Investing The Hard Way: Can Other US Operators Follow Penn’s Lead?

TAGs: Ameristar Casinos, Boyd Gaming, Caesars Entertainment, donald colvin, Elaine Wynn, investing the hard way, Isle of Capri, jacqueline beato, jonathan litt, MGM Resorts, penn national gaming, peter carlino, Pinnacle Entertainment, sheldon adelson, Steve Wynn

Last week I covered Penn National Gaming’s (PENN) plan to spin off its real estate assets into a real estate investment trust (or REIT), a move that caused PENN stock to rise over 28% the day it was announced. In that piece, I discussed the rationale behind, and the mechanics of, the spin-off, and noted its possible effects on other US regional casino operators.

In the short term, those effects included a boost in share prices across the sector, as Ameristar Casinos (ASCA) rose 15%, while Isle of Capri (ISLE), Boyd Gaming (BYD), and Pinnacle Entertainment (PNK) saw a nice bounce as well. As I predicted, the stocks failed to maintain that momentum during the shortened Thanksgiving week, with PENN, ISLE, and ASCA all dropping despite a 4% gain in the broad market. But, over the long run, can other operators follow Penn’s lead and spin off their real estate assets? And might the new Penn REIT – as yet unnamed and expected to begin operations in early 2014 – provide relief to some of its highly indebted competitors?

Can Other US Operators Follow Penn's Lead?No Penn competitor is more indebted than Caesars Entertainment (CZR); indeed, few companies in the world can match the operator’s $23 billion debt load. Caesars was left out of the Penn-led party in the sector; its stock actually fell some 2 percent that day, just two days after hitting an all-time low of $4.54 per share, down 75% from its highs following a brazenly manipulated initial public offering in February. Yet, surprisingly, CZR showed some life last week, rising over 17 percent in just four sessions. The catalyst appeared to be the hiring of new CFO Donald Colvin, who oversaw a successful long-term debt reduction at his previous employer, ON Semiconductor. It certainly seems unlikely that Caesars benefited from a delayed reaction to the Penn news, because the company simply is too highly indebted to take advantage of the tax and capital benefits created by the REIT model. Despite having 52 properties, Caesars cannot create a REIT of its own, because nearly all of its properties are already pledged to bondholders through Caesars’ secured debt, with many of the properties seeing secondary claims. To create its own REIT, Caesars would have to re-finance nearly all of its $23 billion in debt, which is simply an impossibility, given that its unsecured debt – backed solely by the strength of the company’s operating business – yields a staggering twenty percent at current prices. Indeed, when Director of Investor Relations Jacqueline Beato presented at a credit conference this week, not a single analyst mentioned the possibility of monetizing Caesars’ admittedly vast base of real estate assets, showing that Wall Street understands a Caesars REIT is simply not going to happen.

Caesars could see a modest benefit from the Penn REIT itself, however; in a conference call announcing the restructuring, Penn National management noted that the new company – currently referred to as “PropCo” – would look at buying competing properties under an asset sale-leaseback arrangement. Caesars, desperate for cash to shore up its balance sheet – witness last week’s sale of a stake in the company’s assets in Uruguay – could sell real estate to the REIT, getting cash up front to pay interest and/or buy back debt, and then lease that property back from the PropCo on a long-term basis. (This is essentially what Penn National Gaming will do when the PropCo is established.) Caesars and Penn have already done business, with Penn buying Harrah’s St. Louis for $610 million just this past spring.

But once again, Caesars’ monstrous debt loads stand in the way – it is simply too big. There is no way that Penn’s REIT can create enough capital through the issuance of its own debt or the sale of new shares to substantially affect Caesars’ financial position. Penn’s total assets are less than $5 billion, and its cash balance a little over $200 million as of September 30th; there is simply no way that Penn – or anyone else – can help Caesars re-finance even a moderately substantial part of its debt. Caesars’ strategy has been to push its debt out as far as possible – currently about 2015 – and hope that either online poker legalization or a strong rebound in the US economy can allow the company to, as Beato put it, “grow into this capital structure.” It remains a long shot, and Penn’s move does little to improve Caesars’ odds.

Similar – although less pressing – concerns exist for MGM Resorts International (MGM), which has seen a nice, and much-needed, bounce in its stock price in the wake of Penn National’s announcement. The stock had been nearing $9 per share, moving toward lows not seen since the tail end of the 2008-09 financial crisis as continual losses and its own debt burden – nearly $14 billion – have weighed on the stock. But MGM has another problem: it’s not making any money, which removes the tax benefits of REIT restructuring. MGM could use a Penn REIT, or a similar vehicle, to perhaps monetize non-essential properties in Tunica or Detroit and use those funds to pay for its ambitious expansion plans in Maryland, Massachusetts, and Toronto. But as with Caesars, the sheer size of MGM’s balance sheet would seem to preclude any substantial long-term benefit from either a restructuring or the use of a competing REIT.

Two of MGM’s competitors in Macau, Wynn Resorts (WYNN) and Las Vegas Sands (LVS) have also been mentioned as potential candidates for a restructuring. In August, LANDandBUILDINGS analyst Jonathan Litt argued that LVS was worth as much as $88 per share, recommending a REIT spin-off of only the company’s shopping and lodging operations. Under Litt’s “ideal structure,” Las Vegas Sands would spin off a mall REIT – comprised of the company’s retail operations in Macau and Singapore – and a lodging REIT, which would receive the company’s lodging assets in both the US and Asia. Las Vegas Sands would continue to manage gaming operations, while Sands China would continue to be a publicly traded subsidiary. In a presentation detailing his case, Litt noted that CEO Sheldon Adelson had already sold his US mall assets to General Growth Properties (GGP), showing that Adelson had the “willingness” to think creatively and perhaps either sell or spin off similar assets in Asia.

Litt did not argue that Sands should create a REIT with the gaming real estate, as Penn plans to; given the nature of the license process in Macau and Singapore, it seems likely that such a restructuring might get more than a second look from Chinese authorities. But Litt did not mention one key problem with a potential LVS REIT: what is known as the “related party rent rule.” Under this rule, cash flows from a “related party” count as “non-qualifying income,” meaning they that must be taxed before being distributed. Indeed, Penn National CEO Peter Carlino and his family were forced to accept an altered distribution in their restructuring, under which they will own no more than 9.9 percent of Penn National Gaming following the spin-off to comply with that rule. Sheldon Adelson owns some 52.4 percent of LVS stock, according to a proxy statement issued in June, and so a major restructuring along the lines of that undertaken by Penn would seem to be unlikely, at best; certainly it’s hard to foresee any circumstance under which Adelson would agree to own less than 10 percent of the gaming operations. But in the third quarter conference call, Adelson did mention the strength of the company’s retail business, and noted that a sale of the company’s retail operations could, in and itself, pay down the company’s entire debt balance. The company is building a covered, air-conditioned bridge between properties in Macau, and Adelson noted that “I’m not going to sell Macau until we finish the bridge.” That bridge should be finished in December, and investors should be watching, as the announcement of a sale or spin-off will without a doubt drive up Las Vegas Sands’ share price.

There has been far less chatter about monetization at Wynn, but on his own Q3 call CEO Steve Wynn emphasized retail strength in Macau, noting that the company had leased 2,000 square feet of retail space at the Wynn Macau for a staggering $500,000 a month. With Wynn only owning 10 percent of his company’s stock – now ex-wife Elaine Wynn owns another 9.7 percent – Wynn could be a candidate for a REIT spin-off of some sort. But, given the lack of buzz around the company’s plans, and the fact that Penn’s own REIT announcement took some 18 months from start to finish, a Wynn restructuring seems unlikely, at least for the near future.

In short, it seems likely that the companies most likely to follow Penn’s lead, at least at first, are the companies whose business models are most similar: the US-focused regional operators such as Ameristar, Pinnacle, and Isle of Capri. And while Ameristar got the biggest bounce, Pinnacle may be the stock to focus on if REIT conversion does indeed become a trend. Ameristar has a higher debt load – with $1.92 billion versus $1.44 billion at Pinnacle – but both companies have roughly equivalent asset bases. Both Ameristar and Pinnacle own properties, fixtures, and equipments currently worth (after depreciation) roughly $1.6 billion to $1.7 billion. Pinnacle, should it create a REIT or partner with the Penn REIT, could execute a transaction that would allow it to pay back all or nearly all of its debt, cutting interest costs substantially. A Pinnacle REIT would own the properties and receive rent from Pinnacle; meanwhile, Pinnacle’s positive cash flow from the gaming operations could be maintained, as pain of the new rent expense is eased by the diminished or removed interest expense.

Ameristar should have similar options open, if it wants to pursue a path similar to that of Penn, as both Ameristar and Pinnacle are showing positive earnings and positive cash flows. In addition, both companies have more balance sheet flexibility than Isle of Capri, and in particularly, Boyd Gaming (whose debt exceeds that of Ameristar and Pinnacle combined.) And both companies should be able to creatively use a potential REIT structure – or another form of real estate monetization – to either lower their tax expense, lower their interest expense, or lower their cost of capital. If anybody is going to follow Penn’s model, the two most likely contenders are Ameristar and Pinnacle. Given the boost to Penn’s share price, investors should look seriously at Ameristar and Pinnacle right now, hoping that they too can use the REIT structure to boost their own share prices.


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