|Shares Out. (in M):||107||P/E||23.0x||20.0x|
|Market Cap (in $M):||5,503||P/FCF||13.8x||10.9x|
|Net Debt (in $M):||2,470||EBIT||442||542|
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On November 15, 2012, Penn National Gaming (PENN) announced their intention to spin out into a REIT (PropCo) and Operating Company (OpCo) and concurrently issue a special one-time dividend of $5.35. They are aiming for the transaction to close effective January 1, 2014. While the “REIT-ing” trade is justifiably questionable in its trendiness as a piece of financial engineering, it has generally been quite successful in terms of stock performance (see LAMR and AMT as recent examples). In theory, one can argue if this type of restructuring generates any value for the economy, as it is primarily a tax arbitrage, and secondarily a play on investors’ quest for yield in a zero interest rate world. In practice however, these transactions have unlocked a lot of value for investors in companies that are cash flow rich and not currently getting a lot of credit for high levels of stable, but often not dramatically growing, free cash generation.
PENN is a regional casino company operating 29 properties in 19 jurisdictions. Their properties are drive-to locations serving local customers. Profits come primarily from slot machine operations, and the most profitable players are the most frequent visitors. Typical customers come with a pre-set betting budget, often $100 or less. This is a business of catering to “low rollers”. As one might expect given the clientele, the business is highly economically cyclical and can be impacted greatly by factors such as employment levels, regional housing prices, and gas prices. The profitability of any given regional casino can also be greatly impacted by 1) the level of state gaming taxes which vary greatly state to state, 2) the number of competitors within a reasonable driving distance. The investment in any given property is driven to a large extent by these two factors, the first of which is unlikely to change, but the second of which is an ongoing risk, as new properties can always be built and there has been a general trend to new jurisdictions adding gaming licenses as state budgets become increasingly strapped and are looking for new tax revenue sources.
The transaction proposed creates a PropCo (the REIT) which will lease out the casino real estate to a casino management company (the OpCo), who will pay all the operating expenses of the casino as well as a fixed rent. Essentially about 50% of current EBITDA is being targeted as the fixed rent, with annual escalators. OpCo will pay this rent out to PropCo, and in addition will reimburse PropCo for its real estate taxes, insurance, and some maintenance and utility expenses, making PropCo what is called a triple net REIT. Since only about 50% of current EBITDA is going to fixed rent, EBITDA would have to be cut in half before PropCo’s ability to collect rent is affected. Under the terms of the fixed rents proposed, PropCo should be able to pay a dividend of $2.36 per year. Most triple net REITs trade at a dividend yield of 7% or less. At the average 6.6% triple net REIT yield, the PropCo would be worth $36.
The creation of a PropCo stock also creates a potentially valuable currency, the sale of which can be used to finance growth initiatives. Raising money to build new properties may in fact prove much cheaper within the PropCo/OpCo structure because the PropCo will get a higher value than the legacy PENN security did (because it caters to an investor class looking for yield). At $36, the PropCo REIT would trade around 13x EBITDA, which compares to regional casinos which generally trade around 6-7x EBITDA and the current PENN entity which trades around 9x (a premium to other regionals because of this pending transaction). Growth at PropCo in terms of number of properties or size of existing properties would ultimately create an opportunity for the revenue stream at OpCo to grow as well.
OpCo will manage all of PropCo’s properties, and additionally will own and manage the JV interests currently residing at PENN. Given its high rent commitments, OpCo will be fairly leveraged and will have a more volatile cash flow stream than both PropCo and the current PENN. On the plus side, PENN always has been the best operator in the regional business, and the creation of a management company with their people opens up new growth opportunities that potentially weren’t there when they owned the real estate – they can manage properties for a fee for other casino companies, or sign on with developers as a manager to future projects. The best way to value this piece of the business is using an EV/EBITDA multiple. Using 7x projections of $411mm in EBITDA (and assuming $1.2 bn in debt and 83.5 mm shares) gets you to $20 (which incidentally correlates with about an 11% free cash flow yield).
$36 for PropCo plus $20 for OpCo plus $5.35 for the cash dividend yields a target price of $61.35, approximately 19% above the closing price on 2/14/13 of $51.58. While the potential for 19% returns may not seem like the most sexy trade in the world, the ratio of potential return to risk is very good because fair value on the old PENN based on a conservative 10% yield on free cash flow after maintenance capex yields a base case price of $47.50, only 8% down from here, versus the 19% upside potential. I would be more aggressive in accumulating the stock under $50 (where it has recently traded), because at $50, the reward to risk ratio expands from the current 2.4 to 1 to a more attractive 4.5 to 1. While a 2.4 to 1 reward to risk ratio is good not great, the stock is definitely trading like an event name, and seems fairly immune to price movements based on current business trends. In late January, PENN reported fairly tepid results for Q4 and gave weak guidance for 2013. The stock nevertheless held quite steady, suggesting the shareholder base is looking beyond current results and is most concerned with just getting this proposed transaction to close. The reasons for the weakness in results and guidance included a slower than expected ramp up of revenues at their new Ohio properties, reduced visitation frequency by lower end customers in all markets (the economy), and pressure in the Gulf Coast markets. Essentially, weak macro conditions are pressuring the top line. The stock brushed off the gloom and doom of the fundamentals because the company said on the Q4 call that they had gotten a Private Letter Ruling from the IRS about the proposed transaction, so one element of risk to the deal closing had been eliminated. Also, I think people knew a guide down was likely given the monthly gaming revenue numbers being reported by individual states, so new 2013 EBITDA guidance that was only 3% below previously issued guidance was a relief to many.
It’s worth noting that the management team of PENN has proven themselves extremely financially savvy in recent years. These guys are not only best operators of all the regional players by a mile; they are extraordinary manipulators of the capital markets. Whereas LVS and MGM almost bankrupted themselves by making unfunded capital commitments in 06 and 07, these guys sold themselves in an LBO at the top of the market to Fortress, and managed to negotiate into the deal a huge break-up fee which later allowed them to accretively buy distressed assets when the deal broke in the financial crisis of 2008. They used their break up money to buy both their own bonds and a great locals-oriented property in Vegas when the owner/developer got in trouble. But they were judicious – they almost bought the half-built Fontainebleau in Vegas but walked away, leaving it for Icahn to take. That property remains mothballed and probably will be for the next decade, at which point it will have had huge structural deterioration. It feels like this currently proposed financial engineering transaction is just one more in a long line of rabbits pulled out of a hat by this management team.
The main risk here is regulatory. These REIT break-up corporate transactions have been popular, but it is hard to argue that they create any value for the economy, and instead create benefit only for investors. At some point, the government could theoretically get stricter about what they allow to take on a REIT status, as REITs were traditionally a tax structure reserved for companies whose primary function was renting out real estate, e.g., office property companies, apartment landlords, mall owners, and warehouse developers. The chance of this risk materializing is hard to handicap, although I would say that there are other companies that have done a REIT transaction where the argument that the business was a property business was a far bigger stretch than at PENN (e.g., the cell towers). There is also the risk that the transaction slips to January 1, 2015 as opposed to January 1, 2014, which would lower the IRR from here to the target price. And of course anytime you invest in anything related to gaming, you are taking on the regulatory risk of changes to state licensing and tax levels, and the emergence of new competition taking advantage of such changes. The final risk is that this is a classic event-driven situation and popular with the arbitrage hedge funds, so if something were to happen with the deal, you would have a lot of funds that don’t know or care the fundamentals of the sector selling, and the stock would overshoot the fair value of “old PENN” on the downside. The fair value if this transaction doesn’t happen is still probably $47.50 or higher based on cash generation, but supply/demand would force it lower if the deal broke.
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