It can happen fast, and without much provocation. It’s happened to companies from eBay to Family Dollar, Ann Taylor to Neiman Marcus, Safeway to PepsiCo. Even Apple.
Activist investors are making waves throughout the retail industry and beyond – and they will only continue to play a bigger role going forward. Understanding your company’s vulnerability to an activist and how to respond accordingly is a key ingredient to success in today’s retail environment.
Activist investors are nothing new, but they have recently broadened their scope from just trying to sell off a target company to influencing the company’s future performance through board representation, reorganization, returning capital to shareholders, changes in strategic direction, capital allocation plans and corporate governance reforms.
Activist hedge funds’ superior returns – up an average 5.9% this year compared to 3.9% for all hedge funds, according to BB&T Capital Markets – have helped them garner attention and develop alliances with more passive institutional investors.
That means activist investors have more money – close to $84 billion between them, according to Hedge Fund Research. This is nearly triple the assets they had under management five years ago. Of course, this doesn’t necessarily sound like good news for the companies these investors are targeting.
But it doesn’t have to be that way. Activists have the potential to make incredibly positive changes – and even the threat of one can motivate a company to shape up on its own.
As such, it’s important for all retailers to assess their vulnerability to activist investor takeover and plan accordingly.
Activists are generally attracted to companies that have a perceived weakness or are not optimizing shareholder value.
A.T. Kearney’s Activist Vulnerability Index helps companies understand their likelihood of being targeted. We believe there are seven key categories that influence whether activists will target a company.
1. Financial Performance
As expected, fundamental financial underperformance is one of the key factors that can trigger activist investor intervention. Activist investors focus on top-line growth, profit margins, same store sales and cash flow. Financial underperformance should be measured both against industry peers as well as absolute declines.
2. Shareholder Returns
Large cash balances and strong cash flow – when not returned to shareholders – are also strong indicators of potential activism. For example, activist Carl Icahn wrote an open letter to Apple CEO Tim Cook arguing that Apple should buy back stock from shareholders.
3. Strategic Considerations
Even companies that have the financial performance of a well-run company can be susceptible to activism if the company is undervalued due to missed strategic opportunities.
This can manifest itself in different ways, including loss of market share or the opportunity to improve margins. For example, teen retailers such as Abercrombie & Fitch and Aeropostale have recently been losing out at the expense of fast-fashion retailers. Sensing this missed opportunity, Sycamore Partners bought Aeropostale earlier this year, while activist investor Engaged Capital got four new directors installed at Abercrombie & Fitch.
4. Consolidation Opportunities
Activists look to create value through consolidation or privatization. For example, in 2013, Barrington Capital Group, which owned 2% of Jones Group – the Nine West, Anne Klein and Jones New York brands – scored a board seat and began to petition Jones to focus on its shoe brands. Later that year, Sycamore Partners bought Jones Group for $15 per share, a $0.93 premium over the share price the day Barrington’s stake was disclosed.
Or consider PayPal, which is finally being spun off from eBay after months of lobbying by Carl Icahn. Icahn believes the next logical step for PayPal is to roll up or merge with other players in the increasingly competitive payments space.
5. Management Changes
Activists like to keep their eyes open for companies that may be having management issues, often times
an indicator of trouble within. Complacent executives or a change in executive management will trigger activist investors to track a company’s performance and strategic direction. For example, Aeropostale replaced its CEO at the urging of an activist investor and board, leading to a 19% surge in share price.
6. Corporate Governance
If street perception is negative or trending down, one of the first places activist investors look is the corner office. Corporate governance issues – including complacent board members, lack of transparency, and questionable compensation practices – are often leading indicators of trouble ahead and are often cited in open letters to the board.
7. Expectation Management
Missed street expectations are often lagging indicators of activist interest – most activists are already paying attention once missed estimates are expected, long before they’re actually reported. Almost every company targeted misses earnings expectations or shows a decline in same store sales.
Preparing for an Activist’s Approach
Understanding your vulnerability is the most important way to prepare for a potential approach. Armed with your index score, there are additional steps companies can take to help fend off activists.
First, look at the company the way an activist would – conduct an unbiased, thorough performance assessment to identify weak spots and address them preemptively. While this is happening, it’s critical to maintain frequent, clear communication with shareholders.
Board members should focus on management’s ability to communicate its vision in a way that convinces the market and institutional investors.
Even taking these steps is no guarantee against activist investors. As such, it’s important to prepare for an approach. Management should have clear guidelines on how the executive team and board will manage their reactions to help minimize confusion in the heat of the confrontation.
After the Approach
Once an activist approaches, it’s best to listen to their requests with an open mind.
After that open letter criticizing Apple’s shareholder returns, CEO Tim Cook had dinner at activist Carl Icahn’s home. The two men are still at odds but the relationship hasn’t turned hostile. A few years ago, that type of meeting would’ve been unheard of. But industry stigma toward activist investors has since faded.
Review the types of campaigns previously launched by the activist. Typically, campaigns launched with private letters or one-on-one discussions tend to be more collaborative, while campaigns launched with public letters or proxy statements are often more hostile.
Most importantly, amid all these distractions, management must remain focused on performance, moving the company’s strategy forward and ensuring its changes are being effectively communicated to shareholders and the market. This is the time to take calculated risks, such as privatization, as long as the outside world supports the motives behind them.
One thing is clear – activist investors are not going away. In fact, they are becoming more powerful and influential, their campaigns more prolific. But this shouldn’t cast fear into the hearts of retail executives. Instead, by understanding your own company’s vulnerability and formulating a plan, you can ensure your company isn’t derailed by an activist investor – or the threat of one – but set back on the right track.