Macy's won't be the only retailer facing activists

Customers shop in Macy's flagship store in Herald Square, New York.
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Customers shop in Macy's flagship store in Herald Square, New York.

Macy's may only be the tip of the iceberg.

After a year of underperforming the broader stock market — and amid forecasts that they will record their weakest quarterly earnings performance in nearly two years — analysts have identified retail as the next sector that's likely to get rattled by activist investors.

The potential targets aren't limited to one category. Instead, analysts said they span across specialty apparel, hard goods and department stores, with companies that have a depressed valuation or rich real estate assets particularly at risk.

"For quite a long time, I would say that the apparel and the department stores specifically have been left alone by the activists," said Farla Efros, president of HRC Advisory. "Now, when you've seen the last quarter results across the board were not very encouraging, that typically is what kicks them into high gear."

Activists, who use their stake in the company to try to influence how it is run, have developed a reputation as brazen investors who are often willing to sacrifice a retailer's long-term well-being for a quick profit.

"Every board is trying to figure out, 'Are we going to get picked on?'" -Colin Welch, president and chief operating officer of Financo advisory firm

Macy's, for example, has come under pressure by activist investors who want to unlock the value of its estimated $19 billion in real estate. Though the department store agreed it's in its best interest to find ways to monetize its real estate, management said in November that it would not spin off a REIT. Although this would have generated big short-term gains for the company, analysts said it would also bog down the department store with rent expenses, and deteriorate its credit quality.

Activism has become a prevalent issue across industries, with every investment bank now boasting a corporate activism practice, said Colin Welch, president and chief operating officer of Financo advisory firm.

Whereas in the past, a board's first reaction to activists was that it wouldn't be subjected to such attention, "the whole mentality has totally changed," Welch said.

"Every board is trying to figure out, 'Are we going to get picked on?' "

Welch said the best defense to stay out of activists' crosshairs is to have a good share price and valuation. But on the coattails of a dismal year for retail stocks — which are down nearly 15 percent over the past 365 days — that isn't the case for many names in the space.

Things aren't expected to get much better for retailers anytime soon. According to Retail Metrics' latest forecast, the group's earnings are expected to fall 0.7 percent during the fourth quarter. That's down from a forecast of 3.5 percent growth at the beginning of November, and would mark the fourth quarter of sequential decline for the group.

Retail Metrics' President Ken Perkins said there are a number of retail segments expected to underperform, with home furnishings "surprisingly" forecasted to be the worst performer, down 14 percent, followed by footwear with a 12 percent decline. Department stores and teen apparel retailers are also expected to perform poorly.

Among the department store set, recent stock purchases by investor Bruce Berkowitz's Fairholme Capital suggest Sears could be the next target. After ramping up its stake in the department store last year, SEC filings show that as of Tuesday, Fairholme had already added another 276,100 shares to its portfolio during the first few days of 2016.

All in, the investment firm is Sears' second-largest shareholder, at roughly 25 percent. CEO Eddie Lampert is the company's largest shareholder, owning about 29 percent. ESL Investments, Lampert's hedge fund, ranks third, with a near 21 percent stake. Fairholme didn't respond to a request for comment. Sears said it doesn't comment on shareholders.

But while certain pockets of retail have been more challenged than others, Deloitte's Rod Sides said retailers' vulnerability to activism depends more on how their financials are constructed.

"If you've got a strong asset base that maybe is underleveraged, I think that puts you more at risk than others," he said. "So is it one particular sub-segment of retail? Not necessarily in my view, but I do think it's a structural question."

Retail execs talk shop: Is the consumer spending?
Retail execs talk shop: Is the consumer spending?   

Macy's isn't the only retailer trying to spoil the appetite of activist investors who are hungry for their property. Likewise, Ethan Allen's real estate assets have attracted the attention of Sandell Asset Management, which estimated their worth at roughly $450 million.

But in a presentation to investors in November, the retailer said its strategy of owning select real estate assets "ensured that Ethan Allen survived the Great Recession that devastated much of the cyclical furniture industry and led to the bankruptcy and demise of several major furniture industry competitors."

There have been plenty of examples of failed activism in the sector, from Bill Ackman's push for a Ron Johnson-led J.C. Penney, to Eddie Lampert's work to combine the Sears and Kmart nameplates, resulting in a downward spiral of revenues at Sears Holdings. Other cases that were less lethal — yet nonetheless not very successful — were Apex's stake in The Container Store, and Leonard Green & Partners' involvement with The Sports Authority.

Still, PwC's Steve Barr emphasized that activist meddling and private equity acquisitions can "really transform" retail businesses.

One example of this is Restoration Hardware. The high-end home furnishings shop was taken private in 2008 for roughly $175 million. Today, the company's market cap sits at $2.5 billion.

Paul Altman, managing director at The Sage Group, said pressure on bricks-and-mortar retailers has not slowed down appetite mergers and acquisitions in the sector.

He said his firm is seeing a "high level of activity" in the space, which he attributed to traditional retailers' need to find ways to keep innovating. The difference, however, is that buyers used to complete transactions simply for growth's sake; now, the action now has to check off a strategic box.

"We've found the capital to be really hungry for very good brands, but very disciplined," he said.

As far as going private, HRC Advisory's Efros said she is a "huge proponent" of retailers taking this route — one that recent reports have suggested department store Kohl's is considering. (The company recently declined to comment on the headlines, citing their quiet period.)

Going private provides a company the opportunity to fix its business without the scrutiny of investors, in many cases allowing the retailer to emerge as a stronger public entity a few years later, Efros said.

"You're stronger, you're leaner, you're firmer and you're focused on the right things," she said.

Correction: This story has been updated to correct attribution.