Penn National Gaming: Deal or No Deal?

Penn National Gaming (PENN) has a buyout offer in progress for $67 per share. On February 29, PENN closed at $45.83. Obviously, there’s a big disconnect somewhere. There are also big potential profits to be made whether the deal goes through or not.

On or about June 15, 2007, Penn National Gaming agreed to a Merger Agreement (buyout) from funds affiliated with Fortress Investment Group LLC ("Fortress") (FIG) and Centerbridge Partners, L.P. ("Centerbridge") at $67 per share. With a long approval process as a multi-jurisdiction gaming company, the deal was targeted for completion on June 15, 2008, after which the take-out begins to increase by a fractional amount daily. PENN, which had been trading in the mid to low 50s, jumped to over $63 per share on the announcement.

Since that time, the price has slowly deteriorated along with the market to its current level in the mid $40s. Investors can potentially gain more than 45% in 4 months if the deal goes through as planned at the $67 buyout price. “The Market” obviously thinks the deal will fall through, or the stock price wouldn’t be where it is. Without additional information, saying that “The Market” indicates that the deal must be falling through is no more intelligent than saying “it must be true because I saw it on TV”.

I believe there has been a snowball effect of bad information, fears, conjecture, market conditions and investor over-reactions causing PENN to be unfairly priced. Investors are afraid of the deal because of the long time frame necessarily involved. The Harrah’s Entertainment (HET) buyout was originally supposed to be completed by the end of December, but closed about one month late. Fortress (FIG) itself has been under pressure like many financial stocks and has suffered some downgrades by analysts. Penn’s gaming competitors like Pinnacle (PNK), Boyd (BYD) and Ameristar Casinos (ASCA) have faced steep declines in stock price (multiple compression), causing the Penn deal to suddenly look expensive. Buyout deals in other industries have fallen through, although they have been deals that were easier to walk away from than this one. Finally, Penn National Gaming has “turned off” quarterly conference calls and most other communications. It is a standard practice in a buyout situation as there is usually not much to say – a buyout deal is already in place at a fixed price.

In this case however, it’s had a very unsettling effect on investors as credit markets are in chaos and the deal still won’t be completed until summer. Many general investors obviously feel that the deal will fall through. A recent article in a respected publication even suggested that the deal could be “re-cut”. I believe a close study of the deal itself and the deal documents suggest that the transaction will go through as planned.

There’s nothing in the deal to suggest that it could be re-cut. Either the deal goes through at $67 or it doesn’t and break-up fees and other ramifications are triggered. Any other price would be a new and different deal requiring shareholder approval among numerous other additional steps.

We must remember that acquiring gaming approvals in numerous jurisdictions is a long and expensive process that’s not to be taken lightly. Fortress and Centerbridge want to be in the casino business. They aren’t looking for short-term profits on PENN’s stock price. They are looking for the long term income streams that gaming can provide. They want PENN for its existing properties and exceptional management team, but they also want it for its ability to grow into additional markets like Atlantic City or even Las Vegas in the future.

While recent gaming revenues have eroded somewhat – especially for small and mid market regional operators like PENN – there have been some bright spots. In February, the Illinois Gaming Board decided to allow Penn National to retain their Empress Casino in Joliet, a property that most thought would have to be divested after their Argosy Gaming acquisition. Newly opened slot facilities in Pennsylvania itself are performing very well and exceeding many expectations.

There is a great deal of real information to say that the deal is going through on time and at the original price. In late December, some Penn Executives exercised options and completed stock sales. They really could not do so legally if they knew there was something going wrong in the deal. Also, some “change in control” payments to Penn executives for the deal were accelerated into 2007 for tax reasons; again, signaling that the deal is in motion as planned. The company even filed an 8K on January 16th just to provide an update on the deal progress and answer the numerous questions they were receiving. Additional company filings since that time also indicate that the approval process is progressing as planned.

In addition, Fortress and Centerbridge are now allowed to buy PENN shares on the open market. The financing for this deal is in place with Wachovia (WB) and Deutsche Bank (DB), and Penn shareholders overwhelmingly approved the deal in December. A great deal of time and money has already been spent on this transaction, and the penalties are fairly steep if Fortress or Centerbridge attempt to pull out. The break up fee of $200 million has been well publicized, but most people don’t realize how tight this agreement is in other ways, even providing for Penn National Gaming to seek an injunction for “specific performance” if they choose.

Although I like this deal to complete, it would be impudent to think at a 45% gain could be had in only 4 months without associated risks. Of course the deal could fall through. Anything can happen. I feel that a smart way to invest in Penn National Gaming may be long equity along with a married put or protective put position to guard against the risk of break up. Another smart strategy may be an option straddle or strangle based on the thought that the deal will go through at $67, or the deal will fall apart and PENN will trade in the $40s.

Deal or no deal? We’ll know this summer.

Disclosure: Author holds a position in PENN

Comments

[CrossProfit_:]

Wachovia (WB) is the fly in the ointment. Just look at what they are doing in the Clear Channel (CCU) deal where they have less risk/exposure and you will understand why investors are nervous.

In the CCU scenario, Bain and Lee may substitute Wachovia with UBS if they have to. In this deal there is no available substitution for now. Just try to get a verbal confirmation from Wachovia that the deal is as first envisioned and that there is no material change in circumstance and you will see where they stand (as in 'no comment'). On the other hand Deutsche Bank (DB) is willing to confirm.

We think that Wachovia may be going out on a limb here, however it is well known in the industry that Wachovia has had a change of heart regarding ALL of its outstanding commitments and is actively looking to reduce funding to as many as possible.

Until ALL regulatory issues are resolved and implemented, there is no way of knowing if the deal will go through or not. WB can use any hiccup as an excuse to pull out; claiming that there is a material change etc.

1)"Fortress and Centerbridge are now allowed to buy PENN shares on the open market."

The volume says they aren't and that could be spooking investors to a degree though at this stage it doesn't really mean anything.

2)"In late December, some Penn Executives exercised options and completed stock sales. They really could not do so legally if they knew there was something going wrong in the deal."

Disagree. At the time they had no way of knowing the outcome of the regulatory issues. In addition these were more or less 'planned' sales.

3)"Also, some “change in control” payments to Penn executives for the deal were accelerated into 2007 for tax reasons...deal is in motion as planned."

Or a good way to pay out bonuses in a declining business environment at the expense of shareholders. Either way, the money 'ain't cumin back'.

4) Agree that there is no re-cut option.
5) The problem for Wachovia isn't the $200M reverse fee, as it is still less than the 'hit' they would take on the debt.
6) The problem for Wachovia is 'Texaco'. Read your history!

That's the price difference.

CrossProfit

2008 Mar 02 07:26 PM

[Bobcat Fan:]

I think that it should be pointed out that Wachovia may have a bit of a conflict of interest that jumped out at me right away when I first heard about this story. Wcahovia is the company that has the very large 401k assets for the employees for Penn and Penn subsidiary Argosy Gaming. This suggests to me Wachovia may not want to do anything to upset the management of Penn National.

2008 Mar 04 10:41 AM

[User 160750:]

If the deal falls through for any reason Penn National should have to buy back all stocks that were purchased based on the deal of their buyout. Or be sued out of business by a class action suit. The SEC should clean up it's act as well and stop helping the big money playboys screw the small investors who are manipulated by these greedy degenerates.

2008 Mar 06 05:25 AM

[appletree:]

I agree with the above. This stock was recomended to me by a Wachovia Financial Specialist so I invested a chunk in January. If the deal doesn't happen, I have a lot at stake down the drain. A suit sounds good to me.

2008 Mar 06 11:31 AM

[User 161156:]

you guys are crazy. you bought fully aware of all of the risks. there is no way penn should be forced to buy back your shares. also, how can they even tell you bought soley based on the deal?

2008 Mar 06 05:37 PM

[CrossProfit_:]

Bobcat Fan,

There is so much going on that pulling out of this deal will not be construed as 'upsetting' or intentionally trying to hurt PENN management.

If and when Whachovia pulls the plug, it will be with the full knowledge and perhaps behind closed door consent of PENN management. The more likely scenario is with the full and open co-operation of PENN.

As an aside, the 401k assets are not invested exclusively in PENN and most likely will not take a larger hit than other 401k assets from other companies during the credit (liquidity) crunch.

CrossProfit

2008 Mar 07 07:29 AM

[SteveM:]

Based on multiples and 2008 estimates, it appears that the market is pricing in about a 30% chance of a deal at current price of $41

2008 Mar 07 10:25 AM

[ABS:]

Private equity is in this for the long run- Penn is going full steam ahead on a number of deals- including purchases in AC- they are doing this with the knowledge and consent of Fortress and Centerbridge. If this was a buyout by a publicly traded company there would be a greater risk of this not happening because of the scrutiny from the shareholders- even though Fortress is publicly traded- it's a small part of Fortress. Everyone thought Harrahs wouldn't happen - there was doubt until the day before it closed.

2008 Mar 08 01:10 PM

[jerry p:]

Why would PENN management co-operate in WB pulling the rug out from under the deal? That makes no sense and is a pretty stupid statement.

2008 Mar 12 04:46 PM

[CrossProfit_:]

jerry pham,

Now that we have seen a restructured CCU deal and the strongest deal, HUN, just fell apart it is time to reconsider your comment. PENN management realizes that without the buyout shares will trade in the mid 20's based on current market multiples the market is awarding peers.

PENN management would WANT to work together with the banks and restructure the deal at a lower and more realistic price. The problem isn't PENN. The problem will be convincing FIG not to walk and pay the $200M break-up fee.

The latest rumor is that PENN is willing to settle for $53 though some of the banks are not too thrilled about that price as well. If we can get a price that is acceptable to both PENN and the banks, then they will convince FIG to go ahead. It seems to be somewhere in the mid 40's to low 50's. In any event, there would have to be a new shareholder vote.

As of today there is no way of assessing a fair buyout price simply because we do NOT have any information pertaining to new finance arrangements.

WB is still the key.
PENN shares closed at $37.04 on 6/20/08. If there is no confirmation from the BANKS - primarily WB - about a closing, then shares will continue to drift lower. If you are into arbitrage, going long on a half position at around $35 looks good. Do NOT recommend the call options just yet.

CrossProfit

2008 Jun 22 09:27 AM