Drama on Aisle Four: The Battle for Kohl's

Activist rumblings led to a surprising bidding war... Back in December, activist hedge fund Engine Capital published an open letter to the shareholders of retailer Kohl's (KSS), urging the company to explore ways to prop up its stock price. Engine, which owns roughly 1% of Kohl's, lobbied the board to consider either spinning off its […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] Drama on Aisle Four: The Battle for Kohl's By Berna Barshay Activist rumblings led to a surprising bidding war... Back in December, activist hedge fund Engine Capital published an open letter to the shareholders of retailer Kohl's (KSS), urging the company to explore ways to prop up its stock price. Engine, which owns roughly 1% of Kohl's, lobbied the board to consider either spinning off its e-commerce business or putting the whole company up for sale. I'm not a fan of Engine's first suggestion... Frequent readers will recall that I think splitting e-commerce from stores completely ignores the operational reality of what it takes to succeed in retail in 2022. Customers clearly want an omnichannel experience, so separating brick-and-mortar stores from digital operations not only creates financial dyssynergies (more costs!), but also degrades the customer experience in an environment characterized by ever increasing competition. [I didn't like the idea when it was proposed for luxury department store Saks](... I didn't like it when [it was proposed for department store Macy's](... and I don't like it for Kohl's. As for pursuing a sale... sure, why not? Prior to Engine Capital's cage rattling, KSS shares were trading around $48... Based on analyst estimates at the time, the shares were modestly valued at a price-to-earnings (P/E) ratio of 8 times and a multiple of earnings before interest, taxes, depreciation, and amortization ("EBITDA") of a bit over 4 times. These may seem like very cheap multiples if you are used to looking at tech or health care... but for a mature, low-growth retailer with fashion risk, like Kohl's, they're sort of average. KSS shares certainly weren't expensive... but they weren't cheap in an unprecedented way either... Right now, you can buy shares of Macy's at a P/E ratio of less than 6 times and an enterprise value ("EV") to EBITDA multiple of less than 4 times. In mid-January, a second activist – Macellum Advisors, which has a nearly 5% stake in Kohl's – issued a letter criticizing the company's execution and board composition. The fund asserted that Kohl's sits on substantial real estate assets that could make the company worth $100 per share, and urged it to put itself up for sale, as Engine had suggested. Macellum had previously issued a letter in April of 2021 demanding changes at Kohl's. The pressure was building... On January 22, Kohl's received an unsolicited $9 billion buyout offer from Acacia Research, an investment consortium led by activist hedge fund Starboard Value. This equates to a price of around $64 per share and a P/E ratio on current estimates of around 9 times. The next day, private equity firm Sycamore Partners reportedly approached Kohl's with a $65 per share offer in hand. After a busy weekend of deal activity, KSS shares soared when the markets opened on January 24. KSS closed up 36% that day, for the biggest one-day gain in its history...  Why on earth are people fighting each other to buy Kohl's? Recently, Kohl's, like all retailers, has struggled with supply chain challenges. These have been a drag in the women's apparel category... but that headwind has been more than offset by the robust consumer demand environment. While earnings per share of more than $7 for the fiscal year that ended in January will be the highest in the company's history, estimated profits of approximately $1 billion are still down about 14% from their peak 10 years ago. Given the rapid adoption of e-commerce over the past decade, this doesn't seem like a terrible result. Kohl's is certainly doing infinitely better than its mid-tier department store peers from a decade ago... Its former peers like Sears, J.C. Penney, Bon-Ton, and Mervyn's have all filed for bankruptcy. Kohl's has benefitted over the past decade from having locations in strip centers as opposed to enclosed malls, where traffic has dropped precipitously. The company has also leaned hard into the athleisure trend, which has had much longer legs than most people expected when the category began to take off years ago. Kohl's has also been smart with striking partnerships that help it maintain foot traffic in an increasingly more digital world. In 2019, it struck a deal with tech giant Amazon (AMZN) to accept returns from Amazon.com at its stores. In the first three weeks after the partnership launched, traffic to Kohl's stores was up a whopping 24%... Kohl's estimates the deal helped bring 2 million new customers through its doors in 2020. Then last year, Kohl's announced a deal to open "Sephora at Kohl's" shop-in-shops. This new partnership brings 125 prestige beauty brands into Kohl's for the first time, and there will be 850 locations opened by 2023. In-store boutiques from popular cosmetics retailer Sephora were one of the only things working at J.C. Penney in its final declining years, and when J.C. Penney filed for bankruptcy, Kohl's swooped in to grab that relationship.  Source: USA Today Kohl's also has a healthy e-commerce presence, with around $6 billion – or about one-third of total – sales made online. --------------------------------------------------------------- Recommended Links: [Missed out on FAANG? 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[Read the full details here](. --------------------------------------------------------------- As legacy retailers go, Kohl's has navigated the evolution of e-commerce quite well... But the private equity buyers clearly think there is more to do, and the retailer's ample free cash flow ("FCF") – which should top $1 billion this year – and its real estate holdings make it a good candidate for levering up with debt to juice equity returns. But the strategy isn't without risk. The history of large leveraged buyouts ("LBOs") in retail is not great... Consider the high-profile bankruptcies of big box store Toys "R" Us or luxury department store Neiman Marcus after their LBOs. Retail is quickly evolving, and consumers are fickle... This isn't a great recipe for forecasting long-term sales, margins, and cash flows with great accuracy. Considering the debt, these bids are valuing Kohl's at an EV of around $14 billion. This isn't far off the 10-year peak EV of around $15.5 billion seen in 2015. Sure, if you go back to before 2008, Kohl's was once worth almost $25 billion... but that was the case more than 15 years ago. Back then, the world was different, with far lower e-commerce adoption. Also, Kohl's was different – it was a growth retailer with only around 800 stores. Now it has nearly 1,200... and that number has been relatively stable for about five years. I'm not in love with this deal... but it could work because of the FCF. I trust that the buyers realize they may be buying Kohl's at peak FCF. Not only has an unusually robust consumer environment and a flood of stimulus checks into middle class homes bolstered Kohl's sales over the past year, but the company has also been spending less on inventory than usual because it can't get its hand on product with the current supply chain issues. The FCF, even with a haircut, certainly supports an LBO in the $60s, as long as they don't put too much debt on the company. But if the bidders plan to extract value from this deal by engaging in a financial engineering technique where they sell the real estate and lease it back from the new owners, that's where I get bearish. This tactic sounds great in theory, but in practice... it's something that contributed to the bankruptcies at Sears and Mervyn's, among others. As I shared on Twitter, I think a sale-leaseback strategy could be a disaster for Kohl's, even though it is a stable company right now...  Source: Twitter/@Hedge_FundGirl Another problem with this deal – Kohl's isn't selling, at least not at $64 or $65... Last Friday, Kohl's rejected the buyout offers, saying the valuations were too low, and adopted a shareholder rights plan, also known as a "poison pill," which is a defense mechanism against a hostile takeover. Jonathan Duskin, managing partner of activist Macellum, wasn't happy. As he expressed in a public statement... Even if some of our fellow shareholders want the Board to compare sale opportunities to management's go-forward strategy, we fear the Company's actions and statements demonstrate a lack of impartiality and strategic thinking in the boardroom... It seems to us that the Board is taking unprecedented steps to derail a credible process and kill interest among the growing crop of possible buyers of Kohl's. It's possible that Kohl's is willing to sell – at a higher price... This all may be posturing to try and extract an extra 20%... If the bidders are willing to pay up, maybe you can make some quick money here. But it's also possible that the board is committed to staying public and not selling. Macellum's Duskin shared in an interview with Yahoo that the company is giving the bidders the cold shoulder... They didn't give them access to management. I thought they had access to a data room. They really didn't do anything to engage with these potential buyers and are doing everything they can to shut the process down. They obviously could have engaged with the buyers, tried to provide them information to see if a higher price was available. They didn't do any of that. They sent a very chilling message to the market and to other potential buyers by putting out a poison pill. This is a tough one to call. On the one hand, if these bidders come back at $75 or more, Kohl's board probably has a fiduciary responsibility to consider the offer. That strikes me as a fair price. But the higher the bidding goes, the more risk there is with the bidders getting adequate debt financing, given the crappy history of big retail LBOs. Lenders may also worry that Kohl's offers limited opportunities to boost profits in a turnaround... The company could be operated better, but it's not like it is awful now. There's also the macro risk that we just saw with "peak retail" for the cycle in 2021. I would handicap the chances of a deal happening at $75 at maybe 65%... A 65% chance of making 20% quickly isn't bad. That's an expected return of 13%. But there's also a 35% chance the whole thing blows up and the stock goes back to $55, its average price over the last year. In that case, you lose 11%... A 35% chance of that spits out a negative 4% return. Putting it all together, the total expected return is 13% + (-4%), or 9%. That's alright... but there are better opportunities in the market. I'll leave Kohl's to the professional arbitrageurs. In the mailbag, readers share thoughts on online gambling... Do you shop at Kohl's? What do you think the company does well? As a consumer, does it worry you if it goes private? Does anyone have an opinion on whether or not this deal goes through? Share your thoughts in an e-mail by clicking [here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). "Once the rush for customers ends, what will stop sportsbooks from competing with better odds (-105 on basic spreads vs. -110 you often see now)? A bet on the Jets to lose is the same everywhere. Seems very similar to what happened with online brokerages and commissions. "Also, how do personal income taxes work for these sites? From what I understand, it's easy to book wins as income but harder to deduct losses." – Matthew Y. "I definitely think casinos, and especially poker, should be available on-line. I have been playing with an 'offshore' company, with no assurance of odds, or of fair play. The out of country sites are not regulated or monitored to my knowledge, which leaves many possibilities open, to the detriment of the players. "There is also no tax revenue being generated by my play for my state. "It makes no sense to leave this up to foreign companies, with no oversight." – Rpmcoop Berna comment: I agree entirely. You are a case in point that people are going to gamble online whether we regulate and tax it... or not. "Thank you, I was talking to a group of young adults the other day who were telling me about the latest gambling craze that's taken their generation by storm; they said it was something called 'the stock market.'" – Ricky M. Berna comment: Ricky, I believe it! Regards, Berna Barshay February 9, 2022 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2022 Empire Financial Research. All rights reserved. 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