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 September 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 November 3, 2006

Common Stock, par value $.01 per share

 

84,919,324 (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; 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

 

4

 

 

 

 

 

ITEM 1.

 

FINANCIAL STATEMENTS

 

4

 

 

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

 

4

 

 

Consolidated Statements of Income — For the Three and Nine Months Ended September 30, 2006
and 2005

 

5

 

 

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

 

6

 

 

Consolidated Statements of Cash Flows — For the Nine Months Ended September 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)

 

23

 

 

 

 

 

ITEM 3.

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

40

 

 

 

 

 

ITEM 4.

 

CONTROLS AND PROCEDURES

 

40

 

 

 

 

 

PART II. OTHER INFORMATION

 

41

 

 

 

 

 

ITEM 1.

 

LEGAL PROCEEDINGS

 

41

 

 

 

 

 

ITEM 6.

 

EXHIBITS

 

41

 

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)

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(unaudited)

 

Assets

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

136,322

 

$

132,620

 

Receivables, net of allowance for doubtful accounts of $3,046 and $2,994 at September 30, 2006 and December 31, 2005, respectively

 

58,857

 

47,632

 

Insurance receivable

 

 

51,160

 

Prepaid expenses and other current assets

 

53,083

 

26,780

 

Deferred income taxes

 

33,992

 

48,150

 

Total current assets

 

282,254

 

306,342

 

 

 

 

 

 

 

Property and equipment, net

 

1,317,614

 

1,059,892

 

Other assets

 

 

 

 

 

Investment in and advances to unconsolidated affiliate

 

16,277

 

17,184

 

Goodwill

 

1,894,074

 

1,848,661

 

Other intangible assets

 

727,555

 

743,521

 

Deferred financing costs, net of accumulated amortization of $13,629 and $7,349 at September 30, 2006 and December 31, 2005, respectively

 

60,196

 

70,960

 

Other assets

 

72,954

 

92,861

 

Restricted assets held for sale

 

 

50,983

 

Total other assets

 

2,771,056

 

2,824,170

 

Total assets

 

$

4,370,924

 

$

4,190,404

 

Current liabilities

 

 

 

 

 

Current maturities of long-term debt

 

$

18,481

 

$

18,567

 

Accounts payable

 

43,472

 

25,549

 

Accrued expenses

 

105,821

 

116,552

 

Accrued interest

 

30,449

 

33,303

 

Accrued salaries and wages

 

59,108

 

54,579

 

Gaming, pari-mutuel, property, and other taxes

 

56,176

 

47,724

 

Income taxes payable

 

26,168

 

18,284

 

Insurance financing

 

26,490

 

6,115

 

Other current liabilities

 

27,857

 

20,636

 

Total current liabilities

 

394,022

 

341,309

 

 

 

 

 

 

 

Long-term liabilities

 

 

 

 

 

Long-term debt, net of current maturities

 

2,783,713

 

2,767,662

 

Deferred income taxes

 

370,222

 

259,708

 

Other noncurrent liabilities

 

244

 

659

 

Liabilities held for sale

 

 

274,523

 

Total long-term liabilities

 

3,154,179

 

3,302,552

 

 

 

 

 

 

 

Shareholders’ equity

 

 

 

 

 

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

 

 

 

Common stock ($.01 par value, 200,000,000 shares authorized, 86,533,864 shares at September 30, 2006, and 85,064,886 shares at December 31, 2005, issued)

 

865

 

850

 

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

 

(2,379

)

(2,379

)

Additional paid-in capital

 

241,299

 

206,763

 

Retained earnings

 

580,207

 

340,469

 

Accumulated other comprehensive income

 

2,731

 

840

 

Total shareholders’ equity

 

822,723

 

546,543

 

Total liabilities and shareholders’ equity

 

$

4,370,924

 

$

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

 

For the Nine Months

 

 

 

Ended September 30,

 

Ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

 

 

 

 

 

 

 

 

Gaming

 

$

536,901

 

$

249,824

 

$

1,531,155

 

$

749,962

 

Racing

 

13,075

 

11,627

 

40,277

 

36,731

 

Management service fee

 

4,819

 

5,201

 

14,127

 

13,968

 

Food, beverage and other

 

59,198

 

34,113

 

164,183

 

111,263

 

Gross revenues

 

613,993

 

300,765

 

1,749,742

 

911,924

 

Less promotional allowances

 

(27,882

)

(13,828

)

(78,056

)

(47,353

)

Net revenues

 

586,111

 

286,937

 

1,671,686

 

864,571

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Gaming

 

278,079

 

136,535

 

788,705

 

403,557

 

Racing

 

10,094

 

9,173

 

31,020

 

28,241

 

Food, beverage and other

 

52,703

 

25,603

 

149,931

 

75,328

 

General and administrative

 

85,984

 

39,248

 

234,595

 

131,488

 

Hurricane expense

 

 

19,142

 

 

19,142

 

Settlement costs

 

 

 

 

28,175

 

Depreciation and amortization

 

31,196

 

14,942

 

88,642

 

46,406

 

Total operating expenses

 

458,056

 

244,643

 

1,292,893

 

732,337

 

Income from continuing operations

 

128,055

 

42,294

 

378,793

 

132,234

 

 

 

 

 

 

 

 

 

 

 

Other income (expenses)

 

 

 

 

 

 

 

 

 

Interest expense

 

(49,732

)

(12,824

)

(145,927

)

(41,652

)

Interest income

 

882

 

958

 

2,652

 

3,180

 

(Loss) earnings from joint venture

 

(1,665

)

230

 

(678

)

1,216

 

Other

 

(593

)

532

 

(519

)

438

 

Loss on early extinguishment of debt

 

 

 

(10,022

)

(16,673

)

Total other expenses

 

(51,108

)

(11,104

)

(154,494

)

(53,491

)

 

 

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

76,947

 

31,190

 

224,299

 

78,743

 

Taxes on income

 

36,548

 

11,386

 

99,222

 

27,793

 

Net income from continuing operations

 

40,399

 

19,804

 

125,077

 

50,950

 

 

 

 

 

 

 

 

 

 

 

Loss from discontinued operations, net of tax

 

 

(2,291

)

 

(5,512

)

Gain on sale of discontinued operations, net of tax

 

114,661

 

37,888

 

114,661

 

37,888

 

Net income

 

$

155,060

 

$

55,401

 

$

239,738

 

$

83,326

 

 

 

 

 

 

 

 

 

 

 

Earnings per share-Basic

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.48

 

$

0.24

 

$

1.49

 

$

0.62

 

Discontinued operations, net of tax

 

1.36

 

0.43

 

1.36

 

0.39

 

Basic earnings per share

 

$

1.84

 

$

0.67

 

$

2.85

 

$

1.01

 

 

 

 

 

 

 

 

 

 

 

Earnings per share-Diluted

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.47

 

$

0.23

 

$

1.45

 

$

0.59

 

Discontinued operations, net of tax

 

1.32

 

0.41

 

1.32

 

0.38

 

Diluted earnings per share

 

$

1.79

 

$

0.64

 

$

2.77

 

$

0.97

 

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

 

Income (Loss)

 

Equity

 

Income

 

Balance, December 31, 2005

 

85,064,886

 

$

850

 

$

(2,379

)

$

206,763

 

$

340,469

 

$

840

 

$

546,543

 

 

 

Stock option activity, including tax benefit of $9,405

 

1,028,978

 

11

 

 

33,249

 

 

 

33,260

 

$

 

Restricted stock activity

 

440,000

 

4

 

 

1,287

 

 

 

1,291

 

 

Change in fair value of interest rate swap contracts, net of income taxes of $1,041

 

 

 

 

 

 

1,823

 

1,823

 

1,823

 

Foreign currency translation adjustment

 

 

 

 

 

 

68

 

68

 

68

 

Net income

 

 

 

 

 

239,738

 

 

239,738

 

239,738

 

Balance, September 30, 2006

 

86,533,864

 

$

865

 

$

(2,379

)

$

241,299

 

$

580,207

 

$

2,731

 

$

822,723

 

$

241,629

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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 $16,754

 

1,841,946

 

18

 

 

27,114

 

 

 

27,132

 

$

 

Restricted stock activity

 

 

 

 

358

 

 

 

358

 

 

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

 

 

 

 

 

 

106

 

106

 

106

 

Net income

 

 

 

 

 

83,326

 

 

83,326

 

83,326

 

Balance, September 30, 2005

 

84,973,886

 

$

849

 

$

(2,379

)

$

205,931

 

$

302,865

 

$

648

 

$

507,914

 

$

82,386

 

 

See accompanying notes to consolidated financial statements.

 

6




 

Penn National Gaming, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(in thousands) (unaudited)

 

 

 

Nine Months Ended

 

 

 

 

September 30,

 

 

 

 

2006

 

2005

 

 

 

 

 

 

Revised -
see Note 2

 

Operating activities

 

 

 

 

 

Net income

 

$

239,738

 

$

83,326

 

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

 

 

 

 

 

Depreciation and amortization

 

88,642

 

46,406

 

Amortization of deferred financing costs charged to interest expense

 

8,551

 

2,318

 

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

 

792

 

2,185

 

Book value of assets tranferred to insurance receivable

 

 

29,770

 

Loss (earnings) from joint venture

 

678

 

(1,215

)

Loss relating to early extinguishment of debt

 

2,255

 

7,246

 

Deferred income taxes

 

(14,766

)

(87,112

)

Charge for stock compensation

 

15,235

 

358

 

Gain on sale of discontinued operations

 

(114,661

)

(37,888

)

Tax benefit from stock options exercised

 

 

16,754

 

(Increase) decrease, net of businesses acquired

 

 

 

 

 

Accounts receivable

 

(11,225

)

2,862

 

Insurance receivable

 

(22,809

)

(38,870

)

Prepaid expenses and other current assets

 

(23,440

)

(2,475

)

Prepaid income taxes

 

 

5,706

 

Other assets

 

19,158

 

(10,717

)

Increase (decrease), net of businesses acquired

 

 

 

 

 

Accounts payable

 

17,923

 

(4,864

)

Accrued expenses

 

(9,511

)

16,211

 

Accrued interest

 

(2,854

)

(7,421

)

Accrued salaries and wages

 

4,529

 

1,642

 

Gaming, pari-mutuel, property and other taxes

 

7,868

 

4,575

 

Income taxes payable

 

8,663

 

87,177

 

Other current and non-current liabilities

 

2,320

 

(11,757

)

Operating cash flows from discontinued operations

 

12

 

(4,259

)

Net cash provided by operating activities

 

217,098

 

99,904

 

Investing activities

 

 

 

 

 

Expenditures for property and equipment

 

(246,673

)

(68,485

)

Proceeds from sale of property and equipment

 

2,270

 

690

 

Proceeds from sale of business

 

 

274,523

 

Acquisition of businesses, net of cash acquired

 

 

(1,050

)

Payments to joint venture

 

 

(20

)

Investing cash flows from discontinued operations

 

 

(1,131

)

Net cash (used in) provided by investing activities

 

(244,403

)

204,527

 

Financing activities

 

 

 

 

 

Proceeds from exercise of options

 

9,911

 

10,376

 

Proceeds from issuance of long-term debt

 

167,383

 

250,000

 

Principal payments on long-term debt

 

(176,025

)

(470,797

)

Increase in deferred financing cost

 

(42

)

(7,687

)

Proceeds from insurance financing

 

29,432

 

 

Payments on insurance financing

 

(9,057

)

 

Tax benefit from stock options exercised

 

9,405

 

 

Net cash provided by (used in) financing activities

 

31,007

 

(218,108

)

Net increase in cash and cash equivalents

 

3,702

 

86,323

 

Cash and cash equivalents at beginning of period

 

132,620

 

87,620

 

Cash and cash equivalents at end of period

 

$

136,322

 

$

173,943

 

 

 

 

 

 

 

Supplemental disclosure

 

 

 

 

 

Interest expense paid

 

$

148,216

 

$

46,508

 

Income taxes paid

 

$

94,069

 

$

21,456

 

 

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 nine months ended September 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 had no effect on operating income, net income or earnings per share for the three and nine months ended September 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 nine months ended September 30, 2006 and 2005 are as follows:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

Rooms

 

$

3,200

 

$

1,604

 

$

8,780

 

$

5,196

 

Food and beverage

 

22,950

 

11,053

 

62,186

 

35,250

 

Other

 

1,732

 

1,171

 

7,090

 

6,907

 

Total promotional allowances

 

$

27,882

 

$

13,828

 

$

78,056

 

$

47,353

 

 

8




 

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

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

Rooms

 

$

1,341

 

$

891

 

$

3,656

 

$

3,028

 

Food and beverage

 

15,737

 

7,335

 

43,322

 

23,600

 

Other

 

939

 

530

 

4,552

 

2,131

 

Total cost of complimentary services

 

$

18,017

 

$

8,756

 

$

51,530

 

$

28,759

 

 

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 2,147,084 and 2,090,016 shares of common stock were outstanding for the three and nine months ended September 30, 2006, respectively, but were not included in the computation of diluted earnings per share because they are antidilutive. Options to purchase 60,000 and 75,000 shares of common stock were outstanding for the three and nine months ended September 30, 2005, respectively, but were not included in the computation of diluted earnings per share because they are antidilutive.

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

(in thousands)

 

Determination of shares:

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

84,385

 

83,259

 

84,124

 

82,754

 

Assumed conversion of dilutive stock options

 

2,195

 

2,927

 

2,381

 

3,023

 

Diluted weighted-average common shares outstanding

 

86,580

 

86,186

 

86,505

 

85,777

 

 

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

 

9




25”), as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain 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 nine months ended September 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

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2005

 

 

 

(in thousands)

 

 

 

 

 

 

 

Net income, as reported

 

$

55,401

 

$

83,326

 

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

 

76

 

232

 

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

 

(2,487

)

(7,525

)

Pro forma net income

 

$

52,990

 

$

76,033

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

Basic-as reported

 

$

0.67

 

$

1.01

 

Basic-pro forma

 

0.64

 

0.92

 

 

 

 

 

 

 

Diluted-as reported

 

0.64

 

0.97

 

Diluted-pro forma

 

0.62

 

0.89

 

 

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 $9.4 million of excess tax benefits in the Company’s cash flows from financing activities for the nine months ended September 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 4.26 years, in order to match the expected life of the options at 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 following are the weighted-average assumptions used in the Black-Scholes option-pricing model at September 30, 2006 and 2005:

10




 

 

 

September 30,

 

 

 

2006

 

2005

 

Risk-free interest rate

 

5.11

%

3.40

%

Expected volatility

 

43.29

%

40.00

%

Dividend yield

 

 

 

Weighted-average expected life (years)

 

4.26

 

6.00

 

Forfeiture rate

 

4.00

%

 

 

Beginning on January 1, 2006, the Company’s estimated forfeiture rate was 2.00%. During the third quarter of 2006, due to the departure of one of the Company’s senior executives, the Company changed its estimated forfeiture rate to 4.00%.

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 on the statements of cash flows. For the nine months ended September 30, 2006 and 2005, cash flows relating to discontinued operations have been separately disclosed within operating and investing activities. For the nine months ended September 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 effect 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 reflects the continuing efforts of the Company to diversify by reducing its dependency on individual properties and

11




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.

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 a current tax liability for identified tax contingencies and 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. The current and deferred tax liabilities, which increased the amount of goodwill recorded in the acquisition, are subject to change upon recognition and/or settlement of tax contingencies. These changes, 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 nine months ended September 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

 

Nine Months Ended

 

 

 

September 30, 2005

 

September 30, 2005

 

Pro Forma

 

 

 

 

 

Net revenues

 

$

537,971

 

$

1,605,077

 

Income from continuing operations

 

92,802

 

278,533

 

Net income from continuing operations

 

27,989

 

73,905

 

Basic earnings per share

 

0.34

 

0.89

 

Diluted earnings per share

 

0.33

 

0.86

 

 

“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, Hollywood Casino Bay St. Louis (formerly known as Casino Magic — Bay St. Louis) and Boomtown Biloxi, were significantly damaged, many employees were displaced and operations ceased at the two properties.  Boomtown Biloxi reopened on June 29, 2006 and Hollywood Casino Bay St. Louis reopened on August 31, 2006.

The Company had significant levels of insurance in place at the time of Hurricane Katrina to cover the losses resulting from the hurricane, 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, all as defined in the policies. The comprehensive business interruption and property damage insurance policies had an overall limit of $400 million, and was subject to property damage deductibles for Hollywood Casino Bay St. Louis and Boomtown Biloxi of approximately $6.0 million and $3.5 million, respectively. The business interruption insurance component of this policy was subject to a five-day deductible.

The Company recognized a pre-tax charge of $19.1 million associated with the expenses incurred from Hurricane Katrina during the nine months ended September 30, 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’s 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 Hollywood Casino Bay St. Louis and Boomtown Biloxi, as this amount was not yet known. Although the Company believes that insurance proceeds will be sufficient to fund replacement costs, at September 30, 2006, a $3.9 million liability is included within other current liabilities on the Company’s balance sheet, since the refunds received are considered advances against the overall claim and the details of the claim are not yet settled. The $51.2 million insurance receivable recorded at December 31, 2005 was 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 nine months ended September 30, 2006, the Company received $27.1 million and $79.4 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.

On August 8, 2006, the Company renewed its property insurance coverage in the amount of $200 million. The $200 million coverage is “all risk”, including “named

 

12




windstorm”, flood and earthquake. Also, the Company purchased an additional $250 million of “all risk” coverage that is subject to certain exclusions including, among others, exclusion for “named windstorms” and floods. There is a $25 million deductible for “named windstorm” events, and lesser deductibles as they apply to other perils.

6.             Property and Equipment

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

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Land and improvements

 

$

179,768

 

$

155,735

 

Building and improvements

 

770,650

 

699,584

 

Furniture, fixtures, and equipment

 

394,163

 

314,741

 

Transportation equipment

 

2,281

 

1,401

 

Leasehold improvements

 

14,947

 

13,175

 

Construction in progress

 

242,126

 

82,971

 

Total property and equipment

 

1,603,935

 

1,267,607

 

Less accumulated depreciation and amortization

 

(286,321

)

(207,715

)

Property and equipment, net

 

$

1,317,614

 

$

1,059,892

 

 

Depreciation and amortization expense, for property and equipment, totaled $29.5 million and $83.7 million for the three and nine months ended September 30, 2006, respectively, as compared to $14.3 million and $44.5 million for the three and nine months ended September 30, 2005, respectively. Interest capitalized in connection with major construction projects was $5.6 million and $.7 million for the nine months ended September 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 September 30, 2006 and December 31, 2005, and accumulated amortization of $17.8 million and $12.8 million at September 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 September 30, 2006 and December 31, 2005 (in thousands):

 

 

 

 

September 30,
 2006

 

December 31,
 2005

 

 

 

Gross
Carrying
Value

 

Accumulated
Amortization

 

Net Book
Value

 

Gross
Carrying
Value

 

Accumulated
Amortization

 

Net Book
Value

 

Goodwill

 

$

1,894,074

 

$

 

$

1,894,074

 

$

1,848,661

 

$

 

$

1,848,661

 

Gaming licenses and trademarks

 

700,198

 

 

700,198

 

711,174

 

 

711,174

 

Other intangible assets

 

45,126

 

17,769

 

27,357

 

45,126

 

12,779

 

32,347

 

Total

 

$

2,639,398

 

$

17,769

 

$

2,621,629

 

$

2,604,961

 

$

12,779

 

$

2,592,182

 

 

                During the nine months ended September 30, 2006, goodwill increased by $45.4 million, primarily due to the finalization of certain fixed asset and deferred tax valuations associated with the Argosy and Bangor Historic Track, Inc. acquisitions.  This increase was partially offset by an $11.0 million decrease in the value assigned to the Argosy gaming license intangible asset.

The Company’s intangible asset amortization expense was $1.7 million and $5.0 million for the three and nine months ended September 30, 2006, respectively.

13




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

2006 (three months)

 

$

1,665

 

2007

 

6,655

 

2008

 

6,488

 

2009

 

5,988

 

2010

 

5,119

 

Thereafter

 

1,442

 

Total

 

$

27,357

 

 

8.             Long-term Debt

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

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Senior secured credit facility

 

$

2,316,000

 

$

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 6¾% senior subordinated notes

 

250,000

 

250,000

 

$200 million 9% senior subordinated notes

 

10

 

10

 

$350 million 7% senior subordinated notes

 

 

153

 

Other long term obligations

 

24,607

 

 

Capital leases

 

11,577

 

12,191

 

 

 

2,802,194

 

2,786,229

 

Less current maturities of long-term debt

 

(18,481

)

(18,567

)

 

 

$

2,783,713

 

$

2,767,662

 

 

 

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

 

Within one year

 

$

18,481

 

1-3 years

 

193,190

 

3-5 years

 

558,629

 

Over 5 years

 

2,031,894

 

Total minimum payments

 

$

2,802,194

 

 

At September 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 totaling $83.6 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

14




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 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 September 30, 2006 was 5.49% for the $960 million swaps and 5.50% 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 6¾% senior subordinated notes that mature on March 1, 2015. Interest on the notes is payable on March 1 and September 1 of each year, beginning September 1, 2005. The 6¾% notes are general unsecured obligations and are not guaranteed by the Company’s subsidiaries. The 6¾% 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 11⅛% senior subordinated notes due March 1, 2008 and to repay a portion of the term loan indebtedness under the previous senior secured credit facility.

Other long-term obligations

On October 15, 2004, the Company announced the sale of The Downs Racing, Inc. and its subsidiaries to the Mohegan Tribal Gaming Authority (the “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 was not considered final for accounting purposes until the third quarter of 2006, as the MTGA had certain post-closing termination rights that remained outstanding until August 7, 2006. 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

15




the Lehigh Valley (Allentown). The sale agreement provided 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 the Purchase Agreement and Release of Claims (“Amendment and Release”) with the MTGA pertaining to the October 14, 2004 Purchase Agreement (the “Purchase Agreement”), and agreed to pay the MTGA an aggregate of $30 million over five years, beginning on the first anniversary of the commencement of slot operations at Mohegan Sun at Pocono Downs, in exchange for the MTGA’s agreement to release various claims it raised against the Company under the Purchase Agreement and the MTGA’s surrender of  all post-closing termination rights it might have had under the Purchase Agreement. The Company recorded the $24.6 million present value of this liability within long-term debt, as the amount due to the MTGA is payable over five years, with the first payment date estimated to occur in late 2007.

Covenants

The Company’s senior secured credit facility and $200 million 67/8% and $250 million 6¾% 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 6¾% 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.

During the three months ended September 30, 2006, the Company made certain amendments to its existing $2.725 billion senior secured credit facility, including the modification of the applicable covenants to enable the Company to repurchase up to $200 million of its equity or debt securities, the modification of the Company’s capital expenditure covenant to increase certain permitted expenditures consistent with the Company’s development and expansion projects, and the modification of the Company’s collateral documents in accordance with requirements of the Pennsylvania gaming authorities.

At September 30, 2006, the Company was in compliance with all required financial covenants.

9.             Commitments and Contingencies

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 intends to file dispositive motions by December 1, 2006.  The parties have also engaged in active settlement negotiations, but have not yet reached a final

16




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. Pursuant to the dispute resolution procedures, the Company deposited $30 million in escrow, pending a resolution. This amount is included within the other assets line item on the Company’s consolidated balance sheets at September 30, 2006 and December 31, 2005. The parties are currently 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.   The Company has filed numerous dispositive motions.  On October 2, 2006, the Company prevailed on a partial summary judgment motion which limited plaintiff’s damages to its out-of-pocket costs in seeking its gaming license, thereby eliminating any recovery for potential lost profits.  The plaintiff is attempting to appeal this ruling.  Three other motions for summary judgment filed by the Company are currently pending and will be heard in November and December of 2006.  Plaintiff has filed a partial summary judgment motion on liability which will be heard in December.   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.

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.  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 $7.9 million and $20.9 million for the three and nine months ended September 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.

17




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

Within one year

 

$

13,110

 

1-3 Years

 

21,127

 

3-5 Years

 

15,364

 

Over 5 years

 

218,487

 

Total

 

$

268,088

 

 

Capital Expenditure Commitments

At September 30, 2006, the Company is contractually committed to spend approximately $52.2 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 (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 September 30, 2006, there were 4,215,500 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 nine months ended September 30, 2006:

 

 

 

 

 

 

 

Weighted-

 

 

 

 

 

 

 

Weighted-

 

Average

 

Aggregate

 

 

 

Number of

 

Average

 

Remaining

 

Intrinsic

 

 

 

Option

 

Exercise

 

Contractual

 

Value

 

 

 

Shares

 

Price

 

Term (in years)

 

(in thousands)

 

Outstanding at December 31, 2005

 

7,733,814

 

$

17.09

 

 

 

 

 

Granted

 

1,746,500

 

33.24

 

 

 

 

 

Exercised

 

(1,028,978

)

9.63

 

 

 

 

 

Canceled

 

(92,500

)

21.57

 

 

 

 

 

Outstanding at September 30, 2006

 

8,358,836

 

$

21.33

 

5.13

 

$

145,835

 

 

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 September 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,

18




 

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 nine months ended September 30, 2006 and 2005 were $14.55 and $12.15, respectively.

The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2006 and 2005 was $28.7 million and $50.7 million, respectively.

At September 30, 2006, there were 2,954,836 shares that were exercisable, with a weighted-average exercise price of $13.51, a weighted-average remaining contractual term of 3.83 years, and an aggregate intrinsic value of $74.7 million.

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

 

 

 

Exercise Price Range

 

Total

 

 

 

$2.03 to

 

$14.56 to

 

$30.18 to

 

$2.03 to

 

Outstanding options

 

$12.15

 

$29.22

 

$41.37

 

$41.37

 

Number outstanding

 

3,557,676

 

2,872,160

 

1,929,000

 

8,358,836

 

Weighted-average remaining contractual life (years)

 

3.69

 

5.80

 

6.80

 

5.13

 

Weighted-average exercise price

 

$

9.57

 

$

27.92

 

$

33.24

 

$

21.33

 

Exercisable options

 

 

 

 

 

 

 

 

 

Number outstanding

 

2,213,676

 

708,660

 

32,500

 

2,954,836

 

Weighted-average exercise price

 

$

8.80

 

$

27.28

 

$

33.95

 

$

13.51

 

 

Compensation costs related to stock-based compensation for the nine months ended September 30, 2006 totaled $15.2 million pre-tax ($11.0 million after-tax), or $.13 per diluted share, and are included in the consolidated statements of income under general and administrative expenses.

At September 30, 2006, the total compensation cost related to nonvested awards not yet recognized equaled $50.1 million, including $42.4 million for stock options and $7.7 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 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 $16.3 million (less than .4 % of total assets at September 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 nine months ended, September 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 nine months ended, September 30, 2006, as Penn had no significant independent assets and no independent operations at, and for the three and nine months ended, September 30, 2006, the guarantees are full and

19




 

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 6⅞% 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 6⅞% 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 nine months ended, September 30, 2006. There are no significant restrictions within the $200 million 6⅞% 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, excluding discontinued operations, at, and for the three and nine months ended, September 30, 2006 and 2005 for Penn, the subsidiary guarantors of the 6⅞% 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.

 

 

 

 

 

Subsidiary

 

Subsidiary

 

 

 

 

 

 

 

Penn

 

Guarantors

 

Non-Guarantors

 

Eliminations

 

Consolidated

 

At September 30, 2006

 

 

 

 

 

 

 

 

 

 

 

Condensed Consolidating Balance Sheet (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Current assets

 

$

(34,743

)

$

298,602

 

$

15,729

 

$

2,666

 

$

282,254

 

Property and equipment, net

 

166,258

 

1,151,356

 

 

 

1,317,614

 

Other assets

 

3,486,461

 

2,684,761

 

(5,055

)

(3,395,111

)

2,771,056

 

Total

 

$

3,617,976

 

$

4,134,719

 

$

10,674

 

$

(3,392,445

)

$

4,370,924

 

Current liabilities

 

47,531

 

340,291

 

6,768

 

(568

)

394,022

 

Long-term liabilities

 

2,750,881

 

3,423,333

 

 

(3,020,035

)

3,154,179

 

Shareholders’ equity

 

819,564

 

371,095

 

3,906

 

(371,842

)

822,723

 

Total

 

$

3,617,976

 

$

4,134,719

 

$

10,674

 

$

(3,392,445

)

$

4,370,924

 

Three months ended September 30, 2006
Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

581,353

 

$

4,819

 

$

(61

)

$

586,111

 

Total operating expenses

 

20,156

 

433,244

 

4,717

 

(61

)

458,056

 

(Loss) income from operations

 

(20,156

)

148,109

 

102

 

 

128,055

 

Other expenses

 

4,987

 

142,834

 

16

 

 

147,837

 

(Loss) income before income taxes

 

(15,169

)

290,943

 

118

 

 

275,892

 

Taxes on income

 

(14,811

)

135,533

 

110

 

 

120,832

 

Net (loss) income

 

$

(358

)

$

155,410

 

$

8

 

$

 

$

155,060

 

Nine months ended September 30, 2006
Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

1,657,764

 

$

14,127

 

$

(205

)

$

1,671,686

 

Total operating expenses

 

51,768

 

1,227,615

 

13,715

 

(205

)

1,292,893

 

(Loss) income from operations

 

(51,768

)

430,149

 

412

 

 

378,793

 

Other expenses

 

(15,697

)

60,208

 

(60

)

 

44,451

 

(Loss) income before income taxes

 

(67,465

)

490,357

 

352

 

 

423,244

 

Taxes on income

 

(47,896

)

231,075

 

327

 

 

183,506

 

Net (loss) income

 

$

(19,569

)

$

259,282

 

$

25

 

$

 

$

239,738

 

Nine months ended September 30, 2006
Condensed Consolidating Statement of Cash Flows (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

$

125,855

 

$

91,529

 

$

(286

)

$

 

$

217,098

 

Net cash used in investing activities

 

(156,089

)

(88,314

)

 

 

(244,403

)

Net cash provided by (used in) financing activities

 

31,774

 

(767

)

 

 

31,007

 

Net increase (decrease) in cash and cash equivalents

 

1,540

 

2,448

 

(286

)

 

3,702

 

Cash and cash equivalents at beginning of period

 

(1,841

)

133,863

 

598

 

 

132,620

 

Cash and cash equivalents at end of period

 

$

(301

)

$

136,311

 

$

312

 

$

 

$

136,322

 

 

20




 

 

 

Penn

 

Subsidiary
Guarantors

 

Subsidiary
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 September 30, 2005
Condensed Consolidating Statement of Income (in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

 

$

281,849

 

$

12,516

 

$

(113

)

$

294,252

 

Total operating expenses

 

7,137

 

232,634

 

9,679

 

(113

)

249,337

 

(Loss) income from operations

 

(7,137

)

49,215

 

2,837

 

 

44,915

 

Other income (expenses)

 

8,872

 

(23,846

)

56,009

 

 

41,035

 

Income before income taxes

 

1,735

 

25,369

 

58,846

 

 

85,950

 

Taxes on income

 

22,950

 

7,496

 

103

 

 

30,549

 

Net (loss) income

 

$

(21,215

)

$

17,873

 

$

58,743

 

$

 

$

55,401

 

Nine months ended September 30, 2005
Condensed Consolidating Statement of Income (in thousands)