by owners and not drivers, but racing is an ego-driven event and both owners and drivers want to play to packed stands.

3) MPH team owners collectively own a significant piece of MPH’s outstanding equity (roughly 15%). This limits any incentive they might have to move to the IRL and further depress MPH’s value.

4) New-CEO Chris Pook has respect in the industry that former-CEO Heitzler was sorely lacking. Pook was the founder of the Long Beach Grand Prix and has been involved in open-wheel racing for 30 years. He is intimately familiar with the racing teams, the suppliers, and the sponsors – all of whom are critical constituencies in a successful racing league.

5) Current concerns over Toyota departing MPH as an engine supplier are overblown. Ford-Cosworth is firmly behind the series and MG Rover is prepared to step into the breach. In addition, engine specs for MPH and IRL, respectively, have been converging in recent years making it more likely that a given supplier can supply both series with engines. Open wheel racing is the premier venue for auto manufacturers, as well as an important testing ground for their technology. They crave the exposure and experience that it supplies them.

Risks/issues: Most of MPH’s sponsorship contracts require that the league field a minimum of 16 racing teams. Currently, the total stands at 19 but there is clear concern that continued departures for IRL could put the sponsorship revenue stream in jeopardy. For reasons described above, I believe that this is unlikely. NASCAR’s continued popularity is a potential concern as well. Open-wheel racing is a distant second in popularity to NASCAR racing in the U.S. TV viewership for open-wheel racing is disappointing, and MPH has been forced to bear more of the risk under their new television contract than they did in the past. However, in this regard MPH once again fields a superior product to IRL. MPH is a much more international product than IRL, with races in seven countries, which makes it an easier sponsorship sell. Moreover, its focus on road races differentiates it from the NASCAR product. Last of all, there is the personality factor. Many open-wheel racing enthusiasts believe that a merger of IRL (which is privately held) and MPH would be the best outcome for the sport. This is probably a remote possibility, at best, though as a result of the bad blood between the two leagues. IRL’s founder, Tony George, would probably like nothing more than to see MPH die a slow, unseemly death.

Stock movement: MPH has declined precipitously from $13.30/shr several weeks ago to a recent low of $8/shr. Not coincidentally, this decline coincided directly with Memorial Day weekend and the running of the Indy 500. The Indy 500 this year was won by a Penske racing team (recall that Penske is a recent defector from MPH to IRL), and relative to the last several years was very well attended. In addition, the race this year coincided with Honda’s announcement that it would no longer be supplying engines for MPH. In typical sell-side analyst fashion, the few analysts that cover the stock have begun to panic as the stock has dropped and lowered their ratings. In fact, there have been no material changes surrounding MPH’s prospects for the last several months, and it is my contention that as the rosy sheen from the Indy 500 begins to die off the stock will lift. It has been widely known in the automotive press for months now that Honda would depart MPH this year; apparently the sell-side analysts and a few large holders of the stock were the only ones that hadn’t been keeping their eye on the ball.

Valuation: MPH’s historical financial performance (30%+ EBIT margins) is not a good proxy for the business going forward. There have been a number of fundamental changes to the economic model, the most significant of which have been the expiration (via bankruptcy of MPH’s marketing agent) of guaranteed minimum sponsorship revenues and a new television contract that requires to MPH to bear more advertising sales risk. That being said, I believe that a 10% EBIT margin should be easily achievable once the current restructuring takes hold (the company delivered an 11% operating margin excluding 1-time charges in 2001 in a very tumultuous year). 2002 is a transition year for the business, during which operations are expect to break even. Assuming a 10% EBIT margin, $75mm in revenues, 40% tax rate, and 14.7mm shrs, normalized earnings approximate $0.30/shr. The business has very favorable operating economics, with negative net working capital and high incremental returns on invested capital. Even under a very low growth scenario, the business should trade at 15x earnings, or $4.50/shr. These calculations exclude interest income from the company’s cash balance.

MPH currently has $8.25/shr in cash. Cash balance is mildly seasonal. I am assuming a $4mm seasonal drawdown in the cash balance, in addition to a $10mm direct investment in the racing teams this year in order to cement their continued participation. Be aware that management has not guided the Street to this incremental $10mm spend, this is my assumption. This yields a low point of roughly $7.25/shr in cash.

Total value = $4.50 + $7.25 = $11.75/shr

Given the cash level and minimal burn, downside should be limited. At current levels, you are effectively getting a free option on the company’s ability to generate a positive operating margin going forward.

Catalyst

Dissipation of hype from this year’s Indy 500, announcement of Toyota’s continued participation in MPH for 2003, merger of MPH and IRL (long-shot), going private transaction