Five years ago, monetizing real estate was a popular move recommended by activist investors trying to "unlock" value from struggling department store operators. Since then, plunging retail real estate values, caused by an imbalance of supply and demand, forced activists to abandon this strategy. But with e-commerce valuations soaring, they have a new favorite scheme, proposing that department stores separate their e-commerce and brick-and-mortar operations.
Over the weekend, Engine Capital launched the latest campaign along these lines. The hedge fund criticized Kohl's (KSS 1.83%) for its poor share price performance over the past decade. It wants Kohl's to fix that either by spinning off its e-commerce operations or selling the whole company. Management should ignore both suggestions.
What Engine Capital wants
In an open letter released on Monday morning, Engine Capital highlighted how Kohl's stock has lagged the S&P 500 by huge margins over the past three, five, and 10 years. The stock's performance has also trailed that of its closest peers over the past few years.
Engine Capital says Kohl's can't keep asking shareholders to be patient. Instead, it wants the board to launch a strategic review to evaluate alternative ways to boost the share price.
First, the hedge fund speculates that the e-commerce business alone could be worth $12.4 billion, slightly more than the company's current enterprise value. This assumes a valuation of 2 times sales, which is what Insight Partners paid for a 25% stake in Saks' e-commerce unit earlier this year. Engine Capital says that splitting in two would allow the e-commerce business to raise capital cheaply and that the two successor companies could work together to continue offering a seamless experience between Kohl's stores and the company's website.
Alternatively, Engine Capital believes that private equity firms would offer at least $75 per share to buy Kohl's. That would represent a roughly 50% premium over the department store chain's recent share price.
Two terrible ideas
Neither of Engine Capital's proposals is worthy of serious consideration. For Saks, separating e-commerce operations from its stores made some sense for two reasons. First, as a luxury retailer, it sells items at very high price points, making it easier for a pure e-commerce business to absorb shipping costs and still make money. Second, Saks has very few stores, so many of its customers may not care much about tight integration between its brick-and-mortar and e-commerce operations.
By contrast, Kohl's has low price points and operates more than 1,100 stores. Using those stores to fulfill online orders, particularly via in-store or curbside pickup, is critical for balancing revenue maximization and profitability. As a result, separating the stores from the e-commerce unit would be a clear strategic error.
Kohl's shouldn't sell itself for as little as $75 per share, either. That might seem like a hefty premium, but it represents barely more than 10 times the company's projected 2021 earnings per share of $7.10 to $7.30. If management successfully executes its current strategy, Kohl's stock could easily surge past $100 within a few years.
Stick to the plan
Last fall, Kohl's unveiled a new strategy to get sales growing again while improving its profitability. The early results look good. EPS will reach a new record this year, though to be fair, the combination of surging demand and limited supply throughout the retail industry has provided a short-term earnings lift.
In many respects, Kohl's remains early in its turnaround, though. The company has just started to bring in merchandise from new brands to replace a slew of weaker brands that it discontinued last year. Similarly, a promising partnership with Sephora launched just a few months ago. Most of the 850-plus Sephora shops the company plans to open within its stores won't roll out until 2022 or 2023.
As these growth drivers kick in over the next two years, top-line growth should accelerate. That bodes well for the company's earnings, too.
Meanwhile, Kohl's has been repurchasing shares at a ferocious pace. It plans to buy back $1.3 billion of stock this year, shrinking its share count by 15% or more. That will still leave it with plenty of excess cash to continue its share buyback program in 2022 and beyond. The reduced share count will bolster EPS growth.
Shareholders are likely to reap bigger rewards by being patient and allowing management to execute its strategy, rather than trying to make a quick buck through financial engineering.