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$5 in free cash flow – ‘nuff said.  Umm, not so fast.  There’s a lot more to say.

That is the bull case in a nutshell - $5 in free cash flow per share post deal.  I’ve heard it/read it from the buy side and sell side alike.  In fact, I’d go so far as to say it is consensus.  PNK is a consensus long.  There, I said it.  And why wouldn’t it be?  With the acquisition of Ameristar (ASCA), $5 in free cash flow per share is coming in 2015 for a yield of 25%.

But wait, wasn’t that $5 calculated pre-divestitures?  And if you like PNK with 25% yield, then you must love Boyd Gaming (BYD) at over 25% with less leverage.  Come to think of it, there are a lot of holes in the long PNK thesis.

  • $5 is not sustainable.  PNK maintains $271 million in federal NOLs – which have value but should be valued separately (NPV of over $1 per share) – so the $5 should be tax effected to calculate recurring FCF.  This adjustment results in FCF per share of $4.05 to $4.25.  But…
  • The $5 was calculated before the FTC forced PNK to divest ASCA Lake Charles and Lumiere Place.  Assuming these assets can be sold for 7.0-7.5x EBITDA, the $5 becomes $4.30-4.50.  Tax effected, FCF per share drops to $3.25-$3.45.
  • So $3.35 is not a bad number right?  Well, let’s not forget about leverage and its impact of FCF yield.  More than 6.5x post deal leverage is not sustainable.  Free cash flow will not accrue to equity holders until PNK reduces its leverage to under 4x or 2018 at the earliest.
  • All this FCF accretion and calculations are predicated on the sustainability of this ridiculously low interest rate environment.
  • As a reality check, let’s evaluate the old gaming valuation standby metric of EV/EBITDA.  I calculate a multiple of over 8.0x 2014 EV/EBITDA and 7.5x 2015.  Remember that regional gaming companies have traded within a range of 5.0-8.0x forward 12 months EBITDA.
  • But valuations have been re-rated higher as gamers are viewed through the real estate prism.  PENN’s announced REIT conversion certainly had this impact.  However, we don’t think PNK will reach low enough leverage to pursue a REIT conversion until 2019.
  • The real estate angle notwithstanding, do we really want to put historically high multiples on a business with declining ROICs and falling ROIs on new builds?  The US is already saturated with slots and there is no end in sight in terms of potential for new states legalizing casinos. 
  • At the same time that supply is increasing, demand is waning – and it’s not the economy, stupid!  Domestic casinos face a declining slot customer base.  The data suggests that Baby Boomers are the last of the generational slot players.  I’m Generation X – the Atari generation – and I’m not going to start playing slots when I turn 60.