In the past year, activist investors have pushed for retailers like Macy’s and Kohl’s to separate their eCommerce operations into separate listed entities. The argument goes that eCommerce retail growth is rapidly outpacing bricks-and-mortar business growth, and saddling a high-growth business to an ex-growth legacy company depresses enterprise value. Separating them into two listed entities liberates the trapped value and allows investors to benefit: the eCommerce business for growth, the bricks-and-mortar business for its stable (if declining) cash flows, real estate holdings and intellectual property (e.g., brand) value.
Not so fast. There are counter-arguments to making this separation, and not just that a growing eCommerce division covers up for a struggling traditional retail operation.
Principal among the arguments for keeping the business whole is that even with - and perhaps especially because of - COVID, there’s a strong argument that the omnichannel strategy is the strongest hand to play. Omnichannel requires a seamless customer experience that independent eCommerce and physical store legal entities will struggle to curate. It stands to reason that what is good for the brick and mortar business is not necessarily the same as what is good for the eCommerce business, and vice-versa. Having eCommerce and brick-and-mortar working independently - if not at cross-purposes - will do little to harmonize the customer experience, not helpful at a time when doing so is deemed essential to survival.
An extension of this argument is that an omnichannel strategy doesn’t distinguish among channels, so separating the two - and thereby creating a distinction between them - is solely an act of financial engineering. Assessed as a financial act, the obvious question is, who wins? The consultants, attorneys and banks that collect fee income from the separation are clear beneficiaries: they’ll collect their fees regardless the outcome. Investors may or may not win out, as bond and equity prices in both legal entities may plummet after their separation, but at the start they will have no less value than they do today plus upside exposure through clearer value realization paths. Unfortunately, it’s hard to imagine how the pre-separation business itself gains from the separation: does it stand to reason that even more formalized organizational silos, redundant corporate overhead functions, and executives with polarized incentives are customer-value generative outcomes?
This flare-up in retail is interesting because it is the latest incarnation of a long-lived phenomenon of companies touting a change in their capital structure as a strategic initiative. I first wrote about this almost nine years ago. At the time, activist investors were attacking tech firms to create new classes of preferred shares or issue new bonds solely for the purpose of extracting cash flows from operations for the benefit of investors. But it wasn’t just an outside-in phenomenon of investors pressing tech firms: Michael Dell had at that time proposed to take Dell private, which did soon thereafter. With only wolly words to describe the justification for going private, it raised the question, what can Dell do as a private company that it cannot do as a public one?
The current kerfuffle in retail allows us to ask this question more broadly. Changing capital structure is no different from any other use of corporate cash, be it distribution of dividends, to replatforming operations, to simply strengthening the credit rating. Those bankers, lawyers and consultants don’t come cheap. The question is, what does it let the business do that it couldn’t do before?
With the benefit of hindsight, we know that Dell the publicly listed company became Dell the private equity fund. Among its acquisitions was EMC, and in particular EMC’s stake in VMWare, a position so lucrative that when Dell went public again in 2018 the implied value of the business excluding that holding was effectively nil. Dell the public company could have acquired EMC; publicly listed tech companies make acquisitions all of the time. What going private let the business do that it couldn’t do before was to concentrate ownership, and subsequently the returns from those acquisitions, in fewer people’s hands.
In the retail sector, the answer is not necessarily so cynical. Saks made the split into separate bricks & mortar and eCommerce legal entities earlier this year. In the words of the eCommece CEO, as quoted in the WSJ this week, both businesses benefit overall because they don’t have the same dollars chasing conflicting investment opportunities exclusively in an IRL and online realm, the eCommerce business has expanded its eCommerce offerings and reach, the brick and mortar business has better integration with eCommerce than it did before, and eCommerce now has an employer profile attractive to tech sector workers. In short, to destroy a longstanding phrase, by being two entities, the Saks eCommerce CEO argues that the sum of the parts is greater than the whole could ever have been. The CEO argues that the separation lets Saks do something - probably many somethings - it could not do before.
This, in turn, begs the question why.
There’s a quote attributed (quite probably erroneously) to the late Sir Frank Williams of the eponymous Williams Formula 1 team. When asked whether he approved of a proposed change to the race car, the legend is that his only response was, “does it make the car go faster?” It’s a deceptively simple question, one that I long misunderstood, because I took it at face value. Engineers can do any number of things to make a car go faster that also make the car less reliable, less stable, incompatible with sporting regulations, and so forth. While the question “does it make the car go faster” appears a simple up-or-down question, it actually questions the reasons behind the proposed change. How does it make the car go faster? Why hasn’t anybody thought to do this before? In answering those questions, we find out if the proposed change is clever, or too clever by half.
And that’s the question facing traditional retail. A commercial restructuring that alleges it creates value for the business (that is, not just investors) flies in the face of conventional wisdom. Sometimes that conventional wisdom is correct: Dell shareholders who accepted something less than $14 / share in 2013 lost out on a quadrupling of the enterprise value over an 8 year span (and no the S&P 500 didn’t perform quite that well over that same timeframe). But then, as John Kenneth Galbraith pointed out, conventional wisdom is valued because it is convenient, comfortable and comforting - not because it is necessarily right. Perhaps Saks and parent HBC are onto something more than just financial engineering, if in fact separating eCommerce from bricks & mortar let them do something they could not do before.
