3 Reasons To Own Vornado

By Will Ashworth | April 24, 2012 AAA
Up until Vornado Realty (NYSE:VNO) released its annual letter to shareholders April 13, its stock's been stuck in the mud. Investors are unhappy with the diversified real estate investment trust's lack of change and CEO Steven Roth acknowledged as much in the letter. Vowing to put every possible option on the table, from selling "non-core" assets to splitting the company into several firms specializing in different types of property, Vornado looks to take matters into its own hands to add value for shareholders. At this point, I see its stock as an interesting buy. Here are three reasons why.

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Toys "R" Us

As Roth indicated, everything is up for discussion, including selling its 32.7% interest in Toys "R" Us. Now would be a perfect time to realize its investment in the toy retailer as the IPO market is very strong. Michael Kors Holdings (NYSE:KORS) went public at $20 a share in December and is up roughly 110% in just four months. Houston-based Mattress Firm's (Nasdaq:MFRM) IPO was last November and its stock's up about 139% in just five months. At the time of its IPO, Mattress Firm was valued at 7.2 times adjusted EBITDA. Michael Kors, due to its higher margins, was valued at 16.2 times EBITDA.

Given its strong name, I'd expect the valuation for Toys "R" Us somewhere in between, leaning more towards Mattress Firm rather than Michael Kors. Let's go with 10 times EBITDA, which gives it a value of $11 billion and gross proceeds for Vornado of $3.6 billion or $18.68 a share. That's a good chunk of change, especially when you consider it carries Toys "R" Us equity on its books at $1.69 billion on an original investment of $507 million.

J.C. Penney

In October 2010, Vornado acquired 23.4 million shares (11% of its stock) of the department store at an average cost of $26.31, or $615.6 million. As of April 20, that's an unrealized profit of $168 million in 18 months. While I believe it makes sense to divest of its interest in Toys "R" Us, I can't say the same about J.C. Penney (NYSE:JCP).

Hedge fund manager Whitney Tilson made a presentation at the Value Investing Congress last October discussing the reasons why an investment in J.C. Penney at this point in its history is a wise one. The management team, led by CEO Ron Johnson, who came over from Apple (Nasdaq:AAPL) in 2011, are implementing a new plan for the company that will make it more competitive. Johnson brought in his old Target (NYSE:TGT) colleague Michael Francis to be President. Francis spent 21 years at the Minneapolis company, most recently its Chief Marketing Officer from August 2008 through September 2011. The duo provides it with strong leadership at the top. Hedge fund activist Bill Ackman owns 26.1% of its shares and sits on the board along with Steven Roth. Together, the two board members bring a great deal of experience to the management team.

Operationally, Tilson argues that there's plenty of improvement in its sales per square feet, which peaked at $177 in 2007 and trails its department store peers. Tilson suggests that a 15% improvement in sales per square foot would add $8 to its stock price. That's doable. Another initiative is online sales, while significant at $1.53 billion in 2010, have remained flat in the last few years. Johnson and his team will work to unstick the growth engine. Online sales are vital because they deliver higher profits and margins.

Tilson believes it could create as much as $15 a share in additional value with a 300 basis point improvement in EBITDA margin. Most importantly, as it concerns Vornado, Tilson estimates J.C. Penney's real estate is worth $12 to $15 a share. Put it all together and its stock could be worth as much as $65 a share, and Steven Roth understands this. There's plenty Johnson can correct to enhance the value of its shares and he's only getting started. This is one "non-core" asset it will hang on to.

SEE: Is Online Shopping Killing Brick-And-Mortar?

Office Properties

Vornado's New York and Washington office properties generated 53% of its 2011 EBITDA. This is the core of its business. Everything else, including its retail properties, which include 134 shopping malls, is potentially up for sale. Vornado is one of the largest landlords in both New York City and Washington D.C.; however, New York is what drives the engine. Its average annual rent per square foot in 2011 was $59.68, $5.68 higher than when I last covered Vornado in 2009.

In its shareholder letter, Steven Roth indicated that it is going to pull all of its Manhattan assets including the Hotel Pennsylvania and its 32.4% investment in Alexander's (NYSE:ALX) under one roof. I think that's a wise idea. More than anything, Vornado is about New York City. Long-term, its New York and Washington properties provide stable cash flow so that it can make side bets along the lines of Toys "R" Us and J.C. Penney. Perhaps in the future it should focus those bets on retail-related businesses in the New York City area exclusively.

The Bottom Line

Vornado's stock has been a mercurial performer the past five years. At times it's done OK. Its annualized return over a three-year period outperformed both its peers and the S&P 500. The more it's able to deliver a story that makes sense to investors, the better its stock will perform. I think Steven Roth's frank admission that it has lost some of its luster is evidence it's serious about getting its game back. Buy now before it does.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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