Why are investors betting on Penn National Gaming?
Michael Fowlkes 10/28/2013
Earnings season is an important time for investors. Fortunes
can be made or lost in the matter of days following a good or bad
earnings report, and it is typically easy to predict. If a
company tops estimates it tends to trade higher, and the opposite
is likely to occur following an earnings miss.
However, this is not always the case. One example of a stock
that broke that trend this earnings season is Penn National
), which missed its earnings estimate earlier this month.
Analysts were expecting earnings of 44 cents per share, but the
company's actual earnings were just 40 cents per share.
In addition to missing on earnings, the company also reported
revenue of $714.4 million, which was 1% higher than the same
period last year, but well short of the $725.1 million analysts
Based on its earnings and revenue miss, you could easily
assume that Wall Street punished the stock, but in fact the
opposite is true. The company reported its quarterly numbers
before the market opened on October 17. The stock closed trading
the previous day at $55.62, but in the days following the report
it rose another 3.4% to $57.51.
The question is why?
A big reason is that the company is going through a major
transformation on November 1. On that day it will split into two
different parts. One will be a real estate investment trust, and
the other will be an operating business.
Following the separation, the casino business will no long be
burdened with the real estate-heavy part of the business, and its
high cash flows will be more valuable to investors. At the same
time, the REIT business could attract more investors that are
interested in boosting income in their portfolio, since REITs are
required by law to return 90% of their earnings to investors. The
separation will result in an immediate special dividend for
investors of $3.33, and then the REIT will turn around and lease
its properties back to the casino business.
Another reason why investors are betting on Penn is that it is
both growing and generating a profit despite a tough economic
landscape. Sales during the recent quarter were up 1%. The
company is also looking to expand, recently making a $610 million
purchase of Caesar's (
) Maryland Heights Harrah's.
With the company growing, and preparing to split its business,
investors have been more than willing to bet on the U.S. based
gaming stock, but there are reasons to be cautious. The company
opted to suspend its forward guidance program and withdraw its
2013 full year guidance. Despite suspending its guidance program,
the company did state that its outlook was "fundamentally
For investors that want to bet on the stock ahead of the
spinoff, I would suggest taking a hedged approach. With the
recent earnings miss, and continued weakness in some gambling
regions, the stock could easily erase some of its recent gains,
so I would prefer to build a little protection into any trade on
A nice hedged trade on PENN would be the January 45/50 bull
put credit spread. In this trade, you would sell the January 50
put while buying the same number of January 45 puts for a credit
of 40 cents. The current spread on these options is 25 cents, but
the bid/ask spread is very wide, so you should be able to fill
the trade at 40 cents. This trade has a target return of 8.7%,
which is 37.3% on an annualized basis (for comparison purposes
only). With PENN currently trading at $57.73, this trade has
12.7% downside protection. This trade will remain open during the
PENN spinoff, so after the split, the option values will likely
end up being determined by a combination of the two new entities'