When Penn National Gaming, Inc (NASDAQ: PENN) launched the real estate investment trust (REIT)Gaming and Leisure Properties Inc (NASDAQ: GLPI) in 2013, it tried to split up the company's low-risk real estate assets from its higher-risk gaming operations. In theory, that could attract investors looking for stability in a REIT who wouldn't demand the same return as gaming investors do for taking a lot of risk.
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What it also did was leverage Penn National's operations even further than they were before. A higher percentage of every dollar of new revenue flows to the company's bottom line, which is great when times are good. But the same will be true on the downside if operations struggle. With Penn National and now MGM Resorts (NYSE: MGM) moving to this REIT model, it's worth delving into how the leverage will look for investors.
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How a REIT makes a gaming bet even bigger
There's almost always operating leverage in a business, meaning that a 1% increase in revenue usually results in a greater-than-1% increase in earnings. But Penn National took this leverage to another level when it launched Gaming and Leisure Properties.
Below is a look at Penn National's guidance change for the first quarter of 2016, announced on Thursday. You can see that revenue is expected to be nearly $10 million higher than previous guidance and earnings before interest, taxes, depreciation, and amortization (EBITDA) is adjusted higher by a similar amount. In the table below, adjusted EBITDA is essentially the same figure that would have been reported before the REIT and the 1.2% increase in revenue corresponds to a 6.3% increase in adjusted EBITDA.
|Metric||Previous Guidance||Current Guidance (midpoint)||Change|
|Revenue||$761.0 million||$770.5 million||1.2%|
|Adjusted EBITDA||$209.3 million||$222.5 million||6.3%|
|Adjusted EBITDA after master lease||$97.4 million||$110.5 million||13.4%|
Data source: Penn National.
What's new now is the adjusted EBITDA after the master lease cost. Remember that the lease payment won't change if adjusted EBITDA goes up or down, giving the business more leverage. Instead of jumping 6.3% like adjusted EBITDA did, the adjusted EBITDA after master lease jumped 13.4%. Suddenly, a small increase in revenue has a huge impact on the bottom line.
The risk and reward of a leveraged gaming business
Gaming companies have always been leveraged businesses because their depreciation and operating costs for dealers, housekeeping, and restaurant staff stays constant while revenue from hotel rooms and gamblers goes up and down. The REIT model just puts a magnifying glass on the leverage that was already built into the business model. When times are good it's a positive for investors -- just like it was for Penn National in their guidance update. Just keep in mind that the effect will have similar magnitude if revenue falls.
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