Debt Keeps Johnson Controls a Hold

We rate Johnson Controls, Inc. (JCI) a Hold, as anemic demand, high inventory levels and continuous loss of market share at original equipment manufacturers keep plaguing the diversified manufacturer. The company is experiencing weakness in North America, following a general softness in the industry. Although it has a healthy backlog that would drive automotive sales in the long run, launch costs could weigh on near-term results. A weak product mix is also affecting Johnson Controls.

On a positive note, Johnson Controls' cost reduction efforts, accretive acquisitions, and healthy operating cash flows are driving the stock. We believe the company will further benefit further as it begins to integrate the Delphi Battery business. JCI has a reputation for stronger-than-average growth prospects relative to other automotive suppliers, due to strong market positions it enjoys across its fairly diverse businesses.

Currently, JCI shares trades at about 13.1x our 2008 estimate of $2.51. The company is expected to report higher earnings in the coming years, backed by acquisition benefits and success in overcoming increasing raw material costs and weakening prices. However, it has debt that will take three-to-four years to be repaid. The higher debt levels will raise interest expenses and thereby hurt margins. We set a target price of $35 on the stock, which is 14.0x our 2008 EPS estimate.

Activision Success Accounted For

Activision (ATVI) reported revenues of $602.5 billion in the fourth quarter of fiscal 2008 (ended March), almost double from a year ago. The year-over-year growth was fuelled by success of Guitar Hero III: Legends of Rock and Call of Duty 4: Modern Warfare. Gross margin improved to 41.8% from 31.0% year over year, but was down from 48.5% recorded in the third quarter.

For fiscal 2008, the company reported record revenues of $2.9 billion, compared to $1.5 billion in 2007, driven by the releases of Call of Duty 4, Guitar Hero III, Spiderman 3, Transformers, Shrek the Third and Tony Hawk's Proving Ground. Margins improved both on a GAAP and a non-GAAP basis.

For Q1 2009, management expects revenues of $500 million and diluted EPS of $0.04. For full-year 2009, management expects revenues of $2.75 billion and EPS of $0.72 on a stand-alone basis (excluding Vivendi games). We maintain our Hold rating on shares of Activision and target price of $30.

The company's portfolio of proven franchises, success of newly launched properties, impressive product pipeline and excellent financial condition paves the way for further growth. However, we think the prospects are largely built into the stock at the current time, leading us to our Hold rating.

The shares are trading at roughly 26.1x our revised fiscal 2009 EPS estimate of $1.28, which excludes stock option expense and 29.2x our 2009 EPS estimate that includes stock option expense (GAAP). Our current target price of $30 implies a P/E multiple of 23.4x our FY2009 EPS estimate.

Soft Market Felt at Vornado Realty

We rate Vornado Realty Trust (VNO) a Hold as the country heads towards a recession and there are concerns that job growth will slow considerably in 2008. We expect the New York office sector to weaken in the face of continued job cuts at financial firms. Rent growth in the company's retail holdings will also soften as consumer confidence drops at a rapid pace. Worse still, this could only be the beginning of a prolonged decline in spending, and retail landlords will be faced with declining rents and more vacant space in the coming quarters.

Operationally, Vornado's office markets have held steady due to strong infill locations in urban areas and we expect it to continue increasing rents in New York and to a lesser extent in Washington DC, while maintaining steady occupancy in the near term. Vornado also has some attractive development initiatives in the pipeline, which should add to earnings over the next few years. We believe this puts Vornado well ahead of many competitors who have assets in less desirable markets that are still struggling with high vacancies and little pricing power.

Vornado has one of the top office and retail portfolios among companies that we cover. On a P/FFO [price/funds from operation] basis, the company still trades at a slight discount to office sector averages. VNO does deserve a premium valuation to its worse-positioned peers, as it has an irreplaceable asset base in some of the best long-term office markets.