Jeremy Johnson's  Instablog

Penn National Gaming (PENN) is a casino company operating in four major regions: Midwest, East/West, Southern Plains and Other. The Midwest includes operations in Illinois, Indiana and Ontario and represents about 35% of EBITDA (all figures based off first six months of 2012). East / West includes operations in the states of West Virginia, Pennsylvania, Nevada (off strip), Maryland, Maine and New Mexico and represents about 52% of EBITDA. The Southern Plains segment includes operations in Mississippi, Missouri, Louisiana and Iowa and represents about 25% of EBITDA. Finally, the other segment primarily contains the company's horse racing operations which generally lose money and therefore represent a negative 11% contribution to total company EBITDA.

Penn is currently building a number of facilities in Ohio that will be classified in the Midwest segment of the business. One facility in Toledo recently opened, while another in Columbus will open in the fourth quarter of 2012. The company also plans to open two more facilities in Ohio in 2014.

The largest industry factor facing the locals casino market in the U.S. is the continued expansion of those areas where gaming is legal. This trend is currently impacting Penn in a number of jurisdictions, including Illinois, Pennsylvania and Louisiana where new casinos are either opening or will very likely open in the near future which will impact operations at various Penn casinos. In Kansas, Penn was effectively forced to compete with itself by opening a new casino less than 20 miles from an existing facility lest the new facility be opened by another operator.

Even beyond these concrete examples, the trend is toward increasing gaming capacity throughout the U.S. which should be expected to have some impact on returns on investment for casino operators.

In 2005, Penn completed a major corporate transaction (the purchase or Argosy) almost doubling the revenue base. In 2006, the company generated $2.2 billion of revenue, $612 million of gross cash flow (net income, depreciation, interest and current year lease expense) and generated a ratio of gross cash flow to gross assets of 16.1%.

By 2011, while revenue had grown to $2.7 billion and gross cash flow had growth to $557 million, return on gross assets had decreased to 12.8%. Some of the decline has likely been driven by the vagaries of purchasing accounting which tends to make returns on gross capital look better than it is in reality; however, the trend has clearly been negative implying that returns have come down in the industry in the face of increased supply and higher costs, the latter especially in the cost of gaming licenses and revenue splits with states.

On an IRR basis, Penn is currently generating an IRR of about 9.2% based on $2.65 of EPS, somewhat above the inflation-adjusted cost of capital of 5.6%. This implies that corporate investments at Penn generate value for shareholders and therefore growth should have some limited value.

Penn currently has about $2.1 billion of debt outstanding for which it pays a quite low interest rate. For 2012, interest payments should total about $72 million for a 3.4% rate. This is made possible by borrowing largely at a short-term interest rate through bank loans leaving the company somewhat exposed to interest rate risk. Meanwhile, the company is able to boost its return on equity by a couple points (including the value of the preferred convertible discussed below).

Turning to capital structure, Penn has outstanding a rather large amount of convertible preferred stock held by two large financial investors. The genesis of this preferred funding was as compensation for a failed buyout attempt due to the financial crisis. The preferred does not trade on a public market therefore no market price is readily available. However, the value is likely in the range of $1.1 to $1.3 billion payable in stock or cash at the company's discretion in 2015. In my view, the preferred should really be thought of as additional equity value at the company, making the current market value of Penn about $4.1 billion.

Running Penn through a residual income valuation model, the company's current market equity valuation of $37.68 seems fairly reasonable if not a few dollars high, at least in light of current low financing costs (as noted above). It is important to note that the company will need to grow profit in order to justify the current valuation and it cannot just muddle through, but given constant returns on capital an increase in profit of about 40% over the next 10 years, exclusive on inflation, should make the valuation work. At $33.00 a 20% increase over the same period should suffice.

A big risk factor in addition to growth are financing costs. In my view, a one percentage point increase in financing costs would cost the company about $5 of equity value. However, increasing short-term rates may imply a better economy and more gaming revenue which could be an offset; still that should impact all sorts of firms, many of which will not bear significantly higher interest costs at the same time and therefore, Penn may lag in that scenario.

My view is that there is a lot of value in Penn's assets. The locals gaming market, while experiencing increased competition, should perform rather well in a benign economic environment. However, the valuation seems somewhat stretched even after the 15% fall the company's shares have experienced in recent months. It is unlikely that the market has the same fears about refinancing risk that I have (in fact, rates could even go lower); therefore, the shares could bounce from the $33-35 level.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.