Penn National Gaming (NASDAQ: PENN), the gambling operator which recently spun off it's real estate assets into a publicly traded REIT, is currently misunderstood and therefore undervalued by Wall Street. It is undervalued due to it's spinoff transaction, shortsightedness toward goodwill asset writedowns, and the significant chance of a takeover bid. While atake-over would provide a near term catalyst for large share appreciation, it is not the only way Foolish investors stand to gain as Penn's enterprise multiple is approximately half peer average.
A spinoff is when a company separates itself into two parts, with the goal of making the company more efficient. On November 1, 2013, Penn completed it's real estate asset spinoff by distributing one share of Gaming and Leisure Properties (NASDAQ: GLPI) common stock to Penn shareholders. This spinoff transaction was a first of its kind in the gaming business. As a result, Gaming and Leisure Property owns substantially all of Penn's former real estate assets (19 facilities) and leases them back to Penn under a 15-year lease agreement. Penn continues to operate the gaming facilities and hold the associated gaming licenses.
Historical spinoff returns
The value of spinoffs was examined by Patrick Cusatis, the author of "Streetsmart Guide to Valuing a Stock" in his Ph.D thesis "Restructuring through Spinoffs". The value of spinoffs was also detailed in Joel Greenblatt's first book "You Can Be A Stock Market Genius", which also used Cusatis' research. The thesis summarized in 2 points is surprisingly relevant to Penn.
1. "Despite being similar to IPOs, my spinoff findings are in direct contrast to the reported IPO results: whereas IPOs offer positive returns at issuance but under perform thereafter, spinoffs initially perform poorly but provide positive returns over an extended period of time."
The common belief is that forced selling occurs because of investment fund mandates (the funds strategy). An example of a mandate is market capitalization. Interestingly enough, Penn's stock has depreciated approximately 9% since the spinoff occurred. This drop started at the beginning of 2014, which is the typical time for annual portfolio rebalancing.
2. "In the long term following a spinoff, positive abnormal returns can be observed for spinoffs and parent firms. These results can be mostly attributed to a high incidence of takeovers."
In 2007 Pennactually committed to a buyout by Fortress Investment Group (NYSE : FIG) and Centerbridge Partners. The deal fell through in 2008 due to the credit crisis. With the deal unable to be executed, $225 million in termination fees were paid, and 12,500 shares of newly issued non-cumulative preferred B stock was exchanged for $1.25 billion. The purchase of preferred shares from Fortress appears to be a strategic move providing Fortress the option to make an offer at a later date, because there was no obligation after the deal fell through. Also, investing in non-cumulative preferred stock with no issued dividend is irrational during the beginning of a credit crisis since it gets wiped out before debt-holders even start taking losses.
This "option" hypothesis was further supported in October 2013 when Penn paid Fortress $397 million and issued 8,624 preferred C shares convertible at 1/1000 to redeem the B shares. The Gaming and Leisure Properties 1000/1 distribution to Fortress has a current market value of $330 million. These three transactions created a current payout of $832 million. It is reasonable to assume that the savvy private equity Fortress Group would not invest $1.25 billion in preferred stock to receive $832 million 5 years later unless it went toward a future acquisition.
Fortress' October 2013 conference call illustrated their excitement for the spinoff. "Other activity we had in the quarter that was material that may not be as apparent is we're a big investor in Penn Gaming. They're splitting the company into an Opco/Propco as the first casino gaming REIT. I think that has got a ton of optionality to it. We're excited about that." This excitement is likely to play out in two ways; accumulating more shares on the open market, or a takeover. These are both good scenarios for Foolish investors.
Essentially, what the spinoff did was decrease Penn's market capitalization and enterprise value by not carrying the real estate assets on it's balance sheet. This lowers potential financing costs greatly for any company interested in buying Penn.
An enterprise multiple valuation highlights the value of Penn relative to it's peers, while also providing a more accurate picture than a TTM P/E multiple due to the spinoff transaction and goodwill write-off. Enterprise multiple is enterprise value (EV) / earnings before interest, taxes, depreciation, and amortization (EBITDA). The enterprise multiple relates a firm's takeover cost to its earnings potential. As such, it serves as a proxy of how long it would take for the company to pay its entire value back.
EV reflects the market value of an entire company. To calculate EV, add up stock, debt, other pieces in the capital structure, and subtract its cash. Penn has $749 million in bank debt outstanding, $296 million in senior notes, and convertible preferred shares, which were included into the market cap for simplicity. After summing these and subtracting the $293 million in cash, EV comes out to $1.85 billion.
EBITDA ignores non-cash expenses such as depreciation and amortization of goodwill since they do not impact pre-tax cash flow. Penn's 2013 EBITDA was $695 million. Its 2014 estimated EBITDA is $280 million. The decrease is due to the $422 million rent expense paid to Gaming and Leisure Properties under the terms of the master lease.
Penn's 2013 and expected 2014 enterprise multiple is 2.67 and 6.62 respectively. The 2014 expected multiple of 6.62 is a more accurate number because it reflects the yearly rent cost that will be incurred moving forward. Penn's enterprise multiple means it can earn back its entire value in approximately 6.62 years. Close competitors such as Ceasars Entertainment Corporation (Nasdaq : CZR) and Las Vegas Sands (NYSE : LVS) have enterprise multiple's of 13.35 and 16.32 respectively. Penn's enterprise multiple of 6.62 will likely normalize as an appreciation in stock price occurs.
The recent $1 billion impairment reduced earnings and decreased total assets. This certainly gave a bad taste to investors overly focused on the short-term. Long-term investors see the cup half full, as it provides a cheaper entrance and creates a potential cash saving through deferred tax assets. What's more is that the impairment increases the probability of a buyout since the acquirer will pay less in goodwill.
Penn National Gaming is undervalued because of the unique spin-off of its real estate, large chance of a takeover, and recent goodwill writedowns. Future quarterly and annual financial statements will likely illuminate the hidden value of the spinoff. If a takeover occurs, the premium may resemble Fortresses 31% offered in the prior attempt. There appears to be substantial upside and a limited downside at the current market price making shares in the gaming operator at least worth a closer look by Foolish investors.
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