Penn National Gaming Inc. (PENN:US), the casino operator spinning off properties into a real estate investment trust, will call competitors “10 seconds” after its deal closes to see who’s willing to sell their resorts.
“This idea will absolutely revolutionize and open up capital for gaming companies that’s not available today,” Chief Financial Officer Bill Clifford said in a Dec. 13 interview in New York. “Gaming companies could become asset-light, where the only capital they need to raise in order to operate casinos will be the cost of the furniture, fixtures and equipment, and gaming license.”
If successful, Penn National would lead the casino industry down a path pursued by hotels, offices, malls and timber plantations. The pitch: the other casinos could free up capital, allowing them to fund expansions, reduce debt or return cash to shareholders, Clifford said. Companies would then lease-back from Penn National’s REIT and continue operating the casinos as before.
Penn said on Nov. 15 it planned to split into two public companies in the second half of 2013 by placing most of its properties into a REIT to be owned by existing shareholders. REITs pay investors pretax earnings as dividends.
“If the price is right, I think people will definitely consider selling to the Penn REIT,” said Joel Simkins, an analyst at Credit Suisse Group AG in New York, who rates the stock outperform. “Some publicly traded companies may have a handful of assets that they look to monetize,” along with some of the more than 100 closely held gaming properties in the U.S., Simkins said.
Casino companies with the most U.S. properties include Caesars Entertainment Corp. (CZR:US), MGM Resorts International (MGM:US), Boyd Gaming Corp. (BYD:US), Ameristar Casinos Inc. (ASCA:US), Pinnacle Entertainment Inc. (PNK:US), Station Casinos LLC and Isle of Capri Casinos Inc. (ISLE:US)
While Penn can’t approach other owners until the spinoff is completed under Internal Revenue Service rules, it will “be picking up the phone 10 seconds after the spin is effective and begin having conversations, setting up meetings, and try to engage their interest in doing a transaction with us,” Clifford said.
To be sure, other casino companies are likely evaluating whether they can replicate a REIT spinoff themselves, rather than sell assets to a rival, said Joseph Greff, a JPMorgan Chase & Co. analyst in New York.
Still, most U.S.-focused casino companies today don’t have Penn’s combination of low debt, high cash taxes and strong free cash flow yields that make its spinoff strategically smart, Greff said. More highly levered rivals would struggle to generate sufficient cash to pay both rent and service debt. Many have accumulated losses resulting in lower tax burdens that make the REIT tax benefits less compelling, he said.
Similar moves have already succeeded in the hospitality industry, where REITs such as Host Hotels & Resorts Inc. own and lease hotels while operators including Marriott International Inc. and Starwood Hotels & Resorts Worldwide Inc. have sold real estate to focus on managing properties. Gaylord Entertainment Co. earlier this year sold its hotel brands and management business to Marriott and converted to a REIT now called Ryman Hospitality Properties Inc.
Penn needs approval from casino regulators in the 19 jurisdictions that it operates before splitting the company, a process executives say they’re confident of achieving by the fourth quarter of 2013. The company received a private-letter ruling from the IRS related to the spinoff’s tax treatment that took more than 18 months, clearing a key hurdle to proceed.
Wyomissing, Pennsylvania-based Penn’s shares have surged 32 percent since the Nov. 15 announcement. Chief Executive Officer Peter Carlino built Penn National via acquisitions (PENN:US) and development from a single horse-racing track near Harrisburg, Pennsylvania, into the operator of 29 casinos and racetracks across North America.
Clifford, 55, has been Penn’s CFO since 2001. He was previously CFO at Sun International Resorts Inc., developer of the Atlantis resort in the Bahamas, and earlier served as controller at Las Vegas casinos including Treasure Island.
Both the REIT and the operating company will continue to pursue acquisitions and developments, Clifford said, and the two entities may partner on some projects. The REIT will have a lower cost of capital, allowing it to potentially pay more while still getting a better return than the casino operating company, he said.
“Penn has scoured the U.S. and scoured the globe for acquisition deals and development deals,” said JPMorgan’s Greff. “I would imagine potential sellers who wanted a certain price that Penn wasn’t willing to pay before” will be back in touch.
Penn is initially placing 17 of its properties into the REIT and will pay investors a one-time dividend of about $5.35 a share plus stock in the property trust, and forecast an annual dividend of about $2.36 per share based on 2013 earnings.
“It shows casino companies are looking for ways to unlock value,” said Keith Foley, an analyst at Moody’s Investors Service. “I wouldn’t be surprised if two or three other avenues are being considered by different companies.”
REITs, which don’t pay federal income taxes, are required to distribute at least 90 percent of income to investors, and must pay out earnings already accumulated. The reliability of regular payments appeals to a larger pool of investors than casino companies enjoy.
REITs raised $67 billion from debt and equity offerings this year through Nov. 30, the highest in records going back to 1996, according to data from the National Association of Real Estate Investment Trusts, a Washington-based industry trade group.
The dividend yield on the Bloomberg REIT Index was 3.5 percent yesterday, attracting investors pursuing yields higher than U.S. Treasury securities. The yield on the benchmark 10- year Treasury note was 1.82 percent yesterday and 3 percent for 30-year bonds.
Penn’s plan seeks to protect investors by ensuring the casino company must renew all leases together, preventing it from dropping individual properties, and requires the operating company to sell the license and equipment to the REIT at the end of the lease.
“They can’t just take their gaming license and go down the street and build another casino and compete,” Clifford said. “They have to leave the gaming license and the gaming equipment at the facility.”
The casino operating company is also responsible for paying all building costs including maintenance, property taxes, utilities and insurance, minimizing expenses for the REIT. The so-called triple net lease structure is similar to Lexington Realty Trust, Omega Healthcare Investors Inc. and National Retail Properties Inc.
Penn’s REIT will charge rent of about half the cash flows of the casinos, and take 4 percent of the net revenue from most of them for five years, before renegotiating that rate.
“That’s what allows the REIT to participate in the revenue growth of the properties,” Clifford said. “It’s very much modeled after a mall REIT.”
Unlike retailers in malls, casinos are “somewhat less risky” tenants, said Credit Suisse’s Simkins. Because licenses are scarce and tightly regulated, “the odds of somebody opening up a shop next door to yours tomorrow are fairly limited.”
The property company should begin trading as a REIT in January 2014, and Penn expects the bulk of casino acquisitions to occur in the following three years, before expanding into other types of real estate, Clifford said.
“REITs that don’t grow don’t trade at as high a multiple as REITs that are successful at growing,” he said. “We’re going to be approaching anybody who has an interest in potentially monetizing their real estate holdings” to grow.
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