Penn National: A Better Bankroll
Some bets are just too good to be true. Such was the case with the failed buyout of regional casino operator Penn National Gaming (symbol PENN) by two private equity firms for $67 per share, or $8.9 billion. The market never took the offer -- announced at the height of merger mania -- seriously, but the prospect of a quick double-digit return if the deal was consummated seemed difficult to pass up given what looked like a very favorable risk-reward ratio. Or so I thought a few months back.
But the deal did fall through, and the stock has cratered. It closed July 14 at $25, down 60% from its 52-week high of $62 last October. Much of the slide occurred in the two weeks before the official announcement on July 3 that private equity firms Fortress Investment Group (FIG) and Centerbridge Partners had ended their bid to buy Penn. But the stock has since dropped another five bucks.
Now that the deal has been scrapped, the stock trades off fundamentals. And those don't look so hot right now. In the first quarter, Penn National's net income fell 5%, to $40.7 million, from the same period in 2007. The deteriorating economy and declining consumer confidence are hurting the entire casino industry but have been especially harmful for regional casino operators in the U.S. These casinos are "the ground zero of the gaming implosion," says Charles Norton, manager of the Vice fund (VICEX), which invests in stocks of gaming, alcohol, tobacco and defense companies.
But unlike many failed corporate marriages, Penn is not leaving empty-handed. It will receive $1.475 billion in cash, consisting of a $225-million breakup fee and $1.25 billion of redeemable preferred-stock investment from Fortress and Centerbridge. The $1.25 billion in preferred stock pays zero interest and lasts for seven years, essentially making it an interest-free loan to Penn, says Sterne Agee analyst Nicholas Danna.
Penn has plenty of ways it could use the cash: to reduce debt, repurchase shares, acquire new properties and rehab existing ones. Danna expects the company to save at least $35 million per year by paying off some debt and thinks the company will buy back $200 million in stock. "Penn has a history of prudent capital management," Danna says. For example, he points to how the company turned a run-down horse-racing track in central Pennsylvania into a small gaming empire that includes 24 casinos, racinos (horse-racing tracks with casinos) and off-track betting parlors with a focus on slot machines in 11 states and Ontario, Canada.
The settlement means Penn National holds better financial cards than its regional rivals. "Penn has weathered competitive and regulatory challenges with more profitability and maintains higher margins than other riverboat and racino operators," says Oppenheimer analyst David Katz. "Penn will ultimately have the greatest financial flexibility among the casino operators we cover." That matters because casino financing is so scarce that in Atlantic City, developers of the $2-billion Revel project recently asked the city for financial assistance.
Meanwhile, Penn is pressing its bets. The Wyomissing, Penn., company has secured an option to buy a 23-acre parcel in Atlantic City that could be developed into a casino if rezoned. And since the breakup with FIG and Centerbridge, Penn says, it bought an option to acquire Maryland land on which it would build a casino if the state's slot-machine gambling referendum passes this November.
In addition to building new casinos, Penn is using some cash to improve its current locations. In February, it opened the $260-million Hollywood Casino in Grantville, Pa. Business is brisk enough for the company to buy more slot machines and add high-end restaurants to the casino complex, Danna says. Penn also plans to upgrade its Argosy Casino in Lawrenceburg, Ind. -- the company's largest riverboat casino in terms of revenue and income.
Yet Penn stock is priced as though all the company's riverboats have sunk. The stock, which is within a hair of its 52-week low, trades at 13 times the $1.97 per share that analysts expect the company to earn this year and just 10 times 2009 estimates. Given that the company is flush at a time when its competitors are hurting for cash, Danna upgraded Penn stock from "Hold" to "Buy" on July 7. He gives it a 12-month target price of $36. Katz re-established his "Outperform" rating on Penn after the buyout broke down. He thinks the shares are worth $39.