A tale of two Penns

Update: Seeking Alpha’s Brad Thomas has run the numbers on the Penn split and doesn’t like the risk/reward scenario.

Fifteen years and many consolidations ago, the casino industry was seized by a brain fever. It was set off by the bidding war between Hilton International (led by Steve Bollenbach) and Starwood Resorts (then run by current Riviera owner Barry Sternlicht) for the ITT/Sheraton portfolio, which included Caesars Palace and the Desert Inn. Starwood’s winning pitch was that it was going to roll ITT/Sheraton into a real estate investment trust (or REIT). This sparked a furor among gaming executives, who collectively began to gobble like so many turkeys, “REIT! REIT! REIT-REIT-REIT! We’re gonna become a REIT. Everybody’s gonna turn into a REIT!”

In the end, nobody did. The phenomena, which I dubbed “REITmania” in the pages of Casino Executive magazine almost led to a takeover of Station Casinos, but that ended acrimoniously. By 2000, Starwood had shucked its casino assets and the acronym “REIT” was largely forgotten … until late, late yesterday, when over the wires went what Deutsche Bank analyst Carlo Santarelli rightly called “a shocking and somewhat confusing release.”

Penn National Gaming has announced that it will split itself into an operating company and a REIT. The casino properties will be cleft between the two entities, with Penn National leasing most of them from the REIT. OK, let’s get right to the bottom line: This is a big-ass tax dodge. REITs are exempt from federal taxes. Ergo, Penn rents property to itself and then is “required by law to distribute at least 90 percent of [its] taxable earnings to shareholders as dividends.” That only leaves 10% of taxable earnings for reinvestment, so make of that what you will. The devil is in one, unspecified detail: How are the gross gaming revenues divided? If the operating entity keeps all the lolly from the slots and tables, where does the property company get the cash flow to both keep expanding and pay down debt?

The split also enables Penn to make an end-run around anti-trust laws limiting concentration of ownership (think Indiana, Maryland, Pennsylvania, Colorado, Maine) and dabble in overseas casino ventures: “No, it’s not this Penn National that’s bidding on the license, it’s my identical twin cousin.” It remains to be seen how well regulators will be beguiled by that sophistry.

Penn execs even claimed “it would encourage other casino companies to sell properties to the REIT and lease them back as operators.” Uh-huh. Yeah, like David Cordish is going to offload all that money he’s making from Maryland Live in return for a management fee and a performance-based gratuity (and the higher tax rate). At the end of the day, Penn owns the place, you don’t. Speaking of gratuities, minority owner Fortress Investment Group gets to trade in 21.7 million preferred shares, worth $45 a pop, for 14.6 million common shares — but at premium price of $67 apiece. It can resell a portion of them to Penn, also at $67/share.

So Wall Street is orgasmic over the announcement, with Penn shares making their biggest leap since 1994, already exceeding Deutsche Bank’s target price. (J.P. Morgan subsequently hiked its price target to $61/share and Deutsche Bank further upped the ante to $65.) A promised $1.4 billion dividend, including $487 million in cash, most have stockholders positively giddy. (Interestingly, both CEO Peter Carlino (above) and director John Jacquemin exercised thousands of stock options last week.) The Carlinos will no longer have to apply for casino licenses in Nevada, either, as their share of the operating company will fall to 9.9%. Funny how that worked out, isn’t it? Carlino will run the cash cow, er, property company, while President Tim Wilmott (right) does the heavy lifting at the operating company.

(If you want the dividend goodies you have to hang onto one share of ‘OpCo’ stock for every share of ‘PropCo’ stock, since Carlino’s half of the company is paying out all the booty. Employee options are being converted to REIT ones, so they’re covered if the operating company goes south.)

The operating entity will fork over $450 million in annual rent to the REIT or, in the cases of Hollywood Casino Toledo and Hollywood Casino Columbus, the REIT would take a 20% share of net revenues (or monthly ones — sources differ). In 2011, that would have represented 16% of gross revenue … but would have swung a $242 million profit to a $208 million loss. It would reduce anticipated 2012 cash flow to $315 million. The REIT would also sequester hot property L’Auberge Baton Rouge and stinker Hollywood Casino Perryville (above) in a taxable subsidiary. Why? In part, so Penn can sidestep Maryland’s one-casino-per-owner rule. Also, the Perryville failure makes a nice tax writeoff, don’t you think?

Penn National REIT keeps almost all of the premium properties, including projects in Dayton and Youngstown, Ohio. Wilmott’s operating company is allowed to own a pack of dogs (two Texas horse tracks, Rosecroft Raceway in Maryland, a greyhound track in Florida and my favorite-named grind joint, Bullwhackers Casino [redolent of unnatural acts involving livestock] in Black Hawk, Colorado, where the men are men, and the cattle are nervous). But Wilmott gets a tribal-casino management contract in Ontario and Kansas-owned Hollywood Casino at Kansas Speedway, and all the casino licenses. Most of the aforementioned casinos, racinos and parimutuels are joint ventures, hence their sequestration into the submissive, operating-company half of Penn. The dominant, property-company half gets nearly all of the wholly owned assets. (But should Texas, say, legalize racinos, don’t be surprised if assets move from Pocket A to Pocket B and vice versa.)

Santarelli picks Ameristar Casinos as the most likely candidate to follow Penn’s lead. And why not? REIT-owned properties are projected to sell at 11X cash flow, compared to 7X for gaming-sector ones. You’ve increased the asset price of your casinos 57% just by doing a little paperwork. Debt can be refinanced at lower rates. However, since two of analyst Joseph Greff‘s criteria for successful REIT conversion are “low balance sheet leverage” and “high levels of free cash flow,” Caesars Entertainment and MGM Resorts International can forget about joining the parade (Boyd Gaming, too), and Las Vegas Sands would be a long shot, although the matter has been discussed in the past and CEO Sheldon Adelson has toyed with spinning off Sands’ retail holdings. Wynn Resorts, however, would appear to be well-positioned for REIT conversion, should Steve Wynn fancy becoming a glorified landlord.

As for Penn, the order of the day — pending completion of the split — is to vacuum up individual properties, devour small companies outright and broaden its tribal-management activity. Since one of Penn’s goals is to circumvent anti-monopolistic rules, the consumer stands to lose big-time … and Penn is not known for “george” customer treatment already, as does Uncle Sam. It may look, walk and quack like a scam but it’s all perfectly legal, I assure you. Merely business as unusual.