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Investing The Hard Way: How and Why Penn National is Splitting Up

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It really is a big deal for the casino industry. On Friday, shares in Penn National Gaming (PENN) rose 28.2% after the company announced plans to spin off the ownership interest in most of its casinos into a real estate investment trust, or REIT. The new REIT will own Penn’s physical assets, while Penn National’s remaining operating business will lease those properties under a lease that could last as long as 35 years.

Investing The Hard Way: How and Why Penn National is Splitting UpThe idea itself is not necessarily new – Las Vegas Sands (LVS) CEO Sheldon Adelson noted the possibility of a similar move in the conference call following his company’s third quarter earnings release – but Penn is the first company in the industry to actually commence the process of monetizing its real estate holdings. Indeed, the as-yet-unnamed REIT will be, as Penn noted in its press release announcing the move, “the first gaming focused REIT” in history. The potential for a new operating model in the casino industry boosted a number of stocks, including Penn’s domestic competitors. Ameristar Casinos (ASCA) rose nearly 16%, while Isle of Capri Casinos (ISLE), Boyd Gaming (BYD), and Pinnacle Entertainment (PNK) all gained 7% in trading Friday.

The details are massively complicated, particularly given the nearly $1 billion in Penn preferred stock held by private equity firm Fortress Investment Group (FIG). That preferred stock will be exchanged for common stock, then Fortress will sell all or a portion of its stake (perhaps to PENN itself); Penn must also re-finance the entirety of of its existing debt, some $2.7 billion. Penn will then distribute shares of the new spin-off (currently referred to as PropCo, short for “property company”) to its shareholders; that initial distribution is expected in the fourth quarter of 2013, according to a presentation prepared by Penn for analysts and investors. An additional, taxable dividend, paid by the PropCo and consisting of approximately $5.35 per share in cash and $10 per share in PropCo shares, will follow shortly thereafter. By early 2014, the PropCo will have been certified as a REIT, and will own 19 of Penn National’s current properties. The remaining Penn National segment – currently referred to as OpCo, short for “operating company” – will retain ownership of seven racetracks, the Hollywood Casino at Kansas Speedway joint venture, and a few other tangible and intangible assets.

In short, within 15-18 months, current Penn shareholders will have received $5.35 in cash, and 1.38 shares in the PropCo REIT, while maintaining ownership in the legacy operating company. That company will lease the 19 properties under a “triple net” master lease. Under the terms of a triple net lease, the Penn operating company – not the REIT – is responsible for maintenance, insurance, and taxes on the property. The REIT will then collect rent from the OpCo – currently estimated at about $450 million annually, according to the company – and distribute that rent to its shareholders.

It is the move of the property company to REIT status that is the key benefit for Penn shareholders, and a main reason why Penn stock gained so dramatically on Thursday. Under US tax law, REITs do not pay any federal income tax, provided they distribute 90 percent of their profits to shareholders. That dividend would be about $2.36 per current PENN share in 2013, according to the guidance given by Penn National. According to Morningstar, the average dividend yield for REITs in September 2012 was 4.3%, down sharply from a historical average of 7-8%. With US Treasury bills offering interest rates below one percent, and personal savings accounts offering even less, investors have flocked to dividend-paying instruments such as REITs to gain some sort of return on their money.

Were the PropCo to pay out $2.36 per current PENN share in 2014 – repeating its hypothetical performance from 2013 – its per-share distribution would be $1.71 for the full year. At a 4.3% yield, that would value each PropCo share at nearly $40, meaning the PropCo spin-off alone could be worth as much as $55 per current share of Penn National. Moving back toward more historical REIT valuations – or accounting for the perhaps more risky business of leasing a casino, versus single-family homes or apartments – at 7.5% yield, the PropCo spin-off would still be worth over $31 per current PENN share. Add in a $5.35 cash dividend, and it’s easy to see why PENN stock jumped to $48.23 on Friday. Even with a 28% jump, it is still possible that investors at the $48 per share price could, in a little more than a year, get the Penn National operating business for free if the market has faith in the profit potential of the REIT. According to theflyonthewall.com, analysts at Deutsche Bank have a similarly rosy projection, arguing that Penn’s “sum-of-the-parts” valuation was $65 per share; RBC Capital meanwhile, put the company’s updated value in a range between $41 and $67 per share, maintaining an “Outperform” rating on the stock.

While it may seem somewhat ridiculous on its face that a simple financial restructuring could create nearly $1 billion in shareholder value in a single day – as Penn’s announcement did – the tax and valuation implications of the move to REIT status are a game-changer. There’s a reason that not only Penn National, but Ameristar, Pinnacle, and others – including international players MGM Resorts International (MGM) and Las Vegas Sands – saw their own stocks jump on Friday. Simply put, the REIT structure means that a company can make the same amount of profits – yet its shareholders will receive better returns, since the US federal government will not receive a slice of the earnings. Nor is this a loophole – like an offshore account or the moving of a company’s headquarters to a P.O. Box in the Cayman Islands – that is legally or ethically questionable, or might be closed down by regulators or Congress. There are over 150 publicly traded REITs, with holdings ranging from residential properties to office buildings to hospitals and nursing homes, and many thousands more that are privately held. And Penn’s innovative restructuring – complete with a per-negotiated blessing from the Internal Revenue Service – has laid a blueprint for other casino operators to create similar plans to unlock the value of their real estate assets.

All that said, it seems likely that many casino stocks may pull back in the short term. The effect of Penn’s restructuring on share prices in the sector will likely be similar to the effect of the US Department of Justice‘s re-interpretation of the Wire Act late last year. The news of new potential profits from legalized American online gambling drove up stock prices; but, within days, as investors digested the long, slow road to those profits, the euphoria faded, and so did share prices. Penn spent over eighteen months developing the REIT proposal; its competitors will need to spend significant time as well if they want to mimic Penn’s restructuring. It would be unsurprising if investors again showed their impatience in the next week or two; but, in the long term, a wave of REIT restructurings could energize the domestic stock sector, an industry that has long been facing the twin challenges of low growth and high competition.

There is a secondary aspect to Penn’s move that was far less covered in initial coverage of the restructuring, one that may have an additional transformative effect on the space. In its presentation accompanying the spin-off announcement, Penn listed the rationale behind the transaction. The first bullet point read “Competitor Opportunities.” Penn wrote that the spin-off would give the company the “ability for REIT (PropCo) to enter into agreement with PNG [Penn National Gaming] competitors and utilize first-mover advantage to secure transaction flow.” Translated from corporate-speak, this means that Penn’s REIT is not going to sit quietly, collect quarterly rent checks from its nineteen properties, and pass along 90 or 93 percent of that cash to its shareholders. The PropCo is going to offer the same services to other US casino operators that it has to Penn’s OpCo. It will attempt to create what are known as “asset sale-leaseback” transactions, in which a casino owner sells a property to the PropCo – generating potentially a few hundred million in cash – and then signs a long-term lease for that property. In other words, Ameristar, MGM or Pinnacle could take the time and expense to create their own casino REITs, or they could just go sell their real estate to the Penn National PropCo, lease the property – or properties – back, and use the upfront cash to pay down debt, lower interest expense, and boost near-term earnings. For companies like Isle of Capri, MGM, and Boyd Gaming, whose debt loads substantially exceed their market capitalizations, asset-sale leasebacks could provide additional financial flexibility. A leaseback deal could be used to repurchase existing debt, or to fund a new project without issuing additional bonds at a potentially high interest rate.

For companies like Ameristar and Pinnacle, with less debt-heavy balance sheets, leasebacks could be used to create special dividends for shareholders, or repurchase stock. Private equity firms could use leasebacks to fund buyouts of entire companies, using the cash raised from asset sales to offer a premium for a company’s stock.

Again, this is a big deal for the US, and potentially the international, casino industry. The fact that the REIT structure has moved from a hypothetical concept detailed in analyst notes and hedge fund proposals to a concrete proposal opens up entirely new sources of funding, and new potential for profits and shareholder returns in the industry. Friday’s share price gains make sense; the monetization of real estate assets could potentially mark a sea change for the casino industry.

But what hasn’t changed in casino stocks, particularly in the US, is the need for investors to focus on management, execution, and balance sheets. Just last month, I called Penn “the best-in-breed regional operator” and complimented the “long-term success of Penn National’s management,” notably CEO Carlino. (Ignore the fact that I also wrote that “at its current share price, it doesn’t look like that will be enough.”) Good management comes up with innovative ways to create shareholder value, and Penn’s restructuring does exactly that. It creates a more tax-efficient way to return capital to shareholders; and the REIT itself could take advantage of the shaky financial standing of other operators to negotiate favorable asset sale-leaseback transactions. Execution still matters; no matter who owns the casino, there will still be a fierce battle for the customers coming in those doors. And balance sheets remain key. For companies with less debt, the financial engineering unleashed by REIT conversions could allow for creative, profitable ways to reward shareholders, expand operations, or purchase existing properties with a lower cost of capital. For companies struggling under the weight of debt-heavy balance sheets, leasebacks may provide some room for maneuvering, but they can’t be a cure. Note the one exception to Friday’s broad gains in the casino sector: Caesars Entertainment (CZR). With $20 billion in debt, there simply isn’t enough capital from a Penn REIT – or anywhere else – to monetize enough properties to change Caesars’ fundamental problems. Nor can the company create its own REIT, since its existing debt prohibits such a spin-off and it can’t simply re-finance its debt, as the better-capitalized Penn National will this year. Caesars stock fell two percent on Friday, to $4.58, near an all-time low.

But for those companies already well-positioned financially – like Penn and Ameristar – the REIT revolution could bring big changes for the industry and its shareholders. How it plays out is anybody’s guess; but it seems likely that Penn’s restructuring will turn out to be a very big deal indeed.