is published by Dean, Dorton & Ford's Equine Industry Group. We hope you find the information we present regarding thoroughbreds to be interesting and helpful. We welcome your feedback. Located in the heart of central Kentucky, known for its world-class horse farms, racing, and sales, Dean, Dorton & Ford has provided accounting, tax, and business consulting services to the horse industry since our inception in 1979. Our clients cover a broad spectrum of organizations involved in the horse industry, from small boarding farms to large multi-departmental farms involved in boarding, breeding, selling, stallion management, and crop production; from racing stables to a racetrack; from bloodstock agents to equine veterinary firms to equine insurance agencies; and from industry associations to industry publications. Not all of our clients are based in central Kentucky; horse industry clients from other parts of the country and from outside the United States also gain comfort by having our industry specialists work with them. As a firm, we endeavor to know the business of horses, not just accounting and tax rules relating to the industry. We accomplish this in a number of ways, including meeting periodically, often with outside experts, to discuss business topics of interest in the industry; by reading industry periodicals; by studying the abundance of statistical data available regarding different measures of industry performance; and most usefully, by working with our clients in the industry on their business matters. We perform a variety of services for our clients involved in the equine industry and welcome inquiries, whether from new participants in the industry who want assistance in properly structuring and administering their stables or farms, or from long-time industry participants seeking to improve the performance and administration of their equine operations. Members of our Equine Industry Group will be pleased to answer any questions you may have. Please call any of the following: Doug Dean, Richard Dorton, Joe Ford, Martha Jones, Leigh McKee, Emily Carpenter, or Lesley Howard. ADDRESS: 106 West Vine Street, Suite 600 Lexington, Kentucky 40507 TELEPHONE: (859) 255-2341 FAX: (859) 255-0125 WEB SITE: www.ddfky.com E-MAIL: ddean@ddfky.com Dean, Dorton & Ford, P.S.C. Page 1
Dean, Dorton & Ford, P.S.C. - Equine Industry Group Accounting For smaller enterprises, directly performing many accounting, payroll, and clerical functions. Designing and implementing farm accounting and management information systems. Business Consulting Developing strategies to use the optimum forms of organization in which to conduct horse and farm businesses. Developing financial and business plans for farms, breeding operations, and racing stables. Financial analysis of stallion prospects. Designing and implementing retirement plan and other employee benefit programs. Tax Developing strategies to make maximum use of potential tax losses. Avoiding exposure to the hobby loss rules. Structuring transactions to avoid or minimize sales and use taxes. Avoiding or managing the potential impact of the passive activity loss rules. Using current and deferred trades of horses and farms to avoid or postpone income taxes. Using the involuntary conversion tax rules to defer income taxes on insurance recoveries related to horse and farm casualties. Estate planning designed to use special use valuation and family farm conservation incentives, family limited partnership strategies, and deferred tax payments. Handling multi-state tax allocations. Helping foreign owners and breeders to minimize exposure to U.S. taxes and comply with filing requirements. Developing tax accounting systems to comply, where required, with rules requiring capitalization of preproductive period costs. Representing clients with federal and state tax audits. Taking advantage of unique tax depreciation rules. Dean, Dorton & Ford, P.S.C. Page 2
Table of Contents Information and Commentary on Thoroughbred Public Auction Markets 4-7 Information and Commentary on Thoroughbred Breeders' Costs and Profits 8-10 Information and Commentary on Stud Fee Multiples 11-12 Information and Commentary on Changes in Production Costs and Yearling Selling Prices for Thoroughbred Breeders 13-14 Information and Commentary on Racing Purses 15-16 2003 Tax Developments 17-18 Dean, Dorton & Ford, P.S.C. Page 3
$1,200 Graph I Size and Composition of the Public Auction Market in Dollars 1987 to 2003 Data from The Blood-Horse $1,200 In millions of dollars $1,000 $800 $600 $400 $200 $1,000 $800 $600 $400 $200 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Yearlings Weanlings Two-Year-Olds Broodmares Inflation Adjustment 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Graph II Number of Horses Sold at Public Auction by Type of Horse 1987 to 2003 Weanlings Yearlings Broodmares Two-Year-Olds 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Data from The Blood-Horse 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Dean, Dorton & Ford, P.S.C. Page 4
Commentary on Graphs I and II Our 17-year view of the aggregate amount of dollars involved in North American thoroughbred public auction sales readily shows the long, steady decline from 1987 to 1992, followed by an even longer and more pronounced increase from 1992 to 2000. 2003 sales, even with reduced numbers of yearlings due to MRLS, reverses the downward trend experienced in 2001 and 2002. On an inflation-adjusted basis, though, 2003 sales dollars have not reach 1987 s level. The 2003 amount, nominally and inflation-adjusted, substantially exceeds the 1992 low point. Sales by category (in dollars) as a percentage of the total auction market are as follows in recent years: Weanlings 9.9% 7.8% 6.3% 6.5% 8.0% Yearlings 44.6% 48.6% 56.6% 51.4% 50.1% Two-Year Olds 15.9% 14.5% 15.2% 17.1% 16.5% Broodmares 29.6% 29.1% 21.9% 25.0% 25.4% Note that the dollar volume of yearlings in 2003 remained about the same in relation to all auction sales as in earlier years, even with the short, MRLS-impacted yearling crop. The total number of horses sold at auction reached its highest level in 2000 (after seven consecutive years of increases), decreased 9% in 2001 and 4% in 2002, then increased 4% in 2003. There were 2003 increases in every category, weanlings (10%), two-year-olds (12%) and broodmares (9%), except yearlings, which decreased only slightly (1%). 5% of the 2003 North American foal crop sold at public auction as weanlings, and 24% of the 2002 North American foal crop sold at public auction in 2003 as yearlings. The following shows the relationship of these numbers to the three previous years: 2000 2001 2002 2003 Weanlings 7% 5% 5% 5% Yearlings 29% 25% 25% 24% Dean, Dorton & Ford, P.S.C. Page 5
$65,000 $55,000 $45,000 $35,000 $25,000 $15,000 Graph III Average Price at Public Auction by Type of Horse 1987 to 2003 Yearlings Weanlings Two-Year-Olds Broodmares 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 $65,000 $55,000 $45,000 $35,000 $25,000 $15,000 Data from The Blood-Horse Graph IV Average Price by Type of Horse by Decile 1999 to 2003 Yearlings Weanlings Two-Year-Olds $350,000 $350,000 $350,000 $250,000 $250,000 $250,000 $150,000 $150,000 $150,000 $50,000 $50,000 $50,000 Top 10% 2nd 10% Upper20-50% Top 10% 2nd 10% Upper 20-50% Top 10% 2nd 10% Upper 20-50% Data From Auction Review, The Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 6
Commentary on Graphs III and IV After average prices of each category - yearlings, weanlings, two-year-olds, and broodmares - declined in 2001, average prices of weanlings and broodmares increased for the second consecutive year in 2003. Average yearling prices increased in 2003 after two years of decreases. Average two-year-old prices decreased slightly in 2003. After dropping 4% in 2001 and 17% in 2002, 2003 yearlings sold at public auction increased by 10% in average price. Even though the size of the 2003 yearling crop was impacted by MRLS, about the same number of yearlings sold in 2003 as sold in 2002. The average price of weanlings, which had increased 15% in 2002, increased 26% in 2003. The 2003 average price of each category did not reach its respective peak, which was in 2000 for broodmares and yearlings and in 1999 for two-year-olds and weanlings. Graph IV examines the top 50% (by price) of these market segments yearlings, weanlings, and two-year olds - over the last five years. The following table shows the ratio by category of the top decile to the second decile in terms of average prices. Note how much more the top decile of prices has been than the second decile generally from at least three to more than five times: Yearlings 4.5 5.2 5.4 4.0 4.2 Weanlings 3.5 3.5 3.2 3.2 2.8 Two-Year Olds 3.3 3.1 3.0 3.0 3.1 Note that the top decile average yearling price, which experienced a 27% decrease in 2002, had a 13% increase in 2003. The second decile increased 7% and combined third through fifth deciles increased 8% in 2003. Although not shown, the sixth through eighth deciles each had 2003 increases, but the ninth and tenth deciles were unchanged from 2002 to 2003. The average price in the top decile for weanlings increased in 2003 by 26%. The overall average price increase for weanlings of 29% in 2003 was comprised of an increase in each decile. For two-year-olds, the average price in the top decile decreased 8% in 2003. In fact, average prices in every decile declined in 2003. Dean, Dorton & Ford, P.S.C. Page 7
Note: Dollar figures above bars on bar graphs represent amounts remaining after other costs to cover mare and profit. Graph V Breakdown of Price of Yearling Sales into Cost Components -- Stud Fees, Sales Commissions, and Mare and Foal Board and Incidental Expenses -- Balance Available to Cover Cost of Mare and Profit YEARLINGS -- By Stud Fee Range 1999 to 2003 $556,392 Stud Fees and Up $567,224 $542,131 Stud Fees $50,000 to $99,999 Stud Fees $30,000 to $49,999 $243,823 $167,409 $161,133 $146,015 $64,237 $24,112 $46,276 $84,715 $76,061 $79,434 $36,359 $26,101 Stud Fees $20,000 to $29,999 Stud Fees $10,000 to $19,999 Balance After Other Costs to Cover Cost of Mare and Profit Sales Commissions Mare and Foal Board and Other Incidental Expenses $24,302 $37,906 $12,855 $13,733 $12,290 $15,732 $5,984 $512 $762 $3,557 Stud Fees Underlying Data from Auction Review, The Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 8
Note: Dollar figures above bars on bar graphs represent amounts remaining after other costs to cover mare and profit. Graph VI Breakdown of Price of Weanling Sales into Cost Components -- Stud Fees, Sales Commissions, and Mare and Foal Board and Incidental Expenses -- Balance Available to Cover Cost of Mare and Profit WEANLINGS -- By Stud Fee Range 1999 to 2003 Stud Fees and Up Stud Fees $50,000 to $99,999 Stud Fees $30,000 to $49,999 $302,244 $292,166 $235,729 $54,496 $99,623 $92,355 $31,335 $13,055 $26,692 $56,718 $31,741 $48,784 $24,729 $10,594 $23,678 Stud Fees $20,000 to $29,999 Stud Fees $10,000 to $19,999 Balance After Other Costs to Cover Cost of Mare and Profit Sales Commissions Mare and Foal Board and Other Incidental Expenses $21,975 $12,193 $5,546 $3,860 $19,583 $9,137 $1,377 $867 $600 $6,701 Stud Fees Underlying Data from Auction Review, The Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 9
Commentary on Graphs V and VI We have analyzed data which shows the relationship of yearling (Graph V) and weanling (Graph VI) sales results to stud fee costs over 1999-2003, segmented by stud fee ranges (for the breeding year). These graphs show the portion of average sales price consumed by related stud fees, and add two other significant components of cost, a 5% sales commission and the cost of boarding and otherwise caring for the foal from an approximate weaning date until sold and the dam for a year. For this latter cost, primarily board and veterinary, we used $20,000 and $13,000 for yearlings and weanlings, respectively. We have not included sales tax on stud fees, because not all states tax stud fees and because stallion owners who use their seasons are not subject. The balance of average sales prices not consumed by the specific costs outlined above is available principally to cover the cost of using the mare for a year to produce the foal and, hopefully, to provide a profit to the breeder. The table below shows the percentage change from the prior year in the amount of selling price available to cover the cost of using the mare and to produce a profit, broken down by the stud fee ranges shown in the graphs. Percentage Change from Prior Year in Selling Price Available for Mare and Profit Stud Fee Range Yearlings Weanlings 2002 2003 2002 2003 and up -55% -31% -77% 83% $50,000 to $99,999-62% 92% 104% 112% $30,000 to $49,999-54% -28% -57% 124% $20,000 to $29,999 7% -11% -30% 407% $10,000 to $19,999 49% 367% 69% 1117% In Graph V and the above table, note the declining profitability in the case of yearlings resulting from breedings to the highestpriced stallions. In Graph VI and the above table, note the dramatically increasing profitability for 2003 weanling sellers at each of the stud fee ranges presented. Note that this analysis does not take into account costs associated with barren mares and lost foals. Dean, Dorton & Ford, P.S.C. Page 10
Graph VII Ratio of Sales Price to Stud Fee - Yearlings 1994 to 2003 and up $50,000 to $99,999 $30,000 to $49,999 $20,000 to $29,999 $10,000 to $19,999 6.00 4.00 2.00 0.00 1994 1995 1996 1997 1998 6.00 4.00 2.00 0.00 Underlying Data from Auction Review, The Thoroughbred Times Graph VIII Ratio of Sales Price to Stud Fee - Weanlings 1994 to 2003 and up $50,000 to $99,999 $30,000 to $49,999 $20,000 to $29,999 $10,000 to $19,999 6.00 6.00 4.00 4.00 2.00 2.00 0.00 1994 1995 1996 1997 1998 0.00 Underlying Data from Auction Review, The Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 11
Commentary on Graphs VII and VIII Considerable published data is available to breeders on stud fee multiples (sales price of yearling or weanling as a ratio of related stud fees) on a stallion-by-stallion basis. We have taken the data that groups stallions by stud fee ranges see Graphs V and VI and looked in Graphs VII and VIII at trends over time and relationships among different stud fee ranges. In doing this analysis, the stud fees are from the breeding year, not the sales year. The following table shows stud fee multiples for yearlings sold in 1994 through 2003, by stud fee range: Stud Fee 1994 1995 1996 1997 1998 and up 1.5 1.4 2.1 3.7 5.5 5.9 5.9 5.3 2.7 2.1 $50,000 to $99,999 2.4 2.0 4.1 3.9 4.5 4.2 4.0 2.6 1.8 2.1 $30,000 to $49,999 2.3 3.8 4.0 4.0 3.7 4.3 4.0 4.1 2.7 2.5 $20,000 to $29,9999 2.5 2.5 3.1 3.7 4.4 3.2 3.9 2.6 2.5 2.5 $10,000 to $19,999 2.5 3.1 3.0 3.4 3.7 4.2 3.3 2.8 2.8 3.1 We note that yearlings sired by the higher-priced stallions had multiples below the other stud fee categories in the mid-1990s, had substantially greater multiples in 1998-2001, but declined substantially in 2002 and 2003. This table shows stud fee multiples for weanlings sold in 1994 through 2003, by stud fee range: Stud Fee 1994 1995 1996 1997 1998 and up 2.4 2.4 2.9 3.4 5.0 3.5 3.2 2.8 1.5 1.8 $50,000 to $99,999 2.0 2.2 2.8 3.1 2.9 3.0 1.9 1.5 1.6 2.2 $30,000 to $49,999 2.8 3.7 4.0 4.0 3.7 4.3 4.0 4.1 1.8 2.2 $20,000 to $29,9999 2.1 2.2 3.3 3.0 2.4 2.8 2.3 1.9 1.8 2.5 $10,000 to $19,999 2.3 2.3 2.7 2.8 2.8 3.0 2.3 2.3 2.2 2.7 Note that weanling sellers who bred to the highest-priced stallions have not on average achieved the highest multiples, except in 1998. In 2002 and 2003, stud fee multiples generally were lower the more expensive the stallion for weanling sellers. Dean, Dorton & Ford, P.S.C. Page 12
40% Graph IX Changes in Production Costs and Yearling Selling Prices for Breeders by Stud Fee Range and Decile Tier 1 Tier 2 Tier 3 Tier 4 Tier 5 Overall & up $50,000 - $99,999 $30,000 - $49,999 $20,000 - $29,999 $10,000 - $19,999 Average / 1st decile / 2nd decile / 3rd decile / 4th decile / 5th decile All Ranges Shown 29% 20% Change in Price 9% 6% 5% 10% 9% 8% 10% 0% -2% 0% 0% 1% -3% 0% -1% -7% -11% -12% -20% Change in Average Broodmare Change in Average Stud Fees Change in Average Yearling Selling Price by Decile (2002 to 2003) by Stud Fee Range (2003 to 2004) Price by Stud Fee Range (2002 to 2003) Data from the Blood-Horse and Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 13
Commentary on Graph IX In Graph IX, we try to provide insight into a critical question for breeders: Are your production costs increasing at a higher or lower rate than the prices you re receiving for your products? For costs of production, we focus on the two major elements: (1) broodmare costs based on public auction prices and (2) stud fees. For sales prices of breeders products, we examine auction prices of yearlings. The analysis is based on current production costs and current sales prices and does not attempt to correlate sales prices with the costs of producing these foal crops. In other words, we are focusing on current costs replacement costs and current sales prices. Specifically, we are measuring changes in stud fees by the change in published stud fees by stallion from 2003 to 2004. For broodmares, we are measuring the change in this cost by reference to changes in average auction prices from 2002 to 2003. Similarly, the change in sales price of yearlings is measured by reference to average auction prices from 2002 to 2003. We segment our analysis into five tiers: Tier Stallion cost stud fees of: Mare cost prices for reported sales at public auction: Sales prices yearlings sold at public auction and produced from stallions with these fees: 1 + Top 10% + 2 $50,000-99,999 2 nd 10% $50,000-99,999 3 $30,000-49,999 3 rd 10% $30,000-49,999 4 $20,000-29,999 4 th 10% $20,000-29,999 5 $10,000-$19,999 5 th 10% $10,000-19,999 These tiers can be considered to represent approximately the top one-half of the thoroughbred breeders market. We also show the overall changing cost and price levels for all the tiers we analyzed. The data shows mixed results. In the highest end of the market, broodmare prices are increasing but stud fees are declining somewhat. In general, the cost of broodmares is increasing (8%) and stud fees are relatively stable (-1%), resulting in somewhat higher production costs. Selling prices of offspring as yearlings are mixed, down for yearlings bred to the highest priced stallions, but up overall (10% for the stud fee ranges we analyzed see last column). Dean, Dorton & Ford, P.S.C. Page 14
Graph X Racing Purses and Numbers of Horses Racing 1990-2003 $1,300 Gross U.S. & Canadian Purses 100,000 Number of U.S. & Canadian Runners $1,200 $1,100 90,000 In millions of dollars $1,000 $900 $800 $700 $600 80,000 70,000 60,000 $500 1990 1991 1992 1993 1994 1995 1996 1997 1998 50,000 1990 1991 1992 1993 1994 1995 1996 1997 1998 $18,000 $17,000 $16,000 Average U.S. & Canadian Purses per Runner 8.00 7.00 Starts per U.S. & Canadian Runner $15,000 6.00 $14,000 5.00 $13,000 4.00 $12,000 $11,000 $10,000 3.00 2.00 $9,000 1.00 $8,000 1990 1991 1992 1993 1994 1995 1996 1997 1998 0.00 1990 1991 1992 1993 1994 1995 1996 1997 1998 Data from the Blood-Horse and Thoroughbred Times Dean, Dorton & Ford, P.S.C. Page 15
Commentary on Graph X From 1990 to 2003, average purses per runner have increased from $8,700 to $16,600 91%. However, 2003 average purses per runner decreased slightly from the 2002 and 2001 averages and was about the same as the 2000 average. From 1990 to 1994, the increase in purses per runner was due primarily to a decrease in the number of runners (by 17%) gross purses changed only negligibly from 1990 to 1994 and were slightly lower in 1994 than in 1990. From 1994 to 2001, on the other hand, the increase in purses per runner was due primarily to an increase in gross purses available to owners (by 53%). Gross purses flattened-out in 2001-2003, and with an increase in number of runners during this period, average purses per runner declined in 2002 and again in 2003. Note that 2003 was the fourth consecutive year of increases in the number of runners and the tenth consecutive year of increases in gross purses (although gross purses increased only negligibly in 2003). We also note that the increase in average purses per runner from 1990 to 2003-91% - has kept pace with the increase in the average cost of purchasing yearlings over the same period 64%, but is below increases in the cost of purchasing weanlings and two-year-olds 117% and 125%, respectively. Starts per runner continued to decline in 2003, the eleventh consecutive year. In 1992, the highest of the 14 years considered, average starts per runner was just over 8; by 2003, the average had declined to 6.6. Dean, Dorton & Ford, P.S.C. Page 16
2003 TAX DEVELOPMENTS The most noteworthy 2003 tax developments impacting horse and farm owners were favorable federal law changes signed by President Bush in May. The changes which impact owners most directly relate to depreciation deductions and capital gains. Bonus depreciation. In the aftermath of the 9/11/01 terrorist attacks in the U.S., Congress enacted legislation intended to reduce the economic impact. Included was a provision which allowed bonus depreciation of 30% of the cost of qualifying property acquisitions principally assets which are depreciable over not more than 20 years and with original use of the asset commencing with the acquirer. The remaining 70% of the cost of qualifying property was depreciated in the normal manner. In 2003, Congress expanded the bonus depreciation amount to 50% of the cost of qualifying assets placed in service after May 5, 2003 and before January 1, 2005. Note that the 30% and 50% bonus depreciation provisions apply to large and small businesses there are no sized-based limits, and the deduction is allowed whether or not the business has taxable income. Meeting the original use requirement to qualify for bonus depreciation is an issue for many horse purchases. Our interpretations of the rules, as they would be applied to horses, are as follows: A horse acquired for breeding would seem to qualify only if it had been neither bred nor raced previously. A horse acquired for racing would seem to qualify only if it had not raced before. If the acquirer s practice is to treat a racehorse as placed-in-service when it enters training, an acquisition of a horse already in training, even though unraced, may not qualify. If the acquirer s practice is to treat a racehorse as placed-in-service when it first races, an acquisition of an unraced horse in training should qualify. For farm owners, a variety of assets, if the original use requirement is met, will qualify. These include equipment, fences, roads, other depreciable land improvements, and farm trucks. Dean, Dorton & Ford, P.S.C. Page 17
Section 179 expensing election. Prior to the 2003 change, smaller businesses could deduct up to $25,000 annually of the cost of certain depreciable property additions, new or used, subject to a phase-out when qualifying property additions exceeded. The 2003 legislation increased the deduction to and increased the phase-out starting point for qualifying property additions to, effective at the beginning of 2003. As before, the deduction remains available only to the extent of the taxpayer s net business income. The deductible amount is not impacted by when during the year the property is placed in service late year qualifying additions receive full benefit. Because the original use requirement does not apply to this deduction, horses need not be previously unused to qualify. Capital gains. The top rate on most long-term capital gains was reduced from 20% to 15%, effective for gains recognized after May 5, 2003. In general, gains on sales of horses qualify for long-term capital gain treatment if the horse has been held for more than two years. For a horse the seller had been depreciating, only the portion of the sales price exceeding the original cost basis would qualify. Dean, Dorton & Ford, P.S.C. Page 18