Over the last four years, regional gaming operator Penn National Gaming (NASDAQ:PENN) has quietly crushed the stock performance of its biggest competitors across the gaming industry, whether they're on the Las Vegas Strip or Macau. There wasn't any magical project that led to Penn National's performance, but rather management has built a strategy that's created immense value over time. They did so by pioneering a unique financing strategy for resorts and pulling off shrewd acquisitions to increase shareholder value.
If the acquisition of Pinnacle Entertainment (NASDAQ: PNK) closes as planned later this year, the company will be set up to further consolidate its power in the regional gaming market. Here's how it became the market-beating stock it is today and why that performance could continue long-term.
REITs are a big growth lever for Penn National
Penn National was the first major gaming company to launch a real estate investment trust, aka a REIT, known as Gaming and Leisure Properties Inc (NASDAQ:GLPI). The REIT has acquired most of Penn National Gaming's real estate along with the real estate of Pinnacle Entertainment and other gaming companies as well.
What the REIT has done is push real estate assets off Penn National's balance sheet, giving it more operating leverage. Instead of owning billions of dollars in real estate, Penn National has agreed to make lease payments to use its hotels and casinos. Most lease agreements include a fixed portion and a variable portion, which is set at 4% of revenue on a trailing basis at regular intervals.
If revenue goes up, Penn National's rent goes up as well, but the total rent payment doesn't go up as much as revenue, effectively lowering the lease payment as a percentage of revenue. This is operating leverage and it helps drive a company's earnings higher when revenue is growing. As a result of this leverage, we would expect to see property EBITDA, a measure of cash flow from a resort or casino, and operating income grow faster than revenue, which is exactly what we see below.
Buying the gaming industry's scraps
Gaming and Leisure Properties has also played a key roll in Penn Nation's growth strategy over the last few years. Penn National will agree to buy a casino at what it thinks is a discount and then the REIT will acquire the real estate, lowering the net purchase price for Penn National and giving it a larger number of casinos to generate leverage from.
For example, M Resort was acquired in 2011 for $230.5 million and Tropicana Las Vegas was acquired for $360 million in 2015. Penn National doesn't break out the returns of each resort, but the two properties are now the foundation of the South/West segment that has generated $144 million in property EBITDA over the past year, up 10.6% versus a year ago. Operating leverage is at work with past acquisitions.
Pinnacle will be the next acquisition to add leverage to Penn National's business, partially because of the REIT financing structure, as you can see below: $315 million of the $2.76 billion acquisition will be funded by Gaming and Leisure Properties.
The net $1.7 billion acquisition will once again add leverage to Penn National's business through the REIT operating structure and a $1.25 billion term loan that will fund some of the acquisition.
Ultimately, the goal is to improve revenue and cash flow from Pinnacle to make the acquisition a great value for Penn National long-term. Management has identified $100 million of annual synergies and if those hold true, the net implied enterprise value to EBITDA of 6.6 would be considerably less than Penn National's trailing enterprise value to EBITDA ratio of 8.8.
Lever results, acquire more assets, and repeat
The formula Penn National has used to drive stock appreciation faster than competitors is to leverage operations through the use of its REIT and acquire more assets using the REIT, net debt, and cash flow from the business. It has used that strategy with great success over the last decade and if the Pinnacle Entertainment deal closes as planned, it'll repeat the strategy again, which could drive even bigger gains.
What investors should watch for are any hiccups in Penn National's growth strategy. Leverage is great for stock returns when revenue is going up, but when it goes down, leverage works the opposite direction and a company can get itself in trouble quickly. With big gains come risks, which investors need to be aware of.