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The Retail Refragmentation

Shortly before the new year, Nordstrom announced that they are exploring spinning off its off-price department, Nordstrom Rack, into a separate business. They’re not the first retailer to consider breaking up into its component pieces: here’s Kohl’s, Saks, and Macy’s all making similar announcements this year. The conglomerate model is dying, and not just in retail: in November, legendary conglomerate GE announced that it would break itself into three separate companies.


In the case of Kohl’s, activist investor Engine Capital published a letter to the board that posited that if Kohl’s spun out its e-commerce business, that business by itself would be worth $12.4 billion, which is close to 70% greater than the total market cap of Kohl’s at the time of the report. In other words, they were saying that Kohl’s is losing out on billions of dollars in enterprise value by treating its ecommerce and physical stores as a single business.


As strange as that may sound, let’s discuss a few reasons why that may be the case (Matt Levine talks about a lot of this in his piece on the GE breakup).


First, it limits liability. As a simplified example, let’s say you own stock in two businesses and one makes $100 million a year and the other loses $100 million a year (and has no credible plan to change that). Then your stock in business A is worth some positive number and your stock in business B is worth zero. Importantly, your stock cannot be worth less than zero - you are limited in how much money you can lose, and the sum of the value of your stock in both companies is a positive number. Now, let’s say you combined both businesses. So business AB makes a combined $0 a year and your stock is worth zero. By simply combining businesses, you have destroyed value. It’s not a finance trick - that value is the worth to investors of being able to make two independent bets rather than one. It also means that companies can’t prop up one bad business that consistently loses money by subsidizing it from another good, cash-generating business.


Second, it focuses the company. Companies generally have one CEO and one board. When you are a retailer trying to do both e-commerce and traditional physical retail, each business is essentially getting a fractional CEO and board. It’s hard to run both effectively because they are so different - things like margin, merchandising, supply chain management, and labor all look completely different for traditional retailers and e-commerce players. Strategies that work for physical retail may not make sense in an online context, and vice versa.


We see startups making this mistake all the time: they do too much at once. They see that supply chain software or payments are broken, and they set out to build an all-in-one solution. Then they build and build for years, and meanwhile their competitors have passed them by. The solution is to simplify - instead of solving every problem, do one thing and do it better than anyone else. Similarly, large retailers may be experts at selling goods in their physical stores - but that doesn’t necessarily mean they’re good at selling goods online. A company that is focused 100% on online sales is probably going to be better at it than one that is distracted by managing physical retail.


Third, it promotes good corporate governance. Large conglomerates are generally built from cash flow - executives take excess cash from an existing business and use it to buy a new one. But this is counter to the concept of good corporate governance. It should be the shareholders, not the executives, who decide in what direction the company should go. Instead, executives should take excess cash and return it to shareholders in the form of buybacks and dividends, and fund new projects by raising money from investors. That’s how you let the market steer your company in the right direction and avoid making acquisitions that don’t add any value to the company.


So large conglomerates face strong headwinds when competing against more focused, agile companies. GE at its height had its hand in aviation, power, renewable energy, digital industry, weapons manufacturing, locomotives, and finance. Its size gave GE good economies of scale, which is certainly important in manufacturing-heavy businesses, but these were dwarfed by the disadvantages of conglomeration outlined above.


But! Retailers are a different sort of beast, because retailers like Kohl’s and Nordstrom with multiple lines of business enjoy not only economies of scale, but also other benefits. For example, many retailers are leveraging their physical locations to enable same-day curbside pickup or delivery of merchandise to customers. In their Q3 earnings call, Dick’s Sporting Goods said that they fulfilled over 70% of online orders through their stores, either through ship-from-store, in-store pickup, or curbside. If the e-commerce business of one of these retailers spun out, then doubtless it would retain close ties to its sister physical retailer; but even a strong partnership just doesn’t have the same weight and incentives as when shareholders are invested in the success of both businesses under a single entity.


And in some cases, diversification is an asset in itself. Imagine if Kohl’s or Macy’s had done an ecommerce spinout two years ago. It would have been completely disastrous for the company when the pandemic hit just three months later. For many retailers, having an ecommerce business to supplement their physical retail stores saved them when every retail store had to unexpectedly shut its doors for months. Granted, a pandemic is a once-in-a-lifetime black swan event, but that’s exactly the kind of unforeseen circumstance that diversification can protect you against.


I stole the title for this post from a Paul Graham essay in which he talks about the forces that led to the rise of giant conglomerates in the mid 20th century and their fall a few decades later. The most exciting and prestigious companies are no longer giant industrial corporations but agile, nimble startups and tech companies. These trends show no signs of slowing down, and some retailers seem to be the latest to jump on the bandwagon. But others are doubling down on the omnichannel vision and betting that the synergies between their businesses can overcome the inherent challenges in running a more complicated business. Amazon is the poster child for this approach - not only are they investing in physical locations with their acquisition of Whole Foods and development of Amazon Go, but they have transformed from retailer to tech company with AWS and their smart home products.


If you’re a retailer with multiple lines of business, then ask yourself: are the costs of managing a complicated business outweighed by the synergies between the businesses? If not, then it may be time to simplify.


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