In this day and age, when you can’t get the job done as CEO of a public company you are probably going to get attacked by an activist investor.
Such is the case yet again with Kohl’s (KSS) and its CEO Michelle Gass.
Engine Capital — a new activist investor in Kohl’s — dropped a scathing new letter on Monday to the Kohl’s board of directors. In the letter, Engine Capital demands Kohl’s considers a sale in its entirety or splits off its online business (similar to what activist investor Jana is begging Macy’s to do).
The Engine Capital campaign marks the second time Gass and Kohl’s have been targeted for the underperformance of the stock and business in 2021. Back in April, Kohl’s settled with the activist group led by Macellum Advisors. The settlement involved a board shakeup and the approval of a new $2 billion stock buyback plan.
“The Kohl’s board and management team continuously examine all opportunities for maximizing shareholder value. Our strong performance this year demonstrates that our strategy is gaining traction and driving results. We appreciate the ongoing dialogue we are having with our shareholders and value their input and perspectives,” a Kohl’s spokesperson said in a statement to Yahoo Finance.
Here is Engine’s letter in full:
“Dear Members of the Board:
Engine Capital LP (together with its affiliates, “Engine” or “we”) is a long-term shareholder of Kohl’s Corporation (“Kohl’s” or the “Company”), with an ownership position of approximately 1% of the Company’s outstanding shares. We invested in Kohl’s because of its differentiated positioning and underlying strength in the active and casual lifestyle categories. We also believe Kohl’s has a unique retail footprint relative to many mall-based retailers as well as a growing e-commerce presence, strong loyalty program, tremendous free cash flow and valuable real estate holdings. However, much to our disappointment, these considerable assets and operating tailwinds continue to fail to catalyze meaningful value for shareholders.
As you likely know, since Michelle Gass became Chief Executive Officer in May 2018, Kohl’s’ total shareholder return is -10.5% and the stock has underperformed the S&P 500 by 90% and the Company’s peers by 19.1%. As a result of this sustained underperformance, Kohl’s is currently trading at one of the lowest valuations in the public market. The Company has a market capitalization of around $6.7 billion and generated free cash flow of $1.7 billion during the last twelve months, implying a free cash flow yield of approximately 25%. The stock trades at a 2021 price-to-earnings multiple of around 6.8x and at a 2021 EV-to-EBITDA multiple of around 3.5x, implying an extremely low valuation against the backdrop of the U.S. equity markets trading near all-time highs and reflecting investors’ lack of confidence in the management team, the Board of Directors (the “Board”) and the new strategy unveiled in October 2020.
Given leadership’s failure to create value through operational excellence and strategic initiatives over long periods of time, it is time for the Board to accept the fact that the public market is not appreciating Kohl’s in its current form. Even the most patient long-term shareholders cannot be expected to endure the punishing underperformance and perpetual value disconnect seen at Kohl’s. This is why we are urging the Board to publicly commit to conducting a full review of strategic alternatives. Our own analysis and interactions with an array of market participants lead us to believe there are two viable paths for the Board to explore:
First, separating the legacy retail business (“LegacyCo”) and the ecommerce business (“DigitalCo”) so that the market can assign the proper valuation multiple to each business. The Board is hopefully aware that the public market is growing increasingly fond of simpler, more defined corporate structures. This is why an increasing number of large companies are spinning or splitting off assets that are best suited to operate as independent companies. As explained below, we believe a standalone Kohl’s ecommerce business could be conservatively valued at $12.4 billion or more, an amount that dwarfs the Company’s current market capitalization.
Second, given that the Company trades at a massive discount to intrinsic value and its strategy has not resonated with the public market, we believe it is essential to run a market test to see how much well-capitalized financial sponsors would pay for the entire Company. Our own diligence leads us to believe there are financial sponsors who will be able to pay a significant premium of 50%, or at least $75 per share, for the reasons outlined below.
These paths should be evaluated in parallel so that the Board can make the most informed decision to maximize value on a risk-adjusted basis at the end of the review process. As we will show, there is no excuse for the Board to cling to the status quo.
Kohl’s has significantly underperformed the S&P 500 and its peers over the most relevant time periods, including since Ms. Gass became Chief Executive Officer in May 2018 and since Peter Boneparth, Kohl’s’ Chairman, became a director of the Company more than 13 years ago. The long-term underperformance compared to the S&P 500 is especially stunning considering the Company’s free cash flow generation. Over the last 10 years, Kohl’s has underperformed the S&P 500 by 305% despite generating a cumulative $11.8 billion of free cash flow and spending $6.9 billion on share repurchases during that same period.
It would be tempting to conclude that Kohl’s’ fortunes and outlook have changed because the Company has outperformed the S&P 500 over the past year and since the new strategy was disclosed 14 months ago. We believe, however, this would be an incorrect inference. The reason the Company has outperformed the S&P 500 over this recent horizon is simply because retailers’ stocks underperformed massively during the first phase of the pandemic and then outperformed during the recovery phase. Kohl’s’ outperformance relative to the S&P 500 since the new strategy was disclosed is not a stamp of approval for the Board’s strategy, but rather the result of good timing. In our view, the fact that the Company has massively underperformed peers since the new strategy was disclosed (Kohl’s is up 161.0% vs. 357.4% for the peers) is further indication that the new strategy is unfortunately not a game changer.
The Strategic and Financial Rationale for Separating the Ecommerce Business
As noted, one path toward realizing the value trapped in Kohl’s’ assets is separating DigitalCo from LegacyCo. We firmly believe a separate digital business could raise money at a significantly higher valuation, have a significantly lower cost of capital and accelerate its growth as a standalone entity. Under this construct, the two entities could contract to keep the omnichannel experience for the customer seamless. The separation would also allow investors to value both companies and their respective income streams at more appropriate valuations. This is particularly timely considering the high valuations the market continues assigning to ecommerce and technology businesses.
Jeffrey Gennette, Macy’s Inc.’s (“Macy’s”) Chairman and Chief Executive Officer, put it well on his third quarter earnings call on November 18, 2021, in response to an analyst’s question:
“So look, our focus is to ensure the omnichannel behavior of customers is going to be respected at all costs. I think the omnichannel behavior is irrefutable, and we need to respect that. But we’re looking at a range of things, including the net of cost, benefits and execution that’s associated with operating as 1 integrated business versus operating as 2 separate businesses. And ultimately, we just need to see that the additional shareholder value can be unlocked beyond the potential of our current approach with our digitally-led omnichannel Polaris strategy.
So we’re working with our Board and our advisers for some time on this. But based on how the market is assigning value e-commerce businesses, we just added AlixPartners, which we announced this morning as an objective third-party firm to really pressure test all of our analysis. And so we’re in the middle of that work. We need to complete our analysis and we plan to provide an update after the work is complete.”
Assuming online sales revenue of around $6.2 billion and a valuation of 2.0x sales, Kohl’s’ digital business alone would be worth $12.4 billion, around 40% higher than the current enterprise value of the entire business today. This multiple is conservative in light of the rumored 4x sales multiple expectations for the Saks.com initial public offering. We would also note that since the market started to believe Macy’s may consider a separation, its stock is up 23.3% vs. 10.4% for Kohl’s, highlighting investor interest in such a separation as well as its potential value creation.
The Need to Assess a Full Sale of the Company
Given Kohl’s’ unacceptable long-term stagnation, the Board must also consider a sale of the Company to a buyer who can pay a meaningful premium. Our analysis and interactions with market participants lead us to believe the private market value of Kohl’s is far superior to where it currently trades. Perhaps in the private market, buyers will be better positioned to take advantage of Kohl’s’ assets.
A private equity buyer would likely take advantage of Kohl’s’ prodigious free cash flow and run the Company with significantly more leverage than the Board is willing to, which would lower its cost of capital and therefore put a buyer in a position to pay significantly more for the Company than where it currently trades. Our interactions with these types of buyers suggest they would aim to take advantage of the Company’s real estate to lower their equity checks and further increase their internal rate of return, which again would allow them to pay more to public shareholders.
Naturally, the Board may argue this is not the right time to evaluate a sale of the Company and that more time is necessary to see the fruits of the new framework. We would disagree with this assessment. As highlighted above, since the announcement of the new strategy, the Company has significantly underperformed its peers — perhaps because it is one of the very few retailers that has been unable to grow its sales compared to 2019. The Board should be aware that compared to the third quarter of 2019, Macy’s’ and Dillard’s, Inc.’s 2021 third quarter sales were up 9% and 12%, respectively, on a comparable basis. By comparison, Kohl’s’ was flat. Finally, if the Board and management have a credible framework for value creation and a viable five-year plan, sophisticated private equity investors who can perform due diligence on these projections will value the business properly today.
We contend the private market value of Kohl’s is at least 5.5x forward EBITDA, which would imply a conservative purchase price of around $75 per share. This represents a premium of around 50% to the recent trading price, which highlights the massive valuation gap between where the Company trades and its private market value. Once again, we believe these multiples are conservative given the significant real estate ownership of Kohl’s.
In conclusion, it is the Board’s job to drive value and the Board has had ample opportunities to do so over long periods. We are not pushing for one of the aforementioned solutions over the other, but we – and other shareholders, clearly – do not believe the status quo is acceptable. During last year’s proxy contest waged by four shareholders, the Company made several commitments, including that the Board has and will continue to be an agent of change and that the Board is open to new ideas that could enhance shareholder value. We urge the Board to be this agent of change and publicly commit to a review of strategic alternatives to create value for shareholders.
We request a meeting with the Board at its earliest convenience to discuss the initiatives summarized in this letter. On behalf of Engine, we look forward to working cooperatively with you to maximize long-term shareholder value. A review of our numerous engagements with public companies, including the many that have resulted in board representation and cooperation agreements, should signal our desire to be a constructive advocate for all of our fellow shareholders and stakeholders.”