SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2006

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)

Pennsylvania

23-2234473

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification No.)

 

825 Berkshire Blvd., Suite 200
Wyomissing, PA  19610
(Address of principal executive offices)

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer x                    Accelerated filer o              Non-accelerated filer o

Indicate by a 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 registrant’s classes of common stock, as of the latest practicable date.

Title

 

Outstanding as of August 3, 2006

Common Stock, par value $.01 per share

 

86,518,164 (includes 440,000 shares of restricted stock)

 

 




 

This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may vary materially from expectations. Although Penn National Gaming, Inc. and its subsidiaries (collectively, the “Company”) believe that their expectations are based on reasonable assumptions within the bounds of their knowledge of its business and operations, there can be no assurance that actual results will not differ materially from the Company’s expectations. Meaningful factors which could cause actual results to differ from expectations include, but are not limited to, risks related to the following: the ability of the Company to recover under its insurance policies for Hurricane Katrina damage; the passage of state, federal or local legislation that would expand, restrict, further tax or prevent gaming operations in the jurisdictions in which we do business; the activities of our competitors; increases in the effective rate of taxation at any of our properties or at the corporate level; successful completion of capital projects at our gaming and pari-mutuel facilities; our ability to integrate and recognize the benefits of integrating Argosy Gaming Company; the existence of attractive acquisition candidates, the costs and risks involved in the pursuit of those acquisitions and our ability to integrate those acquisitions; our ability to maintain regulatory approvals for our existing businesses and to receive regulatory approvals for our new businesses (including, without limitation, the issuance of a final operator’s license in Pennsylvania); the maintenance of agreements with our horsemen, pari-mutuel clerks and other organized labor groups; our dependence on key personnel; the impact of terrorism and other international hostilities; the availability and cost of financing; and other factors as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 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.

2




PENN NATIONAL GAMING, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

PART I.

FINANCIAL INFORMATION

 

 

 

ITEM 1.

FINANCIAL STATEMENTS

 

 

 

 

Consolidated Balance Sheets — June 30, 2006 and December 31, 2005

 

4

 

 

Consolidated Statements of Income — For the Three and Six Months Ended June 30, 2006 and 2005

 

5

 

 

Consolidated Statements of Changes in Shareholders’ Equity — For the Six Months Ended June 30, 2006 and 2005

 

6

 

 

Consolidated Statements of Cash Flows — For the Six Months Ended June 30, 2006 and 2005

 

7

 

 

Notes to the Consolidated Financial Statements

 

8

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (unaudited)

 

22

 

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

38

 

ITEM 4.

CONTROLS AND PROCEDURES

 

39

PART II.

OTHER INFORMATION

 

 

 

ITEM 1.

LEGAL PROCEEDINGS

 

39

 

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

39

 

ITEM 5.

OTHER INFORMATION

 

39

 

ITEM 6.

EXHIBITS

 

40

 

3




 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Penn National Gaming, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands, except share and per share data)

 

 

 

June 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

130,318

 

$

132,620

 

Receivables, net of allowance for doubtful accounts of $3,001 and $2,994 at June 30, 2006 and December 31, 2005, respectively

 

53,305

 

47,632

 

Insurance receivable

 

20,079

 

51,160

 

Prepaid expenses and other current assets

 

47,312

 

26,780

 

Deferred income taxes

 

32,153

 

48,150

 

Total current assets

 

283,167

 

306,342

 

Property and equipment, net

 

1,194,664

 

1,059,892

 

Other assets

 

 

 

 

 

Investment in and advances to unconsolidated affiliate

 

18,018

 

17,184

 

Goodwill

 

1,832,986

 

1,848,661

 

Other intangible assets

 

740,385

 

743,521

 

Deferred financing costs, net of accumulated amortization of $10,818 and $7,349 at June 30, 2006 and December 31, 2005, respectively

 

63,001

 

70,960

 

Other assets

 

90,656

 

92,861

 

Restricted assets held for sale

 

50,972

 

50,983

 

Total other assets

 

2,796,018

 

2,824,170

 

Total assets

 

$

4,273,849

 

$

4,190,404

 

Current liabilities

 

 

 

 

 

Current maturities of long-term debt

 

18,447

 

18,567

 

Accounts payable

 

20,163

 

25,549

 

Accrued expenses

 

89,221

 

116,552

 

Accrued interest

 

30,254

 

33,303

 

Accrued salaries and wages

 

51,800

 

54,579

 

Gaming, pari-mutuel, property, and other taxes

 

41,307

 

47,724

 

Income taxes payable

 

4,542

 

18,284

 

Other current liabilities

 

23,143

 

26,751

 

Total current liabilities

 

278,877

 

341,309

 

Long-term liabilities

 

 

 

 

 

Long-term debt, net of current maturities

 

2,788,958

 

2,767,662

 

Deferred income taxes

 

254,667

 

259,708

 

Liabilities held for sale

 

275,042

 

275,182

 

Total long-term liabilities

 

3,318,667

 

3,302,552

 

Shareholders' equity

 

 

 

 

 

 

 

 

 

 

 

Preferred stock ($.01 par value, 1,000,000 shares authorized, none issued and outstanding at June 30, 2006 and December 31, 2005)

 

 

 

Common stock ($.01 par value, 200,000,000 shares authorized, 86,495,724 shares at

 

 

 

 

 

June 30, 2006, and 85,064,886 shares at December 31, 2005, issued)

 

865

 

850

 

Treasury stock (1,698,800 shares issued and outstanding at June 30, 2006 and December 31, 2005)

 

(2,379

)

(2,379

)

Additional paid-in capital

 

235,964

 

206,763

 

Retained earnings

 

425,147

 

340,469

 

Accumulated other comprehensive income

 

16,708

 

840

 

Total shareholders' equity

 

676,305

 

546,543

 

Total liabilities and shareholders' equity

 

$

4,273,849

 

$

4,190,404

 

 

See accompanying notes to consolidated financial statements.

4




 

Penn National Gaming, Inc. and Subsidiaries
Consolidated Statements of Income
(in thousands, except per share data)
(unaudited)

 

 

For the Three Months
Ended June 30,

 

For the Six Months
Ended June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

Gaming

 

$  490,804

 

$  254,961

 

$  994,254

 

$  500,137

 

Racing

 

13,635

 

13,306

 

27,202

 

25,105

 

Management service fee

 

4,921

 

4,700

 

9,308

 

8,767

 

Food, beverage and other

 

52,417

 

39,877

 

104,985

 

77,150

 

Gross revenues

 

561,777

 

312,844

 

1,135,749

 

611,159

 

Less promotional allowances

 

(24,004

)

(16,640

)

(50,174

)

(33,525

)

Net revenues

 

537,773

 

296,204

 

1,085,575

 

577,634

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Gaming

 

254,882

 

136,288

 

510,626

 

267,021

 

Racing

 

10,855

 

10,259

 

20,926

 

19,069

 

Food, beverage and other

 

48,871

 

25,869

 

97,228

 

49,725

 

General and administrative

 

73,600

 

46,001

 

148,611

 

92,239

 

Depreciation and amortization

 

27,728

 

15,969

 

57,446

 

31,464

 

Settlement costs

 

 

28,175

 

 

28,175

 

Total operating expenses

 

415,936

 

262,561

 

834,837

 

487,693

 

Income from continuing operations

 

121,837

 

33,643

 

250,738

 

89,941

 

 

 

 

 

 

 

 

 

 

 

Other income (expenses)

 

 

 

 

 

 

 

 

 

Interest expense

 

(47,766

)

(12,324

)

(96,195

)

(28,828

)

Interest income

 

867

 

930

 

1,770

 

2,222

 

Earnings from joint venture

 

574

 

642

 

987

 

985

 

Other

 

184

 

(74

)

74

 

(94

)

Loss on early extinguishment of debt

 

 

(869

)

(10,022

)

(16,673

)

Total other expenses

 

(46,141

)

(11,695

)

(103,386

)

(42,388

)

 

 

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

75,696

 

21,948

 

147,352

 

47,553

 

Taxes on income

 

33,001

 

7,055

 

62,674

 

16,407

 

Net income from continuing operations

 

42,695

 

14,893

 

84,678

 

31,146

 

 

 

 

 

 

 

 

 

 

 

Loss from discontinued operations, net of tax

 

 

(2,774

)

 

(3,221

)

Net income

 

$    42,695

 

$    12,119

 

$    84,678

 

$    27,925

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share-Basic

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$        0.51

 

$        0.18

 

$        1.01

 

$        0.38

 

Discontinued operations, net of tax

 

 

(0.03

)

 

(0.04

)

Basic earnings per share

 

$        0.51

 

$        0.15

 

$        1.01

 

$        0.34

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share-Diluted

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$        0.49

 

$        0.17

 

$        0.98

 

$        0.36

 

Discontinued operations, net of tax

 

 

(0.03

)

 

(0.03

)

Diluted earnings per share

 

$        0.49

 

$        0.14

 

$        0.98

 

$        0.33

 

 

See accompanying notes to consolidated financial statements.

5




 

Penn National Gaming, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
(in thousands, except share data) (unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Other

 

Total

 

 

 

 

 

Common Stock

 

Treasury

 

Paid-In

 

Retained

 

Comprehensive

 

Shareholders’

 

Comprehensive

 

 

 

Shares

 

Amount

 

Stock

 

Capital

 

Earnings

 

(Loss) Income

 

Equity

 

Income

 

Balance, December 31, 2005

 

85,064,886

 

$                  850

 

$             (2,379

)

$          206,763

 

$          340,469

 

$                  840

 

$          546,543

 

 

 

Exercise of stock options including tax benefit of $9,259

 

990,838

 

11

 

 

28,094

 

 

 

28,105

 

 

Restricted stock activity

 

440,000

 

4

 

 

 

1,107

 

 

 

1,111

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of interest rate swap contracts, net of income taxes of $9,075

 

 

 

 

 

 

15,788

 

15,788

 

15,788

 

Foreign currency translation adjustment

 

 

 

 

 

 

80

 

80

 

80

 

Net income

 

 

 

 

 

84,678

 

 

84,678

 

84,678

 

Balance, June 30, 2006

 

86,495,724

 

$                  865

 

$             (2,379

)

$          235,964

 

$          425,147

 

$            16,708

 

$          676,305

 

$          100,546

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2004

 

83,131,940

 

$                  831

 

$             (2,379

)

$          178,459

 

$          219,539

 

$               1,642

 

$          398,092

 

 

 

Exercise of stock options including tax benefit of $16,314

 

1,793,946

 

18

 

 

26,298

 

 

 

26,316

 

 

Restricted stock activity

 

 

 

 

239

 

 

 

239

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of interest rate swap contracts, net of income taxes of $563

 

 

 

 

 

 

(1,046

)

(1,046

)

(1,046

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of unrealized loss on interest rate swap contracts, net of income taxes of $29

 

 

 

 

 

 

(54

)

(54

)

 

Foreign currency translation adjustment

 

 

 

 

 

 

(65

)

(65

)

(65

)

Net income

 

 

 

 

 

27,925

 

 

27,925

 

27,925

 

Balance, June 30, 2005

 

84,925,886

 

$                  849

 

$             (2,379

)

$          204,996

 

$          247,464

 

$                  477

 

$          451,407

 

$            26,814

 

 

See accompanying notes to consolidated financial statements.

6




Penn National Gaming, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(in thousands) (unaudited)

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2006

 

2005

 

 

 

 

 

Revised - see Note 2

 

Operating activities

 

 

 

 

 

Net income

 

$

84,678

 

$

27,925

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

57,446

 

31,464

 

Amortization of deferred financing costs charged to interest expense

 

5,740

 

1,650

 

Amortization of the unrealized gain on interest rate swap contracts charged to interest expense, net of income tax benefit

 

 

(54

)

Loss on sale of fixed assets

 

374

 

222

 

Earnings from joint venture

 

(987

)

(985

)

Loss relating to early extinguishment of debt

 

2,255

 

7,246

 

Deferred income taxes

 

(1,811

)

(110,757

)

Charge for stock compensation

 

10,404

 

239

 

Tax benefit from stock options exercised

 

 

16,314

 

(Increase) decrease net of businesses acquired

 

 

 

 

 

Accounts receivable

 

(5,673

)

(4,803

)

Insurance receivable

 

(21,116

)

 

Prepaid expenses and other current assets

 

4,331

 

(5,150

)

Prepaid income taxes

 

 

5,707

 

Other assets

 

1,079

 

(9,814

)

(Decrease) increase, net of businesses acquired

 

 

 

 

 

Accounts payable

 

(5,386

)

(1,253

)

Accrued expenses

 

(26,552

)

27,997

 

Accrued interest

 

(3,049

)

(3,262

)

Accrued salaries and wages

 

(2,779

)

(2,277

)

Gaming, pari-mutuel, property and other taxes

 

(6,417

)

1,553

 

Income taxes payable

 

(13,992

)

98,424

 

Other current liabilities

 

(3,608

)

(7,180

)

Operating cash flows from discontinued operations

 

(129

)

(10,130

)

Net cash provided by operating activities

 

74,808

 

63,076

 

Investing activities

 

 

 

 

 

Expenditures for property and equipment

 

(118,055

)

(51,693

)

Proceeds from sale of property and equipment

 

840

 

197

 

Proceeds from sale of business

 

 

274,523

 

Acquisition of businesses, net of cash acquired

 

 

(350

)

Distributions from (payments to) joint venture

 

153

 

(20

)

Investing cash flows from discontinued operations

 

 

(1,131

)

Net cash (used in) provided by investing activities

 

(117,062

)

221,526

 

Financing activities

 

 

 

 

 

Proceeds from exercise of options

 

9,553

 

10,001

 

Proceeds from issuance of long-term debt

 

205,028

 

250,000

 

Principal payments on long-term debt

 

(183,852

)

(470,527

)

Increase in deferred financing cost

 

(36

)

(6,393

)

Tax benefit from stock options exercised

 

9,259

 

 

Net cash provided by (used in) financing activities

 

39,952

 

(216,919

)

Net (decrease) increase in cash and cash equivalents

 

(2,302

)

67,683

 

Cash and cash equivalents at beginning of period

 

132,620

 

87,620

 

Cash and cash equivalents at end of period

 

$

130,318

 

$

155,303

 

 

 

 

 

 

 

Supplemental disclosure

 

 

 

 

 

Interest expense paid

 

$

97,488

 

$

30,368

 

Income taxes paid

 

$

68,500

 

$

21,275

 

 

See accompanying notes to consolidated financial statements.

7




 

Penn National Gaming, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements

 

1.                                      Basis of Presentation

 

The accompanying unaudited consolidated financial statements of Penn National Gaming, Inc. (“Penn”) and subsidiaries (collectively, 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 notes to the consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2005 should be read in conjunction with these consolidated financial statements. For purposes of comparability, certain prior year amounts have been reclassified to conform to the current year presentation. Operating results for the six months ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

 

2.                                      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 and for chips in the customers’ possession.

 

Racing revenue includes the Company’s share of pari-mutuel wagering on live races after payment of amounts returned as winning wagers, and the Company’s share of wagering from import and export simulcasting, as well as its share of wagering from its off-track wagering facilities (“OTWs”).

 

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

 

Food, beverage and other revenue is recognized as services are performed.

 

Revenues are recognized net of certain sales incentives in accordance with the Emerging Issues Task Force (“EITF”) consensus on Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s products)” (“EITF 01-9”). The consensus in EITF 01-9 requires that sales incentives and points earned in point-loyalty programs be recorded as a reduction of revenue. The Company recognizes incentives related to gaming play and points earned in point-loyalty programs as a direct reduction of gaming revenue.

 

During the second quarter of 2006, as a result of the Company’s review of trends in interpreting accounting pronouncements and gaming industry practices for accounting for customer cash incentives, the Company reclassified cash redemption coupons to contra-revenue from operating expense.  The reclassification represented approximately 3% of the Company’s revenues for the three and six months ended June 30, 2005, and had no effect on operating income, net income or earnings per share for the three and six months ended June 30, 2005.

 

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 gaming expenses. The amounts included in promotional allowances for the three and six months ended June 30, 2006 and 2005 are as follows:

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Rooms

 

$

2,804

 

$

1,788

 

$

5,580

 

$

3,592

 

Food and beverage

 

19,537

 

11,995

 

39,236

 

24,197

 

Other

 

1,663

 

2,857

 

5,358

 

5,736

 

Total promotional allowances

 

$

24,004

 

$

16,640

 

$

50,174

 

$

33,525

 

 

8




 

The estimated cost of providing such complimentary services for the three and six months ended June 30, 2006 and 2005 that is included in operating expenses was as follows:

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Rooms

 

$

1,174

 

$

1,044

 

$

2,315

 

$

2,139

 

Food and beverage

 

13,644

 

8,099

 

27,585

 

16,240

 

Other

 

817

 

812

 

3,613

 

1,605

 

Total cost of complimentary services

 

$

15,635

 

$

9,955

 

$

33,513

 

$

19,984

 

 

Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income applicable to common stock by the weighted-average common shares outstanding during the period. Diluted EPS reflects the additional dilution for all potentially-dilutive securities, such as stock options.

The following table reconciles the weighted-average common shares outstanding used in the calculation of basic earnings per share to the weighted-average common shares outstanding used in the calculation of diluted earnings per share. Options to purchase 1,645,812 and 1,827,280 shares of common stock were outstanding for the three and six months ended June 30, 2006, respectively, but were not included in the computation of diluted earnings per share because they are antidilutive. Options to purchase 25,000 and 30,000 shares of common stock were outstanding for the three and six months ended June 30, 2005, respectively, but were not included in the computation of diluted earnings per share because they are antidilutive.

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Determination of shares:

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

84,333

 

83,227

 

83,991

 

82,497

 

Assumed conversion of dilutive stock options

 

2,396

 

2,505

 

2,444

 

3,066

 

Diluted weighted-average common shares outstanding

 

86,729

 

85,732

 

86,435

 

85,563

 

 

Stock-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), 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 must be recognized ratably over the requisite service period following the date of grant.

The Company elected the modified prospective application method for adoption, which results in the recognition of compensation expense using the provisions of SFAS 123(R) for all share-based awards granted or modified after December 31, 2005, and the recognition of compensation expense using the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”), with the exception of the method of recognizing forfeitures, for all unvested awards outstanding at the date of adoption. Under this transition method, the results of operations of prior periods have not been restated. Accordingly, the Company will continue to provide pro forma financial information for prior periods to illustrate the effect on net income and earnings per share of applying the fair value recognition provisions of SFAS 123, as amended by SFAS 148.

Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic-value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain

9




 

Transactions Involving Stock Compensation.” Under the intrinsic-value method, because the exercise price of the Company’s employee stock options was equal to the market price of the underlying stock on the date of grant, no compensation expense was recognized. However, there were situations that could have occurred, such as the accelerated vesting of options or the issuance of restricted stock, that required a current charge to income.

The most significant difference between the fair value approaches prescribed by SFAS 123 and SFAS 123(R) and the intrinsic-value method prescribed by APB 25 related to the recognition of compensation expense for stock option awards based on their grant-date fair value. Under SFAS 123, the Company estimated the fair value of stock option grants using the Black-Scholes option-pricing model. The following table reflects the pro forma impact on net income and earnings per share for the three and six months ended June 30, 2005 of accounting for the Company’s stock-based compensation using the fair value provisions of SFAS 123, as amended by SFAS 148. The effects of applying SFAS 123 and SFAS 148 in the pro forma disclosure below are not indicative of future amounts. Additional awards in future years are anticipated.

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2005

 

2005

 

 

 

(in thousands)

 

 

 

 

 

 

 

Net income, as reported

 

$

12,119

 

$

27,925

 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

 

81

 

157

 

Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects

 

(2,674

)

(5,065

)

Pro forma net income

 

$

9,526

 

$

23,017

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

Basic-as reported

 

$

0.15

 

$

0.34

 

Basic-pro forma

 

0.11

 

0.28

 

 

 

 

 

 

 

Diluted-as reported

 

0.14

 

0.33

 

Diluted-pro forma

 

0.11

 

0.27

 

 

Prior to the adoption of SFAS 123(R), the Company included all tax benefits associated with stock-based compensation as operating cash flows in the consolidated statements of cash flows. SFAS 123(R) requires any reduction in taxes payable resulting from tax deductions that exceed the recognized compensation expense (“excess tax benefits”) to be classified as financing cash flows. The Company included $9.3 million of excess tax benefits in the Company’s cash flows from financing activities for the six months ended June 30, 2006 that would have been classified as operating cash flows had the Company not adopted SFAS 123(R).

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 remaining 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 4.52 years, in order to match the expected life of the options up to the grant date. There is no expected dividend yield 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 exercise behavior of the Company’s employees. Forfeitures are estimated at the date of grant based on historical experience. Prior to the adoption of SFAS 123(R), the Company recorded forfeitures as they occurred for purposes of estimating pro forma compensation expense under SFAS 123. The impact of forfeitures is not material. The following are the weighted-average assumptions used in the Black-Scholes option-pricing model for the six months ended June 30, 2006 and 2005:

10




 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2006

 

2005

 

Risk-free interest rate

 

4.34

%

3.40

%

Expected volatility

 

46.98

%

40.00

%

Dividend yield

 

 

 

Weighted-average expected life (years)

 

4.52

 

5.29

 

Forfeiture rate

 

2.00

%

2.00

%

 

Statements of Cash Flows

Beginning with the year ended December 31, 2005, the Company changed the presentation of its cash flows to separately disclose the operating, investing and financing portions of cash flows attributable to the Company’s discontinued operations. The Company had previously reported these amounts on a combined basis. This change was in response to public statements by the Securities and Exchange Commission Staff concerning the classification of discontinued operations within the statements of cash flows. For the six months ended June 30, 2006 and 2005, cash flows relating to discontinued operations have been separately disclosed within operating and investing activities. For the six months ended June 30, 2006 and 2005, there were no cash flows relating to discontinued operations that were financing activities.

Certain Risks and Uncertainties

The Company’s operations are dependent on its continued licensing by state gaming commissions. The loss of a license, in any jurisdiction in which the Company operates, could have a material adverse effect on future results of operations.

The Company is dependent on each gaming property’s local market for a significant number of its patrons and revenues. If economic conditions in these areas deteriorate or additional gaming licenses are awarded in these markets, the Company’s results of operations could be adversely affected.

The Company is also dependent upon a stable gaming and admission tax structure in the states in which it operates. Any change in the tax structure could have a material adverse affect on future results of operations.

3.             New Accounting Pronouncement

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which is an interpretation of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”).

FIN 48 creates a single model to address uncertainty in tax positions, and clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109 by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in an enterprise’s financial statements.  FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition, and clearly scopes out income taxes from SFAS No. 5, “Accounting for Contingencies.”

FIN 48 is effective for fiscal years beginning after December 15, 2006, but earlier application of the provisions of FIN 48 is encouraged if an enterprise has not yet issued financial statements, including interim financial statements, in the period that FIN 48 is adopted.  Differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption should be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings.

The Company is currently determining the impact of FIN 48 on its consolidated financial statements.

4.             Acquisitions

Argosy Gaming Company

On October 3, 2005, the Company acquired 100% of the stock of Argosy Gaming Company (“Argosy”). The acquisition, which was accretive to the Company’s results of operations, reflects the continuing efforts of the Company to diversify by reducing its dependency on individual properties and legislative jurisdictions. The transaction was accounted for as a purchase transaction, in accordance with SFAS No. 141, “Business Combinations.” As a result, the net assets of Argosy were recorded at their fair value, with the excess of the purchase price over the fair value of the net assets acquired allocated to goodwill.

11




 

In order to assist the Company in assigning values of assets acquired and liabilities assumed in this transaction, the Company obtained a third-party valuation of significant identifiable intangible assets acquired, as well as other assets acquired. In addition, the Company recorded an estimate for the deferred tax liability arising from the acquisition due to the difference between the fair value and the tax basis of the net assets acquired. This deferred tax liability estimate increased the estimated amount of goodwill recorded in the acquisition. As the deferred tax liability is an estimate, it is subject to change, as the Company finalizes certain valuations and tax analyses. Changes to this estimate and the current tax liability, if any, will also affect goodwill and will not have a material impact on the Company’s consolidated statements of income.

The pro forma consolidated results of operations for the three and six months ended June 30, 2005, as if the acquisition of Argosy had occurred on January 1, 2005, are as follows (in thousands, except per share data):

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30, 2005

 

June 30, 2005

 

Pro Forma

 

 

 

 

 

Net revenues

 

$

542,234

 

$

1,069,421

 

Income from continuing operations

 

82,180

 

185,731

 

Net income from continuing operations

 

21,001

 

45,916

 

Basic earnings per share

 

0.25

 

0.55

 

Diluted earnings per share

 

0.24

 

0.53

 

 

“Note 5: Acquisitions” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 provides further detail regarding the Argosy acquisition.

5.             Hurricane Katrina

As a result of Hurricane Katrina’s direct hit on the Mississippi Gulf Coast on August 29, 2005, two of the Company’s casinos, Casino Magic—Bay St. Louis and Boomtown Biloxi, were significantly damaged, many employees were displaced and operations ceased at the two properties.  Following extensive reconstruction, Boomtown Biloxi reopened on June 29, 2006.

The Company has significant levels of insurance in place to cover the losses resulting from Hurricane Katrina including an all risk insurance policy covering “named windstorm” damage, flood damage, debris removal, preservation of property expense, demolition and increased cost of construction expense, losses resulting from business interruption and extra expenses, as defined in the policy. The comprehensive business interruption and property damage insurance policies have an overall limit of $400 million, and are subject to property damage deductibles for Casino Magic—Bay St Louis and Boomtown Biloxi of approximately $6.0 million and $3.5 million, respectively. The business interruption insurance component of this policy is subject to a five-day deductible.

The Company recognized a pre-tax charge of $21.1 million ($13.7 million after-tax) associated with the expenses incurred from Hurricane Katrina during the twelve months ended December 31, 2005. The costs included property insurance and business interruption policy deductible expense, compensation being paid to employees through November 30, 2005 that exceeded the ordinary payroll limits under the business interruption policy, the purchase of replacement flood insurance for coverage during the remaining insurance policy term, contributions to the Penn National Gaming Foundation for the Hurricane Katrina relief project and costs for insurance claim consultants. The charge did not reflect any loss resulting from the damage to the land-based facilities and casino barges at Casino Magic—Bay St. Louis and Boomtown Biloxi, as this amount is not yet known. However, the Company believes that insurance proceeds will be sufficient to fund replacement costs.

The $20.1 million and $51.2 million insurance receivables recorded at June 30, 2006 and December 31, 2005, respectively, were limited to the net historical book value of assets believed to be damaged, destroyed or abandoned, fixed business expenses and out-of-pocket costs for certain additional expenses incurred during the period as a direct result of the hurricane. During the three and six months ended June 30, 2006, the Company received $26.9 million and $52.3 million, respectively, from its insurance carriers relating to Hurricane Katrina. Through December 31, 2005, the Company received $27.3 million from its insurance carriers relating to Hurricane Katrina.

12




 

6.             Property and Equipment

Property and equipment, net, consists of the following (in thousands):

 

June 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Land and improvements

 

$

169,766

 

$

155,735

 

Building and improvements

 

734,414

 

699,584

 

Furniture, fixtures, and equipment

 

338,296

 

314,741

 

Transportation equipment

 

2,080

 

1,401

 

Leasehold improvements

 

14,854

 

13,175

 

Construction in progress

 

194,587

 

82,971

 

Total property and equipment

 

1,453,997

 

1,267,607

 

Less accumulated depreciation and amortization

 

(259,333

)

(207,715

)

Property and equipment, net

 

$

1,194,664

 

$

1,059,892

 

 

Depreciation and amortization expense, for property and equipment, totaled $26.1 million and $54.2 million for the three and six months ended June 30, 2006, respectively, as compared to $15.3 million and $30.2 million for the three and six months ended June 30, 2005, respectively. Interest capitalized in connection with major construction projects was $3.3 million and $.7 million for the six months ended June 30, 2006 and 2005, respectively.

7.             Goodwill and Other Intangible Assets

The Company’s goodwill and intangible assets had a gross carrying value of $2.6 billion at June 30, 2006 and December 31, 2005, and accumulated amortization of $16.1 million and $12.8 million at June 30, 2006 and December 31, 2005, respectively. The table below presents the gross carrying value, accumulated amortization, and net book value of each major class of goodwill and intangible asset at June 30, 2006 and December 31, 2005 (in thousands):

 

 

June 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

Gross
Carrying
Value 

 

Accumulated
Amortization 

 

Net Book Value 

 

Gross
Carrying
Value 

 

Accumulated
Amortization 

 

Net Book Value 

 

Goodwill

 

$

1,832,986

 

$

 

$

1,832,986

 

$

1,848,661

 

$

 

$

1,848,661

 

Gaming license and trademarks

 

711,364

 

 

711,364

 

711,174

 

 

711,174

 

Other intangible assets

 

45,126

 

16,105

 

29,021

 

45,126

 

12,779

 

32,347

 

Total

 

$

2,589,476

 

$

16,105

 

$

2,573,371

 

$

2,604,961

 

$

12,779

 

$

2,592,182

 

 

During the six months ended June 30, 2006, goodwill changed by $15.7 million, primarily due to the finalization of certain fixed asset and deferred tax valuations associated with the Argosy acquisition.

The Company’s intangible asset amortization expense was $1.7 million and $3.3 million for the three and six months ended June 30, 2006, respectively,

13




 

The following table presents expected intangible asset amortization expense based on existing intangible assets at June 30, 2006 (in thousands):

2006 (six months)

 

$

3,329

 

2007

 

6,655

 

2008

 

6,488

 

2009

 

5,988

 

2010

 

5,119

 

Thereafter

 

1,442

 

Total

 

$

29,021

 

 

8.             Long-term Debt

Long-term debt, net of current maturities, is as follows (in thousands):

 

June 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Senior secured credit facility

 

$

2,345,625

 

$

2,148,875

 

$175 million 87¤8% senior subordinated notes

 

 

175,000

 

$200 million 67¤8% senior subordinated notes

 

200,000

 

200,000

 

$250 million 63¤4% senior subordinated notes

 

250,000

 

250,000

 

$200 million 9% senior subordinated notes

 

10

 

10

 

$350 million 7% senior subordinated notes

 

153

 

153

 

Capital leases

 

11,617

 

12,191

 

 

 

2,807,405

 

2,786,229

 

Less current maturities of long-term debt

 

(18,447

)

(18,567

)

 

 

$

2,788,958

 

$

2,767,662

 

 

The following is a schedule of future minimum repayments of long-term debt as of June 30, 2006 (in thousands):

Within one year

 

$

18,447

 

1-3 years

 

163,388

 

3-5 years

 

593,056

 

Over 5 years

 

2,032,514

 

Total minimum payments

 

$

2,807,405

 

 

At June 30, 2006 and December 31, 2005, the Company was contingently obligated under letters of credit issued pursuant to its senior secured credit facility with face amounts aggregating $73.1 million and $72.5 million, respectively.

Senior Secured Credit Facility

On October 3, 2005, the Company entered into a $2.725 billion senior secured credit facility to fund the Company’s acquisition of Argosy, including payment for all of Argosy’s outstanding shares, the retirement of certain long-term debt of Argosy and its subsidiaries, the payment of related transaction costs, and to provide additional working capital.

The senior secured credit facility is secured by substantially all of the assets of the Company.

Interest Rate Swap Contracts

The Company has a policy designed to manage interest rate risk associated with its current and anticipated future borrowings. This policy enables the Company to use any combination of interest rate swaps, futures, options, caps and similar instruments. To the extent the Company employs such financial instruments pursuant to this policy, they are generally accounted for as hedging instruments. In order to qualify for hedge accounting, the underlying hedged item must expose the Company to risks associated with market fluctuations and the financial instrument used must be designated as a hedge and must reduce the Company’s exposure to market fluctuations throughout the hedge period. If these criteria are not met, a change in the market value of the financial instrument is recognized as a gain or loss in the period of change. Net settlements pursuant to the

14




 

financial instrument are included as interest expense in the period.

In accordance with the terms of its $2.725 billion senior secured credit facility, the Company was required to enter into interest rate swap agreements in an amount equal to 50% of the outstanding term loan balances within 100 days of the closing date of the credit facility. On October 27, 2005, the Company entered into four interest rate swap contracts with terms from three to five years, notional amounts of $224 million, $274 million, $225 million, and $237 million, for a total of $960 million and fixed interest rates ranging from 4.678% to 4.753%. The annual weighted-average interest rate of the four contracts is 4.71%. On May 8, 2006, the Company entered into three interest rate swap contracts with a term of five years, notional amounts of $100 million each, for a total of $300 million and fixed interest rates ranging from 5.263% to 5.266%.  The annual weighted-average interest rate of the three contracts is 5.26%. Under these contracts, the Company pays a fixed interest rate against a variable interest rate based on the 90-day LIBOR rate. The 90-day LIBOR rate relating to these contracts as of June 30, 2006 was 5.11% for the $960 million swaps and 5.16% for the $300 million swaps.

Redemption of 87¤8% Senior Subordinated Notes

In February 2006, the Company called for the redemption of its $175 million 87¤8 % senior subordinated notes. The redemption price was $1,044.38 per $1,000 principal amount, plus accrued and unpaid interest and was made on March 15, 2006. The Company funded the redemption of the notes from available cash and borrowings under its revolving credit facility.

67¤8% Senior Subordinated Notes

On December 4, 2003, the Company completed an offering of $200 million of 67¤8% senior subordinated notes that mature on December 1, 2011. Interest on the notes is payable on June 1 and December 1 of each year, beginning June 1, 2004. The Company used the net proceeds from the offering, totaling approximately $196.6 million after deducting underwriting discounts and related expenses, to repay term loan indebtedness under its previous senior secured credit facility.

The Company may redeem all or part of the notes on or after December 1, 2007 at certain specified redemption prices. Prior to December 1, 2006, the Company may redeem up to 35% of the notes from proceeds of certain sales of its equity securities. The notes are also subject to redemption requirements imposed by state and local gaming laws and regulations.

The 67¤8% notes are general unsecured obligations and are guaranteed on a senior subordinated basis by certain of the Company’s current and future wholly-owned domestic subsidiaries. The 67¤8% notes rank equally with the Company’s future senior subordinated debt and junior to its senior debt, including debt under the Company’s senior secured credit facility. In addition, the 67¤8% notes will be effectively junior to any indebtedness of Penn’s non-U.S. Unrestricted Subsidiaries.

The 67¤8% notes and guarantees were originally issued in a private placement pursuant to an exemption from the registration requirements of the Securities Act of 1933 (the “Securities Act”). On August 27, 2004, the Company completed an offer to exchange the notes and guarantees for notes and guarantees registered under the Securities Act having substantially identical terms.

6¾% Senior Subordinated Notes

On March 9, 2005, the Company completed an offering of $250 million of 63¤4% senior subordinated notes. Interest on the notes is payable on March 1 and September 1 of each year, beginning September 1, 2005. These notes mature on March 1, 2015. The 63¤4% notes are general unsecured obligations and are not guaranteed by the Company’s subsidiaries. The 63¤4% notes were issued in a private placement pursuant to an exemption from the registration requirements of the Securities Act. The Company used the net proceeds from the offering to redeem its $200 million 111¤8% senior subordinated notes due March 1, 2008 and repay a portion of the term loan indebtedness under the previous senior secured credit facility.

Covenants

The Company’s senior secured credit facility and $200 million 67¤8% and $250 million 63¤4% senior subordinated notes require it, among other obligations, to maintain specified financial ratios and to satisfy certain financial tests, including fixed charge coverage, senior leverage and total leverage ratios. In addition, the Company’s senior secured credit facility and $200 million 67¤8% and $250 million 63¤4% senior subordinated notes restrict, among other things, the Company’s ability to incur additional indebtedness, incur guarantee obligations, amend debt instruments, pay dividends, create liens on assets, make investments, make acquisitions, engage in mergers or consolidations, make capital expenditures, or engage in certain transactions with subsidiaries and affiliates and otherwise restricts corporate activities. At June 30, 2006, the Company was in compliance with all required financial covenants.

15




 

9.             Commitments and Contingencies

Litigation

The Company is subject to various legal and administrative proceedings relating to personal injuries, employment matters, commercial transactions and other matters arising in the normal course of business. The Company does not believe that the final outcome of these matters will have a material adverse effect on the Company’s consolidated financial position or results of operations. In addition, the Company maintains what it believes is adequate insurance coverage to further mitigate the risks of such proceedings. However, such proceedings can be costly, time consuming and unpredictable and, therefore, no assurance can be given that the final outcome of such proceedings may not materially impact the Company’s consolidated financial condition or results of operations. Further, no assurance can be given that the amount or scope of existing insurance coverage will be sufficient to cover losses arising from such matters.

The following proceedings could result in costs, settlements, damages, or rulings that materially impact the Company’s consolidated financial condition or operating results. In each instance, the Company believes that it has meritorious defenses, claims and/or counter-claims and intends to vigorously defend itself or pursue its claim.

In October 2002, in response to the Company’s plans to relocate the river barge underlying the Boomtown Biloxi casino to an adjacent property, the lessor of the property on which the Boomtown Biloxi casino conducts a portion of its dockside operations filed a lawsuit against the Company in the U.S. District Court for the Southern District of Mississippi seeking a declaratory judgment that (i) the Company must use the leased premises for a gaming use or, in the alternative, (ii) after the move, the Company will remain obligated to make the revenue-based rent payments to plaintiff set forth in the lease. The plaintiff filed this suit immediately after the Mississippi Gaming Commission approved the Company’s request to relocate the barge. Since such approval, the Mississippi Department of Marine Resources and the U.S. Army Corps of Engineers have also approved the Company’s plan to relocate the barge. In March 2004, the trial court ruled in favor of the Company on all counts. The plaintiff appealed the decision to the Fifth Circuit, and on May 3, 2005, the Fifth Circuit ruled that the trial court’s decision should be affirmed in part and reversed and remanded in part. In its decision, the Fifth Circuit upheld the tenant’s right to relocate but remanded the case to the trial court because there was insufficient evidence in the record to determine whether the casino barge would be relocated to a place which would trigger the increased rent obligation under the lease. The Court has set a scheduling order setting the trial date for February 26, 2007.  The Company believes this case should be resolved on dispositive motions, which are due to be filed by October 16, 2006.  The parties have also engaged in settlement negotiations, but have not yet reached a settlement of this matter.

In November 2005, Capital Seven, LLC and Shawn A. Scott (“Capital Seven”), the sellers of Bangor Historic Track (“BHT”), filed a demand for arbitration with the American Arbitration Association seeking $30 million plus interest and other damages. Capital Seven alleges a breach of contract by the Company based on the Company’s payment of a $51 million purchase price for the purchase of BHT instead of an alleged $81 million purchase price the sellers claim is due under the purchase agreement. The parties had agreed that the purchase price of BHT would be determined, in part, by the applicable gaming taxes imposed by Maine on the Company’s operations, and currently are disputing the effective tax rate. The dispute is currently in its initial stages. The Company filed a Counter-Statement and Answer on December 15, 2005, and the parties are in the process of choosing arbitrators.

In conjunction with the Company’s merger with Argosy, the Company became responsible for litigation initiated over eight years ago related to the Baton Rouge property formerly owned by Argosy. On November 26, 1997, Capitol House filed an amended petition in the Nineteenth Judicial District Court for East Baton Rouge Parish, State of Louisiana, amending its previously filed but unserved suit against Richard Perryman, the person selected by the Louisiana Gaming Division to evaluate and rank the applicants seeking a gaming license for East Baton Rouge Parish, and adding state law claims against Jazz Enterprises, Inc., the former Jazz Enterprises, Inc. Shareholders, Argosy Gaming Company, Argosy of Louisiana, Inc. and Catfish Queen Partnership in Commendam, d/b/a the Belle of Baton Rouge Casino. This suit alleges that these parties violated the Louisiana Unfair Trade Practices Act in connection with obtaining the gaming license that was issued to Jazz Enterprises, Inc./Catfish Queen Partnership in Commendam. The plaintiff, an applicant for a gaming license whose application was denied by the Louisiana Gaming Division, seeks to prove that the gaming license was invalidly issued and seeks to recover lost gaming revenues that the plaintiff contends it could have earned if the gaming license had been properly issued to the plaintiff. In June 2003, the Louisiana trial court dismissed this lawsuit. The trial court’s decision was affirmed by the First Circuit Court of Appeals, but subsequently reversed by the Louisiana Supreme Court on March 24, 2005, which remanded the case back to the trial court for further proceedings. The Company plans to file further dispositive motions. The trial is scheduled for late January 2007.

The Company has the right to seek indemnification from two of the former Jazz Enterprises, Inc. shareholders for any liability suffered as a result of such cause of action, however, there can be no assurance that the former Jazz Enterprises, Inc. shareholders will have assets sufficient to satisfy any claim in excess of Argosy’s recoupment rights.

16




 

In May 2006, the Illinois Legislature passed into law House Bill 1918, effective May 26, 2006, which singled out four of the nine Illinois casinos, including the Company’s Empress Casino Hotel and Hollywood Casino Aurora, for a 3% tax surcharge to subsidize local horse racing interests. The Company began paying this tax surcharge during the three months ended June 30, 2006, and the Company will continue to pay this tax surcharge in upcoming periods. Prior to the passage of this law, questions were raised regarding its constitutionality. On May 30, 2006, Empress Casino Hotel and Hollywood Casino Aurora joined with the two other riverboats affected by the law, Harrah’s Joliet and the Grand Victoria Casino in Elgin, and filed suit in the Circuit Court of the Twelfth Judicial District in Will County, Illinois (the “Court”), asking the Court to declare the law unconstitutional. The State agreed to the entry of an order that establishes a protest fund for all of the tax surcharge payments and enjoins the Treasurer from making any payments out of that fund pending the final outcome of the litigation. Should the casinos prevail with their challenge, the incremental taxes paid under protest would be refunded. The Company anticipates a long process before a resolution to this matter can be reached.

Operating Lease Commitments

The Company is liable under numerous operating leases for airplanes, automobiles, land for the property on which some of its casinos operate, other equipment and buildings, which expire at various dates through 2093. Total rental expense under these agreements was $7.1 million and $13.0 million for the three and six months ended June 30, 2006, respectively.

The leases for land consist of annual base lease rent payments, plus a percentage rent based on a percent of adjusted gaming wins, as described in the respective leases.

The Company has an operating lease with the City of Bangor for a permanent facility which the Company expects to open in the second quarter of 2008, at a budgeted cost of $90.0 million. This permanent facility is subject to a percentage rent equaling 3% of gross slot revenue. The lease is for an initial term of fifteen years with three ten-year renewal options. The initial term begins with the opening of the permanent facility. An agreement with the City of Bangor calls for a two-year rent moratorium for 2006 and 2007.

The future minimum lease commitments relating to the base lease rent portion of noncancelable operating leases at June 30, 2006 are as follows (in thousands):

Within one year

 

$

17,234

 

1-3 Years

 

32,511

 

3-5 Years

 

21,540

 

Over 5 years

 

213,944

 

Total

 

$

285,229

 

 

Capital Expenditure Commitments

At June 30, 2006, the Company is contractually committed to spend approximately $66.7 million in capital expenditures for projects in progress.

10.                               Stock-Based Compensation

In April 1994, the Company’s Board of Directors and shareholders adopted and approved the 1994 Stock Option Plan (the “1994 Plan”). The 1994 Plan permitted the grant of options to purchase up to 12,000,000 shares of Common Stock, subject to antidilution adjustments, at a price per share no less than 100% of the fair market value of the Common Stock on the date an option is granted with respect to incentive stock options only. The price would be no less than 110% of fair market value in the case of an incentive stock option granted to any individual who owns more than 10% of the total combined voting power of all classes of outstanding stock. The 1994 Plan provided for the granting of both incentive stock options intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended, and nonqualified stock options, which do not so qualify. The 1994 Plan terminated in April 2004.

On April 16, 2003, the Company’s Board of Directors adopted and approved the 2003 Long Term Incentive Compensation Plan (the “2003 Plan”). On May 22, 2003, the Company’s shareholders approved the 2003 Plan. The 2003 Plan was effective June 1, 2003 and permits the grant of options to purchase Common Stock and other market-based and performance-based awards. Up to 12,000,000 shares of Common Stock are available for awards under the 2003 Plan. The 2003 Plan provides for the granting of both incentive stock options intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended, and nonqualified stock options, which do not so qualify. The exercise price per share may be no less than (i) 100% of the fair market value of the Common Stock on the date an option is granted for incentive stock options and

17




 

(ii) 85% of the fair market value of the Common Stock on the date an option is granted for nonqualified stock options. Unless this plan is extended, no awards shall be granted or exchanges effected under this plan after May 31, 2013. At June 30, 2006, there were 4,490,500 options available for future grants under the 2003 Plan.

Stock options that expire between February 8, 2007 and January 12, 2016 have been granted to officers, directors and employees to purchase Common Stock at prices ranging from $2.03 to $41.37 per share. All options were granted at the fair market value of the Common Stock on the date the options were granted.

The following table contains information on stock options for the six months ended June 30, 2006:

 

 

 

 

 

Weighted-

 

 

 

 

 

 

 

 

 

Average

 

 

 

 

 

 

 

Weighted-

 

Remaining

 

Aggregate

 

 

 

Number of

 

Average

 

Contractual

 

Intrinsic

 

 

 

Option

 

Exercise

 

Term

 

Value

 

 

 

Shares

 

Price

 

(in years)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

7,733,814

 

$

17.09

 

 

 

 

 

Granted

 

1,446,500

 

33.19

 

 

 

 

 

Exercised

 

(990,838

)

9.64

 

 

 

 

 

Canceled

 

(52,500

)

20.28

 

 

 

 

 

Outstanding at June 30, 2006

 

8,136,976

 

$

20.84

 

5.32

 

$

145,976

 

 

Included in the above are common stock options that were issued in 2003 to the Company’s Chairman outside of the 1994 Plan and the 2003 Plan. These options were issued at $7.95 per share, and are exercisable through February 6, 2013. At June 30, 2006 and December 31, 2005, the number of these common stock options that were outstanding was 23,750 and 95,000, respectively. In addition, the Company issued 160,000 restricted stock awards in 2004, which fully vest in May 2009, and issued 280,000 restricted stock awards in 2006, which fully vest by 2011. The weighted-average grant-date fair value of options granted during the six months ended June 30, 2006 and 2005 were $14.68 and $12.08, respectively.

The aggregate intrinsic value of stock options exercised during the six months ended June 30, 2006 and 2005 was $28.1 million and $49.3 million, respectively.

At June 30, 2006, there were 2,842,226 shares that were exercisable, with a weighted-average exercise price of $13.43, a weighted-average remaining contractual term of 4.06 years, and an aggregate intrinsic value of $72.0 million.

The following table summarizes information about stock options outstanding at June 30, 2006:

 

Exercise Price Range

 

Total

 

 

 

$2.03 to

 

$14.56 to

 

$30.18 to

 

$2.03 to

 

 

 

$12.15

 

$29.22

 

$41.37

 

$41.37

 

Outstanding options

 

 

 

 

 

 

 

 

 

Number outstanding

 

3,609,176

 

2,888,800

 

1,639,000

 

8,136,976

 

Weighted-average remaining contractual life (years)

 

3.94

 

6.05

 

7.04

 

5.32

 

Weighted-average exercise price

 

$

9.57

 

$

27.92

 

$

33.20

 

$

20.84

 

Exercisable options

 

 

 

 

 

 

 

 

 

Number outstanding

 

2,130,676

 

695,300

 

16,250

 

2,842,226

 

Weighted-average exercise price

 

$

8.73

 

$

27.42

 

$

32.08

 

$

13.43

 

 

Compensation costs related to stock-based compensation for the six months ended June 30, 2006 totaled $10.4 million, and are included in the consolidated statements of income under general and administrative expenses. The net impact for the six months ended June 30, 2006 to earnings was $6.8 million ($.08 per diluted share).

At June 30, 2006, the total compensation cost related to nonvested awards not yet recognized equaled $55.3 million, including $45.5 million for stock options and $9.8 million for restricted stock. This cost is expected to be recognized over the remaining vesting periods, which will not exceed five years.

11.                               Segment Information

In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”), the Company views each property as an operating segment. Historically, the Company aggregated its gaming properties that were economically similar, offered similar types of products and services, catered to the same types of customers and were

18




 

similarly regulated into a reportable segment called gaming, and aggregated its racing properties that were economically similar, offered similar products and services, catered to the similar types of customers and were similarly regulated into a reportable segment called racing.

Beginning in the first quarter of 2006, the Company modified its segment reporting from two reportable segments to one reportable segment, as the Company believes that its gaming and racing properties can now be aggregated together in accordance with SFAS 131, due to ongoing changes at its racing properties, including the upcoming introduction of slot machines at Penn National Race Course.

“Note 15: Segment Information” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, provides further detail regarding the Company’s historical segment reporting.

12.                               Subsidiary Guarantors

Under the terms of the $2.725 billion senior secured credit facility, all of the Company’s subsidiaries are guarantors under the agreement, with the exception of several minor subsidiaries with total assets of $12.7 million (less than .3% of total assets at June 30, 2006). Each of the subsidiary guarantors are 100% owned by Penn. In addition, the guarantees provided by the Company’s subsidiaries under the terms of the $2.725 billion senior secured credit facility are full and unconditional, joint and several, and Penn has no significant independent assets and no independent operations at, and for the three and six months ended, June 30, 2006. There are no significant restrictions within the $2.725 billion senior secured credit facility on the Company’s ability to obtain funds from its subsidiaries by dividend or loan. However, in certain jurisdictions, the gaming authorities may impose restrictions pursuant to the authority granted to them with regard to the Company’s ability to obtain funds from its subsidiaries.

With regard to the $2.725 billion senior secured credit facility, the Company has not presented condensed consolidating balance sheets, condensed consolidating statements of income and condensed consolidating statements of cash flows at, and for the three and six months ended, June 30, 2006, as Penn had no significant independent assets and no independent operations at, and for the three and six months ended, June 30, 2006, the guarantees are full and unconditional and joint and several, and any subsidiaries of the parent company other than the subsidiary guarantors are considered minor.

Under the terms of the $200 million 67¤8% senior subordinated notes, most of the Company’s subsidiaries are guarantors. Each of the subsidiary guarantors are 100% owned by Penn. In addition, the guarantees provided by the Company’s subsidiaries under the terms of the $200 million 67¤8% senior subordinated notes are full and unconditional, joint and several, and Penn had no significant independent assets and no independent operations at, and for the three and six months ended, June 30, 2006. There are no significant restrictions within the $200 million 67¤8% senior subordinated notes on the Company’s ability to obtain funds from its subsidiaries by dividend or loan. However, in certain jurisdictions, the gaming authorities may impose restrictions pursuant to the authority granted to them with regard to the Company’s ability to obtain funds from its subsidiaries.

Summarized financial information at, and for the three and six months ended, June 30, 2006 and 2005 for Penn, the subsidiary guarantors of the 67¤8% senior subordinated notes and subsidiary non-guarantors is presented below. For purposes of comparability, certain prior year amounts have been reclassified to conform to the current year presentation.

19




 

 

 

 

 

Subsidiary

 

Subsidiary

 

 

 

 

 

 

 

Penn

 

Guarantors

 

Non-Guarantors

 

Eliminations

 

Consolidated

 

At June 30, 2006

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Balance Sheet (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Current assets

 

$

(19,954

)

$

287,475

 

$

14,412

 

$

1,267

 

$

283,200

 

Property and equipment, net

 

139,022

 

1,090,024

 

 

 

1,229,046

 

Other assets

 

3,318,784

 

2,859,229

 

(4,871

)

(3,411,539

)

2,761,603

 

Total

 

$

3,437,852

 

$

4,236,728

 

$

9,541

 

$

(3,410,272

)

$

4,273,849

 

Current liabilities

 

(26,218

)

299,463

 

5,632

 

 

278,877

 

Long-term liabilities

 

2,787,765

 

3,701,913

 

 

(3,171,011

)

3,318,667

 

Shareholders’ equity

 

676,305

 

235,352

 

3,909

 

(239,261

)

676,305

 

Total

 

$

3,437,852

 

$

4,236,728

 

$

9,541

 

$

(3,410,272

)

$

4,273,849

 

Three months ended June 30, 2006

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

532,916

 

$

4,921

 

$

(64

)

$

537,773

 

Total operating expenses

 

16,150

 

395,071

 

4,779

 

(64

)

415,936

 

(Loss) income from operations

 

(16,150

)

137,845

 

142

 

 

121,837

 

Other expenses

 

(14,072

)

(32,046

)

(23

)

 

(46,141

)

(Loss) income before income taxes

 

(30,222

)

105,799

 

119

 

 

75,696

 

Taxes on income

 

(15,242

)

48,132

 

111

 

 

33,001

 

Net (loss) income

 

$

(14,980

)

$

57,667

 

$

8

 

$

 

$

42,695

 

Six months ended June 30, 2006

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

1,076,410

 

$

9,308

 

$

(143

)

$

1,085,575

 

Total operating expenses

 

31,613

 

794,368

 

8,999

 

(143

)

834,837

 

(Loss) income from operations

 

(31,613

)

282,042

 

309

 

 

250,738

 

Other expenses

 

(20,684

)

(82,627

)

(75

)

 

(103,386

)

(Loss) income before income taxes

 

(52,297

)

199,415

 

234

 

 

147,352

 

Taxes on income

 

(33,085

)

95,542

 

217

 

 

62,674

 

Net (loss) income

 

$

(19,212

)

$

103,873

 

$

17

 

$

 

$

84,678

 

Six months ended June 30, 2006

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Cash Flows (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

$

88,530

 

$

(13,393

)

$

(329

)

$

 

$

74,808

 

Net cash (used in) provided by investing activities

 

(131,610

)

14,548

 

 

 

(117,062

)

Net cash provided by (used in) financing activities

 

40,520

 

(568

)

 

 

39,952

 

Net (decrease) increase in cash and cash equivalents

 

(2,560

)

587

 

(329

)

 

(2,302

)

Cash and cash equivalents at beginning of period

 

(1,841

)

133,862

 

599

 

 

132,620

 

Cash and cash equivalents at end of period

 

$

(4,401

)

$

134,449

 

$

270

 

$

 

$

130,318

 

 

 

 

 

 

Subsidiary

 

Subsidiary

 

 

 

 

 

 

 

Penn

 

Guarantors

 

Non-Guarantors

 

Eliminations

 

Consolidated

 

At December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Balance Sheet (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Current assets

 

$

3,125

 

$

273,840

 

$

17,622

 

$

11,788

 

$

306,375

 

Property and equipment, net

 

14,739

 

1,079,537

 

 

 

1,094,276

 

Other assets

 

3,171,884

 

3,145,822

 

(4,575

)

(3,523,378

)

2,789,753

 

Total

 

$

3,189,748

 

$

4,499,199

 

$

13,047

 

$

(3,511,590

)

$

4,190,404

 

Current liabilities

 

$

61,537

 

$

270,307

 

$

9,376

 

$

89

 

$

341,309

 

Long-term liabilities

 

2,757,359

 

3,831,787

 

 

(3,286,594

)

3,302,552

 

Shareholders’ equity

 

370,852

 

397,105

 

3,671

 

(225,085

)

546,543

 

Total

 

$

3,189,748

 

$

4,499,199

 

$

13,047

 

$

(3,511,590

)

$

4,190,404

 

Three months ended June 30, 2005

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

291,624

 

$

32,026

 

$

(119

)

$

323,531

 

Total operating expenses

 

7,239

 

250,891

 

33,117

 

(119

)

291,128

 

(Loss) income from operations

 

(7,239

)

40,733

 

(1,091

)

 

32,403

 

Other income (expenses)

 

8,225

 

(19,880

)

(3,075

)

 

(14,730

)

Income (loss) before income taxes

 

986

 

20,853

 

(4,166

)

 

17,673

 

Taxes on income

 

1,805

 

3,713

 

36

 

 

5,554

 

Net (loss) income

 

$

(819

)

$

17,140

 

$

(4,202

)

$

 

$

12,119

 

Six months ended June 30, 2005

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

570,907

 

$

68,979

 

$

(227

)

$

639,659

 

Total operating expenses

 

14,699

 

466,597

 

68,580

 

(227

)

549,649

 

(Loss) income from operations

 

(14,699

)

104,310

 

399

 

 

90,010

 

Other income (expenses)

 

11,569

 

(53,902

)

(5,087

)

(9

)

(47,429

)

(Loss) income before income taxes

 

(3,130

)

50,408

 

(4,688

)

(9

)

42,581

 

Taxes on income

 

15,483

 

(905

)

78

 

 

14,656

 

Net (loss) income

 

$

(18,613

)

$

51,313

 

$

(4,766

)

$

(9

)

$

27,925

 

Six months ended June 30, 2005

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Statement of Cash Flows (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

$

40,596

 

$

22,833

 

$

(353

)

$

 

$

63,076

 

Net cash provided by (used in) investing activities

 

259,802

 

(37,145

)

(1,131

)

 

221,526

 

Net cash (used in) provided by financing activities

 

(216,133

)

(2,220

)

1,434

 

 

(216,919

)

Net increase (decrease) in cash and cash equivalents

 

84,265

 

(16,532

)

(50

)

 

67,683

 

Cash and cash equivalents at beginning of period

 

3,020

 

56,307

 

28,293

 

 

87,620

 

Cash and cash equivalents at end of period

 

$

87,285

 

$

39,775

 

$

28,243

 

$

 

$

155,303

 

 

20




 

13.          Discontinued Operations—Hollywood Casino Shreveport

On August 27, 2004, the Company’s unrestricted subsidiary, Hollywood Casino Shreveport (“HCS”), in cooperation with an Ad Hoc Committee representing a majority of its noteholders, entered into an agreement with Eldorado Resorts LLC (“Eldorado”) providing for acquisition of HCS by certain affiliates of Eldorado. On September 10, 2004, a group of HCS’s creditors, led by Black Diamond Capital Management, LLC, filed with the U.S. Bankruptcy Court, Western District of Louisiana (“U.S. Bankruptcy Court”), located in Shreveport, Louisiana, an involuntary petition against HCS for relief under Chapter 11 of the U.S. Bankruptcy Code. On October 30, 2004, HCS agreed to the entry of an order for relief in the Chapter 11 case that had been filed against it, and HCS I, Inc., HCS II, Inc., HWCC-Louisiana, Inc. and Shreveport Capital Corporation commenced voluntary cases under Chapter 11 of the Bankruptcy Code. HCS’s debt was non-recourse to the Company and its other subsidiaries.

On July 6, 2005, the U.S. Bankruptcy Court entered an order confirming a Chapter 11 plan that provided for the acquisition of HCS by certain affiliates of Eldorado and, on July 22, 2005, the acquisition was completed.

The Company has historically reflected the results of this transaction by classifying the assets, liabilities and results of operations of HCS as assets and liabilities held for sale and discontinued operations in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). The Company held no HCS assets or liabilities at June 30, 2006 and December 31, 2005.  Net revenues, loss from continuing operations and net loss for HCS for the three months ended June 30, 2005 equaled $27.3 million, $1.2 million and $2.8 million, respectively. Net revenues, income from continuing operations and net loss for HCS for the six months ended June 30, 2005 equaled $60.2 million, $.2 million and $3.2 million, respectively.

14.          Discontinued Operations—Sale of The Downs Racing, Inc. and Subsidiaries

On October 15, 2004, the Company announced the sale of The Downs Racing, Inc. and its subsidiaries to the Mohegan Tribal Gaming Authority (“MTGA”). In January 2005, the Company received $280 million from the MTGA, and transferred the operations of The Downs Racing, Inc. and its subsidiaries to the MTGA. The sale is not considered final, as the MTGA received certain post-closing termination rights that remain outstanding. Reflecting taxes, post closing adjustments, fees and other expenses, the Company realized net proceeds of approximately $175 million, which, in accordance with the Company’s credit agreement, were used to retire debt or to reinvest in capital expenditures. The Company recorded the net proceeds, after paying down approximately $60 million of the senior credit facility, as restricted cash. The Company applied the remaining balance of the restricted cash, of approximately $97.0 million, to senior debt reduction in April 2005. Under the terms of the agreement, MTGA acquired The Downs Racing, Inc. and its subsidiaries, including Pocono Downs (a standardbred horse racing facility located on 400 acres in Wilkes-Barre, Pennsylvania) and five Pennsylvania off-track wagering facilities located in Carbondale, East Stroudsburg, Erie, Hazelton and Lehigh Valley (Allentown). The sale agreement also provides the MTGA with certain post-closing termination rights in the event of certain materially adverse legislative or regulatory events. On August 7, 2006, the Company entered into the Second Amendment to Purchase Agreement and Release of Claims (“Amendment and Release”) with the MTGA pertaining to the October 14, 2004 Purchase Agreement (the “Purchase Agreement”) pursuant to which the MTGA purchased The