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Company Overview

Pinnacle Entertainment (NYSE:PNK) is a high growth gaming company with a deep pipeline of development, which should allow PNK to see strong growth for the next 3-4 years. It has new properties coming online in St. Louis, Missouri, and Lake Charles, Louisiana. It also is adding two hotel towers to existing properties, which should open over the next year. In addition, PNK expects to begin construction in Atlantic City, New Jersey in 2008, with an opening sometime in late 2011.

Strong Growth Outlook

We feel that Pinnacle has a strong growth outlook for the next 3-7 years given the current projects that are underway. From four valuation methods, we priced PNK at $31.64, which is a 9.0% premium over the settlement price as of 10/30/2007 of $29.02.

We recommend buying PNK with the intent to hold the stock over the next few years after their growth potential is realized. Pinnaclefs long-term strategy is to build a geographically diverse gaming-entertainment company with casino resorts in major markets, such as New Jersey and Nevada, and a system of high-quality casinos in regional markets that combined will create a national gaming network. We feel that this aggressive growth has not yet been fully priced into Pinnacle.

Valuations

Based on our DCF valuation, we calculated a price of $30.07, assuming a beta of 1.40 and deriving a cost of equity of 22.04%. Using a simple perpetuity model with year 1 FCFE/share as a proxy for a dividend, we derived a price of $23.94. Based on our replication approach under five unique scenarios, we derived an average price of $41.41. Finally, based on our comparable analysis approach, we derived a price of $31.14. Averaging these methods, we derived a short term price target of $31.64.

Pinnacle: Poised for Growth in the Future

Pinnacle Entertainment (PNK) develops, owns, and operates casinos, and related hospitality and entertainment facilities in the United States. As of December 31, 2006, PNK operated six casinos, which include L'Auberge du Lac in Lake Charles, Louisiana; Boomtown New Orleans in New Orleans, Louisiana; Belterra Casino Resort in Vevay, Indiana; Boomtown Bossier City in Bossier City, Louisiana; Boomtown Reno in Reno, Nevada; and President Riverboat Casino in St. Louis, Missouri. Pinnacle Entertainment also operates Casino Magic, which consists of various casinos in the Patagonia region of Argentina; and The Casino in Emerald Bay in the Bahamas. In addition, it operates Embassy Suites hotel located in St. Louis. Pinnacle Entertainment is a high growth gaming company. They have a deep pipeline of projects, which should allow it to see strong growth for the next 3-4 years. It has new properties coming online in St. Louis, Missouri, and Lake Charles, Louisiana. It also is adding two hotel towers to existing properties, which should open over the next year. In addition, it expects to begin construction in Atlantic City, New Jersey in 2008, with an opening sometime in late 2011. We feel that Pinnacle has a strong growth outlook for the next 3-7 years given the current projects that are underway. From four valuation methods, we priced PNK at $31.64, which is a 9.0% premium over the settlement price as of 10/30/2007 of $29.02. We recommend buying this stock with the intent to hold the stock over the next few years after their growth potential is realized.

Investment Thesis

Three of our four valuation methods suggest that Pinnacle is currently underpriced. Pinnacle currently operates six domestic casinos, many of which are expanding or planning to expand. The company also operates several smaller casinos in foreign markets. PNK's long-term strategy is to build a geographically diverse gaming]entertainment company with casino resorts in major markets, such as New Jersey and Nevada, and a system of high-quality casinos in regional markets that combined will create a national gaming network. We feel that this aggressive growth has not yet been fully priced into the stock, which supports our buy recommendation on Pinnacle.

  • Current-property performance continues to grow. Results in the first half of 2007 reflect continued strong performance at L'Auberge du Lac and Belterra, along with the benefit of the recent acquisition of the President Riverboat Casino. At the Boomtown New Orleans property, operating results reflect the sustained improvement anticipated as compared to pre-2005 hurricane business levels.
  • Pinnacle continues progress with future projects. Lumiere Place is preparing for its opening in the fourth quarter of this year, pending final approval of the Missouri Gaming Commission. The River City project, also in Missouri, is completing critical construction processes. The project is expected to open during the first half of 2009 and also subject to licensing by the Missouri Gaming Commission.
  • Significant progress has already been made in multiple development projects. Pinnacle has started the renovation of the former Embassy Suites Hotel adjacent to Lumiere Place, finishing up L'Auberge's 250 guestroom addition, obtaining approval from the Louisiana Gaming Control Board for the architectural plans proposed for the Sugarcane Bay project in Lake Charles, Louisiana, designing our Atlantic City project and securing the land in Baton Rouge, Louisiana.
  • Pinnacle has a strong development pipeline. Current projects from recent financial releases include: LfAuberge du Lac: PNK continues construction of a 250 guest-room addition and expects the tower and accompanying amenities to open in December 2007.

Boomtown New Orleans: PNK plans to break ground in the fourth quarter of 2007 on a 200-guest-room upscale hotel and other upgrades to the property. They also plan to replace the three-level casino riverboat with a large single-deck casino boat, similar to the casino boat at L'Auberge du Lac, with expectations to complete this expansion and renovation in 2009.

Sugarcane Bay Project: On June 7, 2007, the LGCB approved the architectural plans for our proposed Sugarcane Bay Casino resort to be built adjacent to our L'Auberge du Lac facility. Such facility is expected to include approximately 400 guest-rooms and suites, approximately 1,500 slot machines, and 50 table games, including a poker room. We anticipate opening this project in 2009.

Casino Magic Argentina: PNK is building a 31 guest-room hotel adjoining their principal casino in Neuquen, Argentina. The first half of these rooms is expected to open in the third quarter of 2007, with the balance to be completed in early 2008. The new hotel is expected to cost approximately $13 million and is being funded through the property's existing cash balances and cash flows. Atlantic City Project: PNK continues to design their Atlantic City project, which for a project of this magnitude will take more than a year to complete. The new casino resort is expected to open in 2011 or 2012.

Based on our DCF valuation, we calculated a price of $30.07, assuming a beta of 1.40 and deriving a cost of equity of 22.04%. Using a simple perpetuity model with year 1 FCFE/share as a proxy for a dividend, we derived a price of $23.94. Based on our replication approach under five unique scenarios, we derived an average price of $41.41. Finally, based on our comparable analysis approach, we derived a price of $31.14. Averaging these methods, we derived a short term price target of $31.64.

Discounted Cash Flow Analysis

Since PNK does not pay a dividend, the Gordon Growth Model could not be directly applied as it would calculate a price of $0. We decided to treat free cash flows to equity per share as a proxy for a dividend. We do not anticipate PNK to pay a dividend in the near future either, so this proxy was used for the entire forecasted period until terminal growth of -4.9% was reached beginning in FY2023. We estimate that FCFE/share at the end of FY2007 to be $5.47 based on historical operating margins and analyst consensus for projected growth. Since we are using FCFE as a proxy for dividends, we used historic EPS growth of -4.9% for the overall growth rate. Using FY 2007 FCFE/share in a perpetuity model priced PNK at $23.94. This is 17.5% below the settlement price of $29.02. In addition to a simple perpetuity model, we created pro-formas until the terminal growth rate was reached. The terminal growth will be the historical EPS growth of -4.9%. Using analyst reports, past multiples, and future growth plans, we scheduled the growth pattern for PNK over the next 17 years, at which point the terminal growth rate would be met.

Our growth model is set up into 4 growth stages. The first stage, which will last until the end of FY2009 will be an inactivity period, at this stage their new casinos will be coming online and construction will begin on their Atlantic City property. From FY2010 through FY2012, there will be a significant growth in EPS as the planned casinos begin full operation. From FY2013 though FY2022, PNK will transition back to its historical EPS growth rate of -4.9%. The timing of these stages relied heavily upon the planned construction projects of PNK.

Many analysts predict Operating EPS in FY07 through FY10 to be $.80, $.76, $1.05, and $1.41 consecutively. From our analysis, we found EPS for the same periods to be $1.20, $0.97, $1.14, and $1.31, respectively. The differences are the EPS projections can be accounted for by the timing of our growth rates.

We derived the growth rates for the inactivity and growth periods using the 5 year estimated average growth of 14.1% from other analysts. This sequence is characterized by negative growth in the first two years followed by significant positive growth in the following three years, which reflects the completion of some of the casino projects from PNK.

Based on analyst projections, we used a conservative of 10.15% growth rate for the transition period from the high growth period through the stabilized FY2023. This is again based on our own assumptions and analyst consensus. Using the average transitional growth rate, we decreased the growth rate from the last year in the growth period (FY2012) in a linear fashion to end at the stabilized growth rate of negative 4.9% in FY 2023.

To find the cost of capital, we used the CAPM pricing model. Using the NYSE Composite Index as our market portfolio, we correlated PNK with the index over the most recent three years and calculated a beta of 1.40 for PNK. From this we derived a market premium of 12.61% based on the 10]year treasury rate of 4.32% (as of 11/4/07). Within these calculations we assumed 252 trading days in a year. These inputs into the CAPM model resulted in a cost of capital of 22.04%.

Given these inputs, we discounted each FCFE/share at the CAPM cost of equity of 22.04% through FY2022. We then treated the stabilized FCFE/share as a perpetuity and discounted this perpetuity value as well. The price was then calculated as the sum of all present value FCFEs/share, which derived a price of $25.49 at the end of FY2006. By adjusting the price for the time elapsed since the end of FY2006, the target price increased to $30.07.

The results of our DCF analysis gave us a share price of $30.07. This represents a 3.6% premium over the settlement price of $29.02. We also performed a sensitivity analysis of the price estimates based on changes in the CAPM rate from 14.5% to 29.5% and changes in the long term stabilized growth rate from -14.9% to 7.6%. With small changes in CAPM and long term growth rates, the price ranged from $29.56 to $30.63.

Relative Valuation

Pinnacle is significantly different from most other publicly gaming companies such as Harrah's (HET), Wynn (NASDAQ:WYNN), and Las Vegas Sands (NYSE:LVS) do to its size and industry scope. For that reason, our comparable companies were selected based on similar size, profitability ratios, and liquidity ratios. The goal of our comparable set was to match characteristics based on an extensive array of metrics. For our comparable set, we chose the following companies: MGM Mirage (NYSE:MGM), Ameristar Casinos (NASDAQ:ASCA), International Speedway (NASDAQ:ISCA), Live Nation (NYSE:LYV), and Warner Music Group (NYSE:WMG).

MGM Mirage owns and operates casino resorts throughout the United States. As of April 13, 2007, the company owned and operated 19 properties located in Nevada, Mississippi, and Michigan. MGM Mirage was chosen as a comparable company in part because of their broad geographic scope in gaming, similar to that of Pinnacle. MGM also has a similar book value per share, PEG ratio, and enterprise value/EBITDA.

Ameristar Casinos, as of September 18, 2007, operates eight Casinos in Missouri, Iowa, Mississippi, Louisiana, Colorado, and Nevada. Ameristar, like MGM, was selected in part because of their similar geographic scope on gaming in the United States to Pinnacle. Other reasons that they are included in the comparable set include similar market cap, revenue per share, PEG ratio, and number of employees.

International Speedway promotes motor-sports entertainment activities in the United States and therefore included in the services sector along with PNK. International Speedway was chosen because of their similar revenue amount, revenue growth, and book value per share. Live Nation operates as a live music and venue management company. Live Nation, like Pinnacle, also operates on a national level and is included in the service sector. They have a similar return on assets, EBITDA, cash per share, debt to equity ratio, market cap, and PEG ratio.

Warner Music Group provides recorded music and music publishing services worldwide. In addition to being part of the service sector, Warner Music Group was chosen because of their comparable operating margin, return on assets, and market cap.

Replication Analysis

Using our comparable companies, we created 5 scenarios to derive a price for Pinnacle entertainment.

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Under the different scenarios, we get an average price of $41.41, which represents a 47% premium over the replication market price of PNK of $28.14. However, by weighting Scenario A at 60%, and the other scenarios at 10% each, we get a price of $34.17. This weighting best represents the scenarios that are most applicable to PNK’s future performance. We feel that the profitability measures are most representative to pricing Pinnacle. The ratios used in the scenarios above were selected because they represent a broad range of common measures across companies and are used in most other analyst reports in valuing companies similar to Pinnacle.

Comparable Company Analysis

For the comparable company analysis, we chose a broad array of metrics to price the stock. The metrics chosen were the P/E ratio, Enterprise Value/Revenue, Enterprise Value/EBITDA, Price/Assets, PEG Ratio, and also a Market Cap per Employee metric. These metrics cover top and bottom line profitability, price relative to size of the company, and comparable growth measures. After reversing these ratios from our comparable set for Pinnacle, we are confident within a range of prices from $18 to $30, the top limit of the range being close to the settlement price of $29.02. The only metric significantly out of this range was the Market Cap per Employee, which created a range from $45.80 to $83.83. By taking the average of the averages on each metric, we calculated a share price of $31.14, which represents a 7.3% premium over the settlement price.

Source: Pinnacle Entertainment Poised for Future Growth