PENN SHAKES UP VALUATION

The REIT/OPCO split certainly adds value and should create a new valuation paradigm for regional gaming operators.  ASCA – yes; MGM, CZR, LVS, WYNN – no.

In the making for a year, PENN’s blockbuster announcement last night should be a boon to regional gaming stocks, especially PENN.  When the transaction consummates in 9 to 12 months we currently project total value at $44-62.  The news is likely to propel all gaming stocks higher but we believe this structure is only possible for companies with lower leverage and high free cash flow.  Folks, it’s not happening with MGM and CZR and unlikely for WYNN and LVS so we would fade any strength today in those names.  Instead, we would focus on the regional gaming operators – specifically ASCA.  While we caution it would take 2 years for ASCA to pull something off like this, it’s a no-brainer for them.

The details of PENN’s transaction are complicated, the premise is quite simple.  REITs are much more tax efficient so instant value is created.  Moreover, the split capitalizes on the arbitrage card between how REIT investors value companies vs. how gaming investors value companies.  REIT investors value companies based on how much cash they throw off and hence how much they can return to shareholders via a dividend.  Gaming investors use an EBITDA multiple which gets adjusted based on the quality of a management team, growth prospects, and stability of underlying assets.   Using one methodology can get you a premium of 50% over the other, and hence the arbitrage. 

So what is this deal essentially doing?

• PENN is putting roughly 50% of its EBITDA and guaranteeing it as fixed rent with annual escalators into a new REIT entity.  
  • The new entity will be structured as a triple net REIT, meaning that PNG (the operating company) in addition to paying fixed rent to the REIT would also be responsible for real estate taxes, insurance, some maintenance and utility expenses (basically most of the operating expenses). 
  • By setting the fixed rental payments at roughly 50% of the assets existing EBITDA, PENN’s REIT will have 2x coverage.  This means that EBITDA would have to drop by approximately 50% before the rental payments are endangered. 
  • Under PENN’s guidance, the REIT should be able to pay a dividend of $2.36/share in 2013.  Most triple net REITs are currently trading on a dividend yield of 7% or less.
• Create an operating entity that will manage all of PENN’s wholly owned properties and own/manage PENN’s JV interests.  Given the high fixed rental payments due to the PROPCO REIT, the operating company will have a more volatile cash flow stream – akin to a highly leveraged gaming company (MGM/CZR) - and should trade at a lower multiple than PENN currently trades.
  • Regulatory risk (changes in tax rate, gaming legalization of neighboring markets), impact of new competition, and economic risk
  • Maintain the upside of the Ohio VLT facilities

We haven’t had time to go through all the numbers, but based on management’s guidance, we believe the new structure should create a value package of between $44-$62/share at closing.  Below are some of the key variables:

• PROPCO REIT
  • 1x special dividend of $1.4BN or $15.40/share ($487 million is cash)
  • 2013 base case dividend of $2.36/share that we think should be valued at a 6-8% yield or a 12.5x implied 2013 EV/EBITDA multiple ($30-$39/share).  Yes, we realize this is a discount to where most REITs trade, but this is justified given:
    • Unique asset class (i.e. of its own)
    • Single tenant risk
    • Regulatory and competitive risks
    • Less asset diversification than many truly “National” REITs
    • Lower value of underlying Real Estate assets compared to other asset classes
• PNG OPCO
  • Based on today’s closing price, PENN trades at roughly 7x 2013E EBITDA
  • We believe that PNG OPCO should trade at a material discount of 5.0-6.5x ($10-$17/share).
    • When factoring in the rental payments and the 3x leverage, PNG OPCO will in-effect be a highly leveraged entity that bears the following risks:
      • New competition 
      • Regulatory 
      • Economic
  • Offset by some growth opportunities and still a fairly healthy FCF yield

So what are the implications for the other gaming operators and why wouldn’t other operators look at this structure if PENN’s stock reacts favorably to the spinoff?

• The second question is actually easier to answer.  In order to pursue this kind of structure successfully, gaming operators need to have:
  • Low leverage is key and the largest barrier
    • Healthy REITs need to have good dividend coverage ratios – usually at least 1.75x.  So not only will a gaming REIT have to convince investors that its rental base is stable (“bond-like”) but leverage also needs to be reasonable in order to be able to pay a generous dividend yield.  The operating company will also have to have low leverage, given that they will already have a large fixed rental obligation that rating agencies take into consideration.
• Diversified and stable cash flow stream
• Given the regulatory and competitive risks inherent in the gaming business, coupled with the discretionary nature of the product, cash flow diversification is key to getting a good multiple/yield
• Low cash needs
• Since REITs pay hefty dividends, companies that need to save their cash for a development pipeline or that have heavy capex needs are not good candidates for this type of structure
• At the very least, gaming investors should be forced to pay more attention to FCF yields vs. just slapping a multiple on to EBITDA

PENN maintained the lowest leverage of any gaming operator so it was the classic fit.  Given its high free cash flow, stable markets, and low capital needs following the opening of Lake Charles in two years, we think ASCA is the most likely pursuer of the PENN strategy.