- Without revenue growth, PNK is probably worth $45.
- At market multiples for the real estate and DCF for the operation company, it is $55.
- At historical revenue growth rates, it could be worth as much as $65.
On July 21, Pinnacle (NYSE:PNK) and Gaming and Leisure Properties (NASDAQ:GLPI) announced the definitive sale of most of Pinnacle's real estate assets to GLPI. Though Pinnacle's original plan entailed spinning off their real estate assets into a REIT, the transaction with GLPI simplifies that process and shortens the timeline.
As of today, they have published a description of the final structure with some pro forma estimates. PNK shareholders will receive 0.85 shares of GLPI for each share of PNK. Based on GLPI's price at yesterday's close of $33.02, that values the stock portion of the package at $28.07 per share. PNK shareholders also retain their ownership of the casino operating business. If we subtract out the $28.07 above from PNK's current price, that leaves a market implied price for PNK's operating business of $10.71 per share. PNK's management, however, has valued their independent operating business at $17 per share. That represents a 58% increase over the implied price today. We believe that is a conservative number.
Separating the high value real estate from the operating business is the key driver for unlocking value in this transaction. This removes one layer of US taxes on the real estate. In the casino industry, Penn National Gaming (NASDAQ:PENN) has already demonstrated the ability to unlock value through this type of transaction when they spun off their real estate into GLPI back on October 14, 2013. Since they closed that deal, PENN's stock has had an annualized return of 24.1%. Measuring from before PENN announced the transaction in November 2012, the stock has had an annualized return of 34%.
The Real Estate - GLPI + PNK's Property
After this transaction is complete, GLPI will be the third largest triple net REIT behind VEREIT (NYSE:VER) and Realty Income (NYSE:O).
The median EV/EBITDA for large cap triple net REITs is 15.8x compared to 12.5x for small cap REITs.
Applying this to the pro forma $823M EBITDA of GLPI, subtracting the pro forma $4.5B in debt, and dividing by the projected 208M shares yields a value of $40.88 per share. If we discount this by 12% to bring it back to 2015, we get a value of $35.97. This is quite close to GLPI's current share price of $33.02.
The New Operating Company
On Pinnacle's July 21, 2015 investor call to discuss the transaction, Carlos Ruisanchez, PNK's President and Chief Financial Officer, valued the new independent Operation Company ("Op Co") at $17 per share.The current trading values equates to more than $30 a share for the real estate of those properties. On a combined basis, we believe this transaction will provide our shareholders with value in excess of $47 a share.
In their presentation and conference call, PNK management discussed the benefits of the transaction, but did not focus on the fundamental value of the Op Co. The presentation and call highlighted the reduction of debt in the Op Co, increased scale to their business platform, and their ability to continue to increase the profitability of their gambling business.
The key number they provided is the projected free cash flow of $101M per year from the Op Co. This number was derived assuming no growth in revenue for the business. To confirm their assessment of the current value, we used a DCF methodology and assumed a 12% discount rate, with no revenue growth for 5 years followed by the perpetual growth model using a 2.5% growth rate. This presumes that at some point they will grow with inflation. This gives us a value of $20.91 per share. When discounted back an additional 12% to bring the value back one year to 2015, we arrive at $18.40 per share. Although this is very close to management's presumed value, we find these assumptions do not fit with the historical performance of this management team.
In their presentation and on the call, management discusses the excellent new platform for growth, but they don't provide any estimates for growth on the Op Co, or describe how they plan to use this platform for growth. An assumption of zero revenue growth seems far too conservative. This management team has grown PNK's revenue by a 16% CAGR over the last five years and achieved one of the best annualized returns to shareholders of their competitors over that time period.
Through this transaction, PNK and GLPI are implementing a new business model for the gaming industry, separating real estate from the operations of a casino. This structure allows PNK to selectively purchase mismanaged casinos or undeveloped properties, fix the assets thereby increasing their operating value and the value of the real estate, sell the real estate to GLPI (or another buyer), and use those proceeds to return cash to shareholders or make more acquisitions. This structure keeps PNK's balance sheet from getting weighed down by an expensive real estate asset that, in itself, has no additional growth potential.
As they look ahead, the management team has not yet projected any growth beyond the $101M of free cash flow. We think their historic track record for growing revenue, along with the potential for growth in this new structure, should certainly warrant a modest growth assumption, if not the 16% they have achieved over the last five years.
In Figure 1 below, we analyze the value of the two components of this transaction for current PNK owners when the deal concludes in 2016.
Scenario 1
In Scenario 1, we begin with the current market implied value of PNK's real estate portfolio, based on 0.85x GLPI's trading price. We then used PNK management's valuation for the operating business of $17 (as we discussed above, this $17 valuation is built on the assumption of zero revenue growth for the business). Together, this equates to a value of $44.94 per share for PNK holders, a 16% premium to PNK's price today.
Scenario 2
Next, in Scenario 2, we examined how the valuation would change if GLPI traded to the median comparable triple net multiple of 15.8x EV/EBITDA and PNK's Op Co traded to our DCF valuation (still assuming no revenue growth). With pro forma EBITDA of $823, a debt load of $4,500M, and a 15.8x multiple, GLPI shares would be worth $40.88 per share. At a 0.85 exchange ratio, this equates to $34.75 per share to PNK owners.
As outlined in detail above, our DCF of the PNK Op Co yields a value of $20.91 per share. This assumes no revenue growth in the Op Co.
Combining both businesses yields a per share value of $55.66. As this is based on 2016 numbers, we applied a 12% discount to this valuation and arrived at a price in today's dollars of $48.98 or a 26% premium to today's price.
Scenario 3
The expected outcome for a management team is best predicted by their past performance. While that usually leads to a damping down of management's projections, in this case that philosophy is applied to fill in a void that this successful management team has yet to fill. Thus, in Scenario 3, we keep the Scenario 2 valuation of GLPI and the real estate unchanged, and we focus on the Operation Company. In this scenario, we factor in the 16% annual revenue growth rate that this management has achieved into our DCF model. That revenue growth is reduced to 2.5% over 5 years. In this scenario, we value PNK's Operating Company at $30.13 per share. Together with the $34.75 value of GLPI, this equates to a combined value of $64.88 per share. In today's dollars, that is $57.09 or 47% above the current price of PNK.
PNK's management team has grown revenue by 16% per year, and increased shareholder value by over 20% per year over the last 5 years. In this new, independent Operating Company we believe past performance of this management team is our best gauge for understanding what they can accomplish going forward. In Scenario 3 we can see how, if this team is able to execute and find opportunities to grow or at least give the market a better sense of what those growth opportunities look like, the stock price could increase substantially from current levels as we near the conclusion of the transaction.
Risks and Downside
The primary risks in this investment are market related, and driven by exposure to gaming and real estate broadly. REITs have been under pressure with the fear of rising interest rates. Although that is certainly a risk, the market has had plenty of time to price in those risks and we think rates are more likely to remain lower for longer. If one wanted to hedge out interest rate risk, they could. There is also the risk that the gaming industry valuation will decline disproportionately to the market, but the major concern inherent in that risk is the leverage levels carried by many of the gaming companies. To a large extent, success of this transaction and the resultant decrease in leverage at PNK Op Co will be an advantage and could allow PNK to make attractive acquisitions if competitors get pressured. The last large risk is that the deal does not go through. To some extent, this is an opportunity cost for PNK, as the deal with GLPI is an acceleration and improvement on their previous strategy of spinning off their real estate. If the GLPI deal failed, PNK would just move forward with their plan to spin off their real estate into a new REIT.
Conclusion
At the current price of $38.79 per share of PNK, the market is significantly discounting the value of this transaction. There are several ways through this transaction that this new structure and these management teams should be able to unlock existing value, as well as to position to better create value going forward. As we near the transaction, and management continues to share more information, we would expect that some of the voids in information are filled. Both management teams involved are highly skilled business operators that have delivered on commitments. I don't think that will stop here. We would expect a gradual increase in PNK's share price towards our $64 price target as we get closer the conclusion of this deal and management provides greater detail on the potential for growth in this business.
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