requested the IHRC to reconsider its decision, and at its August 2, 2004 meeting, by a vote of 3-2, the IHRC denied a motion which would have limited Kentucky simulcasts to Indiana’s two racetracks and would have prevented Kentucky simulcasts to OTB facilities unless the Kentucky simulcasts were made available to all OTB facilities.  An interim study committee of the Indiana General Assembly held hearings on this subject but there have been no recommendations for legislative changes to Indiana’s pari-mutuel statute.

On October 19, 2004, the Interim Study Committee on Agriculture and Small Business of the Indiana General Assembly endorsed a proposal to put pull-tab machines at Hoosier Park, Indiana Downs and two OTB sites located in Indianapolis and Fort Wayne.  We believe the endorsement provides momentum for the proposal in the 2005 session of the Indiana General Assembly.

Indiana HB 1569, which would have authorized slot machines at Indiana’s two pari-mutuel racetracks, was defeated in the Public Policy Committee of the Indiana General Assembly on February 14, 2005. No other legislation has originated in either chamber calling for slots at the racetracks.  However, it is still possible for legislation pertaining to alternative gaming at racetracks to be amended into existing bills.  The concept could also be incorporated into the state budget.  The Indiana General Assembly is scheduled to adjourn April 29, 2005.

Florida

In Florida, Yes for Local Control (formerly known as The Floridians for a Level Playing Field,Field), a coalition of harness and dog tracks, is seekingpari-mutuel facilities including Calder, successfully gathered the necessary petition signatures to place an EGDa question on the ballot for the November 2004 general election that wouldto allow Dade and Broward counties to hold a referendum on the installation of EGDsslot machines at existing pari-mutuel sites in those respective counties.  The Florida Supreme Court is expected to rule onupheld the constitutionality of thisthe ballot language in May 2004 and the ballot question was officially certified by the Florida Secretary of State on July 21, 2004 and appeared on the ballot as Amendment 4.  On July 23, 2004, a suit was filed against the Florida Division of Elections challenging the format of the initiative duringpetition and was dismissed.  A suit was filed in September 2004 by Floridians Against Expanded Gambling, challenging the first quarter of 2004. If ruled constitutional, the coalition will proceed withmethodology used in the signature gathering effort required forprocess including allegations of fraud, in the initiative to put Amendment 4 on the ballot. However, the court had refused to hear the suit until after the November 2004 election to give proponents time to prepare their case. Calder has funded a pro-rata share of the initiative costs.  On November 2, 2004, Amendment 4 passed by a margin of 1.4 percent.

Voters in Miami-Dade and Broward counties voted March 8, 2005, in separate local referenda to decide whether slot machines can be installed at the seven existing pari-mutuel sites in those counties, including Calder.  Although the measure passed in Broward County, home of Gulfstream Park, it was unsuccessful in Miami-Dade County, where Calder is located.  Pari-mutuel operators in Broward County will now lobby Florida legislature to pass enabling legislation authorizing slot machine gaming at the pari-mutuel facilities.  Failure of the referendum to pass in Miami-Dade County was due primarily to Governor Jeb Bush’s active opposition to the measure during the final days of the campaign.  The Company is preparing a strategy to win passage in Miami-Dade County in 2007 when the issue tocan again be placed on the November 2004 ballot.  Calder Race CourseThe impact on the Company’s results of operations and financial position of the failed referendum in Miami-Dade County is uncertain at this time.

All litigation filed to challenge the signature gathering process and the vote counting on election day for the statewide referendum has been involvedresolved in this effort on a limited basis,favor of Calder and is awaiting the Supreme Court’s decision before deciding on its future level of participation.pari-mutuel coalition.

California

In California, Hollywood Park iswas part of a coalition of racetracks and card clubs seeking to put the Gaming Revenue Act of 2004supporting Proposal 68 on the November 2004 ballot.  The proposal failed to pass by a margin of 16 percent to 84 percent.  If passed, this initiative would directhave directed the governor to re-negotiate all existing compacts with IndianNative American tribes in California.  If the tribes declinehad declined to renegotiate the existing compacts, then five racetracks, including Hollywood Park, and 11 card clubs would behave been allowed to operate EGDs.electronic gaming devices.  We continue to work with other members of the California horse industry on a long-term strategy for developing a legislative agenda that addresses the competitive advantages afforded to Native American casinos.

In addition to Proposition 68 noted above, California Proposition 70, also known as The coalition is currently gathering the voter signatures requiredIndian Gaming Fair-Share Revenue Act of 2004, also failed to place the initiative on the ballot forpass in the November general2004 election.  Proposition 70 called for an unlimited expansion of Native American gaming in return for an 8.8% tax on gaming revenue.  Proposition 70 was actively opposed by Governor Schwarzenegger.

11

Also in California, legislation recently passed which is estimated will generate approximately $10.0 million in the aggregate annually industry-wide from a 0.5% increase in the commission, or take out rate, on exotic wagers placed on California races.  The increased revenue will be used to pay the cost of workers compensation insurance for backstretch workers and to provide a starter participation bonus.  Governor Schwarzenegger signed this bill on May 14, 2004.  During 2004 we funded $1.3 million for worker’s compensation insurance from the 0.5% increase in the commissions.

Illinois

In 1999, the state of Illinois enacted legislation that provides for pari-mutuel tax relief and related tax credits for Illinois racetracks, as well as legislation providing for subsidies to Illinois horse racing tracks from revenues generated by the relocation of a license to operate a riverboat casino gaming facility.  Arlington’sArlington Park’s share of subsidies from the relocation of the license under the 1999 legislation would range from $4.6 million to $8.0 million annually, based on publicly available sources.  In the event Arlington Park receives such subsidies, additional shares of common stock would be issued to Duchossois Industries, Inc. (“DII”), to a maximum of 1.25 million shares only after the proposed casino opens and subsidies have been distributed for one year, under our merger agreement related to Arlington Park.  The additional shares may be issued to DII in the future, subject to the occurrence of certain events as specified in the merger agreement.  In January 2001, the Illinois Gaming Board (“IGB”) denied a license

Return to Index

application of Emerald Casino, Inc. to relocate the license to operate the Rosemont casino.  During 2002, Emerald Casino, Inc. filed for bankruptcy and iswas attempting to sell its license rights subject to the approval of the IGB and the Bankruptcybankruptcy court.  In April 2004, the IGB conducted an auction of the license and awarded that license to Isle Capri Casinos, Inc., which announced plans to locate the license to operate in Rosemont, Illinois.  Both the Governor of Illinois and the Attorney General of Illinois have convened investigations of the award by the IGB.  The date for final approval by the bankruptcy court of the auction and issuance of the license by the IGB is currentlynot known at this time.

Pursuant to the Illinois Horse Racing Act, Arlington Park (and all other Illinois racetracks) is permitted to receive a payment commonly known as purse recapture.  Generally, in any year that wagering on Illinois horse races at Arlington Park is less than 75% of wagering at Arlington Park on Illinois horse races in 1994, Arlington Park is permitted to receive 2% of the difference in wagering in the subsequent year.  The payment is funded from the Arlington Park purse account.  Under the Illinois Horse Racing Act, the Arlington Park purse account is to be repaid via an appropriation by the Illinois General Assembly from the Illinois General Revenue Fund.  However, this appropriation has not been made since 2001.  Subsequently, Illinois horsemen unsuccessfully petitioned the Illinois Racing Board (“IRB”) to prevent Illinois racetracks from receiving bidsthis payment in any year that the Illinois General Assembly did not appropriate the repayment to the racetrack’s purse accounts from the General Revenue Fund.  Further, the Illinois horsemen filed a lawsuit seeking, among other entitiesthings, to purchaseblock the license.

payment to Illinois racetracks as well as to recover the 2002 and 2003 amounts already paid to the Illinois racetracks.  Several bills were filed in the 2003, 2004 and 2005 session of the Illinois legislature whichthat, in part, would eliminate the statutory right of Arlington Park and the other Illinois racetracks to recapture amounts from their purse accounts. Since 2000,continue to receive this payment.  None of these bills passed.  The lawsuit challenging the Illinois General Assembly2002 reimbursement has appropriated money to reimburse each racetrack’s purse account for the amounts not recaptured from horsemen through reductionsbeen resolved in future purses. However, the appropriation was vetoed by Illinois’s governor during 2002favor of Arlington Park and the General Assembly did not make the appropriations in 2003.other Illinois horsemen unsuccessfully petitioned the IRB to prevent the tracks from recapturing purse amounts in any year where Illinois does not appropriate funds for reimbursement. Subsequently, the Illinois horsemen have filed aracetracks.  The lawsuit against the IRB and the Illinois racetracks, including Arlington Park, challenging the recapture of purse account amounts and seeking2003 reimbursement foris still pending.  As the amounts recaptured. Welegal right still exists, we have elected to continue to receive the recapture amountspayment from purses due to horsementhe purse account while the litigation is pending.  If the litigation challenging the reimbursement were to succeed or if Arlington Park loses the statutory right to receive this payment, there would be a material adverse impact on Arlington Park’s results of operations.

During January and February when there is no live racing in Illinois, the IRB designates a Thoroughbred racetrack as the host track in Illinois.  The IRB appointed Arlington Park as the host track in Illinois during January 2005, which is expected to result in pari-mutuel revenues comparable to the same period in 2004.  The IRB did not appoint Arlington Park as the host track in Illinois for February 2005, which is expected to result in an estimated decrease of $1.6 million in net earnings for the month of February in 2005 compared to the same period in 2004.  Arlington Park’s future designation as the host track is subject to the annual appointment by the IRB.

Kentucky

In Kentucky, racetracks with on-track average daily handle of $1.2 million or more pay an excise tax equal to 3.5% of on-track handle while tracks with on-track average daily handle that does not meet the $1.2 million threshold pay an excise tax of 1.5% of on-track handle.  To mitigate the disparity of treatment between larger tracks such as Churchill Downs and other Kentucky racetracks, we successfully pursued legislation creating an excise tax credit for racetracks as part of the 2002-2004 state budget.  The measure resulted in a $12,000 credit against our excise tax liability for each day of live racing starting July 1, 2003 and ending June 30, 2004.  However, average daily wagering

12

(“Fair Grounds”), a Thoroughbred racing operation in New Orleans, Louisiana and the stock of Video Services Inc. (“VSI”), the owner and operator of more than 700 video poker machines in Louisiana.  Additionally, we are the majority owner and operator of Hoosier Park in Anderson, Indiana, which conducts Thoroughbred, Quarter Horse and Standardbred horse racing.  We conduct simulcast wagering on horse racing at eleven23 simulcast wagering facilities in Kentucky, Indiana, Illinois and Illinois,Louisiana, as well as at our sixseven racetracks.

The Churchill Downs Simulcast Network (“CDSN”) was developed in 2002 to focus on the distribution of the Company’s simulcast signal.  CDSN provides the principal oversight of our interstate and international simulcast and wagering opportunities, as well as the marketing, sales, operations and data support efforts related to the Company-owned racing content.

Management Overview and Recent Developments

We completed our acquisition of the assets of Fair Grounds through our wholly owned subsidiary Churchill Downs Louisiana Horseracing Company, L.L.C. (“CDI Louisiana”), on October 14, 2004 for approximately $47 million in cash.  The transaction also included the acquisition of two related New Orleans operations, including certain assets of Finish Line Management Corporation and the stock of VSI, for approximately $10.7 million.  These acquisitions (collectively the “Louisiana Operations”) will supplement our full-year racing calendar and allows us to offer a full-year simulcast product as well as an opportunity to utilize alternative gaming.  The results of operations of the Louisiana Operations are included in our Consolidated Financial Statements from the date of acquisition during the fourth quarter of 2004.

On October 19, 2004, we sold a 19% interest in Kentucky Downs, LLC (“Kentucky Downs”), including debt owed to us, to Kelley Farms Racing, LLC in exchange for 86,886 shares of our common stock valued at approximately $3.2 million.  The consideration paid by Kelley Farms Racing, LLC was shares of our common stock, no par value, held by Brad M. Kelley.  The sale resulted in a $1.6 million gain and is included in our Consolidated Financial Statements.  Mr. Kelley is the sole owner of Bison Capital, LLC and Bison Capital, LLC is the sole owner of Kelley Farms Racing, LLC.  The agreement also includes a contingency payout should Kentucky Downs be approved for alternative gaming legislation.  We retained a 5% interest in Kentucky Downs.

On October 19, 2004, we also acquired 452,603 shares of our common stock from Mr. Kelley in exchange for a convertible promissory note (the “Note”) in the principal amount of $16.7 million.  The Note was amended and restated on March 7, 2005 (as so amended and restated the “Note”) to eliminate our ability to pay the Note at maturity with shares of our common stock.  The Company will pay interest on the principal amount of the Note on an annual basis in an amount equal to what Mr. Kelly would have received as a dividend on the shares that were redeemed. The Note is immediately convertible, at the option of Mr. Kelley, into shares of the Company’s common stock at a conversion price of $36.83. Upon maturity, we must pay the principal balance and unpaid accrued interest in cash.  The Note matures on October 18, 2014 and may not be prepaid without Mr. Kelley’s consent.  As a result of this transaction, we recorded a $4.3 million unrealized loss on derivative instruments during the fourth quarter of 2004 related to changes in the fair market value of embedded derivatives within the Note.

During the third quarter of 2004, we recognized a fixed asset impairment charge of $4.4 million and an intangible asset impairment charge of $1.8 million at our Ellis Park facility.  The asset impairment charges were triggered as a result of Ellis Park’s poor live race meet performance during the third quarter of 2004.  The impairment charges are included in our Consolidated Statements of Net Earnings and are described more fully under Critical Accounting Policies and Estimates.

Initiatives related to the passage of legislation permitting alternative gaming at racetracks, such as slot machines and video lottery terminals, were placed on certain state ballots for voters during the fourth quarter of 2004, including the states in which we operate.  During 2004, we spent $5.9 million at our Hollywood Park and Calder Race Course facilities on the alternative gaming initiatives in California and Florida, respectively.

As a result of the non-deductible legislative initiative costs, intangible asset impairment charges and the unrealized loss on derivative instruments related to the Note discussed above, we revised our year-to-date effective tax rate at December 31, 2004.  The effective tax rates were 61%, 40% and 41% for the years ended December 31, 2004, 2003 and 2002, respectively.

19

Legislative and Regulatory Changes

Federal

On October 11, 2004, the U. S. Congress passed The Foreign Sales Corporation Act. The Act includes a measure that repeals the 30 percent alien withholding requirements that should allow the U.S. horse racing industry to further export its product to foreign markets. President Bush signed the bill into law on October 22, 2004.  The 30 percent withholding effectively precluded common pooling by foreign countries into U.S. wagering pools.  The Company believes that the elimination of the 30 percent withholding requirement will help open the $85 billion international market for wagering on horse racing to U.S. tracks.  The future impact on our results of operations or financial position at this time is uncertain.

Indiana

During the first half of 2004, the Indiana Horse Racing Commission (“IHRC”) considered whether to prevent any Indiana betting facility from accepting wagers on Thoroughbred horse races run at Kentucky racetracks, including Churchill Downs racetrack and Ellis Park, unless all Indiana betting facilities were offered the opportunity to accept wagers on such races.  Pursuant to its statutory right under the Federal Interstate Horseracing Act of 1978, the Kentucky Horsemen’s Benevolent and Protective Association withheld its consent and thereby prevented the Evansville OTB and Clarksville OTB, both owned by Indiana Downs, from accepting wagers on Thoroughbred horse races run at Kentucky racetracks.  To assist the IHRC in reaching a determination on the matter, the IHRC asked the Indiana Department of Gaming Research (“IDGR”) to estimate the impact of simulcast wagering on live horse racing in Kentucky and Indiana.  The IDGR issued a report in June 2004, which concluded the racing industry in both states would lose money if none of Indiana’s pari-mutuel facilities received Kentucky’s racing signals.  As a result, at its July 1, 2004 meeting the IHRC decided not to ban Kentucky simulcast signals at Indiana racetracks.  Indiana Downs requested the IHRC to reconsider its decision, and at its August 2, 2004 meeting, by a vote of 3-2, the IHRC denied a motion which would have limited Kentucky simulcasts to Indiana’s two racetracks and would have prevented Kentucky simulcasts to OTB facilities unless the Kentucky simulcasts were made available to all OTB facilities.  An interim study committee of the Indiana General Assembly held hearings on this subject but there have been no recommendations for legislative changes to Indiana’s pari-mutuel statute.

On October 19, 2004, the Interim Study Committee on Agriculture and Small Business of the Indiana General Assembly endorsed a proposal to put pull-tab machines at Hoosier Park, Indiana Downs and two OTB sites located in Indianapolis and Fort Wayne.  We believe the endorsement provides momentum for the proposal in the 2005 session of the Indiana General Assembly.

Indiana HB 1569, which would have authorized slot machines at Indiana’s two pari-mutuel racetracks, was defeated in the Public Policy Committee of the Indiana General Assembly on February 14, 2005. No other legislation has originated in either chamber calling for slots at the racetracks.  However, it is still possible for legislation pertaining to alternative gaming at racetracks to be amended into existing bills.  The concept could also be incorporated into the state budget.  The Indiana General Assembly is scheduled to adjourn April 29, 2005.

Florida

In Florida, Yes for Local Control (formerly known as The Floridians for a Level Playing Field), a coalition of pari-mutuel facilities including Calder, successfully gathered the necessary petition signatures to place a question on the ballot for the November 2004 general election to allow Dade and Broward counties to hold a referendum on the installation of slot machines at existing pari-mutuel sites in those respective counties.  The Florida Supreme Court upheld the constitutionality of the ballot language in May 2004 and the ballot question was officially certified by the Florida Secretary of State on July 21, 2004 and appeared on the ballot as Amendment 4.  On July 23, 2004, a suit was filed against the Florida Division of Elections challenging the format of the initiative petition and was dismissed.  A suit was filed in September 2004 by Floridians Against Expanded Gambling, challenging the methodology used in the signature gathering process including allegations of fraud, in the initiative to put Amendment 4 on the ballot. However, the court had refused to hear the suit until after the November 2004 election to give proponents time to prepare their case. Calder has funded a pro-rata share of the initiative costs.  On November 2, 2004, Amendment 4 passed by a margin of 1.4 percent.

Voters in Miami-Dade and Broward counties voted March 8, 2005, in separate local referenda to decide whether slot machines can be installed at the seven existing pari-mutuel sites in those counties, including Calder.  Although the

20

measure passed in Broward County, home of Gulfstrem Park, it was unsuccessful in Miami-Dade County, where Calder is located.  Pari-mutuel operators in Broward County will now lobby Florida legislature to pass enabling legislation authorizing slot machine gaming at the pari-mutuel facilities.  Failure of the referendum to pass in Miami-Dade County was due primarily to Governor Jeb Bush’s active opposition to the measure during the final days of the campaign.  The Company is preparing a strategy to win passage in Miami-Dade County in 2007 when the issue can again be placed on the ballot.  The impact of the Company’s results of operations and financial position of the failed referendum in Miami-Dade County is uncertain at this time.

All litigation filed to challenge the signature gathering process and the vote counting on election day for the statewide referendum has been resolved in favor of Calder and the pari-mutuel coalition.

California

In California, Hollywood Park was part of a coalition of racetracks and card clubs supporting Proposal 68 on the November 2004 ballot.  The proposal failed to pass by a margin of 16 percent to 84 percent.  If passed, this initiative would have directed the governor to re-negotiate all existing compacts with Native American tribes in California.  If the tribes had declined to renegotiate the existing compacts, then five racetracks, including Hollywood Park, and 11 card clubs would have been allowed to operate electronic gaming devices.  We continue to work with other members of the California horse industry on a long-term strategy for developing a legislative agenda that addresses the competitive advantages afforded to Native American casinos.

In addition to Proposition 68 noted above, California Proposition 70, also known as The Indian Gaming Fair-Share Revenue Act of 2004, also failed to pass in the November 2004 election.  Proposition 70 called for an unlimited expansion of Native American gaming in return for an 8.8% tax on gaming revenue.  Proposition 70 was actively opposed by Governor Schwarzenegger.

Also in California, legislation recently passed which is estimated will generate approximately $10.0 million in the aggregate annually industry-wide from a 0.5% increase in the commission, or take out rate, on exotic wagers placed on California races.  The increased revenue will be used to pay the cost of workers compensation insurance for backstretch workers and to provide a starter participation bonus.  Governor Schwarzenegger signed this bill on May 14, 2004.  During 2004 we funded $1.3 million for worker’s compensation insurance from the 0.5% increase in the commissions.

Illinois

In 1999, the state of Illinois enacted legislation that provides for pari-mutuel tax relief and related tax credits for Illinois racetracks, as well as legislation providing for subsidies to Illinois horse racing tracks from revenues generated by the relocation of a license to operate a riverboat casino gaming facility.  Arlington Park’s share of subsidies from the relocation of the license under the 1999 legislation would range from $4.6 million to $8.0 million annually, based on publicly available sources.  In the event Arlington Park receives such subsidies, additional shares of common stock would be issued to Duchossois Industries, Inc. (“DII”), to a maximum of 1.25 million shares only after the proposed casino opens and subsidies have been distributed for one year, under our merger agreement related to Arlington Park.  The additional shares may be issued to DII in the future, subject to the occurrence of certain events as specified in the merger agreement.  In January 2001, the Illinois Gaming Board (“IGB”) denied a license application of Emerald Casino, Inc. to relocate the license to operate the Rosemont casino.  During 2002, Emerald Casino, Inc. filed for bankruptcy and was attempting to sell its license rights subject to the approval of the IGB and the bankruptcy court.  In April 2004, the IGB conducted an auction of the license and awarded that license to Isle Capri Casinos, Inc., which announced plans to locate the license to operate in Rosemont, Illinois.  Both the Governor of Illinois and the Attorney General of Illinois have convened investigations of the award by the IGB.  The date for final approval by the bankruptcy court of the auction and issuance of the license by the IGB is not known at this time.

Pursuant to the Illinois Horse Racing Act, Arlington Park (and all other Illinois racetracks) is permitted to receive a payment commonly known as purse recapture.  Generally, in any year that wagering on Illinois horse races at Arlington Park is less than 75% of wagering at Arlington Park on Illinois horse races in 1994, Arlington Park is permitted to receive 2% of the difference in wagering in the subsequent year.  The payment is funded from the Arlington Park purse account.  Under the Illinois Horse Racing Act, the Arlington Park purse account is to be repaid via an appropriation by the Illinois General Assembly from the Illinois General Revenue Fund.  However, this appropriation has not been made since 2001.  Subsequently, Illinois horsemen unsuccessfully petitioned the Illinois Racing Board (“IRB”) to prevent Illinois racetracks from receiving this payment in any year that the Illinois General

21

Assembly did not appropriate the repayment to the racetrack’s purse accounts from the General Revenue Fund.  Further, the Illinois horsemen filed a lawsuit seeking, among other things, to block the payment to Illinois racetracks as well as to recover the 2002 and 2003 amounts already paid to the Illinois racetracks.  Several bills were filed in the 2003, 2004 and 2005 session of the Illinois legislature that, in part, would eliminate the statutory right of Arlington Park and the other Illinois racetracks to continue to receive this payment.  None of these bills passed.  The lawsuit challenging the 2002 reimbursement has been resolved in favor of Arlington Park and the other Illinois racetracks.  The lawsuit challenging the 2003 reimbursement is still pending.  As the legal right still exists, we have elected to continue to receive the recapture payment from the purse account while the litigation is pending.  If the litigation challenging the reimbursement were to succeed or if Arlington Park loses the statutory right to receive this payment, there would be a material adverse impact on Arlington Park’s results of operations.

During January and February when there is no live racing in Illinois, the IRB designates a Thoroughbred racetrack as the host track in Illinois.  The IRB appointed Arlington Park as the host track in Illinois during January 2005, which is expected to result in pari-mutuel revenues comparable to the same period in 2004.  The IRB did not appoint Arlington Park as the host track in Illinois for February 2005, which is expected to result in an estimated decrease of $1.6 million in net earnings for the month of February in 2005 compared to the same period in 2004.  Arlington Park’s future designation as the host track is subject to the annual appointment by the IRB.

Kentucky

In Kentucky, racetracks with on-track average daily handle of $1.2 million or more pay an excise tax equal to 3.5% of on-track handle while tracks with on-track average daily handle that does not meet the $1.2 million threshold pay an excise tax of 1.5% of on-track handle.  To mitigate the disparity of treatment between larger tracks such as Churchill Downs and other Kentucky racetracks, we successfully pursued legislation creating an excise tax credit for racetracks as part of the 2002-2004 state budget.  The measure resulted in a $12,000 credit against our excise tax liability for each day of live racing starting July 1, 2003 and ending June 30, 2004.  However, average daily wagering at Churchill Downs racetrack fell below the $1.2 million threshold for the state’s fiscal year ended June 30, 2004, which resulted in a drop in our excise tax rate from 3.5% to 1.5% for the year.  As a result, the excise tax credit did not apply to Churchill Downs racetrack and a $260,000 refund of tax payments was received from the Kentucky Revenue Cabinet during the third quarter of 2004.  The excise tax credit was not included in the Kentucky state budget currently under consideration.

The Kentucky Horse industry continues to seek legislation to allow alternative forms of gaming at the state’s eight existing racetracks. Alternative forms of gaming would enable our Kentucky racetracks to better compete with neighboring gaming venues by providing substantial new revenues for purses and capital improvements. Several alternative gaming bills were introduced in the 2005 session of the Kentucky General Assembly.  The 2005 session concluded with no action having been taken with respect to such bills.

Louisiana

In 2003, the Louisiana Legislature passed a bill authorizing the operation of slot machines at Fair Grounds subject to amendment of Louisiana’s contract with Harrah’s Casino in New Orleans (which prohibited other land based gaming in Orleans Parish), subject to Orleans Parish voter approval, and subject to the owner and operator of the track securing the necessary gaming licenses from the Louisiana Gaming Control Board.  In addition, video poker operations must be discontinued at the main racetrack location when slot machines become operational.

In October 2003, Orleans Parish voters approved a referendum authorizing slot machine gaming at Fair Grounds conditioned upon the adoption of certain zoning and permitting requirements.  In 2003, the Louisiana Legislature passed an act that limited the number of slot machines that may be operated at Fair Grounds to 400 slot machines through June 30, 2005 and 500 slot machines thereafter.  However, the act provides that if gross gaming revenues at Harrah’s Casino in New Orleans exceed $350.0 million for any previous 12-month period, up to 700 slot machines may be operated at Fair Grounds.

After approval of the amendment to Louisiana’s contract with Harrah’s Casino by the Louisiana Gaming Control Board in December 2004 and by the Joint Legislative Committee on the Budget in January 2005, on February 2, 2005, Harrah’s Casino and the State Of Louisiana executed an amendment to their contract providing for slot machines at Fair Grounds.

22

Churchill Downs Louisiana Horseracing Company, L.L.C. has initiated the process to obtain the necessary gaming licenses to own and operate slot machines at Fair Grounds and to seek the necessary local zoning change and permits.

The City of New Orleans is challenging the live pari-mutuel tax calculation used by the Fair Grounds Corporation, the seller of Fair Grounds to Churchill Downs Louisiana Horseracing Company, L.L.C.  The City’s interpretation is different from the interpretation and methods used by of all of the racetracks in Louisiana.  If the City of New Orleans were to prevail in its interpretation of the tax calculation, the Fair Grounds could be assessed for an underpayment of taxes from the date of our ownership of the track.  As of December 31, 2004, any underpayment would not be significant to the overall operations of Fair Grounds, since there were a limited number of live race days in 2004.

Critical Accounting Policies and Estimates

Our Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States.  Accordingly, we are required to make estimates, judgments and assumptions that we believe are reasonable based on our historical experience, contract terms, observance of known trends in our company and the industry as a whole, and information available from other outside sources.  Our estimates affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results may differ from those initial estimates.  In general, however, our estimates have historically approximated actual results.

Our most significant estimates relate to the valuation of plant and equipment, receivables, goodwill and other intangible assets, which may be significantly affected by changes in the regulatory environment in which we operate, and to the aggregate costs for self-insured liability and worker’s compensation claims.  Additionally, estimates are used for determining income tax liabilities, the valuation of interest rate risk derivative contracts (interest rate swaps) and other derivative instruments.

We evaluate our goodwill, intangible and other long-lived assets in accordance with the application of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Intangible Assets” (“SFAS No. 142”) and SFAS No. 144, “Accounting for the impairment or disposal of Long-Lived Assets”.  For goodwill and intangible assets, we review the carrying values at least annually during the first quarter of each year or whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable.  We assign estimated useful lives to our intangible assets based on the period of time the asset is expected to contribute directly or indirectly to future cash flows.  We consider certain factors when assigning useful lives such as legal, regulatory, competition and other economic factors.  Intangible assets with finite lives are amortized using the straight-line method.

While we believe that our estimates of future revenues and cash flows are reasonable, different assumptions could materially affect our assessment of useful lives and fair market values.  Changes in assumptions may cause modifications to our estimates for amortization or impairment, thereby impacting our results of operations.  If the estimated lives of our intangible assets were to decrease based on the factors mentioned above, amortization expense could increase significantly.

Our business can be impacted positively and negatively by legislative and regulatory changes and by alternative gaming competition.  A significant negative impact from these activities could result in a significant impairment of our plant and equipment and/or our goodwill and intangible assets in accordance with generally accepted accounting principles.

Additional information regarding how our business can be impacted by competition and legislative changes is included in Items 1F and 1G, respectively, in this Annual Report on Form 10-K.

During the third quarter of 2004, we recognized a fixed asset impairment charge of $4.4 million and an intangible asset impairment charge of $1.8 million at our Ellis Park facility.  The asset impairment charges were triggered as a result of Ellis Park’s poor live race meet performance during the third quarter of 2004.  Our review, based on consideration of current fiscal year operating results and the forecasted operating results of the facility, indicated that the estimated future cash flows were insufficient to recover the carrying value of long-lived assets.  Accordingly, we adjusted the carrying value of these long-lived assets, including grandstands and buildings ($3,549), furniture and fixtures ($85), equipment ($217), improvements ($512) and goodwill ($1,839), to management’s estimated fair value.

23

We anticipate that the current carrying value of Ellis Park will be supported by ongoing operations, however, should plans for expected operating results at Ellis Park not be realized, an additional write down of these assets could occur.

We also use estimates and judgments for financial reporting to determine our current tax liability, as well as those taxes deferred until future periods.  Net deferred and accrued income taxes represent significant assets and liabilities of the Company.  In accordance with the liability method of accounting for income taxes as specified in SFAS 109, “Accounting for Income Taxes,” we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns.

Adjustments to deferred taxes are determined based upon changes in differences between the book basis and tax basis of our assets and liabilities, measured by future tax rates we estimate will be applicable when these differences are expected to reverse.  Changes in current tax laws, enacted tax rates or the estimated level of taxable income or non-deductible expenses could change the valuation of deferred tax assets and liabilities and affect the overall effective tax rate and tax provision.

We utilize interest rate swap contracts to hedge exposure to interest rate fluctuations on our variable rate debt and have designated these swaps as cash flow hedges of anticipated interest payments.  Our interest rate swap contracts match the critical terms of the underlying debt, thus qualifying for hedge accounting.  Such critical terms include the notional amounts, benchmark interest rate basis, interest reset dates and payment dates.  The fair market value of the swaps is recorded on the balance sheet as an asset or liability with the offset recorded in accumulated other comprehensive income net of income taxes.  Any changes in the fair market value of the swaps are adjusted to the asset or liability account and recorded net of the income taxes in other comprehensive income.

We maintain an allowance for doubtful accounts receivable that we have deemed to have a high risk of collectibility.  We analyze historical collection trends and customer creditworthiness when evaluating the adequacy of our allowance for doubtful accounts receivable.  Any changes in our assumptions or estimates could impact our bad debt expense and results of operations.

For our business insurance renewals over the past several years, we assumed more risk than in the prior years, primarily through higher retentions and higher maximum losses for stop-loss insurance for certain coverages.  In 2004, our business insurance renewals included substantially the same coverages and retentions as in previous years.  We estimate insurance liabilities for workers compensation and general liability losses based on our historical loss experience, certain actuarial assumptions of loss development factors and current industry trends.  Any changes in our assumptions, actuarial assumptions or loss experience could impact our total insurance cost and overall results of operations.  Our ability to obtain insurance coverage at acceptable costs in future years under terms and conditions comparable to the current years is uncertain.

Our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements included in Item 8 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Consolidated Net Revenues

Our net revenues and earnings are significantly influenced by our racing calendar.  Therefore, revenues and operating results for any interim quarter are not generally indicative of the revenues and operating results for the year, and may not be comparable with results for the corresponding period of the previous year.  We historically have very

Return to Index

few live racing days during the first quarter of each year, with a majority of our live racing occurring in the second, third and fourth quarters, including the running of the Kentucky Derby and Kentucky Oaks in the second quarter. However in 2004, we acquired Fair Grounds, which will provide us with significant live racing days in the first quarter.  Information regarding racing dates at our facilities for 20032005 and 2004 is included in Item 1E, “Licenses and Live Racing Dates” of this Annual Report on Form 10-K.

Our pari-mutuel revenues include commissions on pari-mutuel wagering at our racetracks and off-track betting facilities (net of state pari-mutuel taxes), plus simulcast host fees from other wagering sites and source market fees generated from contracts with our in-home wagering providers.  In addition to the commissions earned on pari-mutuel wagering, we earn pari-mutuel related streams of revenues from sources that are not related to wagering.  These other revenues are primarily derived from statutory racing regulations in some of the states where our facilities are located and can fluctuate materially year-to-year.  Non-wagering revenues are primarily generated from

24

admissions, sponsorships, licensing rights and broadcast fees, Indiana riverboat admissions subsidy, concessions, video poker, lease income and other sources.

Pari-mutuel revenues are recognized upon occurrence of the live race that is presented for wagering and after that live race is made official by the respective states’ racing regulatory body.  Additional non-wagering revenues such as admissions, programs and concession revenues are recognized as delivery of the product or services has occurred.

Greater than 70%75% of our annual revenues are generated by pari-mutuel wagering on live and simulcast racing content and in-home wagering. Live racing handle includes patron wagers made on live races at our live tracks and also wagers made on imported simulcast signals by patrons at our racetracks during our live race meets.  Import simulcasting handle includes wagers on imported signals at our racetracks when the respective tracks are not conducting live race meets and at our OTBs throughout the year.  Export handle includes all patron wagers made on our live racing signals sent to other tracks, or OTBs.OTBs and in-home wagering.  In-home wagering, or account wagering, consistconsists of patron wagers through an advance deposit account.

The pari-mutuel operatorCompany retains as revenue a pre-determined percentage ofor commission on the total amount wagered, and the balance is distributed to the winning patrons.  The gross percentages retained on live racing and import simulcasting at our various locations range from 15.43%approximately 15% to 27.0%27%.  In general, the commissionsfees earned from import and export simulcasting are contractually determined and average approximately 3.49%3.5%.  All commissions and fees earned from pari-mutuel wagering are shared with horsemen through payment of purses based on local contracts and average approximately 50%.

25

Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002

Net Revenues

NetTotal net revenues decreased $14.6 million from $438.8 million in 2002 to $424.2 million in 2003. Kentucky Operations revenues increased $4.3 millionduring the period primarily due to interstate export simulcast wagering resulting from record wagering for the Kentucky Derby and Kentucky Oaks days. CDSN revenues increased $7.0 million primarily due to increases in interstate export simulcast wagering and record wagering on the Kentucky Oaks and Kentucky Derby days. These increases were offset by a $9.5 million decreasereduction in the Indiana riverboat admissions subsidy at Hoosier Park resultingPark.  The reduction in subsidy stemmed from regulatory changes requiring Hoosier Park to split the subsidy revenues with Indiana Downs. Hoosier Park also hadDowns, a decreasenewly built racetrack in pari-mutuelShelbyville, Indiana.  Additionally, total net revenues declined as a result of $2.0 million primarily due to 38 fewer live Standardbred race days. Hollywood Park’s revenue decrease of $5.9 million was primarily due to five fewer live race days during 2003, decreased wagering and attendance as well as higher California worker’s compensation costs resulting in smaller field sizes on races.

Net revenues decreased by $1.1 million at Arlington Park. During January and February when there is no live racing in Illinois, the IRB appoints a Thoroughbred racetrack as the host track in Illinois. The IRB appointed Arlington Park as the host track in Illinois during a portion of January 2003 resulting in increased pari-mutuel revenues compared to the prior period. However, this increase was offset by decreased revenues due to two fewer live race days at Arlington Park as well as the impact of the Illinois harness strike during the first quarter of 2003. Calder Race Course also experienced decreased revenues of $1.7 million caused in part by reduced attendance and

Return to Index

wagering after a smoking ban in Florida went into effect in mid-2003. Net revenues decreased less than the sum of the segment variances described above due to increases in intercompany eliminations of $4.7 million primarily due to increased CDSN simulcast wagering.

Operating Expenses

Operating expenses decreased $7.6 million from $353.5 million in 2002 to $345.9 million in 2003 primarily due to decreased purse expenses of $4.9 million at Hoosier Park consistent with the decrease in Indiana riverboat admissions subsidy noted above. Other direct racing expenses at Hoosier Park decreased $2.2 million primarily due to fewer days of racing, and Hollywood Park and Calder Race Course racing expenses decreased consistent with the decreases in pari-mutuel revenues. Kentucky Operations had an increase in purse expenses of $1.8amounting to a $6.0 million consistent with the increase in pari-mutuel revenues.decrease at that facility.

During 2003, Arlington Park recorded a receivable for an Illinois real estate tax settlement. The amount recorded, net of attorney’s fees and other reductions, approximates $3.1 million reflected as a reduction in operating expenses and $1.0 million in earned interest income at statutory rates. An agreement and collection schedule were finalized during the fourth quarter of 2003. The receivable bears interest at a statutory rate.

Also during 2003, Arlington Park recorded an expense of $1.0 million related to the purse account reflecting the estimated impact of recovering the 2002 purse recapture over an extended period, rather than an immediate total recovery, as allowed by statute.

Gross Profit

Gross profit decreased $7.0 million from $85.3 million in 2002 to $78.3 million in 2003declined during the period primarily due toas a result of the decrease in Indiana riverboat admissions subsidy at Hoosier Park where gross profit fell $5.3 million. In addition, gross profit declined $4.8 millionand the reduction in live race days at Hollywood Park asmentioned above.

Net earnings increased in 2003 due to a result$4.1 million gain recognized during 2003 related to an Illinois real estate tax settlement and an asset impairment charge recorded for Ellis Park Race Course (under Kentucky Operations) during 2002 of reduced revenues and CDSN$4.5 million offset by the decrease in gross profit discussed above.  Additionally, decreases in gross profit mentioned above were offset by an overall decrease in interest expense resulting from a lower interest rate environment.

Consolidated Expenses

The following table is a summary of our consolidated expenses:

Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003

Total expenses increased $2.1 million due to increased interstate export wagering.

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses decreased by $1.4 million from $35.4 million in 2002 to $34.0 million in 20038% during 2004 primarily as a result of a decrease in strategic planningthe $6.2 million asset impairment loss at Ellis Park and the $5.9 million of additional expenses for our corporate segment as well as a decrease inrelated to legislative costs for alternative gaming (included in SG&A expenses) as mentioned above.  Additionally, expenses increased $14.3 million as a result of our Kentuckyacquisition of the Louisiana Operations during the fourth quarter of 2004.  Further discussion of expense variances by our reported segments is detailed below.

Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002

Total expenses decreased by $14.2 million during 2003 compared to 2002.  Consistent with the decrease in riverboat admission subsidy revenues mentioned above, riverboat purse expense declined by $4.5 million. Also, overall expenses were reduced due to the $4.5 million asset impairment loss at Ellis Park during 2002. As a result of 48 fewer live race days in 2003, total expenses were reduced at our racetracks, principally at Hoosier Park and Hollywood Park.  Further discussion of expense variances by our reported segments is detailed below.

27