Seeking Alpha
Deep value, long/short equity, contrarian, hedge fund manager
Profile| Send Message|
( followers)  

REITs have become the spanking boy for the market over the past year and it’s difficult to find a REIT that has not lost at least half of its value from 2007 peaks. While much of this punishment is justified, my basic hypothesis is that the market has overly punished some quality REITs that might be had for sizable discounts at this point in time. Thus far, I’ve analyzed four REITs: Winthrop Realty Trust (NYSE:FUR), Colonial Properties Trust (NYSE:CLP), Agree Realty Corporation (NYSE:ADC), and Douglas Emmett Incorporated (NYSE:DEI). This is Part V in my (unofficially-titled) “Quest for REIT Value” series and I will take a look at New York-based commercial REIT, Alexander’s (NYSE:ALX).

Overview

Alexander’s is perhaps one of the most interesting companies I’ve encountered. It was initially formed as a New York-based department store one year before the Great Depression began. It catered to low- and middle-income consumers and expanded throughout the Depression, becoming a 16-store chain at its height. It began to experience difficulties in the 1970s and would eventually go on to file for bankruptcy in 1992. However, Alexander’s had valuable real estate holdings even at the time of their Chapter 11 filing and it eventually became a full-fledged REIT after emerging from bankruptcy.

Alexander’s is now managed by Vornado Realty Trust (NYSE:VNO), which owns 32.5% of its outstanding stock. Alexander’s owns seven large commercial properties, all in the New York City metropolitan area. It owns retail and office properties and has many notable clients including Citi (NYSE:C), Bloomberg, Home Depot (NYSE:HD), Macy’s (NYSE:M), and IKEA.

In my prior articles, I have mentioned several factors that I am looking for when analyzing REITs in the current environment:

  • Relatively low leverage
  • Insider buying and a substantial amount of inside ownership
  • High levels of liquidity
  • Properties in markets near a bottom
  • Strong asset quality on Balance Sheet
  • Focus on residential RE over commercial RE

Unfortunately, Alexander’s only seems to qualify for the third prong, as it has substantial operating cash flows plus $516 million in “cash and cash equivalents” on their balance sheet. In spite of this, I wanted to analyze it anyway mainly due to curiosity and also in order to test my valuation techniques on a highly levered company.

Speaking of leverage, Alexander’s has it --- a whopping $1.22 billion in long term debt (LTD)! That gives the company an LTD-to-equity ratio of 6.75 and it has a Liability/Value ratio of 88.7%. On the face of it, those are frightening figures, especially in an era of deleveraging! All the same, the fact that it had earnings over $15 per share for FY 2008 means things aren’t completely cut and dry. Also, we should keep in mind that accounting figures (particularly for hard assets) can be deceiving occasionally.

Thus far in this series, I have looked at REITs exclusively from the long perspective. For Alexander’s, I also want to look at the short perspective. But first, let’s take a closer look at their financials.

Funds from Operations, Cash Flows, and Earnings

Alexander’s is a difficult company to decipher from an earnings and cash flow perspective. I decided to take a look at several key measures over the past nine years: Operating Cash Flows (CFOs), Funds from Operations (FFOs), Diluted Earnings Per Share (DEPS), and Free Cash Flows (FCFs). Here are the results in per share amounts:

2008

2007

2006

2005

2004

2003

2002

2001

2000

CFOs

1.82

5.16

11.16

1.20

5.47

1.38

1.48

1.87

2.1

DEPS

14.96

22.44

-14.92

16.19

-6.68

-3.53

4.72

5.48

1.04

FFOs

19.60

26.75

-10.59

20.09

-3.60

-2.05

2.83

1.12

X

FCFs

-24.60

-16.50

1.72

66.43

-21.97

-40.21

-24.28

-2.92

-12.96

Note that all results are approximate and since I used a few different resources to input all of this information, there are probably a few inconsistencies. From these results, there appears to be very little in the way of predictability for Alexander’s. If you take the results above and come up with a yearly average for each, you get the following:

Yearly Average (2000 - 2008)

CFOs

3.52

DEPS

4.41

FFOs

6.77

FCFs

-8.37

Note that free cash flows were decisively negative for most years since Alexander’s was constantly making capital expenditures and acquisitions. There appears to be significant disparities between cash flows and FFOs.

Despite this, recent results have looked impressive. Funds from Operations (FFOs) are encouraging at $7.74 per share for the most prior quarter. Note that FFOs and Earnings were both strong for FY ’08 and FY ’07, as well.

Revenues and Expenses

If earnings, cash flows, and FFOs are a tad contradictory and confusing, Alexander’s revenue picture looks fairly stable. They brought in $199 million in FY ’06, $208 million in FY ’07, and $211 million in FY ’08.

Expenses are not so clear cut, however. “Operating Expenses” and “Depreciation & Amortization” have held fairly steady; but General & Administrative expenses are perplexing. If you discount that line item, their profitability appears to be much more consistent:

Income Statement

2008

2007

2006

Revenues

211.1

208.0

198.8

Operating Expenses

77.1

70.5

72.0

Deprec & Amortization

24.1

22.3

21.8

G&A

-14.6

-38.3

154.8

Operating Income w/ G&A

124.5

153.5

-49.8

Operating Income w/o G&A

109.9

115.2

105.0

All figures approximate; amounts in millions

As the chart above makes clear, the wild fluctuations in earnings are due to that one particular line item. While this is by no means completely scientific, I decided to try to normalize income some by coming up with an average G&A expense. Adding together the past three years and dividing by three, I come up with an average expense of $34 million. Based on that, I came up with this chart for normalized earnings:

Normalized Income

2008

2007

2006

Operating Income

75.9

81.2

71.0

Other Income

15.2

27.4

28.3

Interest Expense

62.5

65.3

67.7

Net Income from CO

28.6

43.3

31.6

EPS from NI - CO

5.62

8.50

6.21

All figures approximate; amount in millions except per share figures

“CO” stands for “Continuing Operations” in case you are wondering, as I eliminated gains on property sales, as well. I’m not sure that this provides us with a completely accurate representation of Alexander’s true profitability, but it at least gives us some basis point, whereas the current Income Statement taken at face value seems completely useless.

Equity and Asset Impairments

While asset impairments are normally a major concern for REITs in this environment, they might not be that huge of an issue for Alexander’s. This isn’t because the values of their properties aren’t declining at a rapid rate --- they are! However, due to the accounting treatment of assets, it's possible (even likely) that many of their properties will never fall below the “book value.”

Alexander’s owns seven major properties. Since all were officially “acquired” in 1992, they are presumably carried at the historical cost from that date. It is important to note that Alexander’s has capitalized significant costs subsequent to 1992, however, so they aren’t completely out of the woods. Since I’d prefer not to spend an inordinate amount of time trying to analyze these costs, I’ll assume that their properties have some chance at being written down, but probably not on a grand scale, such as a company that purchased all of its properties in 2007 might.

Here’s a chart showing potential asset impairments and how they would affect book value for ALX:

Impairment %

Impairment Charge

Adjusted Equity

Adjusted BV

-20%

-$168.91

$347.91

$68.35

-10%

-$84.46

$263.46

$51.76

0%

$0.00

$179.00

$35.17

10%

$84.46

$94.54

$18.57

15%

$126.68

$52.32

$10.28

20%

$168.91

$10.09

$1.98

25%

$211.14

-$32.14

-$6.31

30%

$253.37

-$74.37

-$14.61

The first two rows might look a bit peculiar. Under GAAP accounting, assets values cannot be written up, except in a few select cases where they have been written down. So why would I throw a -20% impairment charge (i.e. a 20% write-up in real estate properties) on the table? Since Alexander’s real estate properties were originally acquired for accounting purposes in 1992, I wanted to consider that their real estate properties are still significant undervalued in the books; particularly when analyzing the company from a short perspective.

Valuation Scenarios

Alexander’s is an extremely tricky company to value due to a large number of issues:

  1. Real estate properties carried at 1992 historical cost on books.
  2. Rapidly plunging real estate prices in New York City.
  3. Extremely inconsistent earnings and FFOs.
  4. Cash flows that have always tended to be significantly less than earnings and FFOs.

All the same, we will try to come up with some reasonable valuations. I’ve set up a few scenarios. For each, I’ll set up the free cash flows for an initial year and I will assume a constant growth rate of 3% after that. Unless otherwise denoted, I will assume a cost of capital (COC) of 12% based on my belief that interest rates will rise significantly in the coming years. “Y1 CFs” denotes “Year 1 Free Cash Flows”:

Scenario #1: Net assets = $35, Y1 CFs= $5
Scenario #2: Net assets = $50, Y1 CFs= $8
Scenario #3: Net assets = $50, Y1 CFs= $10
Scenario #4: Net assets = $50, Y1 CFs= $10, COC = 9%
Scenario #5: Net assets = $50, Y1 CFs= $15
Scenario #6: Net assets = $50, Y1 CFs= $15, COC = 9%
Scenario #7: Net assets = $35, Y1 CFs=$3
Scenario #8: Net assets = $35, Y1 CFs=$10
Scenario #9: Net assets = $20, Y1 CFs= $5
Scenario #10: Net assets = $20, Y1 CFs = $5, COC = 9%

Here are the results:

Scenario #1: $90
Scenario #2: $138
Scenario #3: $160
Scenario #4: $212
Scenario #5: $216
Scenario #6: $292
Scenario #7: $68
Scenario #8: $145
Scenario #9: $75
Scenario #10: $101

This exercise proves that slight changes in a DCF spreadsheet can drive dramatic differences in pricing. However, the other lesson here ought to be that high leverage drives greater uncertainty in valuation.

Of these scenarios, I would use a slight modification of Scenario #1 for my preferred analysis; which yields results in the $100 – 120 range, depending on how I mess around with the variables.

Upside potential for Alexander’s appears to be in the $400 range to me. Downside risk would be $0 and bankruptcy; however, I view that result as unlikely and believe $30 might be a more likely downside. Of course, plugging numbers into a spreadsheet should never constitute a full valuation as risks and uncertainty must always be taken into account. Given the high level of risk and uncertainty with Alexander’s, I would personally value it at $60.

The Long Case

The long case for Alexander’s isn’t very strong to me. Even given their good performance in recent years, I assessed their upside potential at the $400 range (plus dividends) and I view that result as unlikely. I have analyzed four other REITs in this series and I believe all four (FUR, CLP, ADC, DEI) offer better risk-reward metrics than Alexander’s. There is too much risk and uncertainty surrounding Alexander’s and I believe you have to discount the stock significantly based on that.

From a macroeconomic view, I view the New York City market to be the second riskiest in the nation and I believe there’s a significant chance that the current financial crisis causes a paradigm shift for NYC real estate. It will not be as profound or devastating as Detroit’s real estate collapse since NYC has a much more diversified economic base than the “Motor City”, but I would not be surprised to see real estate prices and rental rates falling in NYC for the next decade all the same. Even if we get hit by high inflation, prices could simply level off, while increasing in other areas.

Given this, I do not believe Alexander’s is a buy right now. Even if it dipped down to my valuation price, I am not sure I would touch the stock as a small-time investor until it hit $30 – 40 range. That’s largely due to my high fears about the NYC market and the uncertainties surrounding ALX.

The Case for Shorting

The case for shorting Alexander’s is that the NYC real estate prices will continue to collapse for years to come and their FFOs will weaken as revenues continue to drop due to lower rental prices. Their high leverage in an era of deleveraging might also hinder the company significantly.

Taking a look at our scenarios, several of them have Alexander’s selling under the current price and I believe that even eliminating the risk-reward factor, it shouldn’t be valued over $120 right now.

The Case against Shorting

While I believe Alexander’s to be overvalued, there are still a lot of reasons not to jump in on the short end. The biggest reason is that it might be difficult to ascertain the underlying value of their properties given their accounting treatment, coupled with unstable NYC real estate prices. It’s possible that even my 20% write-up was not enough and that the company's real estate properties should be written up significantly more. Perhaps this underscores the need for fair-value accounting when it comes to real estate; short of having someone assess the value of their properties, I admit that my usual asset valuation metrics are probably somewhat ineffective in this case.

Another factor to think about; a huge chunk of their revenues comes from Bloomberg’s and most of those leases are very, very long-term. Their tenant quality in general is enviable. Alexander’s strong recent performance should also give short sellers some pause.

Concluding Analysis

More than anything, Alexander’s is a testament to the need for better accounting metrics in certain areas. In particular, fair value accounting for real estate properties would probably provide better insight for investors. As is, the uncertainty in asset valuation coupled with very inconsistent earnings performance metrics creates more risk, which means investors should be willing to pay less. On the long end, I’d stay away from Alexander’s as risk-reward metrics are unfavorable compared to many other companies in the REIT sphere.

While I do have some concerns about playing this from the short-side as well, I have initiated a rather minuscule short position on it for my KaChing simulated portfolio. If it bounces back to the $200 - $225 range, I will probably increase that position significantly. At $160, however, shorting is a riskier proposition.

If you are a fan of pair trades, Alexander’s might provide you with a very good opportunity. Going long on any of the REITs I analyzed in my earlier articles while shorting Alexander’s would be an intriguing hedge with potential for reward.

Disclosures: Author holds no position on ALX or VNO. Author recently initiated a long position on FUR.

Source: Alexander's: Clearance Sale or Value Illusion?