Pinnacle Entertainment: Tax Attributes, Remaining Real Estate, Insider Buying

This post is mostly a promo for this month's Special Situations Research Forum meeting hosted by the CFA Society Chicago, I'll be leading the discussion on Pinnacle Entertainment (PNK) and the recent sale of its real estate to GLPI.  We usually get anywhere from 6-12 people, it will be held in the loop on 6/27 at 5:30pm, if you're in the area and would like to attend, sign up here or shoot me an email.  Here's the original post from last month, and then below are some additional thoughts around assets that add to PNK's undervaluation to complete the picture.

Tax Attributes
At the time of the GLPI transaction, old Pinnacle had significant NOLs along with the standard D&A tax shield that made it an insignificant federal income tax payer.  The NOLs were exhausted through the taxable spin of the OpCo and even though the D&A of the real estate will still flow through the GAAP financial statements, they can only depreciate the assets they own for income tax purposes.  But due to the structure of the spinoff, Pinnacle Entertainment will continue to be a minimal income tax payer, below are explanations from both PNK and GLPI executives:

"However, we did receive a step-up basis in our assets.  That step up just to give some shorthand for it.  You look at the enterprise value of the company as a whole.  We had a tax basis on what was spun of roughly about $1 billion and the difference between those two will be amortized over a 15 year period evenly.  That will create a deduction going forward, main point being, that our effective tax rate will be materially lower than the statutory one by virtue of the deduction" - Anthony Sanfilippo, Pinnacle Entertainment CEO

"..and the reason we did it this way [spin the OpCo and merge the PropCo with GLPI], was obviously to help solve for some tax problems.  It also, some people expressed some concern that the Pinnacle NOLs would be going away but the reality is, on the spin they will be getting a stepped-up basis of the NOLs as well as to the extent that we pay gain above and beyond the NOLs, their assets will get stepped up actually higher than their NOLs.  So in the end they should be, from a tax perspective, in very good shape going forward with a higher asset level basis for depreciation." - William Clifford, GLPI CFO

Back to the EBITDA to free cash flow bridge slide:

Pinnacle is projecting only $4MM in cash taxes annually on the current business (including the Meadows acquisition), gaming companies typically aren't significant tax payers due to their considerable fixed assets, but even with the sale of their real estate to GLPI, Pinnacle via the stepped up basis of their assets/goodwill that they'll be able to amortized over 15 years have maintained similar same tax efficiency.  I'd be curious to hear anyone's thoughts on how much their tax attributes could be worth?

Real Estate Remaining at Pinnacle Entertainment (OpCo)
GLPI is a net lease REIT and thus uninterested in development assets, their investors want predictable cash flows and not excess land sitting around generating insufficient revenue for dividends.  As part of GLPI's sweetened offer to buy Pinnacle's real estate they sent a letter to Pinnacle's shareholders outlining the increased value of the second offer, and specifically called out the property assets to be left behind at the operating company.

Belterra Park

In 2013, old Pinnacle began the redevelopment of the River Downs racetrack outside of Cincinnati to be refashioned as Belterra Park (to create an association with the Belterra Casino Resort across state lines in Indiana) a "racino" with video lottery machines and six full service restaurants.  The all-in redevelopment price was approximately $300MM, it opened in the spring of 2014 and almost immediately began to under-perform expectations.  By the time GLPI came knocking with an offer to buy Pinnacle's real estate on an earnings basis the Belterra Park property was generating almost nothing - making it a hard fit for a REIT - it would have to be valued at almost zero for it to make sense to GLPI shareholders who demand a current yield on their assets.

William Clifford, CFO of GLPI said on a call discussing the deal:

"The primary reason why we left off Belterra with the operating company is because on a historical basis it has fairly low levels of EBITDA which meant that we weren't really paying very much for it.  And what we were able to do by leaving it behind, was to take the tax basis of the property and transfer that to OpCo which will eventually save us taxes on the gain relative to spend.  That represented probably somewhere north of $50 million worth of tax savings.  So even on a multiple basis, it seemed to make sense and quite candidly, we think it adds value for OpCo and will depreciate by the Pinnacle team."

The decision to leave Belterra Park with the OpCo was made almost a year ago, since then the property has begun to turnaround its performance.  Ohio built 4 casinos between 2012 and 2013, plus granted licenses to many similar racinos, all that development at once hurt the entire market in the state and is just now beginning to recover, Beltera Park included.  Net win at the racino is up 31% year over year through April of this year.

GLPI valued it at $75MM in its letter, typically I would discount this valuation as GLPI was attempting to convince Pinnacle shareholders the deal was in their best interest.  But if anything, $75MM seems low compared to the initial development costs even considering the properties initial struggles - but improving - and additionally new Pinnacle will benefit from the depreciation tax shield in addition to the step up basis on the sold assets discussed earlier.  It's also clear that Pinnacle's management is willing to sell real estate and may look to do a sale-leaseback of Belterra Park once it fully stabilizes.

Excess Undeveloped Land - Lake Charles & Baton Rouge
Staying with Pinnacle Entertainment is roughly 500 acres of undeveloped land, about 50 of those acres are adjacent to their flagship L'Auberge Lake Charles resort which is positioned as a regional destination with non-gaming amenities (concerts, restaurants, golf course) and has an equally positioned Golden Nugget resort next door (which was supposed to be an Ameristar Casino, but Pinnacle had to divest it at the time of the Ameristar-Pinnacle merger).  This land could potentially be valuable as an additional redevelopment asset for this growing market and could benefit from the Golden Nugget casino as well building up the overall market and land value around the two casinos.

The other 450 acres around the L'Auberge Baton Rouge resort looks a bit more uncertain given its size and isolated location (at least according to Google Maps).  GLPI valued the excess land near both properties at $30MM or roughly $60,000 per acre which seems within reason.

Insider Buying
While the new Pinnacle Entertainment isn't your normal spinoff since all the employees came with the spinoff, it's still encouraging to see management has been buying shares in recent weeks (maybe with proceeds from GLPI shares?) giving more validity to their own thesis that the shares are undervalued.

In addition to the insider buying, the company also announced a $50MM share repurchase plan signaling both confidence in their free cash flow and again that their shares are undervalued.

Summary
Profroma for the Meadows acquisition that should be completed this fall, Pinnacle Entertainment trades for 6.5x EBITDA whereas its near identical peer in Penn National Gaming trades for 7.5x EBITDA.  Yes, the structure is leveraged unconventionally and has some risk, but for a $700MM market cap company with almost no tax liability going forward and ~$105MM in real estate provides additional margin of safety at this valuation.  Additionally, management and the company itself are significant buyers of the company's shares.

Disclosure: I own shares of PNK

Pinnacle Entertainment: GLPI Deal Complete, OpCo Spinoff

In the fall of 2013, regional casino operator Penn National Gaming spunoff Gaming & Leisure Property Inc (GLPI) to hold their real estate assets and lease them back to Penn on a triple-net lease basis where the tenant is responsible for all the maintenance, taxes, and insurance.  The idea behind the move was a simple one, the market places a higher multiple on net lease REITs than it does gaming companies, so by separating the two, value is unlocked.  More recently, MGM did a similar move with MGM Growth Properties, and Caesars is contemplating the same within bankruptcy, it's becoming the industry standard operating model.  However, the IRS is starting to take a harder stance on REIT spinoffs which may lead to more scrutiny and give an advantage to those like GLPI who are already operating as REITs.

Following the Penn transaction, many investors looked to Penn's closest rival in the regional gaming sector, Pinnacle Entertainment (PNK), and pressured them to do a similar real estate spinoff transaction.  Concurrently, GLPI investors had been pressuring the REIT to diversify their tenant base as nearly all their casinos were leased back to Penn, a more diversified tenant base would lead to a higher valuation.  In July 2015, Pinnacle and GLPI came together in a deal that closed last month where GLPI acquired all of Pinnacle Entertainment and then simultaneously spunout the operating business under the same PNK ticker, creating "new" Pinnacle.

In the transaction, Pinnacle shareholders received 0.85 shares of GLPI and 1 share of new PNK for every share of old PNK they owned.  In effect, its a special dividend that recapitalized the company, much of the old debt moved to GLPI with the real estate and was replaced by a big capitalized lease payment.  The master lease has an initial term of 10 years, plus 5 options periods at Pinnacle's option for 5 years each.  The lease payment functions as an interest payment, except Pinnacle doesn't have to repay or refinance the debt, making it less risky in the event capital markets shutdown for a period of time.  While the lease is essentially debt, and I would treat it that way, it's not quite the same and when looking at the implied leverage ratio including the lease.

New Pinnacle Entertainment

The company now operates 15 properties (casinos, racetracks, hotel combinations) across 7 states but is relatively concentrated in Missouri (both Kansas City and St. Louis) and Louisiana with no exposure to Las Vegas or Macau as its larger peers.

Their biggest revenue generating casino is the L'Auberge Lake Charles in Louisiana that opened in 2005, in 2014 the Golden Nugget Lake Charles opened up next door creating competition, but in a "frenemy" sort of way as it's expanded the market, creating more of a regional weekend destination.  Visitors from nearby Houston (and it's energy economy problems) like the ability to easily go from one venue to the next, both have golf courses, spas, complementary restaurants and shuttles between the two properties.  In listening to recent earnings calls across the sector, gaming appears to finally be picking up around the country as consumers have more money to spend and have been moving away from retail to more experienced based spending.

One benefit of having casino REITs is their ability to acquire gaming assets at accretive prices given their low cost of capital, turn around and sell the operations to someone like Pinnacle and make the deal a win-win for both, essentially doing the REIT spinoff in reverse with the same benefits.  GLPI is doing just that with a racetrack and casino property, The Meadows, in Pennsylvania where it paid $440MM in December and sold the operations to Pinnacle for $138MM, which will close in the third quarter.  Ideally, the casino REITs aren't going to want to run the casino operations (GLPI has two they operate for spinoff tax reasons), but they'll be the most flush acquirers of properties that come up for sale giving operators like Pinnacle a source of new deals.  For The Meadows specifically, Pinnacle purchased the property for 6.4x TTM EBITDA and believes they can get an additional $10MM in synergies as it has been run as standalone business dropping the multiple below 5x EBITDA.

Proforma for The Meadows acquisition, Pinnacle did $645MM of TTM EBITDAR (R is rent to account for the capitalized lease expense), they have $130MM in cash, $968MM of conventional debt, and the lease obligation is $2.78B for a total enterprise value of $4.33B or an EBITDA multiple of 6.7x.  Penn National Gaming, it's closest peer in both markets and structure, trades for 7.4x EBITDA, which doesn't sound like a big difference, but when they're both as levered as they are PNK's market cap has some catching up to do.  Without the lease obligation and subtracting out the related rent payments, Pinnacle trades just under 6x EBITDA.

If the market valued Pinnacle at the same EBITDA multiple as Penn, it would be $18-19 versus ~$11.50 today.

Management in their roadshow presentation also laid out the case that Pinnacle was undervalued based on FCF (although a highly levered free cash flow).  On a free cash flow basis bumping it up to PENN gets closer to a $13-14 share price, still a fairly significant disconnect, it's probably worth somewhere in between the two metrics at $14-18 per share.

Overall, we have a slowly improving economy that's bring back some discretionary spending, a quality management team that has consistently driven margin improvements across their properties paired with some spinoff and odd accounting dynamics that are creating a temporary (hopefully) discount in Pinnacle's share price.

Risks:

• Leverage - Management will point to their conventional debt leverage in most discussions, which isn't entirely the wrong way to look at it since it's how their covenants are structured, but it's important to view the GLPI lease as debt when considering the entire picture.  With the GLPI lease, Pinnacle is about 5.6x levered, high for a cyclical consumer company and that leverage can cut both ways in a recession.  On just the convention debt, it's 3.6x levered.
• Lake Charles - Their Lake Charles casino is facing new competition at the same time as the downturn in energy is taking its toll on the Houston and Louisiana economies.
• Competition - Regional casinos were overbuilt in the last two decades, new supply is slowing outside of the northeast, Pinnacle doesn't anticipate any significant new competition coming online in their markets soon.  But local and state governments are always looking for new tax sources and as the economy picks up and casinos do well, its probably only a matter of time before additional gaming licenses are issued.

Disclosure: I own shares of PNK