Penn National Gaming – Workout or Worthless?

February 15, 2008 by Joe Ponzio

There had been a considerable amount of discussion about the acquisition of Penn National Gaming, both in these comments and in a few other comments around the site. As the deal stands right now, Wall Street appears to be leaving $18 a share – or 38% – on the table for today’s workout investors.

What will upset the applecart?

In any workout situation, we ignore the emotions of others (those who offer the premium and price) and start by looking at the proposed merger agreement filed with the SEC. Let’s answer some preliminary questions (assuming, of course, we already know the parties to the transaction):

When is the deal expected to close?

Section 2.1(c) 2.2(c): The companies are shooting for a June 15, 2008 closing date at $67 a share. If the deal is not done by that day, the price ticks up $0.0149 per day until it closes. That’s about 8% a year.

Where are the funds coming from?

Section 5.7: The financing for this transaction is two-fold. Debt financing: The parties have executed commitment letters from Deutsche Bank Securities Inc., Deutsche Bank AG New York Branch, Wachovia Capital Markets, LLC, Wachovia Bank, National Association and Wachovia Investment Holdings, LLC. Equity financing: The acquiring firms, Fortress Investment Group and Centerbridge Partners, have signed equity commitment letters. In short, the financing is in place.

But we have to look at this:

None of the Financing Commitments has been or will be amended or modified, except as consistent with Section 7.9(c), and the respective commitments contained in the Financing Commitments have not been withdrawn or rescinded in any respect as of the date hereof.

Section 7.9(c): Not as exciting as I thought it might be. Basically, no changes or modifications of the financing commitments may be made unless PENN agrees, except that debt financing on better terms may be accepted. In short, it says, “If we find better lenders, we’ll use them. If not, we’ll go with the ones we have.”

Backtracking to Section 7.9(b) – If the financing falls through

Most deals are generally on a “best efforts” basis whereby, if financing falls through, there is no back-up plan other than we’ll try to find money. In this deal, there is a back-up plan: bridge financing.

In this case, the lenders are offering (or have been asked to consider) bridge financing in lieu of the proposed debt financing. As such, the lenders would make a temporary loan, in whole or in part, to float a portion of the debt financing that could not be obtained. The newly private PENN would then be required to find alternative financing or take some other action to quickly pay back that loan (as opposed to paying back the traditional loan over longer periods).

The bridge financing is not guaranteed (is anything?), but it can be a safety net in the event that the banks were overly zealous in their terms when the deal was proposed early in 2007.

So, the terms look good and financing is more or less arranged. Let’s check out the bumps in the road.

The Reverse Termination Fee; Cash Involved

If the acquiring firms kill the deal, they are on the line for a $200 million reverse termination fee on a $9.4 billion deal (including the repayment of some $2.8 billion of PENN debt). The acquiring firms have to bring up to $3 billion of cash to the table to get the deal done. The banks are bringing $5.1 billion in secured loans and throwing in another $2 billion in unsecured loans.

The good news is that the acquiring firms are putting about 30% down when many leveraged buyouts close on 20% or less. The bad news? The termination fee is a drop in the bucket when compared to the size of the companies and the deal. Penn routinely reports having nearly $200 million in cash at the end of each quarter, so the termination fee would not be a major benefit to PENN or its shareholders.

Fortress and Centerbridge run private equity funds. Fortress reports that it manages roughly $40 billion in assets. I don’t know how big Centerbridge is, but I’d be willing to bet it has some dough considering it is partnering with a $40 billion company to acquire a string of casinos.

Something Smells Funny On The 13F-HR

Looking at Fortress’ 13F Quarterly Report of Holdings for December 31, 2007, Fortress reported a new holding – PENN – of 157,396, or $9.4 million. Is this a quiet acquisition of shares or a weak commitment to support an otherwise-ready-to-plummet stock price?

The Regulatory Hurdles

There still remain some regulatory hurdles to the transaction. Personally, I don’t understand the hurdles nor do I know if this transaction will breeze through the regulators or if it will get squashed. Worse yet, we don’t know when the regulators will approve the deal, so out timeframe is not fixed.

I’ll Wait…For Now

Admittedly, the transaction looks appealing, though I attribute that appeal largely to the price. Is this a virtually risk-less workout? Not in my view.

Today’s buyers are expecting a 38+% return by or shortly after the end of the second quarter, about five or six months from now. During that time, a lot can upset the applecart:

  • regulators can squash the deal;
  • there can be a “material” adverse change in the business of any of the parties;
  • the price can drop so much that the buyers no longer see $9 billion of value in a then-priced $3 or $4 billion company (PENN is now trading at $4.1 billion);
  • the acquiring companies can find better value for their $3 billion, even at the expense of a $200 million termination fee.

Let’s Define A Workout

A workout is a virtually risk-less transaction where the timeframe and potential profit are fixed and consummation of the workout depends on corporate action or events, the occurrence of which is highly probable.

At this point, the potential return on PENN is extremely attractive assuming everything falls into place. What I don’t see is the “virtually risk-less” part, the fixed timeframe, or a highly probable close.

To clarify my mindset (which may be skewed and way off base), revisit the arbitrage discussions in 1950s Buffett. I’m looking for “no-brainers” that are mispriced. With the remaining hurdles and variables in the PENN transaction, I can’t say with near-absolute confidence and competence that it is either a no-brainer or mispriced. Of course, there are a lot of smart people out there that can.

If, upon thorough analysis, you see safety of principal and a satisfactory return, and this is one of your best ideas, don’t let my apprehension slow you down.

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