Penn National: A Roll of the Dice

Have you ever wanted to dabble in merger arbitrage -- the purchase of a takeover stock after a bid for the company has been announced?

For the most part, it's something we advise against because it's hard for the average investor to make sound judgments about the likelihood of deals being consummated. And if you bet wrong, the pain to your portfolio can be instantaneous and severe, as shareholders of Clear Channel Communications are discovering as a $19 billion deal to buy the radio giant teeters near collapse.

On the other hand, playing the game with Penn National may be too tempting to ignore.

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A buyout offer of $67 a share is on the table for Penn National, an operator of casinos outside of the nation's two primary gaming locales -- Nevada and Atlantic City, N.J. Financing is in place, and the buyers, a pair of private-equity firms, are obliged to pay a $200 million break-up fee if they walk away from the deal. Moreover, Penn shareholders have already blessed the marriage.

But here's where it gets interesting. The stock (symbol PENN) closed at $44.94 on March 25, up 6.5% for the day. If the buyout closes as planned on June 15, a Penn National investor who buys now would pocket a gain of 49% in less than three months. On an annualized basis, that amounts to a return of 571%.

Merger arbitrageurs only care about deals getting done, not about the prospects of any of the companies involved in a transaction. Arbs buy shares of a target company after the deal has been announced. Usually the target company's stock will rise near the announced purchase price, but not completely. The spread exists because of the risk that the deal might collapse or be renegotiated and because of the time value of money.

The arbitrageur tries to capture the final dollars -- or cents -- of appreciation between the target's post-announcement share price and the price at consummation. If the deal fails, the stock of the takeover target usually tanks to the point at which it traded before the deal was announced, sometimes lower.

The credit crunch has caused the spreads on many pending deals, particularly those that use a lot of borrowed money, to widen. In the Penn National case, the spread is so wide that the market is a suggesting that there's only a one-in-three chance that the deal will go through, says Roy Behren, co-manager of the Merger fund (MERFX), which owned shares of Penn National as of December 31, the date of its most-recent shareholder report.

But based on his assessment of the agreement and 15 years of experience with such deals, Behren says the odds of the deal reaching fruition are 50% to 75%. "Investors need to be aware that we are in a treacherous environment," he says. "There is risk that if credit markets don't loosen up that funding will be difficult, despite the fact that buyers have committed financing from a bank group for this transaction."

The buyers are offering generous terms for Penn National. Private equity firms Fortress Investment Group (FIG) and Centerbridge Partners announced last June that they would pay $9.4 billion for Penn National (the price tag includes money for the repayment of $2.8 billion in Penn debt).

If the merger is not consummated by June 15, the firms agreed to increase the per-share purchase price by $0.0149 per day, which works out to more than $1 million daily. Various Deutsche Bank and Wachovia Corp. entities have committed up to $5.1 billion in secured loans and $2 billion more in unsecured loans. Under the agreement, Fortress and Centerbridge will inject $3 billion of their own cash.

Penn National has stated repeatedly that it plans to complete the merger late in the second quarter. The Wyomissing, Penn., company continues to pursue and receive merger approvals from regulators in the 15 different jurisdictions in which it operates casinos and race tracks. The latest approval came March 20 from the West Virginia Lottery Commission, but the company still needs a nod from the state's racing commission.

The deal has already been approved by regulators in New Jersey and Ohio. "Acquiring gaming approvals is a long and expensive process that's not to be taken lightly," says Dan Ahrens, manager of the Ladenburg Thalmann Gaming and Casino fund (GACFX). His fund owns shares of Penn National, as well as put options to guard against the risk of a steep decline in share price if the deal fails.

The $200 million break-up fee is pittance compared with potential loss from an overpriced buyout. Shares of Penn National, which traded as high as $59.79 on January 3, have lost nearly $1.3 billion in market value since the deal was announced on June 15, 2007.

Since then, the outlook for the casino industry has dimmed because of darkening economic clouds, and Penn's revenues have softened. Under the terms of the deal, Penn National can take Fortress and Centerbridge to court to make them pony up $3 billion for the buyout. But the court can't compel the banks to fund necessary debt, so it's no guarantee the deal will close.

Wall Street is littered with high-profile merger flops. Leveraged buyouts of Sallie Mae (SLM), Alliance Data Systems (ADS), Harman International (HAR), United Rental (URI) and Reddy Ice (FRZ) have failed to close. Each cratered deal pushed the company's shares off a cliff.

"In the case of Penn National, the buyers have a strong case to walk away all together," says John Orrico, manager of the Arbitrage fund (ARBNX), which specializes in deal stocks but doesn't hold shares of Penn National. Orrico gives the buyout only a 5% change of success.

Penn National stock has been beaten to a pulp, so the gut punch of a failed merger may not sting so much. The stock is 12% below its pre-deal share of $51. "Penn National is trading as though the deal is substantially broken," says Jefferies analyst Larry Klatzkin.

Even without the merger going through, he figures the stock is at least worth $43 a share. He reaches that number by applying a price-earnings multiple of ten to the $2.03 per share he expects Penn to earn from operations in 2008, plus the $2.27 per share value of the potential break-up fee. Considering the potential upside price of $67, Klatzkin considers investing in Penn "a risk worth taking" and rates the stock a buy.