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Penn National Gaming, Inc.

Q2 2008 Earnings Call

July 24, 2008 11:00 am ET

Executives

Joseph Jaffoni – Investor Relations

Peter Carlino – Chairman and CEO

William Clifford – CFO

Timothy Wilmott – COO

Leonard DeAngelo – Executive Vice President, Operations

Analysts

Larry Klatzkin – Jefferies & Co.

Brian Shim – Morgan Stanley

[Nisha Dudley] – Halbis HSBC

Dennis Forst – Kebanc Capital Markets

Felicia Hendrix for Neil Portus – Lehman Brothers

Joseph Greff – Bear Stearns

David Katz – Oppenheimer & Co.

[Larry Harfordy] – Gameco

Todd Jordan – Research Edge

[Brian Sells] – Peak Financial

Jeff Gates – Gates Capital

[Zeth Noonson] – [Pine Global Capital]

Operator

Welcome to the Penn National Gaming second quarter results conference call. (Operator Instructions) It’s my pleasure to turn the conference over to Joe Jaffoni, Investor Relations.

Joseph Jaffoni – Investor Relations

Thank you, operator; and good morning, everyone. Thank you, everyone, for joining Penn National Gaming’s 2008 Second Quarter Conference Call. We’ll get to management’s presentation and comments momentarily, as well as your questions, but first let me review the Safe Harbor Disclosure.

In addition to historical facts or statements of current conditions, today’s conference call contains forward-looking statements that involve risks and uncertainties within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements reflect the Company’s current expectations and beliefs but are not guarantees of future performance. As such, actual results may vary materially from expectations.

The risks and uncertainties associated with the forward-looking statements are described in today’s new announcement and in the Company’s filings with the Securities and Exchange Commission, including the Company’s reports on Form 10-K and 10-Q. Penn National Gaming assumes no obligation to publicly update or revise any forward-looking statements.

Today’s call and webcast may include non-GAAP financial measures within the meaning of SEC regulation G. When required, a reconciliation of all non-GAAP financial measures to the most directly comparable financial measure calculated and presented in accordance with GAAP can be found in today’s news announcement, as well on the Company’s website.

With that, please let me turn the call over to Peter Carlino, the Company’s Chairman and CEO. Peter.

Peter Carlino

Thanks Joe. Good morning, everyone. With me this morning both here in this conference room, and in various places elsewhere, we’ve got pretty much the entire Penn Senior Staff. It is our style so that we can answer any and all questions that you may have. At the offset, I can probably say I can’t say I’m happy to be back here again hosting an official quarterly conference call since that had not been the plan, but as we are and now we oriented with a public company mindset to building shareholder value, we with enthusiasm start this process again.

Not a whole lot report since we made the announcement of our deal cancellation just a few weeks ago. Nonetheless, and the numbers that Bill will describe are as pretty much in line with what we projected, so no real difference there. Again, our primary focus will be to answer your questions and let you take the Q&A where you would like it to go.

Clearly this year for us, as it has been for every company in this sector, has been very challenging; and I think surprisingly so. I don’t think any of us kind of expected that the softness pretty much across the board would be what it has been. What I can tell you is that we think that, I knock on wood as I say that, but indications are things that have pretty well settled out, which I might not have been able to tell you even 30 or 40 days ago. But that’s just a general sense that we’re feeling here.

So on balance, our properties are doing very well. Business is still very solid. Frankly, our prospects have never been better. I mean I think you all have a sense of the kind of performance that we have had over a long period of time, with a very high focus on return on investment, a very high focus on free cash flow. I mean the kind of metrics that we think in the end matter to shareholders. That has not changed; and if anything, we’re more determined than ever to make sure that we’re at the top of every bracket that we can be in those very important areas.

So, as I said at the outset, it’s with enthusiasm back to very aggressive business here at Penn, and we’re looking forward to the future. We see really lots and lots and lots of opportunity.

So with that, I’m going to turn it over to Bill Clifford for whatever comments Bill would like to add.

William Clifford

Yeah, there’s really nothing much to add. I think what we’re seeing in our results, there’s the real difference between what we had in the guidance that we gave a couple weeks ago and our actual results really relates to a timing issue on a one-time charge at the corporate level. Obviously we came in a little better than what we said we were going to do in the second quarter; but in the third quarter, we’ve had to move that charge.

Relative to the rest of the year, I think I’ll echo Peter’s sentiment in that what we feel that we’re seeing in our operations is that we’ve got a consistent level of performance in July with the general trend of January through June. Going back into the quarter, May was a good month and then June was just awful. So the good news is what we’re not seeing is June results getting repeated in July, more likely that we’re in a consistent trend with what we’ve seen all year. Hopefully you have to stabilize first before you can improve.

So with that, we’ll open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Larry Klatzkin of Jefferies.

Larry Klatzkin – Jefferies & Co.

One quick bookkeeping, Bill. Capex for the quarter.

William Clifford

Capex for the quarter was roughly, well it was $76.2 million broken up between projects and maintenance, the project capex of $59.2 and maintenance capex roughly $17 million.

Larry Klatzkin – Jefferies & Co.

Perfect. What do you think it will be for the year? Do you guys have an estimate for that?

William Clifford

The year, we’re looking at a total of roughly $395.4 million of which $321.1 is projects and roughly $74.3 of maintenance capex.

Larry Klatzkin – Jefferies & Co.

Perfect. Capitalized interest for the quarter?

William Clifford

Cap interest for the quarter was $3.8 million.

Larry Klatzkin – Jefferies & Co.

I know you gave out debt; did you give out cash on hand too?

William Clifford

Sure. Cash was $124.4 and our debt at the end of the second quarter, it consisted of bank debt of $2.479 billion, cap leases and our obligations on the sale relative to [Pokomil] of $28.3 and then we have bonds of $450 million for a total debt of $2.957.205 billion.

Larry Klatzkin – Jefferies & Co.

Perfect. Then some other questions. As far as, you still… You guys didn’t mention in this note about stock buybacks. Last time you said you were looking possibly $200 million total. Is that still the case, and what would your timing hope to be?

William Clifford

On the buybacks, we did announce the $200 million. The Company has nibbled a little bit. I think we’ve got maybe 500,000 or 600,000 shares that we’ve bought back to date. We’re not going to rush in on the stocks and basically create an artificial bubble, so we’re going to be very slow and patient and deliver it relative to the buyback. It’s going to reflect on what’s happening with the market.

Larry Klatzkin – Jefferies & Co.

You guys had mentioned the last call that you guys may be looking to even buy gaming bonds of companies that you don’t mind taking the assets of if there’s problems and get a great return otherwise. Is that still the case?

William Clifford

Yeah, I think we’re exploring all the options. We haven’t done anything to date. There’s just an enormous number of potential opportunities as we see it and we want to be very thoughtful and take our time to best evaluate the opportunities that are out there. We don’t sense that there’s any, that we need to rush into this stuff, that we think can take our time relative to understanding what those different opportunities might be and quite candidly, they’re very complex in terms of really getting an understanding, an in depth understanding of what would be involved. It sounds very simple, but the reality is you’ve got to understand the other company’s capital structure as well as what your rights are as well as what may be happening down the road in terms of projections, where we think the Company’s going to be, etc. [Inaudible] expects us to do anything for a little bit of time here.

Larry Klatzkin – Jefferies & Co.

No that makes total sense. Las Vegas, Peter, you mentioned that that’s still a place you’d like to look. Obviously there may be a few things available, Tropicana Land and one or two projects under construction now and such. Are you guys seriously taking a look out there?

Peter Carlino

There’s better stuff than that. Look, Larry, you can bet we’re looking at everything. Bill pretty well answered the question, this is now for us: take a deep breath and begin a very, very disciplined approach in looking at all of the opportunities. No shortage of opportunities. The challenge for us is to make the right initial selection. Yeah, of course we’re looking at Las Vegas and now for the first time in a very, very long time it looks to us like there could be some properties that are loose. I obviously can’t tell you what we’re looking at or what we’re thinking about, but it would have to be one that fits the profile of the Penn customer, something that would link with our database customers. Just stay tuned. There are really are some very interesting opportunities. So, yes, you can count on us looking very hard there.

Larry Klatzkin – Jefferies & Co.

Being flush with cash in this market’s not a bad thing. Last question: You got a piece of land away from Bader Field, does that mean Bader Field’s off your track or you still looking at that too?

Peter Carlino

No, we’re still very interested Bader. It’s a gold plated property. We also like our Route 30 property. It’s got approval hurdles to get crossed, but we’ve certainly gotten the first important first step in getting a zillion recommendations at the gaming site. Interestingly, it had formally been a gaming site. Part of our pitch to Atlantic City has long been, look you guys have basically shut down the town, so make up your mind. Are you focused on growth? Do you care about the future, or is all about protecting your existing base? If that’s it, god bless you, but it’s not a very wise strategy. I mean Pennsylvania has begun to have a profound impact on New Jersey, and it’s only just begun. You get the two Philly properties built, big time properties, you add in the significant spend that LB fans are making in Bethlehem, take a look at a map and figure out where all the customers are going to come from. I guarantee more than half of them aren’t in Pennsylvania. So you’re looking pretty bad bleak future for New Jersey, if they don’t act. To act, whether we could do it, begin to reshape the town away from day-trip market to a destination market, none of this is new. I think the question still open is: How committed is the mayor, city council, people who have the votes there to transforming their city and let it be what needs to be and that is a destination market. They don’t need one Borgata’s; they need 8 Borgata’s. I man you need action down there. It remains to be seen how committed… I think the city understands it, certainly the unions understand it, anyone concerned about growth and helping the city. But whether that translates into political action is not clear to us yet.

We’re still focused on Bader. We expect an RFP request to come out any day. Interestingly, one of the arguments that we’re going to make there, and I’ll say it publicly now because I think is serves our purposes, is that whoever they select, whatnot to be able to do what’s been done in the past; and that is: Select a single developer who then sits on the property for 15 years, puts up a single property, sits on the balance. We’re going to do our best to insist that whoever ends up with the property must develop it immediately, and I mean across the board whether it’s three sites or four sites, however it gets to be, that they must be compelled to build. I think that’s going to be a resonant story with the city who has looked at the MGM site year after year after year and seen no action, for whatever reason. I’m not criticizing MGM in that case; but if I were the city, I’d say, “Prove to us that you intend to get this done so…”

We like Atlantic City. We like the future of Atlantic City, but what we’re waiting for is the political mindset that says, “We’re ready to go.”

Operator

Continuing on, our next question comes from the line of Brian Shim of Morgan Stanley.

Brian Shim – Morgan Stanley

Actually my questions have been answered.

Operator

Continuing on, our next question comes from the line of Nisha Dudley of Halbis HSBC.

Nisha Dudley – Halbis HSBC

Actually mine’s been answered. Thanks.

Operator

{Operator Instructions) Our next question comes from the line of Dennis Forst of Keybanc.

Dennis Forst – Kebanc Capital Markets

I had two questions, one on the operation of Joliet. It surprised how well the margins did in the quarter vis-à-vis the first quarter. It looked for Joliet pretty similar revenues both quarters, yet the costs were down significantly. Can you throw a little light on that?

William Clifford

I’ll throw some in and then probably Tim can add on. I think the primary driver there is really around the gaming taxes, the 3% horseman per subsidy sunsetted [sic] in May, and also when compared… What we’ve got is we’ve got a much lower average tax rate in Joliet.

Because quite candidly of our revenue decline, we’re no longer in the max, in the 50% incremental tax bracket, so we’ve got a much lower projected annual gaming revenue level which is lowering overall tax rate. I really didn’t look at it compared to the first quarter, but looking at it compared to last year, last year there was make whole provision in Illinois where Joliet was paying taxes based on a historical run rate or taxes that were based from 2005. So that is having an impact relative to the prior year. So the biggest decline is really on the taxes, gaming taxes at Joliet.

Operational issues, I’ll leave to Tim.

Timothy Wilmott

Dennis, we put a new management team in there late last year and they’ve been rationalizing given the impact on revenues of the smoking ban. They’ve been rationalizing their labor costs and also their marketing spend. We’re preparing, as you’re probably aware, to invest $50 million to improve the facility and make it competitive with the other Chicagoland boats. Up until that time, we’re taking a very prudent focus on costs until we have something more to sell and more to show customers in that market.

Dennis Forst – Kebanc Capital Markets

Great. That explains it, appreciate it. Then just to update some of the discussion we had earlier about debt, how much cash has come in from the settlement so far?

William Clifford

To date, we’ve received $700 million, which is basically in Penn’s bank account. There’s $775 million, which has been received, although that’s sitting in escrow pending the issuance of the redeemable equity.

Dennis Forst – Kebanc Capital Markets

That should happen October 1?

William Clifford

When you do a projection or a model, you got to put a date in there, so we think that’s the date that we feel comfortable that the money will get transferred to us. Obviously that’s somewhat, well entirely depended on the timing around when the gaming regulators approve the transaction and finalize [inaudible] hearing.

Dennis Forst – Kebanc Capital Markets

In addition to the $700, wasn’t there $225 million that came in also?

William Clifford

No, that was part of… The $225 was included in the $700.

Dennis Forst – Kebanc Capital Markets

Oh it is?

William Clifford

Right, so it’s really $200, plus $500 deposit on the redeemable equity and the remaining or $225 and $475 and the remaining portion is all attributable to the redeemable equity.

Dennis Forst – Kebanc Capital Markets

That’s the $775?

William Clifford

Right.

Dennis Forst – Kebanc Capital Markets

So the third quarter shares… For your guidance, the third quarter is the same number of shares of outstanding in the second quarter and then the fourth quarter and full year would reflect the extra $28 million shares out for one quarter. Is that right, Bill?

William Clifford

Right, so what we’re reflecting is a prompt in the fourth quarter to roughly 116.4 million shares. What that will do is give us a weighted average count on the year of roughly 95.6 million.

Dennis Forst – Kebanc Capital Markets

Then next year obviously about 115 million shares, unless you get around to buying more shares, which is highly likely.

William Clifford

Right.

Dennis Forst – Kebanc Capital Markets

Then the $700 million you have now will be earning some modest amount of interest in the quarter and that’ll show up in interest income?

William Clifford

No, the $700 million that we have received was used to pay down the revolver.

Dennis Forst – Kebanc Capital Markets

Oh, it was, okay.

William Clifford

So the revolver balance at 6/30 was $600 million and right now that revolver is completely undrawn.

Operator

Continuing on, our next question comes from the line of Neil Portus of Lehman Brothers.

Felicia Hendrix for Neil Portus – Lehman Brothers

A few questions: Just getting back to Atlantic City, Peter, you talked about some approval hurdles. I was just hoping you could help us understand the timing behind those.

Peter Carlino

Felicia, I wish I could.

Felicia Hendrix for Neil Portus – Lehman Brothers

Just on Route 30.

Peter Carlino

It’s utterly unknown. Look, like any coastal property, there’re environmental questions and more regulatory ones that we have to go through, plus we need a final approval from city council when they approve the entire plan. Our piece, fortunately, came up at a time when they were rezoning many other areas in the city, including Bader Field by the way. So we’re part of a larger process. I’ve got to say, Felicia, it’s utterly unknown.

We’re focused on it every day and we’ll just have to see. In the meantime, we’re waiting for the RFP to appear for Bader. We think we have a very compelling pitch to make there. We’ve probably been at as long or longer than anybody else, and I have personally met with most members of city council, the mayor, the various mayors to make our case. I think everybody recognizes that Penn wants to be in Atlantic City, think it’s a great market, but there’s still a lot of loose ends and we just simply can’t predict where that’s going to go. I also say, and we’re not in hurry. We’re going to get it right. It’ll fall in place when it does. There’s plenty of other things for Penn to do over the next year while we do that.

Felicia Hendrix for Neil Portus – Lehman Brothers

Then moving on to Lawrenceburg, it looks like now it’s going to open in the second quarter of ’09 versus the third quarter. Just wondering what allowed that to move up and what gives you the confidence that it is going to open up ahead of plan?

Timothy Wilmott

I hope we don’t have snafu here. It’s really basically unchanged. I think we’ve always been looking at something in the early third quarter. I wouldn’t say that we moved up the timetable. I take your word for it, we’ll double check; but I would assume we’re still looking at early third quarter.

Felicia Hendrix for Neil Portus – Lehman Brothers

I think in the chart in the press release it says second quarter.

Timothy Wilmott

I’m sure you’re right.

Felicia Hendrix for Neil Portus – Lehman Brothers

I got all excited. Then my next question for you is on West Virginia, if you can just give us an update on any plans for table games?

Peter Carlino

Felicia, we can’t, except to say that we have a very, very, did I say very, focused effort in West Virginia to get all the politics aligned and to sell the message and to tell our story, so I mean we feel as good as one can feel this time around. I always remind folks that our area was only the area that didn’t pass slots the first time around. It’s just a very, if I can say it, un-West Virginia-like demographic there. I mean that whole county is largely filled with people from Maryland and Virginia and others who have come in who escaped the density and all the other urban problems only to find that Charlestown and Jefferson County’s growing extraordinarily rapidly, largely I may as a result of the economic engine that is Charlestown races.

Look, we feel as good as one can feel right now. I haven’t looked at current polling, I think we’re in good shape, as good a shape as we can be. The governor’s made it very clear that he supports us. I think many in the legislature do. They recognize and publicly have pointed to the revenue loss to the state, which is staggering by not having it approved locally and now that they’ve got real numbers to look at with the antis where disputing at the last round, now we kind of what it will do; and it’s pretty impressive. So we’re as well aligned around that issue as we can get.

Let’s see what happens in Maryland. As you know, we’ll be just as glad if Maryland didn’t succeed with slots, and I think we said that publicly; but on the other hand, if it does, we want to join the property and we’ll enthusiastically do so. But that also may have some statement to make after this fall to the voters of Jefferson County. So you just have to stay tuned. Suffice it to say that we are really, really, really on top of that issue.

Felicia Hendrix for Neil Portus – Lehman Brothers

Then just final one, getting back to that question about buying muni bonds, I’m just wondering, can you buy distressed bank loans or only bonds?

William Clifford

We could buy both.

Operator

Continuing on, our next question comes from the line of Joseph Greff of Bear Stearns.

Joseph Greff – Bear Stearns

Most of my questions have been answered, but just a question for you on Kansas. Can you just talk about what the potential returns are there for the Kansas opportunities and whether it’s kind of two or zero in terms of how you look at it?

Peter Carlino

It is two or zero. It’s either both sites or not an ultimatum fashion, but the economic returns on Galena on a standalone basis just don’t make any sense for us and we would unfortunately have to pull out if that basically what showed up. Relative to, in terms of our returns, I think on a combined basis we’re expecting thresholds that are in our normal ranges, in the 15% to 20% return and potentially maybe a little bit better. But we’ll see what happens, and we’ve got a long way to go and there’s actually a lot of our team members are in Kansas today and tomorrow working through issues and giving presentations and doing their very best to help insure that the State of Kansas makes the right choice and picks Penn.

Joseph Greff – Bear Stearns

I know you have ample space at Charlestown to add additional gaming capacity. Is there any chance between now and the end of the year you look to add additional slots, or you just kind of waiting on what goes on in the neighboring State of Maryland?

Peter Carlino

No, Maryland has nothing to do with our view of Charlestown. We’d be doing this anyway. I mean look, anytime you’ve got a huge revenue opportunity, we want to grab it. The state, believe me, is very focused on that. They do math. It’s been very publicly published the very significant revenue that they’re losing by not having table games there, so there as motivated as we are. We just have to share that motivation with the votes of Jefferson County.

Timothy Wilmott

Listen, I think relative to adding more slot machines, we think we’ve got plenty of machines based on current demand levels. They found these obviously giving us a big of challenge and until we start to see a pickup in the demand curve, we think we’re more than have enough slot machines at Charlestown at the current time.

Joseph Greff – Bear Stearns

Then my final question, are you seeing any pressure at Lawrenceburg from the racinos in Indiana?

Peter Carlino

Tim, do you want to take that? The answer is yes, but go ahead.

Timothy Wilmott

Since they opened, Joe, in the early part of June, we’ve seen with the customers that live within a 30 to 45 mile radius of those two tracks, we have seen a loss of business coming to Lawrenceburg and that has continued into early July. The question long-term is: How’s it going to stick? As you know, we are going to be upgrading our facility in the third quarter 2009 to provide additional amenities in a much nicer casino experience to customers in Lawrenceburg to offset some of that loss we’re feeling from those two racinos.

Peter Carlino

Let me add, too: We’re also taking a hard look at the scope of our project in Lawrenceburg. Obviously the complexion of the market has changed significantly with the addition of the racetrack slot, so we may fine tune our program there, add some more amenities, do some things that between now and next quarter we’ll tell you about if we get there, maybe improving some of our restaurant products and doing things to make this project strong as we can make it.

I mean since now, we’ve made some adjustments in design. We’re very excited about that. For those of you who have seen the Penn National property, that has been just so successful and so well received by the public that we’re probably going to roll out something quite similar to that in Lawrenceburg still on time, I might add, to just sort of change our focus there a little bit. I mean we want to be the place that people want to come. It’s as simple as that, so I think we have an opportunity now that we see where the competition’s coming from, understand the issues a little bit better to tweak this project and to make sure that we glean as much business from that market as we can get. So how’s that for sort of a circular answer?

Operator

C0ntinuing on, our next question comes from the line of David Katz of Oppenheimer.

David Katz – Oppenheimer & Co.

Bill, in terms of the convertible preferred, we’re obviously adjusting our share count and my best guess just from looking at the consensus is that some others probably treat it as a dead instrument prior to today also or prior to last week or so and if you could just give us a little bit of color on sort of how the accounting treatment evolved and is there some imputed interest rate that we should be reflecting? Obviously this not necessarily cash or economic matters but more P&L issues.

William Clifford

As we’ve gotten the final interpretation and this instrument is a little bit nonstandard relative to market, so it did take us some time to analyze it and understand. At the end of the day, the answer came back very simple. It’s not debt. It won’t be reflected as debt. It’s 100% equity, and the impact on the diluted share count is that for while the stock is below $45, the dilutive impact of the share count will be based on a conversion price of $45, which is roughly 27.7 million shares. We will have a bit of a tricky situation as our stock price moves between $45 and $67 in that we’ll be recalculating dilutive impact based on where our share price is between $45 and $67, and then once the share prices gets above $67, the dilute impact will be based on the conversion of $67 or the roughly 18.6 million shares that equates to. So there’s no imputive interest. There’s no debt impact. It’s all equity and it’s just a matter of understanding how it impacts share count.

David Katz – Oppenheimer & Co.

One last one since it’s been a long time since we’ve had a chance to get cranked up about this, but there’s been some press about the tenth license in Illinois, which ultimately if it did become a reality, it could potentially have some impact. Do you have any read on whether or not we should be getting ourselves cranked up about this at this point?

Peter Carlino

Tim, do you have a view on that? Eric is not on the call I take it. He’s out in Kansas, but he would know best as he looks at the political situation. But, Tim, do you have a sense about that issue?

Timothy Wilmott

Well, I know they have put out to bid. They’ve begun the process and retained an investment bank to begin the process. I think they’re looking to issue the license by the end of the year. That’s my recollection and there’s no definite understanding of where the license will be located. Until we know when that decision comes down, it’ll be very difficult to assess the impact on our operations in Aurora and Joliet until that time.

David Katz – Oppenheimer & Co.

Then one last one if I may. It’s probably fair to guess that most of us are pleasantly surprised with Zia Park and it didn’t know all that much about that market. What kind of plans do we have for that property over time, and how big does that ultimately become?

Peter Carlino

It’s a very robust area today because of the oil and gas business and that you can pretty well be assured it’s going to continue for quite some time. We will add a hotel in that market. We’re looking at scale and cost and so forth right now. I think we bought the property with that likelihood in mind and I think now we’ve looked at it. The market is dramatic. You build a hotel there just to have a hotel, so having a hotel on our property is a terrific idea. We’re going to move as swiftly as we can to get there. There’s a limit on machine count under New Mexico law. Needless to say, we’ll lobby for more as we can and to stay as close to the politics of all that as possible. We clearly see opportunity to expand even the current footprint.

Operator

Continuing on, our next question comes from the line of Larry Harfordy of Gameco.

Larry Harfordy – Gameco

One theoretical question and then a follow-up: You guys have learned a lot more about the capital markets in the last year or so than probably you’d like. As you look at the capital markets right now, what kind of leverage do you think they would allow a gaming company like yours have? If you can talk in terms of debt to cash flow or cash flow cover of interest, that’d be helpful.

Peter Carlino

Bill should best answer that.

William Clifford

I think a lot of it’s still going to be dependent on what is you’re borrowing for. I think if you’ve proven existing cash flows, you might be able to go as high as 5.5 time EBITDA and still keep it at a sub 10% interest cost. If you’re trying to do a Greenfield project, I think that becomes a lot more problematic. So we kind of look at as the ideal is somewhere in the 4.5 range. We’ve got with this equity that we’ve got in future, we’ve got the capability, depends again on where the purchase multiple is, but assuming nothing too crazy on those that we can probably acquire somewhere between $400 and $600 million of EBITDA and keep our leverage under 4.5. So we’ve got plenty of capacity and I think we can get it done in the current market as what would be perceived as reasonable rates, certainly very unreasonable relative to where we’ve been historically but projects that could still work and acquisitions that could still work for us.

Larry Harfordy – Gameco

So recognizing that you’d like to study sometimes opportunities are transitory and I noticed that Las Vegas Sands pulled out of Kansas I guess yesterday. Some of the folks in Missouri are reasonably optimistic that that loss limit is going to change, which Las Vegas Sands cited as one reason why they pulled out. If you were interested in something in Missouri, wouldn’t it behoove you to move very quickly because those assets it would seem especially relative to the way the regulatory wins are changing are really on a bargain basement level?

William Clifford

I’m not so sure. I mean the reality is: Whoever owns the asset under… If you go in right now and you ask somebody to sell an asset in Missouri, they’re going to quote you a price based on the success of the loss limit, which may or may not be realistic in terms of what’s real impact will be on that property’s EBITDA. So I don’t think, I think you quite honestly would be better served to wait. One, make sure it’s a certainty because otherwise you’re not going to get something cheaper. Two is actually to see what the results might be so that you got a more realistic view on what the real impacts going to be from an increasing loss limit. There are wide ranges of opinion in terms of what the impacts going to be. Part of what I think people forgot about when considering it is the fact that there’s 1% increase in the gaming tax, which is on all revenues, not just the revenues generated on from customers that might take advantage of the $500 loss limit. When you start to extrapolate that out across the entire base of revenue, growing your EBITDA dramatically on that is not a sure thing. I mean I think it’s got upside. I don’t want anybody to get confused. I do think it’s a positive for the industry; I’m just not sure it’s as much as what some people believe.

Peer Carlino

There’s other elements to that. First, just from a philosophical point of view, I, I’ll speak just for me, have an aversion to buying air or buying a promise. I mean you get it. We all who live on the buying side, hear the story. Well it’s going to do this, or it’s going to do that. My answer is always the same: Call me when you got it. I’d be happy to pay you for it, but I’m not going to pay you for it because you think it’s going to be there. It’s simple as that. Further, I think there’s always going to be challenge at both ends. I mean you’ve got a lot of growth in the eastern part of the state, St. Louis market, that’s going to be bad news for all the competitors in that part of the world. Kansas on the other hand is going to get squeezed when the State of Kansas opens these facilities. It’s going to have an impact, so I see more downside in that market than I see upside and that’s simple reality. So if I were anybody doing business there, I’d be incline… Well, it’s hard to say. They want to sell to future I would guess and I’d say, “Good. When do we get there?” I’m not figuring frankly we’re missing a thing or anybody else is missing a thing by not acting today. I’d say it’s a lousy time to jump in there.

Larry Harfordy – Gameco

The last: I was impressed with what you made in Pennsylvania with what is to my knowledge the second worse tax situation on the planet. Do you see any chance of that tax situation changing in Pennsylvania?

William Clifford

No, not legislatively. The one thing that will help down the road is as the standalone facilities come online, they’ll start making contributions into the Horseman’s First Fund, which will have an offset for us because that money will be used to offset the existing race tracks contributions today. It’s a net loss from a statewide perspective, but it’ll help the existing operators.

Peter Carlino

Pennsylvania did do some smart things. We can all moan about the “racetrack model,” which is the higher tax model, but the legislator was pretty smart and they didn’t gouge us enough front seats. I mean I actually talked with some of the guys who were writing the legislation who basically said, “Look, we’d like to get as much as we could possibly get.” You can see all these silly multi-hundreds of millions of dollars apiece, but they said, “Look, we recognize the more we take, the less we get. I mean it’s amazing. Most legislators haven’t figured that out. They also understood the same things, they clearly did on the tax side, that: Look, they want to get all they can get, but there is a tradeoff between high taxes and the investment level.

I mean look Maryland as an example, a very bad piece of legislation. We’ll play in that game, but what are they going to get? Have they maximized revenue, or will they in the State of Maryland with that legislation? Of course not; they’re taking all the money, so what they’re going to get is not a lot. You can’t tax something to success. I mean it’s just simple. Obviously there is a level where if the taxes go high enough, you just don’t get the investment.

So Pennsylvania was very smart about that and one of the objections we raised was the competitive disadvantage the tracks would be and as against the freestanding facilities, and the state recognized that. Incredibly rather than driving all the money themselves, they put the excess difference that these facilities were not paying in purses back into the overall purse pool, which will have a great effect on the racing industry, which by the way when everyone thinks about racing: Employs a lot of people, has a profound effect on the agriculture economy. Look, this is a very prescient move frankly on the part of the Pennsylvania legislature. So when you get into the Pennsylvania legislation… As Bill said, our taxes will fall. But when you look at the total context of this legislation, it’s actually pretty good.

Operator

(Operator Instructions) Our next question comes from the line of Todd Jordan of Research Edge.

Todd Jordan – Research Edge

Two questions, and I apologize if it had been answer already. I’ve been jumping on and off conference calls. But just wondering what the impact has been on Charlestown and what kind of overlap there is from the Penn Casino, and are you able to sort of monitor, I’m assuming databases with both and just looking at the overlap between the two parties? I’ll ask my next question after that’s one been answered.

Peter Carlino

Len, do you want to take that?

Leonard DeAngelo

Sure, I’d be happy to. Yes, when we went into the budget season for this year with the opening of Holiday Penn National, we did look at the overlap and it primarily occurs in the Southern Pennsylvania regions of York and the like in that area. It’s coming in about where we expected in those particular regions. Maybe it has about an impact on the order of a third of the revenue coming out of that overlap between the two properties. About a third of what Charlestown was getting before is now going to Hollywood Casino Penn National. I would expect over time for that number to rise a little bit, but right now it’s coming in where we’d expected, about a third of the overlap is shifting to Penn National.

Todd Jordan – Research Edge

My second question, just real quick, Bill: I’m assuming that even though you’re showing this is preferred as equity that when banks are calculating your leverage ratio that that gets included in the debt portion?

William Clifford

I don’t think it should be. I mean obviously that’s, I mean the GAAP accounting says it’s equity. The reality of the instrument is that the holders of it have equity risk. Perhaps this is one of the arguments I actually made with the rating agencies is that conceivably you could have a company with, if all we did was pay down debt over the course of the next seven years that we could be a AAA rated company in terms of investment grade on the debt side, yet the holders of this paper could be facing principal risk. So I think at the end of the day, it’s very much like an equity or an equity investment. In any event, it’s certainly as safety valve from a debt perspective in that if the company were at the end of seven years were to have any issues around credit, that there’s a mechanism there to basically convert it to equity and candidly if we’re very successful at deploying this capital, and let’s say we do wonderful things over the course of the next seven years, I would say it’s probably more likely than not that we would in fact issue the shares rather than redeem the shares. But obviously that’s going to play itself out over the course of the next seven years.

Todd Jordan – Research Edge

How did the rating agencies respond to your argument?

William Clifford

I don’t know; we haven’t heard yet. I made a lot of arguments, but I want go over all of them on the phone. I think we’re going to wait and see and I think there’s… Listen, there was some nodding as I made my point. That doesn’t necessarily mean that they’re going to accept all the points but, and that they’ll probably come out with some kind of, which as I understand how they work, they give you a percentage credit as equity versus debt. So I don’t think it’s, which is somewhat a little bit illogical, but they’re going to in the gate that they’ll give you a certain percentage credit towards equity and a certain percentage targeted debt, and I think we’ll have to wait and see what the outcome of our meeting was and anxious as anybody else to see what their final thoughts are.

Peter Carlino

Everybody’s knowledge is that this is not like any other instrument out there; it’s very unusual, highly favorable for us. But I think people, these people scratch their heads saying, “What is it?” You’ve got our point of view.

Operator

Continuing on, we now have a follow-up from the line of Larry Klatzkin of Jefferies.

Larry Klatzkin – Jefferies & Co.

A couple of things: One, you received the $225, how much taxes do you have to pay on that? I mean what do we see cash net on that?

William Clifford

I think as we indicated previously, I don’t think we’ve taken a different view. We’re expecting net proceeds of roughly $120 to $130 of the $225.

Larry Klatzkin – Jefferies & Co.

As far as Lawrenceburg goes, the two Indiana slot houses opened up it seems to have had an inpact on you. Are you seeing that as becoming, people going to look at it and now they’re coming back to you, or what are we seeing on that?

Peter Carlino

Tim, do you want to handle that?

Timothy Wilmott

Go ahead, Len, you go ahead and I’ll follow if there’s anything else.

Leonard DeAngelo

Clearly when the properties opened, we saw a dramatic impact in those particular zip codes directly around the new facilities. Clearly there’s a lot closer to those zip codes and they are only slot operations, but there was an initial impact. I would venture to say that it’s too early to see the rebound since they just opened recently yet; but they did have a big impact in those particular zips within 60 miles of…

Larry Klatzkin – Jefferies & Co.

Is that continuing into mid July or is that, are you seeing some people coming back.

Leonard DeAngelo

Too early to say, but I would venture to guess it’s continuing in those zip codes closer to the track.

Larry Klatzkin – Jefferies & Co.

So it’s more of a program effect?

Leonard DeAngelo

This is still early in the day.

Peter Carlino

Too soon to say. Too soon to say.

Larry Klatzkin – Jefferies & Co.

Sure, and you guys are also doing some work in your place.

Peter Carlino

Ask us that question when the third quarter’s over and I think we’ll have a much better feel.

Operator

Continuing on, we have a follow-up from the line of Dennis Forst with Kebanc Capital.

Dennis Forst – Kebanc Capital Markets

Yeah, I just wanted to get a clarification on the preferred, Bill, because I’ve been having discussions with a number of people about it. Seven years from now your stock is at $100 a share, you either pay it off in cash or hand over 18.6 million shares?

William Clifford

Yes, and also, or we could elect to pay any portion and deliver the remaining value in cash. So if you were to take the number of shares times $100, that’s the amount that we owe. We could deliver… We could split it 50/50 and deliver half in shares and half in cash, if that’s what we choose to do.

Dennis Forst – Kebanc Capital Markets

Remind me again, the preferred is 1-point what?

William Clifford

1.25 billion.

Dennis Forst – Kebanc Capital Markets

$1.25 billion, so in that case if the stock were $100, wouldn’t it make sense to sell stock, do a secondary to pay it off $1.25 billion. It doesn’t make any sense to give shares when it’s $100 does it?

William Clifford

Well, we only have to give the $1.25 divided by 67, I think that number…

Dennis Forst – Kebanc Capital Markets

You said 18.6 million shares.

William Clifford

18.6 million shares, we can satisfy the entire obligation for the shares.

Dennis Forst – Kebanc Capital Markets

Yeah, but if the stocks selling at $100, then you’re giving them $1.8 billion worth of stock instead of $1.25 billion worth of cash; isn’t that correct?

William Clifford

No, I understand. Well if we owe… Maybe this will help, and I’m happy to take this call offline: We owe the $1.25 billion. But if the stocks at $100, we owe $1.8 billion, so we could satisfy the $1.8 billion by delivering 18 million shares or we could take the mixture of that.

Dennis Forst – Kebanc Capital Markets

Couldn’t you sell, what would that be, 12 million shares at $100 and then hand over the $1.25 billion in cash to them?

William Clifford

Oh yeah. No, listen, I mean whatever shares we wanted to give, it would make the sense to simply deliver those shares at $100 to the holders of the redeemable equity.

Dennis Forst – Kebanc Capital Markets

So if I have the redeemable preferred and the stocks trading at $100, if you give me a share of common stock, that reduces what you owe me $100?

William Clifford

Yes, each share still carries $100 value.

Dennis Forst – Kebanc Capital Markets

.

Whatever the market is? So in then theory, you only have to give then 12.5 million shares if the stocks at $100?

William Clifford

No, I’d still have to give them the $18 because it’s $18 million shares times $100, that’s my overall liability of 18.6 million.

Dennis Forst – Kebanc Capital Markets

So the simple answer then, if the stocks trading at $100, you’re not going to give them any shares. At $100, you’re paying 1.5 times what you owe them if you use any shares at all?

William Clifford

Well, I own the whole thing. In other words, if our stock goes to $100, I owe them $1.8 billion; I definitely owe them that.

Dennis Forst – Kebanc Capital Markets

Oh you do? So this is the discussion that we’ve been having that’s unclear.

William Clifford

Like I said, give me a call and we can…

Dennis Forst – Kebanc Capital Markets

Good. The other question may be for Tim. We were talking earlier about Joliet and then the sunset of the 3% in May. Now isn’t that back alive?

Timothy Wilmott

No, the session in Springfield ended and no legislation was introduced. So at least until they’re back in session, which I believe is sometime in November, we don’t see anything affecting the balance of 2008 with regard to that horse pack.

Operator

Continuing on, we now have a question from the line of Nisha Dudley at Halbis HSBC.

Nisha Dudley – Halbis HSBC

Is there any dividend component to the preferred stock or any ability to put one in in the future? Is there any dividend attached to the preferred?

William Clifford

Well the Company doesn’t issue dividends or it doesn’t currently have any plans to issue dividends. If the Company were to issue ordinary dividends, there’s a mechanism where they would share on an as converted basis on basically the 18.7 million shares or the conversion of 57, if we didn’t declare an ordinary dividend. If we declared a special dividend, then what would happen is they would share in that dividend and we’d have a reduction of the principal balance due and a reduction of the floor and the ceiling price so that in other words, if we were to declare $10 dividend, they would share in those proceeds and we would lower the floor and the ceiling price by the $10.

Peter Carlino

Let me interrupt by saying, I wouldn’t waste a whole a lot of time thinking about dividends. As a major shareholder, I’m going to say, “Don’t count on it any time soon.

Nisha Dudley – Halbis HSBC

Right, but is there mechanism by which to pay that preferred entity, a dividend and restructure the obligation that way.

William Clifford

I mean I’m sure there’s any number of creative things that we could do if we choose to do that, in terms of paying them a dividend or other concepts to extend the maturity date or any other series of options that would be available to us. But obviously, it doesn’t make any sense to being that today. That would be a conversation that might make some sense sometime down the road in probably five or six years from now.

Operator

Continuing on, we now have a question from the line of Brian Sells of Peak Financial.

Brian Sells – Peak Financial

Peter, can you speak about what you and your management team learned from the failed buyout that would help in the event you were approached again in the future?

Peter Carlino

Look, there’s really little I can or would say on an open phone call about this. I think I said it last time that we had a very good contract with these folks and we unfortunately found ourselves in a credit market that was, let’s face it, a disaster. We could’ve tried to perfect the contract in court and done all kinds of mean and nasty stuff; and if I thought that was going to be a cakewalk, we probably would’ve taken it. I mean I’m not confused about where value for shareholders lie. But nonetheless, you make a business judgment about what your choices are. So look, we opted to look at what we saw as a very, very difficult market and decide that taking a materially impactful settlement was the smarter thing to do taking the long view for the Company and its shareholders because in the end, holding nothing if we didn’t succeed in court, would’ve been a pretty ugly prospect and would have diverted us for years and so on and so forth. So there’s really no lesson to learn except make a deal at a better time, that’s it; or if we were in any other business on the planet, that we could’ve gotten a closing in a 120 days or even six months, I think we would’ve gotten there. It just is the nature of this business that you’re hanging out there for a very, very long time. I guess the message is that in the future for gaming companies, it’s a tough road.

Brian Sells – Peak Financial

So it’s more about the credit markets than the economy and the industry in your opinion?

William Clifford

It was clearly a confluence of everything. I mean it was the credit market. It was the general business conditions, as well as the quite candidly the gaming multiples, all three of these things were a major problem for us. At the end of the day, I think if there’s a lesson learned, your recourse against shell companies even with as good a contract as we had, you don’t have a good resource against the shell companies as you do against a strategic buyer. I think that’s probably as far as I’m going to go without having a heart attack.

Operator

Continuing on, our next question comes from the line of Jeff Gates of Gates Capital.

Jeff Gates – Gates Capital

Question again on the preferred, I guess we should really be looking at this, correct if I’m wrong, as 12, 57 years from now, so even at a 10% basically present value of about half of that today. Then if I understand it right, you effectively a put option at $45 a share.

William Clifford

Right.

Jeff Gates – Gates Capital

But you really don’t have a call option because you don’t own a call option at 67 because if the stock was $100 a share, you’d have to deliver the 27.8 million shares anyway.

William Clifford

No, I’m sorry, we deliver the 18…

Jeff Gates – Gates Capital

I’m sorry, the 18.7, right, you’d have to deliver the full amount of cash. But conversely if the stock was lower than 45, you could satisfy it with less cash than 12.50?

William Clifford

Right.

Peter Carlino

It’s a pretty safe bet for the Company. I mean obviously you look where we are today and we certainly expect and would be delighted to turn those shares over when the stock price is at the kind of level we think it needs to be. The challenge is on their side. We would argue of course it’s not a big challenge given the seven-year time horizon. But we have protection on the downside. I think that’s critical thing for our shareholders.

Jeff Gates – Gates Capital

Basically I would face the debt that that’s really an impressive term, $625 million at 10% IRR and then you own a put option at $45 share.

William Clifford

That is another way to look at it, yes.

Operator

Our final question comes from the line of Zeth Noonson from Pine Global Capital.

Zeth Noonson – Pine Global Capital

As it relates to the preferred then, if you’re really not on the hook for the $12.50 because you do have that explicit put option, how could that be considered debt?

William Clifford

That’s my argument… I’ll bring you along with me, maybe you can be more persuasive than I was.

Zeth Noonson – Pine Global Capital

I’ll be happy to join you.

Peter Carlino

Yeah, we obviously took great pains and Bill worked very hard with his team and our outside consultants, accountants, and so forth to crack an instrument that you see here. We feel pretty confident that we know what it is, but obviously others a little more confused.

Zeth Noonson – Pine Global Capital

What’s the timing to get a final call from the ratings agencies?

William Clifford

I’m not sure. I’m sure they’ll be coming out shortly. The reality is I’m sure they’ll at some level, they’ll be reexamining if they were to come out with an understanding that it was debt, that they would re-look at that as circumstances change. I don’t want to put any words in their mouth or even pre predict where they’re going to come out at. I think we’ve made some very compelling arguments for why it’s equity and we’ll see if they agree. I’m not sure that at the end of the day, and maybe this a little conceded or unrealistic, but I’m not sure if at the end of the day that the people who were going that might be lending us money in the future will necessarily always agree with where the rating agency interpretation is in terms of their risk profile in lending us the money and where this real equity stands in the capital structure. So there’s certainly been situations in the past where the credit markets have not followed exactly what the rating agencies have indicated as reflected where the coupons been on gaming table relative to the rating so. Now obviously that swung a bit today in the current market, but I’m not really that panicked on where the rating agency come out because I think at the end of the day, the underlying economic will speak for themselves, the instrument will speak for itself and I think when it’s time for us to look to raise additional capital in the debt market that the debit market will do their own interpretation of how they see this instrument whether they view it as equity or whether they view it as debt.

Operator

Gentlemen, it appears there are no further questions at this time. We’ll turn it back to you once again to continue or for your concluding remarks.

Peter Carlino

Well thank you all who turned this morning, and we’ll see you next quarter. Thank you.

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Source: Penn National Gaming, Inc. Q2 2008 Earnings Call Transcript
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