Penn National Gaming PENN
August 06, 2003 - 8:34am EST by
2003 2004
Price: 21.51 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 846 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Recommendation is long PENN stock. Priced as of 8/5 @ $21.51

PENN is a leading owner and operator of gaming properties, as well as horse racetracks and associated off-track wagering facilities. PENN owns and operates eight gaming properties located in Canada, Colorado, Illinois, Louisiana, Mississippi and West Virginia. PENN also owns two racetracks and eleven OTWs in Pennsylvania, and operates, through a joint venture, a racetrack in New Jersey.

Management of PENN is routinely regarded as one of the best in the gaming industry. From 1994, PENN’s revenue has grown at a 42% CAGR while EPS has grown at a 34% CAGR (1994-2003E). At the same time, PENN has done a commendable job maintaining a solid balance sheet. At the end of 2Q:03, net debt/EBITDA stood at 3.8x 2003 ests. I expect strong EPS and cash flow growth to continue over the next several years. It is important to note, free cash flow should be over $1 higher than EPS in that ongoing maintenance capex should be roughly $30M compared to $80M in run-rate depreciation expense including the capital required to build-out the racinos.

Estimates follow below:

EPS FCF (maint CapEx) EBITDA Net debt Leverage
2001 $0.75 $1.39 $112.3M $421M 3.7x
2002 $0.94 $1.50 $141.4 $339 2.4x
2003E $1.52 $2.24 $238.1 $991 3.8x
2004E $1.93 $2.96 $288.4 $969 3.4x
2005E $2.88 $3.93 $346.1 $804 2.3x
2006E $3.47 $4.46 $374.6 $613 1.6x

In the midst of a budget crisis, the state of Pennsylvania is on the cusp of legalizing slot machines at horse race tracks (“racinos”) to generate revenue for education and property tax relief. While legislation is never a sure thing, through our extensive checks, we believe the probability that a bill will be passed in the near future is high. The legalization of slots in Pennsylvania should provide material revenue, EPS and cash flow upside to current levels. I believe investors have assigned a low probability to a slots bill passing. Additionally, I believe investors are underestimating the earnings potential of these potential racinos. Here in lies the opportunity.

Penn National owns and operates 2 tracks that would directly benefit from the legalization of slot machines in Pennsylvania. The passing of a slots bill should be a significant accretive event.

• When the slot bill is passed, PENN’s racinos should generate an INCREMENTAL $400M/$100M/ $1.00 in annualized revenue/EBITDA/EPS respectively.

Slot assumptions at full-run rate are as follows:

Upfront license fee: $50M/license ($100M for Penn in total)
Capital costs: $150M ($50M for the slot machines, $100M for the buildings)

# of machines: 5250 (2 tracks)
Win/day/machine $200 (Penn’s Charlestown facility averages $250-$325)
365 days/year
Slot revenue $383M
Taxes/purse cut (54%) (207)
Op costs (19%) (73)
Margin 27%
D&A (15)
Interest (20)
Pre-tax $68M
Taxes (@39%) (26)
Net Income $42M
Diluted shares 41M
EPS $1.00

While this issue is very complex, I will seek to summarize it. The governor, Ed Rendell (Democrat), was elected in November 2002. The legislature (both house and senate) is controlled by the Republicans. The key issue of Rendell’s campaign was to lower the property tax and increase education spending primarily through legalized slot machines at the racetracks and a hike in the personal income tax. In June the senate passed a bill to legalize up to 3000 slot machines at 8 racetracks. In Mid-July the House amended the bill to include 9 racetracks and 2 “slot parlors” in Pittsburgh and Philadelphia.

There are additional wrinkles but in a nutshell the senate has effectively killed the house bill paving the way for negotiations between the house, the senate, and the governor as I have expected. What’s important to note is both the house and the senate bill are nearly identical to PENN. The issues at stake are whether they allow the slot parlors in Pittsburgh and Philadelphia and a few qualitative issues such as whether casino owners can contribute to politicians. The slot parlors in Pittsburgh and Philadelphia will not pose a competitive threat to PENN due to their geographic distance.

Without getting into much more detail, I believe that Pennsylvania will sign a slots bill into law within the immediate future (2 weeks to 2 months). The legislature and the governor are currently at a stalemate and are making little progress in their negotiations towards Rendell’s education agenda as there is no appetite for a personal income tax hike. A majority in both chambers support some form of slot legalization and it is just a matter of time until they work out an agreement.

Hollywood Shreveport, a poorly capitalized casino operated by Penn National, recently announced they will not make an interest payment on its 13% notes. (The notes are non-recourse to Penn National so cross-default is not a risk.) Penn management has publicly stated for some time they will not undertake any transaction that is not accretive to shareholders.

I believe Penn will re-capitalize the casino (with input from bond holders) reducing its cost of capital from 13% closer to 8%. We estimate once recapitalized, annual interest expense will drop to about $8M while EBITDA should rebound from a low of $10M to roughly $20M as PENN management re-focuses its effort on the property. (We believe management has let the asset wither as a negotiating ploy with bondholders.) $20M in EBITDA equates to just a 17% EBITDA margin, conservatively 500bps below PENN’s blended corporate margin of roughly 22%. Under this scenario the recap of Shreveport could add $0.20 to annual operating EPS. We expect a resolution in 6-12 months.

PENN acquired Hollywood Casino Corp in early March 2003. As a result of the Hollywood acquisition, PENN owns a casino in Aurora, Ill. Several months later, Illinois enacted a series of “un-economical” gaming taxes and fees to alleviate its fiscal crisis. As part of the new tax structure, the state raised the marginal tax rates on gaming revenue, enacted a per head fee on gaming patrons as well as raising the parking fee to generate more revenue to offset its own budget crisis.

As an example of the severity of the “anti-gaming” fees, Illinois increased the highest marginal tax rate on REVENUE (not income but revenue) to 70% from 50% on gaming revenue over $250M. So for every $1 in gaming revenue, 70 cents goes to state. At first cut, the Illinois resolution would have been a $0.40 drag on EPS, but management has taken steps to mitigate the additional tax burden by roughly $0.20 through head count reduction, the removal of lower margin table games and the implementation of an entry fee on low-revenue customers.

The Illinois resolution will either “sunset” in two years or reversed if a tenth gaming license is awarded. (There appears to be an appetite in the Illinois market as evidenced by Park Place’s announcement it is interested in building a property in Chicago). Although I am not modeling an improvement in Illinois, managements cost cutting initiatives and the ultimate reversal of the resolution could add a $0.40 tailwind to core operating earnings when it is resolved, not to mention the opportunity to grow the business which was PENN’s intention when acquiring it.

Although I expect the core business to post solid growth going forward, for illustrative purposes, I have presented a simple table to demonstrate the BASE Core earnings power of the business. It is important to note, free cash flow should be over $1 higher/share in that ongoing maintenance capex should be roughly $30M compared to $80M in depreciation expense

2003E base year $1.55
plus: Racinos $1.00
plus: Shreveport $0.20
plus: Illinois $0.40
Pro forma EPS $3.15

Applying a simple relative 10x multiple to 2005 free cash flow yields a $40 price target. We believe this multiple is conservative for a variety of reasons.
• Argosy, an inferior riverboat casino operator with little to no growth prospects and a poor operating track-record trades at 11x forward free cash flow.
• Station Casinos, a faster (albeit not by much) growing casino operator trades at 14x forward free cash flow.
• Gaming analysts typically value gaming stocks using EV/EBITDA (which we do not subscribe to because it fails to capture the capital efficiency and free cash flow generation of the business). On this metric, at $40, PENN will be trading at 7.0X our 2005 EBITDA estimate with projected EBITDA growth in 2005 of 20%

Assuming none of the above mentioned catalysts actually transpire, I believe downside risk is limited supported by the company’s strong free cash flow characteristics. I estimate PENN will generate $2.24 in free-cash flow (using $30M in maintenance capex) this year increasing to $2.54 in 2004. Assuming a modest 10 multiple on free cash flow yields a $22 target on 2003 estimates.

Additionally, PENN’s signature property in West Virginia faces potential competition if Maryland legalizes slot machines in the future. The state has debated this issue but appears to be a dead issue for now, though ultimately even if they were to pass a bill in 2004 the first casino wouldn’t be open until mid 2005 and Charles Town will be significantly larger in two years. I estimate the Charles Town gaming market to be only 15% penetrated where mature gaming markets typically reach 50% penetration. Finally, Charles Town gets approximately 30% of their EBITDA from Maryland but 50% of the Maryland market is closer to Charles Town than to the Maryland racetracks. This means in worst case scenario Charles Town EBITDA would decline by 10-15%, which is highly unlikely given how young the market is.


• Legalization of Slot Machines at Pennsylvania Racetracks (within the next few months)
• Resolution of Shreveport Property (6 months to 1 year)
• Rollback of Illinois Tax Hike (within the next 2 years)
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