MAGNA ENTERTAINMENT CORP - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: June 30, 2004
Commission File Number: 000-30578

MAGNA ENTERTAINMENT CORP.
(Exact Name of Registrant as Specified in its Charter)

Delaware (State or other jurisdiction of incorporation or organization)		98-0208374 (I.R.S. Employer Identification No.)
337 Magna Drive, Aurora, Ontario, Canada L4G 7K1 (Address of principal executive offices, including zip code)
(905) 726-2462 (Registrant's telephone number, including area code)
N/A (Former name, former address and former fiscal year, if changed since last report)

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 ý No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Yes ý No o

The Registrant had 48,878,796 shares of Class A Subordinate Voting Stock and 58,466,056 shares of Class B Stock outstanding as of July 31, 2004.

MAGNA ENTERTAINMENT CORP.
INDEX

			PAGES
PART I — FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and six month periods ended June 30, 2004 and 2003	3
		Condensed Consolidated Statements of Cash Flows for the three and six month periods ended June 30, 2004 and 2003	4
		Condensed Consolidated Balance Sheets at June 30, 2004 and December 31, 2003	5
		Notes to the Consolidated Financial Statements	6
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	17
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30
	Item 4.	Controls and Procedures	30
PART II — OTHER INFORMATION
	Item 1.	Legal Proceedings	30
	Item 2.	Changes in Securities and Use of Proceeds	30
	Item 3.	Defaults Upon Senior Securities	30
	Item 4.	Submission of Matters to a Vote of Security Holders	30
	Item 5.	Other Information	31
	Item 6.	Exhibits and Reports on Form 8-K	31
Signatures
Certifications
Exhibits

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

MAGNA ENTERTAINMENT CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(Unaudited)
U.S. dollars in thousands, except per share figures

			Three months ended June 30,						Six months ended June 30,
			2004			2003			2004			2003
Revenues
Racing
	Gross wagering		$	137,821		$	145,500		$	386,490		$	384,174
	Non-wagering			44,211			37,364			79,825			65,168

				182,032			182,864			466,315			449,342

Real estate and other
	Sale of real estate			12,349			—			16,387			—
	Golf and other			4,109			5,403			7,612			9,040

				16,458			5,403			23,999			9,040

				198,490			188,267			490,314			458,382

Costs and expenses
Racing
	Purses, awards and other			82,001			87,343			235,751			233,064
	Operating costs			76,191			67,534			156,442			140,380
	General and administrative			14,933			15,780			30,895			31,539

				173,125			170,657			423,088			404,983

Real estate and other
	Cost of real estate sold			5,321			—			6,762			—
	Operating costs			5,086			3,985			7,572			5,978
	General and administrative			242			491			622			992

				10,649			4,476			14,956			6,970

Predevelopment and other costs				3,396			2,406			6,529			4,605
Depreciation and amortization				9,158			7,797			17,578			15,234
Interest expense, net				6,237			2,498			11,263			4,782
Write-down of long-lived assets (Note 3)				26,685			—			26,685			—
Equity income				(98	)		(249	)		(240	)		(992	)

				229,152			187,585			499,859			435,582

Income (loss) before income taxes				(30,662	)		682			(9,545	)		22,800
Income tax provision (benefit) (Note 4)				(5,187	)		(129	)		(5,187	)		9,339

Net income (loss)				(25,475	)		811			(4,358	)		13,461
Other comprehensive income (loss)
	Foreign currency translation adjustment			1,889			14,908			(5,488	)		23,746
	Change in fair value of interest rate swap			(112	)		114			445			109

Comprehensive income (loss)			$	(23,698	)	$	15,833		$	(9,401	)	$	37,316

Earnings (loss) per share for Class A Subordinate
	Voting Stock or Class B Stock:
		Basic	$	(0.24	)	$	0.01		$	(0.04	)	$	0.13
		Diluted	$	(0.24	)	$	0.01		$	(0.04	)	$	0.13

Average number of shares of Class A Subordinate Voting Stock and Class B Stock outstanding during the period (in thousands):
		Basic		107,345			107,146			107,302			107,140
		Diluted		107,345			120,592			107,302			118,309

MAGNA ENTERTAINMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(U.S. dollars in thousands)

		Three months ended June 30,						Six months ended June 30,
		2004			2003			2004			2003
Cash provided from (used for):
OPERATING ACTIVITIES
Net income (loss)		$	(25,475	)	$	811		$	(4,358	)	$	13,461
Items not involving current cash flows			23,803			6,572			29,879			15,804

			(1,672	)		7,383			25,521			29,265
Changes in non-cash working capital			(3,778	)		(7,552	)		(22,628	)		(2,585	)

			(5,450	)		(169	)		2,893			26,680

INVESTMENT ACTIVITIES
Real estate property and fixed asset additions			(28,347	)		(15,524	)		(56,609	)		(28,521	)
Other asset additions			(223	)		(12,558	)		(673	)		(11,738	)
Proceeds on disposal of real estate and fixed assets			12,594			681			16,607			681

			(15,976	)		(27,401	)		(40,675	)		(39,578	)

FINANCING ACTIVITIES
Increase (decrease) in bank indebtedness			—			—			2,000			(49,475	)
Issuance of long-term debt			876			—			19,261			16,110
Repayment of long-term debt			(3,230	)		(8,013	)		(4,620	)		(9,393	)
Issuance of share capital			—			—			852			29
Issuance of convertible subordinated notes			—			145,000			—			145,000

			(2,354	)		136,987			17,493			102,271

Effect of exchange rate changes on cash and
	cash equivalents		622			3,850			(256	)		5,817

Net increase (decrease) in cash and cash
	equivalents during the period		(23,158	)		113,267			(20,545	)		95,190
Cash and cash equivalents, beginning of period			102,420			69,604			99,807			87,681

Cash and cash equivalents, end of period		$	79,262		$	182,871		$	79,262		$	182,871

MAGNA ENTERTAINMENT CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(U.S. dollars and share amounts in thousands)

			June 30, 2004			December 31, 2003
ASSETS
Current assets:
	Cash and cash equivalents		$	79,262		$	99,807
	Restricted cash			29,477			24,738
	Accounts receivable			41,424			34,215
	Income taxes receivable			181			1,809
	Prepaid expenses and other			19,700			12,939

				170,044			173,508

Real estate properties and fixed assets, net				870,710			870,225

Racing licenses				234,294			236,098

Other assets, net				11,500			13,079

Future tax assets				36,811			30,030

			$	1,323,359		$	1,322,940

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
	Bank indebtedness		$	8,696		$	6,696
	Accounts payable and other liabilities			114,345			118,997
	Long-term debt due within one year			56,000			58,048

				179,041			183,741

Long-term debt				137,040			122,026

Convertible subordinated notes				218,712			218,167

Other long-term liabilities				11,374			11,725

Future tax liabilities				128,564			130,227

Shareholders' equity:
Capital stock issued and outstanding —
	Class A Subordinate Voting Stock
		(issued: 2004 — 48,879, 2003 — 48,680)		318,003			317,028
	Class B Stock (issued: 2004 and 2003 — 58,466)			394,094			394,094
Contributed surplus				17,282			17,282
Deficit				(112,376	)		(108,018	)
Accumulated comprehensive income				31,625			36,668

				648,628			657,054

			$	1,323,359		$	1,322,940

MAGNA ENTERTAINMENT CORP.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP") for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from estimates. In the opinion of management, all adjustments, which consist of normal and recurring adjustments, necessary for fair presentation have been included. Operating results for the three and six month periods ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2003.

The Company's racing business is seasonal in nature. The Company's racing revenues and operating results for any quarter will not be indicative of the racing revenues and operating results for the year. A disproportionate share of annual revenues and net income is earned in the first quarter of each year.

2. Acquisition and Pro-Forma Impact

On April 16, 2003, the Company received all necessary regulatory approvals for the acquisition of Flamboro Downs Holdings Limited, the owner and operator of Flamboro Downs, and accordingly the shares of Ontario Racing Inc. ("ORI") were transferred to the Company. As the terms of the arrangements between the Company and ORI provided the Company with significant influence over ORI and the entitlements to the undistributed earnings of ORI, the results of operations of ORI were accounted for under the equity method for the period from October 18, 2002 to April 16, 2003. This acquisition is fully disclosed in the Company's consolidated financial statements for the year ended December 31, 2003.

If the acquisition of Flamboro Downs had occurred on January 1, 2003, the Company's unaudited pro-forma total revenues would have been $189.4 million and $465.7 million for the three and six-month periods ended June 30, 2003, respectively. There was no impact on unaudited pro-forma net income or pro-forma basic and diluted earnings per share for the three and six month periods ended June 30, 2003 as the results of operations of ORI were accounted for under the equity method during these periods.

3. Write-down of Long-lived Assets

(a): The Company has commenced a major redevelopment of its Gulfstream Park racetrack. As a result, the Company has recognized a non-cash write-down of $26.3 million in the three month period ended June 30, 2004 related to Gulfstream Park's long-lived assets in connection with the redevelopment.

The project includes significant modifications and enhancements to the racing surfaces and stable area, including the construction of a new, wider turf course. It also includes the construction of a modern clubhouse/grandstand offering an array of restaurants and entertainment facilities. The capital budget for other redevelopment of Gulfstream Park, first announced in April 2004, has been increased to approximately $145 million.

The Company's goal is to minimize the disruption to the 2005 Gulfstream Park race meet during the construction period. To that end, it is the Company's expectation that the new racing surfaces will be completed prior to the start of the 2005 meet. However, since the project entails the demolition of a substantial portion of the current buildings and related structures, temporary facilities will be erected to house the 2005 meet.

The new clubhouse/grandstand facility is expected to be operational for the 2006 Gulfstream Park race meet. Although the redevelopment is being scheduled to minimize any interference with Gulfstream Park's racing season, with a project of this magnitude, there will be a temporary disruption of Gulfstream Park's operations during the 2005 meet and there is a risk that the redevelopment will not be completed according to schedule. Any interference with the racing operations during the meet would result in a reduction in the revenues and earnings generated at Gulfstream Park during that meet.

(b): The Company has also commenced the redevelopment of the racing surfaces at Laurel Park. As a result, the Company has recognized a non-cash write-down of $0.4 million in the three month period ended June 30, 2004 related to Laurel Park's long-lived assets in connection with the redevelopment.

The project includes significant modifications and enhancements to the racing surfaces, including the construction of a new, wider turf course. It is the Company's expectation that the new racing surfaces will be completed prior to the start of Laurel Park's 2004 fall meet.

4. Income Taxes

In accordance with U.S GAAP, the Company estimates its annual effective tax rate at the end of each of the first three quarters of the year, based on current facts and circumstances. The Company has estimated a nominal annual effective tax rate for the year ended December 31, 2004 and accordingly has applied this effective tax rate to the loss before income taxes for the three and six month periods ended June 30, 2004. The income tax benefit for the three and six month periods ended June 30, 2004 represents a reduction in enacted income tax rates in Austria.

5. Long-term Debt

In the three months ended March 31, 2004, one of the Company's European subsidiaries entered into a 15 million Euro term loan facility. The facility, which bears interest at the European Interbank Offered Rate ("EURIBOR") plus 2%, is secured by a first and second mortgage on land in Austria owned by the European subsidiary. At June 30, 2004, $18.5 million was outstanding on this facility, which matures on December 15, 2006.

6. Capital Stock and Long-term Incentive Plan

(a): Capital Stock

Changes in the Class A Subordinate Voting Stock and Class B Stock for the six months ended June 30, 2004 are shown in the following table (number of shares and stated value have been rounded to the nearest thousand):

	Class A Subordinate Voting Stock			Class B Stock			Total
	Number of Shares	Stated Value		Number of Shares	Stated Value		Number of Shares	Stated Value
Issued and outstanding at December 31, 2003	48,680	$	317,028	58,466	$	394,094	107,146	$	711,122
Issued under the Long-term Incentive Plan	24		123	—		—	24		123
Issued on exercise of stock options	175		852	—		—	175		852

Issued and outstanding at March 31, 2004 and June 30, 2004	48,879	$	318,003	58,466	$	394,094	107,345	$	712,097

(b): Long-term Incentive Plan

The Company has a Long-term Incentive Plan (the "Plan") (adopted in 2000), which allows for the grant of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock, bonus stock and performance shares to directors, officers, employees, consultants, independent contractors and agents. A maximum of 7.6 million shares of Class A Subordinate Voting Stock are available to be issued under the Plan, of which 6.3 million are available for issuance pursuant to stock options and tandem stock appreciation rights and 1.3 million are available for issuance pursuant to any other type of award under the Plan. During the three months ended June 30, 2004, no shares were issued under the Plan. During the six months ended June 30, 2004, 199,000 shares were issued under the Plan, including 175,000 shares issued on the exercise of stock options.

The Company grants stock options to certain directors, officers, key employees and consultants to purchase shares of the Company's Class A Subordinate Voting Stock. All of such stock options give the grantee the right to purchase Class A Subordinate Voting Stock of the Company at a price no less than the fair market value of such stock at the date of grant. Generally, stock options under the Plan vest over a period of two to six years from the date of grant at rates of 1/7^th to 1/3^rd per year and expire on or before the tenth anniversary of the date of grant, subject to earlier cancellation upon the occurrence of certain events specified in the stock option agreements entered into by the Company with each recipient of options.

During the three months ended June 30, 2004, no stock options were granted, exercised, cancelled or expired. During the six months ended June 30, 2004, 150,000 stock options were granted, 175,000 stock options were exercised and 144,000 stock options were cancelled. At June 30, 2004, there were 4,672,500 stock options outstanding with exercise prices ranging from $3.91 to $9.43 per share and a weighted average exercise price of $6.16 per share.

There were 3,901,311 options exercisable at June 30, 2004 with a weighted average exercise price of $6.11 per share.

Financial Accounting Standards Board Statement No. 123 ("SFAS 123"), "Accounting and Disclosure of Stock-Based Compensation", provides companies an alternative to accounting for stock-based compensation as prescribed under APB Opinion No. 25 ("APB 25"). SFAS 123 encourages, but does not require, companies to recognize an expense for stock-based awards at their fair value on the date of grant. SFAS 123 allows companies to continue to follow existing accounting rules (intrinsic value method under APB 25 which does not give rise to an expense) provided that pro-forma disclosures are made of what net income (loss) and earnings (loss) per share would have been had the fair value method been used. The Company accounts for stock-based compensation under APB 25 and provides pro-forma disclosure required by SFAS 123.

There were 150,000 stock options granted during the six months ended June 30, 2004 with an average fair value of $2.25 per option. During the six months ended June 30, 2003, there were 640,000 stock options granted with an average fair value of $1.50 per option.

The fair value of stock option grants is estimated at the date of grant using the Black-Scholes option valuation model with the following assumptions:

	Three months ended June 30,			Six months ended June 30,
	2004	2003		2004		2003
Risk free interest rate	N/A	2.0	%	3.0	%	2.0	%
Dividend yield	N/A	0.84	%	0.84	%	0.84	%
Volatility factor of expected market price of Class A Subordinate Voting Stock	N/A	0.534		0.578		0.534
Weighted average expected life (years)	N/A	4.0		4.0		4.0

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options.

The Company's SFAS 123 pro-forma net income (loss) and the related per share amounts are as follows:

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net income (loss), as reported	$	(25,475	)	$	811		$	(4,358	)	$	13,461
Pro-forma stock compensation expense determined under the fair value method, net of tax		(317	)		(895	)		(492	)		(1,762	)

Pro-forma net income (loss)	$	(25,792	)	$	(84