Why are investors betting on Penn National Gaming?

By Michael Fowlkes,

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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 Gaming ( PENN ), 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 were expecting.

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 ( CZR ) 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 unchanged".

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 PENN.

Image courtesy of stockcharts.com

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' stock prices.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Originally published on InvestorsObserver.com

This article appears in: Investing Options
Referenced Stocks: CZR , PENN

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