In my last article about Penn National Gaming (NASDAQ:PENN), I wrote that PENN stock would rebound once it reopened all of its casinos. Since then the stock has fallen off of its near-term highs to about $29.
But I believe that this is a temporary situation. As soon as gaming rebounds, PENN stock will likely recover as the company benefits from higher gaming revenue. The timing of when recovery will happen is still up in the air. Certainly, as long as higher cases of the novel coronavirus occur, casinos will have a difficult time attracting visitors.
As of July 10, Penn National Gaming reported that 90% of its 41 casinos were now open. This is very good news as it ensures that the company can make enough revenue to eventually produce free cash flow (FCF).
FCF Will Push PENN Stock Higher
FCF occurs when its cash flow from operations less all capital expenditures is a positive number. This cash flow figure is important for a casino since it includes all cash expenses, including changes in working capital. It also excludes all the non-cash expenses that are otherwise included in GAAP earnings these days. This helps analysts understand how a company’s cash and liquidity will evolve.
It is likely that Penn National Gaming had a negative earnings and FCF quarter in Q2. Analysts and investors already discount this in the PENN stock price. They are more interested in the outlook for FCF.
I argued in my last article that Penn National’s normalized FCF is on the order of about $400 million. Now that 90% of the casinos are open, it implies that Q3 will likely be close to achieving positive FCF.
But that also depends on how much traffic the company is receiving. Undoubtedly there is still a fear factor. My personal observance of casinos, as I am an avid poker player, is that traffic in casinos is still very brisk. Therefore, I suspect that by the end of Q3 and into Q4, the company will be estimating that it is on a positive FCF run rate.
This will push up PENN stock. Another major cash flow driver will be the emergence of a clear Covid-19 vaccine. That will take away people’s fears of attending casinos.
The Barstool Sports Driver
Another driver for PENN stock is Penn National’s 36% stake in the sports app, Barstool Sports. Penn National also has the right to buy a controlling 50% stake in the company in three years for $62 million.
As a result, people see PENN stock as a pseudo-alternative to buying DraftKings (NASDAQ:DKNG). DKNG stock has shot up dramatically since it went public in late April. It completed a reverse merger and has since shot up over 250%. The thinking by investors is that sports betting will eventually catch on throughout the country and Barstool Sports will benefit just like DraftKings.
For example, in late May, Nomura Instinet analyst Harry Curtis cited PENN stock as a buy primarily because of its stake in Barstool Sports. He set a price target of $39 per share for the stock. He wrote that this was based on a valuation of 9.6 times the company’s estimated EBITDAR numbers. EBITDAR is a cash flow number known as earnings before interest, taxes, depreciation, amortization, and rent or restructuring expenses.
Casino.org pointed out that that was the third price increase from analysts in the prior 10 days, including JPMorgan and Morgan Stanley.
What to Do With PENN Stock
The present FCF yield of 10% is way too high. You can derive this by dividing its normalized FCF of $400 million by the stock’s market value of $4 billion.
A yield as high as 10% would normally represent a company in trouble. That is because analysts would be expecting cash flow to fall by 40 or 50%. But this is not the case here. A more appropriate figure would be an FCF yield of 5% to 6%.
That implies that the market value and stock price should be significantly higher. For example, dividing $400 million by 6% derives an implied market value of $6.667 billion. This is 66.7% higher than the present $4 billion market value.
In other words, PENN stock is worth at least $49.05 per share (i.e. 1.667 times the price of $29.43 on July 10). The patient investor will wait for this to occur.
Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks. As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities.