Description

Recommendation: Long Pinnacle Gaming (PNK)

Base Case Return: 10-20% upside (3-6 months)

At PNK’s current $30/share price, investors are creating both PNK’s operating business and GLPI at an attractive valuation. Investors in PNK will receive two considerations for selling – 0.85 GLPI and shares in PNK opco. PNK opco is valued at an implied 4.5x FCF multiple, which is a 45% discount to its closest competitor – Penn National Gaming.

Additionally, GLPI is trading at a low level given worries over GLPI financing the equity and debt portions of the PNK deal despite having a full bridge backing on the debt and reducing the equity raise from $1.1bn to $500mm.

Post-deal closing (Mid-April), investors will likely recognize that GLPI has multiple paths for growth and that its rent cash flows are dependable and less economically sensitive relative to other REIT sectors, resulting in an in-line or premium multiple to triple net lease sector. Assuming GLPI remains at $28/share today and PNK trades at a 1x discount to PENN, investors receive $36/share sometime in the second half of April, equating to a 18% gross return. This is a more than adequate return for the duration of risk but, assuming a normalization in GLPI’s stock price (the PNK deal is 10-12% accretive), the gross return could more than double to 40% with GLPI at $35/share (still a AFFO discount to the GLPI price pre-PNK announcement price).

Catalysts

·         Closing of GLPI/PNK alleviates short pressure from merger arb

·         Buybacks/Deleveraging of B/S at PNK

·         Acquisition Growth by PNK

·         Acquisition of PNK 

Valuation Scenarios (ignoring dividend return)

·         Downside Case (-11% return) ~ GLPI at 7.5x ‘pro-forma AFFO ($3/share), PNK at 5x ’15 FCF ($1.47/share) = $26.95/share

·         Base Case (+33% return) ~ GLPI at 11.5x pro-forma AFFO ($3/share), PNK at 7x ’15 FCF ($1.47/share) = $39.73/share

·         Upside Case (+55% return) ~ GLPI at 13.5x pro-forma AFFO ($3/share), PNK at 10x ’15 FCF ($1.47/share) = $46.32/share

Pinnacle Operations & Regional Gaming

Pinnacle is a regional gaming company run by gaming veteran (Anthony Sanfilippo) with 14 casinos across 9 states and 12 distinct gaming markets.

Regional gaming has been one of the last segments of the consumer space to recover from the financial crisis of 2008. Increased supply of regional gaming assets coupled with a financially crippled consumer made it difficult to regain traction. The supply side hasn’t dramatically improved, but new constructions have definitely slowed and PNK is behind the risk of Tillman Fertitta’s Golden Nugget cannibalizing PNK’s Lake Charles L’auberge property. Capacity issues are very market specific and in the case of Lake Charles, capacity utilization has been (and continues to be) very high. Even though the Golden Nugget ended up taking some business from L’auberge, the cannibalization was more on the food & beverage (F&B) and entertainment front vs. gaming revenues.

As opposed to the 20%+ cannibalization that the sell side predicted for L’Auberge in late 2014 for 2015, PNK appears to have done a solid job of reducing market share loss and flow through. Property GGR and EBITDA declined by only -6.8% and -13% in 2015, which I believe is commendable under the circumstances.

Despite January ’16 being the first month after fully lapping the entrance of the Golden Nugget into Lake Charles, January’s -8% GGR decline is less indicative of an anticipated decline in 2016. This is because L’Auberge is comping a strong January 2015 (+6%). Feb ’15 was also strong (+5), so March ‘16 should be a more telling comparison as it relates to extrapolating the magnitude of the impact from the weaker Texas feeder. 

A significant portion (50%+) of business at L'Auberge Lake Charles comes from Houston, TX (“feeder market”). Given the decline in oil prices and troubles in oil & gas, it is possible that a slowdown in Houston consumer spending could result in slower growth for the Lake Charles market. However, based on conversations with 2 management teams in the region, it doesn’t appear that the oil crisis is having an outsized effect on Lake Charles’ ADR rates and close to 100% occupancies over weekends.  Even if Lake Charles and L’Auberge were to decline single digits in 2016 on top of their single digit decline in 2015, PNK’s -47% discount to PENN (which doesn’t have the same magnitude of exposure to oil & gas markets) doesn’t justify the discount in my opinion.

Valuation

Assuming 2015 PNK EBITDAR YoY ($617mm), an investor could conservatively get to $1.47/share in FCF. If the price is normalized for management’s extra conservative guidance around maintenance capex and cash taxes, FCF an investor could get closer to $1.79/share in FCF. Using a 10x FCF multiple, an investor could arrive at a valuation range from $15-18/share vs. an implied value today at $6.44. The incremental step up in FCF comes from a more accurate assessment of capex ($75mm excluding 1x remaining Ameristar integration costs ~ 12 cents) and the amortization of the step-up (20 cents). I have assigned no value to recycling of free cash flow for buybacks, deleveraging, M&A inorganic growth or takeout.

Deal Break Downside – Assuming the deal breaks and PNK maintains its real estate holdings, I arrive at a downside of $29/share or at the current PNK levels. Given PNK is highly levered both financially and operationally, an 8x terminal multiple for a business that is rapidly deleveraging and owns its own real estate seems rational in my opinion. From a technical trading standpoint, if the deal was to break, PNK could trade down 20% to $25 for an interim period.

I believe the probability of a deal break is low at this point as the largest complaint currently circulating is coming from an organized casino union group, called Unite Here. This group is historically known for making a lot of noise and generating a lot of negative press coverage. Unite Here is arguing that certain covenants in the lease agreement should result in the FTC supporting GLPI’s  de facto ownership of PNK. Although the complaint by Unite Here admits that there is little precedence in support of treating sale lease back lessors as owners, it does highlight several lease terms that could be construed as ownership.

·         GLPI approval before undertaking large construction projects

·         GLPI has right of first refusal to finance investments greater than $2mm

·         GLPI approval needed to sublet

·         GLPI approval to build casinos w/in a certain radius miles

·         GLPI approval for Opco change of control assuming buyer doesn’t meet tenant guidelines 

In the event the FTC grants GLPI “effective control,” the union will argue that GLPI’s ownership limits competition and that divestitures in St. Louis, Kansas City and Baton Rouge should be explored given these are the markets where GLPI “owns” the most assets. PNK’s lawyers think the claim is very weak and I would concur.

GLPI Valuation

GLPI is the only pure play gaming REIT in the market (MGM Grand is supposedly IPO’ing its own REIT in the 1H16) after spinning out of Penn National Gaming in 2013. Even though GLPI has created tremendous value for PENN shareholders, GLPI on a stand-alone basis has been met with mediocre reception from long-only investors given the 1) lack of sector depth (no comps), 2) inability to consistently make acquisitions/grow dividend and 3) higher peer leverage. After effectively an 18 month hiatus from doing a decent sized deal (Casino Queen in 2014 for $140mm), GLPI effectively removed the “monkey from its back” with the PNK deal. Everyone knows Peter Carlino and GLPI paid-up for the deal, but given the cheap financing, the PNK deal is still low double digit accretive to AFFO.

Rebuttals to Bearish Thesis

·         Tapped out on TAM (low dividend growth potential) – GLPI has historically underestimated the size of its addressable market as the $25bn market size or 50 properties only includes small, private casinos. As seen with PNK, I expect GLPI to do a better job going forward of highlighting both the small as well as the one-off larger deals similar to PNK. Including both segments of the market materially increases GLPI’s TAM and provide a runway for more consistent M&A and dividend growth.

·         Lower Rent Coverage – One of the pushbacks from LO investors is that GLPI’s EBITDAR coverage ratio is low relative to other REITs. In response to this, management points to the stickiness of the cash flows and high barriers to entry within the gaming sector. Given that regional gaming rents are effectively a “toll on sin,” one could derive more comfort vs. a traditional office or lodging property.

·         High P/B Ratio vs. Peers – GLPI’s assets acquired through PENN came via a tax-free spin resulting in a very low tax basis on the collection of properties. As a result, GLPI does not provide a traditional book value estimate, which makes it difficult for traditional LO REIT investors to get comfortable. PNK is contemplating coming up with an adjusted book value estimate in an effort to provide investors with a more apples to apples comparison with triple net lease peers. 

GLPI AFFO – GLPI’s business is a rent collection business that is predictable and cushioned given that close to 2x rent coverage (on a property EBITDAR basis). With ’16 escalators, GLPI is expected to do $2.73 in AFFO. Assuming, GLPI issues the $500mm secondary at a 10% discount to the current price today ($28.50), the accretion would be 11% leading to $3.05/share in pro-forma 2017 AFFO on a run-rate basis. Using 80% dividend payout ratio (historical DPR), the pro-forma dividend is $2.44 a share or 8.6% yield.

With GLPI trading at 9.3x AFFO today, I believe the 2 turn discount will abate post equity raise and leading GLPI to normalize back to 12x AFFO. At 13.5x EBITDA vs. Triple Net Lease Comps at 16x, GLPI has room to close the gap post the financing overhang going away. Assuming a 15x EBITDA multiple (still a discount to comps), GLPI is worth close to 30% up from here.

Peer Comps Table – GLPI’s doesn’t have any pure comps, but can be compared to EPR Properties (EPR), Realty Income and Store Capital. I believe EPR is the closest comp as both focus on “alternative asset classes” and trades at 15x EBITDA. However, one could argue that GLPI deserves a higher multiple than EPR given the lower competition in gaming REITs and high quality cash flow of casinos vs. amusement parks/recreational destinations.

Risks

• Slowdown in regional gaming consumer and SSS GGR
• Houston Feeder Weakness at Lake Charles
• Texas approval of state gambling 
• Inability for PNK to find growth projects post spin

Catalyst

·         Closing of GLPI/PNK alleviates short pressure from merger arb

·         Buybacks/Deleveraging of B/S at PNK

·         Acquisition Growth by PNK

·         Acquisition of PNK