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Boosting Values

Is it necessary to re-engineer companies to get the right valuation?

Boosting Values

Casino company stocks have long sold at valuations well below their brothers in the lodging industry and their cousins in entertainment.

On the surface, that seems strange given that casinos generate so much cash and, in most markets, are protected from competition by laws that limit the number of casinos or restrict them to certain parts of a state or city.

One reason often cited is legislative risk. Legislators rarely look at hotels or movie theaters as politically easy targets to tax as they do casinos. We can look at places like Illinois to see the effect of that.

Another reason is that, although protected from competition, the high capital and high operating-cost industry is vulnerable when competition does come along, as the casinos of Atlantic City, Delaware and Connecticut have shown thanks to competitors arriving in neighboring states.

Finally, many investors just don’t like volatility of earnings, and the big casino operators that cater to the highest of the high rollers do risk crimped earnings when their biggest customers play lucky.

So what can be done to raise valuations?

Until recently, not much, except hope investors buy the argument that valuations should be higher, a case that got slammed when debt-laden casino companies crashed during the financial freeze of 2008 and 2009.

However, Penn National and Caesars Entertainment are addressing the matter through re-

engineering.

PENN, as all know by now, has decided to split into two by putting its properties into a real estate investment trust, or REIT, and running the properties under contract through the existing Penn National, which becomes a management company.

There are variations on that theme, but that’s the gist of it.

PENN expects that this structure will allow Penn National to be asset-light, earning management fees and being able to expand without the burden of debt.

The REIT, meanwhile, will pay out a big dividend, meaning that it both returns capital to shareholders, who in turn will support the share price, and it can seek expansion projects, both to the benefit of its favorite casino manager, Penn National, and independent of PENN if that is in its best interest.

In short, PENN promises the best of all worlds.

So far, investors are believers. The stock has risen in anticipation of the split even as regional casinos have struggled with somber consumers and increasing competition.

Caesars is taking a different approach. It is spinning off some of its assets into a new company that will get an infusion of up to $1.2 billion from investors while carrying far less debt than its parent, whose $22 billion owed has weighed down on CZR in a number of ways.

The name of the new company describes its purpose: Caesars Growth Partners.

Owning Planet Hollywood, most of the new casino rising in Baltimore, and Caesars Interactive, Growth Partners is expected to be able to invest in new projects while CZR manages them.

Casino stocks rose after PENN’s initial announcement as investors began speculating that others could split in two, though most do not have the size and geographic diversity that makes a PENN REIT appear attractive.

Some, such as Las Vegas Sands or MGM Resorts, could do a modified REIT approach, some have said, though LVS has a more conventional way of creating value—selling off non-core assets such as shopping malls when they mature to the right price.

Still, everyone will be watching PENN and CZR to see if they succeed. If so, other casino companies will consider restructuring to unlock the value so many think has long been there.

READY TO TURN?

Like so much of the rest of the economy, the casino industry has been waiting for recovery to gain steam.

After so many false starts, a steady and accelerating recovery might finally be taking hold.

The statistical evidence remains mixed, but most measures are now positive, with the biggest of them—job creation, consumer confidence and home prices—definitely solid.

So, when will the improvement show in casino revenues?

Perhaps we have begun. After showing some fit-and-start improvements last year, the first quarter finished flat with last year, but that was because of new casino openings. Factor out the new casinos and revenues nationally fell in Q1.

But there are other variables to be factored out, like a shorter February than last year and a return to normal winter weather from a balmy 2012.

Those looking for hopeful signs might have found it in March when regional gaming revenues rose 4.11 percent, though same-store declined 3.43 percent.

The good news is that the largest revenue states, which should be more representative of overall trends, performed better in March than January and February, as evidenced by these March and year-to-date percentage comparisons:

State               March              Year-to-date
Connecticut     -3.27 percent     -11.86
Iowa               +1.20                -4.32
Louisiana         +1.76                -1.12
Mississippi        -2.52                -7.61
Missouri           +1.95                -2.80
New York         +8.76               +5.15
Pennsylvania    +0.58                -1.87

The lone exception was Atlantic City, which fell 10.45 percent vs. a year-to-date drop of 9.17 percent. AC, however, has almost become its own case, declining regardless of the environment elsewhere.

Nationally, we’ll need to see some momentum build before saying the recovery for casinos is firmly in place, but March was encouraging, and there’s reason to think that January and February were not typical.

A solid recovery could have an outsize positive impact on regional casino operators who cut expenses during the recession and will enjoy significant benefit when revenues really turn north.

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