Did Vornado go After the Wrong Retailer?

Reprinted by permission from REIT Wrap dated November 15, 2010.

By David Shulman

In early October, Pershing Square Capital Management and Vornado Realty Trust (VNO) announced they acquired beneficial ownership of 16.8% and 9.9%, respectively of JC Penney Co. (JCP) common shares. Both are widely regarded as savvy real estate investors; so, JCP shares spiked 45% on the news and are now trading at around $31 a share.

JCP is loaded with real estate, but much of it is leased and only 49% of their stores are located in malls, -- mostly Class B malls.

JCP operates just over 1100 stores encompassing 112 million square feet. JCP owns 416 of their stores, but 119 are on ground leases yielding a free and clear total of 297 stores. In addition it owns approximately 4.7 million square feet of warehouse/distribution space.

Goldman Sachs has valued JCP’s real estate at between $1 and $1.5 billion based on low in-place lease rates. Based on a per box valuation Newport Beach, California headquartered Green Street Advisors pegs JCP’s real estate value between $3-$4 billion on an equity market cap of just north of $7 billion. The Green Street Estimate, in my opinion, is the more accurate one.

There is no question that as a stock trade, Pershing Square and Vornado have made a lot of money for their investors/shareholders. (Something both have done before previously, albeit separately, when they both bought Sears (SHLD) shares.) That said, at its current valuation, it is hard to make a compelling case for JCP based on its real estate valuation.

First, I am not a believer in the “REITCO/OPCO” strategy of spinning off the real estate assets of a department store into a REIT and keeping the retail in an operating company. Something Pershing Square’s Ackman proposed when he went after Target (TGT). Simply put, all the leasing real estate at market rates would do is weaken JCP’s already below investment grade rating.

Second, though JCP’s most recent earnings provided some hope, JCP has of late been a very weak retailer. Sales have gone nowhere since 2003 and profits have collapsed. In contrast JCP’s major competitor, Kohl’s (KSS) has seen its sales nearly double over the same time period.

Third, unlike interior mall stores, the department store business model is based on paying minimal rents and Goldman Sachs estimated that JCP pays an average rent of $3.55 a square foot. Perhaps a new tenant would be able to pay far more creating the opportunity to create “sandwich” leases.

In addition JCP’s stores sales generate an unimpressive $150 a square foot in sales. Kohl’s, on the other hand, generates just under $200 a square foot in sales. Further, like most department store chains, its store base is relatively old with just over 60% built before 1990. Against that statistic, 20% of their stores are located in the Sunbelt states of California, Texas and Florida.

Neither Pershing Square nor Vornado has tipped its hand on what it views as the “end game” for their JCP investments. One possibility would be to close many department stores (a lot of them) and harvest their value for alternative uses, such as in-line mall stores or possibly residential, in the case of stand-alone stores. Such a strategy, however, would take considerable time and in the case of mall-stores it would involve amending reciprocal easement and operating agreements.

If JCP isn’t a real estate story, what might VNO and Pershing Square have in mind? My guess is that JCP is a retailing turnaround story where capital could be allocated far better than it has been. For instance, pre- recession, JCP earned $4.86 a share and $4.75 a share in 2006 and 2007, respectively. On those earnings JCP sold above $80 a share.

In contrast consensus estimates call for earnings of $1.43 a share in 2010 and the consensus for 2011 is $1.79 per share. Prior to the recent Pershing Square/Vornado announcements , JCP was changing hand in the low 20s.To be sure, JCP earnings are somewhat understated because of noncash GAAP charges ($237 million in 2009) for their now fully funded pension plan. Those charges will go away by 2014.

In order the bring earnings back to anywhere near their prior peaks management would have to, in the words of Goldman Sachs analysts Adrianne Shapira and Jonathan Habermann, improve capital allocation by lowering cap-ex and buying back shares with the $3 billion in cash on their books, rationalize and monetize real estate assets and reinvigorate their basic retailing business.

No question that VNO and Pershing Square can bring skill sets to the table that would enable JCP management to accomplish at least two of those goals. However, given the “poison pill” that JCP just put into place, a meeting of the minds (at least near term) seems unlikely.

Further, at least near-term, Vornado may be handicapped as a result of the recently announced departure of its retail head, Sandeep Mathrani who takes over early next year as CEO General Growth Properties’ (GGP).

Yes, JCP’s earnings appear to be at or nearing a cyclical trough. However, the retailing environment is far from benign. Deleveraging middle-market consumers wracked by substantial losses on their homes, makes for a powerful headwind facing JCP. Which means it will be awhile, at least, before JCP can execute a turnaround.

JCP stock was cheap when Pershing Square bought their shares at 23 and when VNO bought its shares at 26. There is certainly less of a margin of safety today. Nevertheless, with JCP trading at under 7X EBITDA it seems a better investment than VNO stock trading at 18X EBITDA. The larger question, however, is whether investing in JCP was the best use of capital for a REIT acting like a hedge fund.

Given Vornado’s retailing roots I wasn’t surprised to see Steve Roth and Mike Fascitelli go after a retailer. JCP would not have been my first choice, however. From a strategic standpoint, Macys (M) is a far better fit for VNO. M has much better mall-based assets than JCP and its flagship store is adjacent to VNO’s vast holdings in Manhattan’s Penn Station submarket. If the VNO’s Hotel Pennsylvania site is worth X, then under certain circumstances the Macys full block position on 34th Street is worth 2X. Of course, at its current price of roughly $25 a share, M can hardly be called “cheap.”

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu