PENN Entertainment, Inc. - Quarter Report: 2014 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2014

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from        to

 

Commission File Number:  0-24206

 

PENN NATIONAL GAMING, INC.

(Exact name of registrant as specified in its charter)

 

 

825 Berkshire Blvd., Suite 200

Wyomissing, PA 19610

(Address of principal executive offices) (Zip Code)

 

610-373-2400

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Title		Outstanding as of July 25, 2014
Common Stock, par value $.01 per share		78,638,108 (includes132,747 shares of restricted stock)

 

 

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This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  These statements can be identified by the use of forward-looking terminology such as “believes,” “estimates,” “expects,” “intends,” “may,” “will,” “should” or “anticipates” or the negative or other variation of these or similar words, or by discussions of future events, strategies, or risks and uncertainties.  Actual results may vary materially from expectations.  Although Penn National Gaming, Inc. (“Penn”) and its subsidiaries (together with Penn, collectively, the “Company”) believe that our expectations are based on reasonable assumptions within the bounds of our knowledge of our business, there can be no assurance that actual results will not differ materially from our expectations.  Meaningful factors that could cause actual results to differ from expectations include, but are not limited to, risks related to the following: our ability to obtain timely regulatory approvals required to own, develop and/or operate our facilities, or other delays or impediments to completing our planned acquisitions or projects, including favorable resolution of any related litigation, including the ongoing appeal by the Ohio Roundtable addressing the legality of video lottery terminals in Ohio and litigation against the Ohio Racing Commission concerning opposition to relocating the Company’s Toledo racetrack to the Dayton area; our ability to secure federal, state and local permits and approvals necessary for our construction projects; construction factors, including delays, unexpected remediation costs, local opposition, organized labor, and increased cost of labor and materials; our ability to maintain agreements with our horsemen, pari-mutuel clerks and other organized labor groups; with respect to the proposed Jamul project near San Diego, California, particular risks associated with financing a project of this type, sovereign immunity, local opposition (including several pending lawsuits), and building a complex project on a relatively small parcel; the passage of state, federal or local legislation (including referenda) that would expand, restrict, further tax, prevent or negatively impact operations in or adjacent to the jurisdictions in which we do or seek to do business (such as a smoking ban at any of our facilities); with respect to our Massachusetts project, the ultimate location of the other gaming facilities in the state and, more significantly, the outcome of the referendum to repeal the gaming legislation in Massachusetts which could result in substantial litigation as well as a significant loss to our investment in the state; with respect to our joint venture project in New York, risks related to our ability to secure local support for our site, licensing from the state and the extent and location of other applications and competition; the effects of local and national economic, credit, capital market, housing, and energy conditions on the economy in general and on the gaming and lodging industries in particular; the activities of our competitors and the rapid emergence of new competitors (traditional, internet and sweepstakes based and taverns); increases in the effective rate of taxation at any of our properties or at the corporate level; our ability to identify attractive acquisition and development opportunities and to agree to terms with partners/municipalities for such transactions; the costs and risks involved in the pursuit of such opportunities and our ability to complete the acquisition or development of, and achieve the expected returns from, such opportunities; our expectations for the continued availability and cost of capital; the outcome of pending legal proceedings; changes in accounting standards; our dependence on key personnel; the impact of terrorism and other international hostilities; the impact of weather; and other factors as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, subsequent Quarterly Reports on Form 10-Q and Current Reports on Form 8-K as filed with the United States Securities and Exchange Commission.  The Company does not intend to update publicly any forward-looking statements except as required by law.

 

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PENN NATIONAL GAMING, INC. AND SUBSIDIARIES

 

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PART I.	FINANCIAL INFORMATION	4
ITEM 1.	FINANCIAL STATEMENTS (Unaudited)	4
	Condensed Consolidated Balance Sheets — June 30, 2014 and December 31, 2013	4
	Condensed Consolidated Statements of Operations — Three and Six Months Ended June 30, 2014 and 2013	5
	Condensed Consolidated Statements of Comprehensive Income (Loss) — Three and Six Months Ended June 30, 2014 and 2013	6
	Condensed Consolidated Statements of Changes in Shareholders’ Equity — Six Months Ended June 30, 2014 and 2013	7
	Condensed Consolidated Statements of Cash Flows — Six Months Ended June 30, 2014 and 2013	8
	Notes to the Condensed Consolidated Financial Statements	9
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	39
ITEM 4.	CONTROLS AND PROCEDURES	39
PART II.	OTHER INFORMATION	40
ITEM 1.	LEGAL PROCEEDINGS	40
ITEM 1A.	RISK FACTORS	40
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	40
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	40
ITEM 4.	MINE SAFETY DISCLOSURES	40
ITEM 5.	OTHER INFORMATION	40
ITEM 6.	EXHIBITS	41
SIGNATURES		42
EXHIBIT INDEX		43

 

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

Penn National Gaming, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(in thousands, except share and per share data)

 

		June 30,			December 31,
		2014			2013
		(unaudited)
Assets
Current assets
Cash and cash equivalents		$	251,299		$	292,995
Receivables, net of allowance for doubtful accounts of $2,338 and $2,752 at June 30, 2014 and December 31, 2013, respectively		69,521			52,538
Prepaid expenses		70,056			62,724
Deferred income taxes		76,189			71,093
Other current assets		30,036			29,511
Total current assets		497,101			508,861
Property and equipment, net		557,044			497,457
Other assets
Investment in and advances to unconsolidated affiliates		187,307			193,331
Goodwill		492,515			492,398
Other intangible assets		375,200			359,648
Debt issuance costs, net of accumulated amortization of $3,861 and $922 at June 30, 2014 and December 31, 2013, respectively		28,085			30,734
Other assets		116,606			101,562
Total other assets		1,199,713			1,177,673
Total assets		$	2,253,858		$	2,183,991
Liabilities
Current liabilities
Current maturities of long-term debt		$	27,823		$	27,598
Accounts payable		60,773			22,580
Accrued expenses		89,172			98,009
Accrued interest		2,997			5,027
Accrued salaries and wages		80,205			86,498
Gaming, pari-mutuel, property, and other taxes		56,062			52,053
Insurance financing		7,871			3,020
Other current liabilities		70,777			66,684
Total current liabilities		395,680			361,469
Long-term liabilities
Long-term debt, net of current maturities		1,027,976			1,023,194
Deferred income taxes		10,492			13,912
Noncurrent tax liabilities		25,533			19,966
Other noncurrent liabilities		6,424			7,050
Total long-term liabilities		1,070,425			1,064,122
Shareholders’ equity
Series B Preferred stock ($.01 par value, 1,000,000 shares authorized, 0 shares issued at June 30, 2014 and December 31, 2013)		—			—
Series C Preferred stock ($.01 par value, 18,500 shares authorized, 8,624 shares issued at June 30, 2014 and December 31, 2013)		—			—
Common stock ($.01 par value, 200,000,000 shares authorized, 78,627,483 and 77,788,393 shares issued at June 30, 2014 and December 31, 2013, respectively)		781			775
Additional paid-in capital		908,271			887,556
Retained deficit		(121,601		)	(130,314		)
Accumulated other comprehensive income		302			383
Total shareholders’ equity		787,753			758,400
Total liabilities and shareholders’ equity		$	2,253,858		$	2,183,991

 

See accompanying notes to the condensed consolidated financial statements.

 

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Penn National Gaming, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
Revenues
Gaming		$	576,158		$	679,829		$	1,146,841		$	1,397,754
Food, beverage and other		110,574			121,044			215,444			242,904
Management service fee		3,105			3,667			5,563			6,714
Revenues		689,837			804,540			1,367,848			1,647,372
Less promotional allowances		(37,691		)	(43,169		)	(74,622		)	(87,755		)
Net revenues		652,146			761,371			1,293,226			1,559,617
Operating expenses
Gaming		284,107			341,889			570,184			703,907
Food, beverage and other		80,403			88,910			157,941			179,175
General and administrative		107,898			128,730			215,637			264,307
Rental expense related to Master Lease		104,613			—			208,922			—
Depreciation and amortization		47,183			80,615			94,549			157,686
Impairment losses		4,560			71,846			4,560			71,846
Insurance deductible charges		—			2,500			—			2,500
Total operating expenses		628,764			714,490			1,251,793			1,379,421
Income from operations		23,382			46,881			41,433			180,196
Other income (expenses)
Interest expense		(10,892		)	(27,060		)	(22,187		)	(54,984		)
Interest income		790			343			1,257			605
Income from unconsolidated affiliates		1,473			3,821			3,956			5,542
Other		(1,823		)	2,402			(192		)	3,066
Total other expenses		(10,452		)	(20,494		)	(17,166		)	(45,771		)
Income from operations before income taxes		12,930			26,387			24,267			134,425
Income tax provision		8,754			38,567			15,554			81,334
Net income (loss)		$	4,176		$	(12,180	)	$	8,713		$	53,091
Earnings (loss) per common share:
Basic earnings (loss) per common share		$	0.05		$	(0.16	)	$	0.10		$	0.55
Diluted earnings (loss) per common share		$	0.05		$	(0.16	)	$	0.10		$	0.51

 

See accompanying notes to the condensed consolidated financial statements.

 

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Penn National Gaming, Inc. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income (Loss)

(in thousands) (unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
Net income (loss)		$	4,176		$	(12,180	)	$	8,713		$	53,091
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustment during the period		619			(608		)	(81		)	(999		)
Change in fair value of corporate debt securities
Unrealized holding losses on corporate debt securities arising during the period		—			—			—			(98		)
Less: Reclassification adjustments for gains included in net income		—			(1,296		)	—			(1,296		)
Change in fair value of corporate debt securities, net		—			(1,296		)	—			(1,394		)
Other comprehensive income (loss)		619			(1,904		)	(81		)	(2,393		)
Comprehensive income (loss)		$	4,795		$	(14,084	)	$	8,632		$	50,698

 

See accompanying notes to the condensed consolidated financial statements.

 

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Penn National Gaming, Inc. and Subsidiaries

Condensed Consolidated Statements of Changes in Shareholders’ Equity

(in thousands, except share data) (unaudited)

 

		Preferred Stock					Common Stock					Additional Paid-In			Retained Earnings			Accumulated Other Comprehensive			Total Shareholders’
		Shares		Amount			Shares		Amount			Capital			(Deficit)			Income			Equity
Balance, December 31, 2012		12,275		$	—		77,446,601		$	769		$	1,451,965		$	795,173		$	3,022		$	2,250,929
Repurchase of preferred stock		(225	)	—			—		—			(22,275		)	—			—			(22,275		)
Stock option activity, including tax benefit of $4,920		—		—			1,159,426		11			48,563			—			—			48,574
Restricted stock activity, including tax benefit of $840		—		—			248,763		—			1,692			—			—			1,692
Change in fair value of corporate debt securities		—		—			—		—			—			—			(1,394		)	(1,394		)
Foreign currency translation adjustment		—		—			—		—			—			—			(999		)	(999		)
Net income		—		—			—		—			—			53,091			—			53,091
Balance, June 30, 2013		12,050		$	—		78,854,790		$	780		$	1,479,945		$	848,264		$	629		$	2,329,618
Balance, December 31, 2013		8,624		$	—		77,788,393		$	775		$	887,556		$	(130,314	)	$	383		$	758,400
Stock option activity, including tax benefit of $8,914		—		—			909,958		9			19,886			—			—			19,895
Restricted stock activity, including tax benefit of $677		—		—			(70,868	)	(3		)	829			—			—			826
Foreign currency translation adjustment		—		—			—		—			—			—			(81		)	(81		)
Net income		—		—			—		—			—			8,713			—			8,713
Balance, June 30, 2014		8,624		$	—		78,627,483		$	781		$	908,271		$	(121,601	)	$	302		$	787,753

 

See accompanying notes to the condensed consolidated financial statements.

 

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Penn National Gaming, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(in thousands) (unaudited)

 

Six Months Ended June 30,		2014			2013
Operating activities
Net income		$	8,713		$	53,091
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		94,549			157,686
Amortization of items charged to interest expense		3,022			4,300
Accretion of settlment value on long term obligation		—			1,217
(Gain) loss on sale of fixed assets		(47		)	2,675
Hollywood Casino St. Louis tornado deductible charges		—			2,500
Income from unconsolidated affiliates		(3,956		)	(5,542		)
Distributions of earnings from unconsolidated affiliates		11,000			9,000
Deferred income taxes		(7,401		)	10,720
Charge for stock-based compensation		5,096			11,701
Impairment losses and write downs		7,860			71,846
Gain on investment in corporate debt securities		—			(1,325		)
(Increase) decrease, net of businesses acquired
Accounts receivable		(16,983		)	(698		)
Prepaid expenses and other current assets		(5,749		)	(8,528		)
Other assets		4,303			(23,330		)
Increase (decrease), net of businesses acquired
Accounts payable		24,115			(3,272		)
Accrued expenses		(8,837		)	(30,990		)
Accrued interest		(2,030		)	(2,041		)
Accrued salaries and wages		(6,293		)	(15,605		)
Gaming, pari-mutuel, property and other taxes		4,009			10,247
Income taxes		1,337			40,142
Other current and noncurrent liabilities		3,467			3,552
Other noncurrent tax liabilities		5,698			4,084
Net cash provided by operating activities		121,873			291,430
Investing activities
Capital project expenditures, net of reimbursements		(36,041		)	(70,771		)
Capital maintenance expenditures		(44,273		)	(45,846		)
Advances to Jamul Tribe		(18,856		)	—
Proceeds from sale of property and equipment		176			2,818
Proceeds from sale of investment in corporate debt securities		—			6,679
Investment in joint ventures		(1,000		)	(500		)
Decrease in cash in escrow		18,000			26,000
Acquisition of businesses and gaming and other licenses		(88,185		)	(52		)
Net cash used in investing activities		(170,179		)	(81,672		)
Financing activities
Proceeds from exercise of options		6,034			32,805
Repurchase of preferred stock		—			(22,275		)
Proceeds from issuance of long-term debt, net of issuance costs		—			20,064
Principal payments on long-term debt		(13,866		)	(275,713		)
Proceeds from insurance financing		14,816			15,306
Payments on insurance financing		(9,965		)	(11,037		)
Tax benefit from share based awards exercised		9,591			5,760
Net cash provided by (used in) financing activities		6,610			(235,090		)
Net decrease in cash and cash equivalents		(41,696		)	(25,332		)
Cash and cash equivalents at beginning of year		292,995			260,467
Cash and cash equivalents at end of period		$	251,299		$	235,135
Supplemental disclosure
Interest expense paid, net of amounts capitalized		$	21,187		$	52,020
Income taxes paid		$	3,030		$	28,248

 

See accompanying notes to the condensed consolidated financial statements.

 

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Penn National Gaming, Inc. and Subsidiaries

Notes to the Condensed Consolidated Financial Statements

(Unaudited)

 

1.  Organization and Basis of Presentation

 

Penn National Gaming, Inc. (“Penn” and, together with its subsidiaries, collectively, the “Company”) is a diversified, multi-jurisdictional owner and manager of gaming and pari-mutuel properties. As of June 30, 2014, the Company owned, managed, or had ownership interests in twenty-seven facilities in the following eighteen jurisdictions: Florida, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Massachusetts, Mississippi, Missouri, Nevada, New Jersey, New Mexico, Ohio, Pennsylvania, Texas, West Virginia and Ontario. On July 30, 2014, the Company closed its facility in Sioux City, Iowa.

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

 

The condensed consolidated financial statements include the accounts of Penn and its subsidiaries. Investment in and advances to unconsolidated affiliates are accounted for under the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses for the reporting periods. Actual results could differ from those estimates.

 

Operating results for the six months ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. The notes to the consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2013 should be read in conjunction with these condensed consolidated financial statements.  The December 31, 2013 financial information has been derived from the Company’s audited consolidated financial statements.

 

2.  Spin-Off of Real Estate Assets through a Real Estate Investment Trust

 

On November 1, 2013, the Company completed its plan to separate its gaming operating assets from its real property assets by creating a newly formed, publicly traded real estate investment trust (“REIT”), known as Gaming and Leisure Properties, Inc. (“GLPI”), through a tax free spin-off (the “Spin-Off”). Penn effected the Spin-Off by distributing one share of common stock of GLPI to the holders of Penn common stock and Series C Convertible Preferred Stock (“Series C Preferred Stock”) for every share of Penn common stock and every 1/1000th of a share of Series C Preferred Stock that they held at the close of business on October 16, 2013, the record date for the Spin-Off. In addition, through a series of internal corporate restructurings, Penn contributed to GLPI substantially all of the assets and liabilities associated with Penn’s real property interests and real estate development business, as well as all of the assets and liabilities of Hollywood Casino Baton Rouge and Hollywood Casino Perryville, which are referred to as the “TRS Properties.” As a result of the Spin-Off, GLPI owns substantially all of Penn’s former real property assets and leases back those assets (other than the TRS Properties) to Penn for use by its subsidiaries, under a “triple net” master lease agreement (the “Master Lease”) (which has a 15-year initial term that can be extended at Penn’s option for up to four five-year renewal terms), as well as owns and operates the TRS Properties. Penn continues to operate the leased gaming facilities and hold the associated gaming licenses with these facilities.

 

3.  Summary of Significant Accounting Policies

 

Revenue Recognition and Promotional Allowances

 

Gaming revenue is the aggregate net difference between gaming wins and losses, with liabilities recognized for funds deposited by customers before gaming play occurs, for chips and “ticket-in, ticket-out” coupons in the customers’ possession, and for accruals related to the anticipated payout of progressive jackpots. Progressive slot machines, which contain base jackpots that increase at a progressive rate based on the amounts played, are charged to revenue as the amount of the jackpots increase.

 

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Food, beverage and other revenue, including racing revenue, is recognized as services are performed. Racing revenue includes the Company’s share of pari-mutuel wagering on live races after payment of amounts returned as winning wagers, its share of wagering from import and export simulcasting, and its share of wagering from its off-track wagering facilities.

 

Revenue from the management service contract for Casino Rama is based upon contracted terms and is recognized when services are performed.

 

Revenues are recognized net of certain sales incentives in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605-50, “Revenue Recognition—Customer Payments and Incentives.” The Company records certain sales incentives and points earned in point-loyalty programs as a reduction of revenue.

 

The retail value of accommodations, food and beverage, and other services furnished to guests without charge is included in gross revenues and then deducted as promotional allowances. The estimated cost of providing such promotional allowances is primarily included in food, beverage and other expense.

 

The amounts included in promotional allowances for the three and six months ended June 30, 2014 and 2013 are as follows:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
		(in thousands)
Rooms		$	8,426		$	8,993		$	16,497		$	18,312
Food and beverage		26,794			31,232			53,392			63,722
Other		2,471			2,944			4,733			5,721
Total promotional allowances		$	37,691		$	43,169		$	74,622		$	87,755

 

The estimated cost of providing such complimentary services for the three and six months ended June 30, 2014 and 2013 are as follows:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
		(in thousands)
Rooms		$	2,530		$	3,121		$	5,240		$	6,360
Food and beverage		18,482			21,119			37,354			43,098
Other		1,471			1,383			2,801			3,027
Total cost of complimentary services		$	22,483		$	25,623		$	45,395		$	52,485

 

Gaming and Racing Taxes

 

The Company is subject to gaming and pari-mutuel taxes based on gross gaming revenue and pari-mutuel revenue in the jurisdictions in which it operates. The Company primarily recognizes gaming and pari-mutuel tax expense based on the statutorily required percentage of revenue that is required to be paid to state and local jurisdictions in the states where or in which wagering occurs. In certain states in which the Company operates, gaming taxes are based on graduated rates. The Company records gaming tax expense at the Company’s estimated effective gaming tax rate for the year, considering estimated taxable gaming revenue and the applicable rates. Such estimates are adjusted each interim period. If gaming tax rates change during the year, such changes are applied

prospectively in the determination of gaming tax expense in future interim periods. Finally, the Company recognizes purse expense based on the statutorily required percentage of revenue that is required to be paid out in the form of purses to the winning owners of horse races run at the Company’s racetracks in the period in which wagering occurs. For the three and six months ended June 30, 2014, these expenses, which are recorded primarily within gaming expense in the condensed consolidated statements of operations, were $223.2 million and $442.6 million, respectively, as compared to $267.0 million and $549.0 million for the three and six months ended June 30, 2013, respectively.

 

Rental Expense related to the Master Lease

 

As of June 30, 2014, the Company leases from GLPI real property assets associated with 17 of the Company’s gaming and related facilities used in the Company’s operations. The rent structure under the Master Lease, which became effective November 1, 2013, includes a fixed component, a portion of which is subject to an annual 2% escalator if certain rent coverage ratio thresholds are

 

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met, and a component that is based on the performance of the facilities, which is prospectively adjusted, subject to certain floors (i) every 5 years by an amount equal to 4% of the average change to net revenues of all facilities under the Master Lease (other than Hollywood Casino Columbus and Hollywood Casino Toledo) during the preceding five years, and (ii) monthly by an amount equal to 20% of the change in net revenues of Hollywood Casino Columbus and Hollywood Casino Toledo during the preceding month.

 

In April 2014, an amendment to the Master Lease was entered into in order to amend certain provisions relating to the Sioux City property.  Per the amendment, upon ceasing gaming operations at Argosy Casino Sioux City due to the termination of its gaming license, the annual rent will be reduced by $6.2 million (see Item 6.Exhibit 10.4).  On July 30, 2014, the Company closed its facility in Sioux City, Iowa.

 

The Master Lease is commonly known as a triple-net lease. Accordingly, in addition to rent, the Company is required to pay the following, among other things: (1) all facility maintenance; (2) all insurance required in connection with the leased properties and the business conducted on the leased properties; (3) taxes levied on or with respect to the leased properties (other than taxes on the income of the lessor); and (4) all utilities and other services necessary or appropriate for the leased properties and the business conducted on the leased properties. At the Company’s option, the Master Lease may be extended for up to four five-year renewal terms beyond the initial 15-year term, on the same terms and conditions.

 

Total rental expense under the Master Lease was $104.6 million and $208.9 million for the three and six months ended June 30, 2014, respectively.

 

Long-term asset related to the Jamul Tribe

 

On April 5, 2013, the Company announced that, subject to final National Indian Gaming Commission approval, it and the Jamul Indian Village (the “Jamul Tribe”) had entered into definitive agreements to jointly develop a Hollywood Casino-branded casino and resort on the Jamul Tribe’s trust land in San Diego County, California.  The definitive agreements were entered into to: (i) secure the development, management, and branding services of the Company to assist the Jamul Tribe during the pre-development and entitlement phase of the project; (ii) set forth the terms and conditions under which the Company will provide a loan or loans to the Jamul Tribe to fund certain development costs; and (iii) create an exclusive arrangement between the parties.  The proposed $360 million development project will include a three-story gaming and entertainment facility of approximately 200,000 square feet featuring over 1,700 slot machines, 50 live table games, including poker, multiple restaurants, bars and lounges and a partially enclosed parking structure with over 1,900 spaces.  In mid-January 2014, the Company announced the commencement of construction activities at the site and it is anticipated that the facility will open in mid-2016.  The Company may, under certain circumstances, provide backstop financing to the Jamul Tribe in connection with the project and, upon opening, will manage and provide branding for the casino and resort.

 

In accordance with this project and the related agreements, the Company has a note receivable with the Jamul Tribe for $29.5 million and $7.0 million at June 30, 2014 and December 31, 2013, respectively, which is included in Other Assets within the condensed consolidated balance sheets.  Collectability of the note receivable will be derived from the revenues of the casino operations once the project is completed.  Based on the Company’s current progress with this project, the Company believes collectability of the note is highly certain.  However, in the event that the Company’s internal projections related to the profitability of this project and/or the timing of the opening are inaccurate, the Company may be required to record a reserve related to the collectability of this note receivable.

 

Earnings Per Share

 

The Company calculates earnings per share (“EPS”) in accordance with ASC 260, “Earnings Per Share” (“ASC 260”). Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding during the period. Diluted EPS reflects the additional dilution for all potentially-dilutive securities such as stock options and unvested restricted shares.

 

At June 30, 2014, the Company had outstanding 8,624 shares of Series C Preferred Stock and at June 30, 2013, had outstanding 12,050 shares of Series B Redeemable Preferred Stock (“Series B Preferred Stock”). The Company determined that both classes of preferred stock qualified as a participating security as defined in ASC 260 since these securities participate in dividends with the Company’s common stock. Under ASC 260, a security is considered a participating security if the security may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. In accordance with ASC 260, a company is required to use the two-class method when computing EPS when a company has a security that qualifies as a “participating security.” The two-class method is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. A participating security is included in the computation of basic EPS using the two-class method. Under the two-class

 

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method, basic EPS for the Company’s common stock is computed by dividing net income applicable to common stock by the weighted-average common shares outstanding during the period. Diluted EPS for the Company’s common stock is computed using the more dilutive of the two-class method or the if-converted method.

 

Since the Company reported a net loss for the three months ended June 30, 2013, it was required by ASC 260 to use basic weighted-average common shares outstanding, rather than diluted weighted-average common shares outstanding, when calculating diluted EPS for the three months ended June 30, 2013. In addition, since the Company reported a loss from operations for the three months ended June 30, 2013, the Series B Preferred Stock was not deemed to be a participating security for the three months ended June 30, 2013, pursuant to ASC 260 as the Series B Preferred Stock is not obligated to participate in the losses of the Company. The basic weighted-average common shares outstanding for the three months ended June 30, 2013 were 78,306,436.

 

The following table sets forth the allocation of net income for the three months ended June 30, 2014 and the six months ended June 30, 2014 and 2013 under the two-class method:

 

		Three Months Ended June 30,			Six Months Ended June 30,
		2014			2014			2013
		(in thousands)
Net income		$	4,176		$	8,713		$	53,091
Net income applicable to preferred stock		414			866			9,983
Net income applicable to common stock		$	3,762		$	7,847		$	43,108

 

The following table reconciles the weighted-average common shares outstanding used in the calculation of basic EPS to the weighted-average common shares outstanding used in the calculation of diluted EPS for the three months ended June 30, 2014 and the six months ended June 30, 2014 and 2013:

 

		Three Months Ended June 30,		Six Months Ended June 30,
		2014		2014		2013
		(in thousands)
Determination of shares:
Weighted-average common shares outstanding		78,458		78,189		77,932
Assumed conversion of dilutive employee stock-based awards		1,800		1,903		3,058
Assumed conversion of restricted stock		54		97		92
Diluted weighted-average common shares outstanding before participating security		80,312		80,189		81,082
Assumed conversion of preferred stock		8,624		8,624		22,850
Diluted weighted-average common shares outstanding		88,936		88,813		103,932

 

Options to purchase 935,147 shares were outstanding during the three and six months ended June 30, 2014, but were not included in the computation of diluted EPS because they were antidilutive. Options to purchase 10,638,637 shares were outstanding during the three months ended June 30, 2013, but were not included in the computation of diluted EPS because they were antidilutive since the Company reported a loss from operations for the three months ended June 30, 2013. Options to purchase 99,625 shares were outstanding during the six months ended June 30, 2013, but were not included in the computation of diluted EPS because they were antidilutive.

 

The following table presents the calculation of basic EPS for the Company’s common stock (in thousands, except per share data):

 

		Three Months Ended June 30,			Six Months Ended June 30,
		2014			2014			2013
Calculation of basic EPS:
Net income applicable to common stock		$	3,762		$	7,847		$	43,108
Weighted-average common shares outstanding		78,458			78,189			77,932
Basic EPS		$	0.05		$	0.10		$	0.55

 

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The following tables present the calculation of diluted EPS for the Company’s common stock (in thousands, except per share data):

 

		Three months ended June 30,			Six months ended June 30,
		2014			2014
Calculation of diluted EPS using two-class method:
Net income applicable to common stock		$	3,762		$	7,847
Diluted weighted-average common shares outstanding before participating security		80,312			80,189
Diluted EPS		$	0.05		$	0.10

 

		Six months ended June 30,
		2013
Calculation of diluted EPS using if-converted method:
Net income		$	53,091
Diluted weighted-average common shares outstanding		103,932
Diluted EPS		$	0.51

 

Stock-Based Compensation

 

The Company accounts for stock compensation under ASC 718, “Compensation-Stock Compensation,” which requires the Company to expense the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This expense is recognized ratably over the requisite service period following the date of grant.

 

The fair value for stock options was estimated at the date of grant using the Black-Scholes option-pricing model, which requires management to make certain assumptions. The risk-free interest rate was based on the U.S. Treasury spot rate with a term equal to the expected life assumed at the date of grant. Expected volatility was estimated based on the historical volatility of the Company’s stock price over a period of 5.45 years, in order to match the expected life of the options at the grant date. Historically, at the grant date, there has been no expected dividend yield assumption since the Company has not paid any cash dividends on its common stock since its initial public offering in May 1994 and since the Company intends to retain all of its earnings to finance the development of its business for the foreseeable future. The weighted-average expected life was based on the contractual term of the stock option and expected employee exercise dates, which was based on the historical and expected exercise behavior of the Company’s employees.  The Company granted 916,522 stock options during the six months ended June 30, 2014.

 

The Company’s cash-settled phantom stock unit awards (“PSUs”), which vest over a period of four to five years, entitle employees and directors to receive cash based on the fair value of the Company’s common stock on the vesting date.  The PSUs are accounted for as liability awards and are re-measured at fair value each reporting period until they become vested with compensation expense being recognized over the requisite service period in accordance with ASC 718-30, “Compensation—Stock Compensation, Awards Classified as Liabilities.” The Company has a liability, which is included in accrued salaries and wages within the condensed consolidated balance sheets, associated with its PSUs of $3.4 million and $6.8 million at June 30, 2014 and December 31, 2013, respectively.

 

For the Company’s stock appreciation rights (“SARs”), the fair value of the SARs is calculated during each reporting period and estimated using the Black-Scholes option pricing model based on the various inputs discussed below. The Company’s SARs, which vest over a period of four years, are accounted for as liability awards since they will be settled in cash. The Company has a liability, which is included in accrued salaries and wages within the condensed consolidated balance sheets, associated with its SARs of $10.3 million and $11.4 million at June 30, 2014 and December 31, 2013, respectively.

 

In connection with the Spin-Off of GLPI, the Company’s employee stock options and SARs were converted into two awards, an award in Penn with an adjusted exercise price and an award in GLPI. The number of options and SARs and the exercise price of each converted award were adjusted to preserve the same intrinsic value of the awards that existed immediately prior to the Spin-Off. As such, no incremental compensation expense was recorded as a result of this conversion. In addition, holders of outstanding restricted stock awards and PSUs received an additional share of restricted stock or PSUs in GLPI common stock at the Spin-Off so that the intrinsic value of these awards were equivalent to those that existed immediately prior to the Spin-Off. The unrecognized

 

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compensation costs associated with GLPI restricted stock awards, GLPI PSUs, GLPI stock options and GLPI SARs held by Penn employees will continue to be recognized on the Company’s financial statements over the awards remaining vesting periods.

 

Stock-based compensation expense for the three and six months ended June 30, 2014 was $2.5 million and $5.1 million, respectively, as compared to $5.4 million and $11.7 million for the three and six months ended June 30, 2013, respectively. The decrease is primarily due to the fact that certain members of Penn’s executive management team transferred their employment to GLPI following the Spin-Off.

 

For PSUs held by Penn employees, there was $13.1 million of total unrecognized compensation cost at June 30, 2014 that will be recognized over the grants remaining weighted average vesting period of 2.60 years. For the three and six months ended June 30, 2014, the Company recognized $1.2 million and $2.6 million, respectively, of compensation expense associated with these awards, as compared to $2.2 million and $5.0 million for the three and six months ended June 30, 2013, respectively. Amounts paid by the Company for the three and six months ended June 30, 2014 on these cash-settled awards totaled $0.1 million and $6.0 million, respectively, and for the three and six months ended June 30, 2013 totaled $0.1 million and $3.7 million, respectively.

 

For SARs held by Penn employees, there was $9.2 million of total unrecognized compensation cost at June 30, 2014 that will be recognized over the awards remaining weighted average vesting period of 2.60 years. For the three and six months ended June 30, 2014, the Company recognized ($0.2) million and $0.1 million, respectively, of compensation expense associated with these awards, as compared to $0.9 million and $3.7 million for the three and six months ended June 30, 2013, respectively. The reason for these declines was due to a drop in the stock prices of GLPI and Penn common stock during 2014.  Amounts paid by the Company for the three and six months ended June 30, 2014 on these cash-settled awards totaled $0.7 million and $1.2 million, respectively, and for the three and six months ended June 30, 2013 totaled $0.6 million and $1.3 million, respectively.

 

The following are the weighted-average assumptions used in the Black-Scholes option-pricing model at June 30, 2014 and 2013:

 

		2014		2013
Risk-free interest rate		1.68	%	1.08	%
Expected volatility		44.80	%	46.27	%
Dividend yield		—		—
Weighted-average expected life (years)		5.45		6.57

 

Segment Information

 

The Company’s Chief Executive Officer, who is the Company’s Chief Operating Decision Maker as that term is defined in ASC 280, “Segment Reporting” (“ASC 280”), measures and assesses the Company’s business performance based on regional operations of various properties grouped together based primarily on their geographic locations. In January 2014, the Company named Jay Snowden as its Chief Operating Officer and the Company decided in connection with this announcement to re-align its reporting structure. Starting in January 2014, the Company’s reportable segments are: (i) East/Midwest, (ii) West, and (iii) Southern Plains.

 

The East/Midwest reportable segment consists of the following properties: Hollywood Casino at Charles Town Races, Hollywood Casino Bangor, Hollywood Casino at Penn National Race Course, Hollywood Casino Lawrenceburg, Hollywood Casino Toledo and Hollywood Casino Columbus. It also includes the Company’s Casino Rama management service contract and the Mahoning Valley and Dayton Raceway projects in Ohio, which the Company anticipates completing in the third quarter of 2014, as well as the Plainville project in Massachusetts which the Company expects to open in the second quarter of 2015. It also previously included Hollywood Casino Perryville, which was contributed to GLPI on November 1, 2013.

 

The West reportable segment consists of the following properties: Zia Park Casino and the M Resort, as well as the Jamul development project, which the Company anticipates completing in mid-2016.

 

The Southern Plains reportable segment consists of the following properties: Hollywood Casino Aurora, Hollywood Casino Joliet, Argosy Casino Alton, Argosy Casino Riverside, Argosy Casino Sioux City, Hollywood Casino Tunica, Hollywood Casino Bay St. Louis, Boomtown Biloxi, and Hollywood Casino St. Louis, and includes the Company’s 50% investment in Kansas Entertainment, LLC (“Kansas Entertainment”), which owns the Hollywood Casino at Kansas Speedway. It also previously included Hollywood Casino Baton Rouge, which was contributed to GLPI on November 1, 2013.

 

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The Other category consists of the Company’s standalone racing operations, namely Beulah Park, Raceway Park, Rosecroft Raceway, Sanford-Orlando Kennel Club, and the Company’s joint venture interests in Sam Houston Race Park, Valley Race Park, and Freehold Raceway, as well as the Company’s 50% joint venture with the Cordish Companies in New York. It also previously included the Company’s Bullwhackers property, which was sold in July 2013. If the Company is successful in obtaining gaming operations at these locations, they would be assigned to one of the Company’s reportable segments. The Other category also includes the Company’s corporate overhead operations which does not meet the definition of an operating segment under ASC 280.

 

The prior year amounts were reclassified to conform to the Company’s new reporting structure in accordance with ASC 280.  See Note 9 to the condensed consolidated financial statements for further information with respect to the Company’s segments.

 

Other Comprehensive Income

 

The Company accounts for comprehensive income in accordance with ASC 220, “Comprehensive Income,” which establishes standards for the reporting and presentation of comprehensive income in the consolidated financial statements. The Company presents comprehensive income in two separate but consecutive statements. The net of tax changes in accumulated other comprehensive income by component were as follows (in thousands):

 

		Foreign Currency			Available for sale securities			Total
Other comprehensive income (loss):
Balance at December 31, 2012		$	1,628		$	1,394		$	3,022
Foreign currency translation adjustment		(999		)	—			(999		)
Unrealized holding losses on corporate debt securities		—			(98		)	(98		)
Realized gain on redemption of corporate debt securities		—			(1,296		)	(1,296		)
Ending balance at June 30, 2013		$	629		$	—		$	629
Balance at December 31, 2013		$	383		$	—		$	383
Foreign currency translation adjustment		(81		)	—			(81		)
Ending balance at June 30, 2014		$	302		$	—		$	302

 

Fair Value of Financial Instruments

 

The following methods and assumptions are used to estimate the fair value of each class of financial instruments for which it is practicable to estimate:

 

Cash and Cash Equivalents

 

The fair value of the Company’s cash and cash equivalents approximates the carrying value of the Company’s cash and cash equivalents, due to the short maturity of the cash equivalents.

 

Long-term Debt

 

The fair value of the Company’s Term Loan B component of its senior secured credit facility and senior unsecured notes is estimated based on quoted prices in active markets and as such is a Level 1 measurement. The fair value of the remainder of the Company’s senior secured credit facility approximates its carrying value as it is variable rate debt and as such is a Level 2 measurement.

 

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The estimated fair values of the Company’s financial instruments are as follows (in thousands):

 

		June 30, 2014						December 31, 2013
		Carrying Amount			Fair Value			Carrying Amount			Fair Value
Financial assets:
Cash and cash equivalents		$	251,299		$	251,299		$	292,995		$	292,995
Financial liabilities:
Long-term debt
Senior secured credit facility		735,110			735,628			748,777			748,150
Senior unsecured notes		300,000			284,250			300,000			297,000

 

4.  New Accounting Pronouncements

 

In April 2014, the FASB issued guidance that amends the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity’s operations and financial results. Examples of a strategic shift that has (or will have) a major effect on an entity’s operations and financial results could include a disposal of a major geographical area, a major line of business, a major equity method investment, or other major parts of an entity.  In addition, the amended guidance requires expanded disclosures for discontinued operations, including disclosures about a disposal of an individually significant component of an entity that does not qualify for discontinued operations presentation in the financial statements.  The amendments are effective for all disposals (or classifications as held for sale) of components of an entity that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance.  The Company early adopted this revised guidance and will apply the amendments to all disposals of a component of the Company going forward.

 

In May 2014, the FASB issued new revenue recognition guidance, which will supersede nearly all existing revenue recognition guidance. The core principle of the guidance is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve the core principle, the new guidance implements a five-step process for customer contract revenue recognition. The guidance also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows arising from contracts with customers. This new guidance is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and early adoption is prohibited. Entities can transition to the new guidance either retrospectively or as a cumulative-effect adjustment as of the date of adoption. Management is currently assessing the impact the new revenue recognition guidance will have on the consolidated financial statements but does not believe it will have a significant impact.

 

5.  Acquisitions

 

In September 2013, the Company entered into an option and purchase agreement to purchase Plainridge Racecourse in Massachusetts with sellers having no involvement in the business or operations from that date forward.  The Company subsequently began to operate Plainridge Racecourse effective January 1, 2014 pursuant to a temporary operations agreement. On February 28, 2014, the Massachusetts Gaming Commission awarded the Company a Category Two slots-only gaming license, and in early March 2014, the Company exercised its option to purchase the Plainridge Racecourse. This acquisition reflects the continuing efforts of the Company to expand its gaming operations through the development of new gaming properties. The fixed portion of the purchase price was paid on April 11, 2014.  The option and purchase agreement also contained contingent purchase price consideration that is calculated based on the projected earnings of the gaming operations over the first ten years of operations.  Based on the option and purchase agreement, the first payment will be made 60 days after the completion of the first four full fiscal quarters of operation, and every year for ten years after the first payment. The fair value of this liability was determined to be $18.5 million based on an income approach from the Company’s internal earning projections and was discounted at a rate consistent with the risk a third party market participant would require holding the identical instrument as an asset. This liability is included in long-term debt on the condensed consolidated balance sheet at June 30, 2014.  The preliminary purchase price allocation resulted in an increase in land and buildings of $57.9 million and $3.0 million of goodwill.

 

Plainridge Park Casino is anticipated to be a $225 million (inclusive of licensing fees) fully integrated racing and gaming facility featuring live harness racing and simulcasting with 1,250 slot machines, various dining options, structured and surface parking, a 26,000 square foot grandstand, and a 13,000 square foot clubhouse. On March 14, 2014, the Company broke ground on the

 

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