• Activist group Jana Partners is hoping to tap into what has been a buzzy market for digital retailers that is driving valuations higher.
• Investors have largely favored tech-focused names promising faster growth over traditional department store operators.
• Activist Jana Partners believes Macy's e-commerce business could snag a market capitalization of at least $15 billion.

An activist investor is pressuring Macy's to split its digital operations from its stores in a bid to unlock value at the 162-year-old department store chain.

And while it might be an attractive move in the short term, some experts are raising red flags about the proposal's long-term logic.

Activist shareholder Jana Partners is hoping to tap into what has been a buzzy market for digital retailers that is driving valuations higher. Investors have largely favored tech-focused names since the companies promise faster growth over traditional department store operators. The former have seen sales accelerate as consumers buy more goods online. E-commerce savvy retailers, such as Mytheresa and Zalando, are also considered asset-light because they have few to no stores. This allows management to invest in other areas of the business, like marketing.

"The market is willing to pay a big multiple on an e-commerce-oriented business," said Michael Kollender, head of consumer and retail investment banking at Stifel. "So how do we unlock that value?"

A separation at Macy's could mimic a similar move earlier this year by the luxury department store chain Saks Fifth Avenue. Run by President Larry Bruce, Saks stores are still entirely owned by HBC. Saks' digital unit, however, received an investment from the venture capital firm Insight Partners, which now has a minority stake in the business. Marc Metrick, formerly chief executive officer of the combined Saks businesses, leads the digital side.

Although the two businesses are separate financially, customers likely don't know anything has changed because their experience is seamless.

Jana eyes sky-high valuation

The thinking at Jana, according to a recent investor presentation, is that Macy's e-commerce business could snag a market capitalization of at least $15 billion, or roughly twice what the combined company was worth before news started swirling about the potential break-up. Macy's stock has rallied roughly 18% since Bloomberg first reported on Oct. 6 that Jana was calling for a digital spinoff.

Pushing that valuation higher is the fact that Macy's e-commerce business is still growing, despite its entire revenue base shrinking. Digital sales grew 7.7% in 2019 and then by 23.7% in 2020. Overall, Macy's revenue declined by 1.6% and 29% during those same years, respectively.

Rapid e-commerce gains have propelled the multiples of other online retailers, too. Fashion giant Revolve Group is trading at 6.5-times expected 2021 revenue. Farfetch, another online luxury fashion platform, fetches a multiple of 5.9-times. While Macy's is trading at a multiple of 0.3-times expected 2021 sales.

And just a few months after its separation was official, Saks' digital arm is reportedly aiming to go public with a valuation of $6 billion, or roughly six-times revenue. It had a $2 billion valuation as recent as March.

A representative from HBC declined to comment.

But one calls it 'insane financial engineering'

But some experts still don't think the structure makes much sense.

"It's insane financial engineering," said David Shiffman, co-head of the global consumer retail group for Solomon Partners. "It's impossible to separate the two. I'm not saying someone's not going to try, and I'm not saying that someone's not going to pay a lot of money for that. But at some point, it doesn't work."

One retail entity can't be making all the money while the other is holding onto all the assets, he explained.

Saks has arranged its businesses so that the stores segment receives affiliate fees that account for online sales and other benefits that having a physical presence can drive. The Saks.com entity, meantime, has used its extra capital to invest in website upgrades and amplified marketing to consumers.

"It completely goes against everything we've learned," said Steve Dennis, a retail strategist and former senior vice president at Neiman Marcus. "It's all about these nutty valuations that are being ascribed to online-only businesses."

Dennis said brands such as Warby Parker and Allbirds, which initially started only on the internet, are now plotting massive store expansions. The companies say having more shops will help raise awareness for brands and boost profitable sales.

"There's no question that if you were Saks.com, an independent organization, you would need to have stores," Dennis said.

Furthermore, Dennis predicts there could be a slowdown coming soon for digital fashion players, which have benefited during the pandemic from consumers stuck at home and surfing the web from the couch. Wealthier consumers have had more money in their bank accounts, but that could change as they shift spending back to travel, dining out and other experiences. That wouldn't bode well for the standalone e-commerce operations, he said.

"It's hard not to see how online fashion doesn't have significant headwinds going into next year," Dennis said. "You've got this dead cat bounce in the numbers and an unnatural amount of e-commerce business."

"That's not to say that e-commerce isn't going to continue to grow. But the growth rates are going to moderate a lot," he added.

Macy's touts 'retail ecosystem'

Macy's declined to comment, ahead of its fiscal third-quarter earnings report. In August, though, Chief Executive Jeff Gennette touted on an earnings conference call that the department store chain was running a "fully integrated business," between its roughly 800 stores — including Bloomingdale's — and website.

"Our commitment to delivering a dynamic, seamless omnichannel experience across a customer shopping journey has never been stronger," he said. "To me, it is clear that a comprehensive retail ecosystem with physical stores in the best malls and the most productive off-mall locations integrated with a best-in-class e-commerce offering is a powerful combination."

Macy's has also said previously that customers who visit both its stores and website spend two-and-a-half to three and-a-half times as much money compared with a customer who only purchases from one channel. And the company has said it sees a drop off in e-commerce sales in regions where it closes a department store.

Stores also serve other purposes, such as acting as a mini-fulfillment center for online orders. Macy's said 24% of its digital sales in the fiscal second quarter were fulfilled by stores.

So, while a potential separation could offer a near-term boost to Macy's share price, it could end up causing more headaches later.

"This raises an enormous number of operational questions in terms of how loyalty schemes, branding, product development, marketing, and customer communication would function," said GlobalData Retail Managing Director Neil Saunders. "There is a huge potential for muddle and confusion, especially if the separate companies want to diverge over time."