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The analysis and research of the gaming sector keeps bringing me back to a few themes: liquidity, cost of capital, and return on investment. Excess liquidity kept borrowing costs artificially low, allowing most gaming companies to over earn for a long time. Meanwhile, the same excesses allowed these same companies to pursue lower ROI projects and over leverage their balance sheets. As the ROIC chart shows, lower ROI on incremental developments began to push down industry ROIC in Q4 2006. Obviously, this also impacted ROE which began to fall in Q1 2007. The problem for the industry is that ROIC will likely continue to decline with the double whammy of escalating borrowing costs. ROE should fall at a faster rate over the next two years. Not good for equity holders.
  • A bear might counter that falling industry ROIC should have the same impact on PENN. A surface analysis might indeed conclude that. However, PENN has the ability, liquidity, balance sheet, and a buyer’s market to actually improve its economic ROE, even if the negative industry ROIC trend continues. Why would an investor buy any other similarly valued equity when the economic ROE spread between PENN and everyone else is widening, not that it isn’t already wide. See the ROE chart.
  • Why do I keep referring to economic ROE? I’ll have another post on that shortly but for now, accounting ROE is likely to look worse for PENN following the termination of the merger agreement with Fortress and Centerbridge. The $1.25 billion zero coupon preferred equity investment will be treated as equity which is rarely a positive in the ROE calculation. On an economic basis, however, ROE should climb post deployment of those funds, again even in a declining ROIC environment for basically three reasons:

    • Given management’s track record, any acquisition will likely be ROE enhancing
    • It is a buyer’s market for gaming assets/companies and PENN should face limited competition
    • Additional debt will lever returns

  • PENN holds all the cards in a very trying time for the gaming industry. The environment appears ripe for management to do what it has always done: create shareholder value.