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L-Brands LB
October 04, 2017 - 1:01pm EST by
danconia17
2017 2018
Price: 41.61 EPS 3.13 3.21
Shares Out. (in M): 284 P/E 13.5 13.15
Market Cap (in $M): 11,998 P/FCF 7.7 7.6
Net Debt (in $M): 4,408 EBIT 1,758 2
TEV (in $M): 16,408 TEV/EBIT 9.33 8.94

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  • Retail
 

Description

Idea: Long LB
 
Our contrarian view is that the company represents a great investment for a long term investor with several upside levers. 
 
Basic Information
Market Cap: $11.81B
Enterprise Value:$16.22B
Shares Outstanding: 283.85m
Float: 238.16m
Shares short (% of float): 9%
Dividend yield: 5.7%
LTM Revenues: $12,262
LTM EBITDA: $2,337
LTM FCF: $738
2016 Revenues: $12,574
2016 EBITDA: $2,521
2016 FCF: $900
 
 
The debacle in retail stocks as well as changing consumer behavior in the mall based retail business has taken down the parent company of specialty retailers Victoria’s Secret and Bath and Body Works. LB is down 45% from its 52wk high and 32% YTD. Led by owner-operator Les Wexner (16% ownership of stock through personal holdings and trusts) and a talented CEO for VS in Jan Singer (former head of Spanx) we believe that LB resembles classic “baby with bathwater” characteristics. The Company operates 3077 stores in the US, Canada , UK and China and has 750 additional franchised locations worldwide. In 2016 LB produced nearly $12.6B in revenue with nearly $7.4B coming from Victoria Secret in the US, $4B from Bath and Body Works and the remainder from international
operations and other smaller brands. 
 
We were attracted to LB after surveying the retail carnage due to the following:
• Differentiated and less-crowded products (intimates and beauty)
o Limited direct competition of VS in women lingerie retailing – Gap/Aerie at lower price point and La Perla at higher price point
o VS has 3 of the top 10 fragrances in the US in form of Bombshell, Heavenly and Tease
o BBW maintains lead over Body Shop, 130m transactions in 2016; number one brand in its category.
• Durable brand appeal
o VS fashion show over 200 countries, generates 100 billion measurable media impressions
o Direct channel has been growing in response to Amazon
o Fast growing e-commerce business at 17% of sales
• Strong customer service and experiential environment.
• Habit forming behavior in intimates and underwear i.e. ultimate channels may shift but consumers will still care about their products
• Continued store count growth and retail sales growth
o SSS (ex swimwear) still ok and growing in BBW
o $ per sq.ft. still attractive
• Rational store fleet / lease flexibility
o B and the c-mall stores are on month-to-month contracts
o Flexibility with leases – co-tenancy and occupancy changes
o 24% in A malls, 26% in B malls and 22% in C malls.
• Growth in international particularly China
o 200 stores in rest of world; market leading in Canada and UK with platform launched in China – which will ultimately be the largest market in the world.
• Quantitative metrics: Trading at 8xEBIT, 7x LTM EBITDA and a 2017E FCF yield of 6%. Share buyback of $250m. 5.7% dividend yield (supported by operating cashflows).
• Healthy Balance Sheet (as of Q2-17 / July 29, 2017 period): total cash of $1.36B, total debt of $5.77B (nearest maturity is June 2019, LTM EBITDA of $2.34B (Net debt/EBITDA = 1.88x). Ample liquidity with an undrawn revolving facility of $1B and annual interest costs of $381m are easily managed.
• Management Team - Strong operator in Les Wexner
o Regarded as one of the greatest retailers ever involved in nearly every large retail brand in existence
o Sold Limited in 2007 (700 stores) at height of market due to fast fashion threat
o Fired CEO, cut swim, took over main role
o Focused on maximizing return on capital by specializing in nhiche products that had a high turnover rate on racks with healthy margins
 
If you search for Joel Greenblatt’s notes on Special Situations you will find a section where he invited his wife Linda to speak to the Columbia MBA class about investing in retail. While this part may be outdated (September 2005) there are some nuggets here that are still valuable in today’s market.
 
I like retail because you are constantly getting information. You get it on a monthly basis and sometimes on a weekly basis. Retailers put out same store sales numbers-Comparable sales in stores for a year-over-year period. Monthly basis but most industry groups you normally get quarterly numbers. The more information you have, the more people try to trade on the information before, after and during. You get a tremendous volatility in this sector. A lot of people don’t like volatility. As far as I am concerned, I can live with volatility if there is a good opportunity over the long term. And if I am taking a two years’ time horizon that is actually my greatest opportunity--are these monthly numbers. 
 
I don’t know how to pick the next trend. I really don’t know fashion. I say this: nobody can predict fashion. It is really is not about hitting the next trend on a continuous basis. Are these companies running a good business over the long-term? Are they running a business that can weather the ups and downs? The best time to get in is when they missed a season of merchandise because if you look at the fundamentals of the company and it is well-run and the stock gets crushed because they miss a season of merchandise, then it is an opportunity to own for the long term. It is really irrelevant if they pick the hot trends or not. It is very interesting because the Street misses the point on retail. Most analyst reports focus on how this company will do in Oct? How will this company be affected by Katrina or higher heating prices for Christmas? These are all relevant questions, but not relevant if this is a good business. Fundamentally it will be around. If you buy it at the right price it really doesn’t matter what is happening to the customer today because they will be around and they will continue to buy. 
 
You have to buy these things when people hate it because that, obviously, is when your opportunities are available. So you have to be a contrarian.
 
Despite Year-to-Date SSS declines of -9% across all L Brand products (-14% in VS and +4% in BBW), LB still exhibits strong return on capital of 31% with CFROIC is 16%. Gross margins have been in the 40 to 41% range historically with EBIT margins at healthy 16%. Returns on Assets of 14-16% historically outpace the 8% WACC and long term weighted average debt costs of 6.68%. 
 
In the past 5 years sales are up 22% and operating income up 22%. Expenses are growing slower than sales in the last 4 out of 5 years. And finally, inventory growth has been slower than sales last 4 out of 5 years (key indicator of fashion business). During this 5 year period the dividend has increased from $1/share to $2.40/share and a total of $7.1B has been returned to shareholders through dividends and share repurchases.
 
People overly focus on SSS instead of focusing on whether this is a good fundamental business with solid management. We believe this is a fundamentally good business with long term secular tailwinds run by an excellent management team.
 
 
 
Setup and Key Investment Considerations
(1) Setup – why does this opportunity exist?
 
VS had discontinued swim-wear as well as removed the VS iconoic catalog and promotional items (“free panty or $10 off a bra”).
 
This has had an impact on YTD 2017 performance as follows:
• Total L Brands comparable sales down 9%
o VS comparable sales down 14%
o BBW comparable sales up 4%
 
However removing the swimwear component we see a different picture:
• Total L brands comparable sales down 3%
o VS comparable sales down 5%

As such 70% of negative SSS in 2017 is due to VS’ exit of swim line.
 
Further VS did not anticipate the bralette and sports bra business becoming a larger replacement item for bras which has been lowering AURs across the market.
 
In light of all of this, only 32 stores (out of 3000+) are negative; 99% of store fleet is cash flow positive on after-tax cash basis Bath and Body works continues to perform including – 32 consecutive positive comps in the overall division; 14 consecutive positive comps in just retail.
 
 
(2) What is LB’s response?
 
Management has taken a proactive approach to steering the ship right for VS. This includes:
 
• Organizational change to three separate units in VS: (1) Lingerie (run by Jan Singer formerly at Spanx) (2) PINK and (3) Beauty
• Focus on core lingerie business (eliminating swim and apparel) and stripping out 40% of non-core lines
• Evolve promotional strategy – more geared towards loyalty building
• Increase efficiency (eliminate 300 jobs)
• New bra launches – Body by Victoria and Illusion
 
(3) Strong brand and experience based player with a product moat translating into high ROIC
 
• Deliver emotional experiences beyond products alone
• Differential experiential nature of products makes them resistant to permanent disruption in retail space
• 62% of lingerie market; 35% market share in women’s underwear through VS and PINK subsidiary sells 6 out of every 10 bras in the US. Next closest competitor in bra and panties is Fruit of Loom with 5.5% share.
• High margin products with high turnover = strong RoC
 
(4) Vertically integrated – make their own branded products
 
• VS has economies of scale
• Lower cost of marketing due to word of mouth
• Well positioned store fleet
• Social media strength
• Cost advantages vs competition – investments in supply chain have led to inventory discipline. Average inventory days of 53.8 vs 180.9 at HBI 
• Days Inventory and Inventory turnover are strong – shifting product despite headline worries
 
(5) Untapped global expansion opportunity particularly in China
 
a. Operating in 77 countries right now.
b. Most of international business is partnership model (except for UK and China where they are taking risk / using own balance sheet)
i. Partnership model – LB owns assortments, pricing architecture; Partners bring capital, real estate and people. LB gets paid on retail royalty basis
c. 1st BBW in Canada now 102 BBW Canada Stores; 1st BBW International in 2010 now 188 international stores
d. 1st VSFA in Canada in 2010 now 48 VSFA Canada Stores and 67 international stores
e. China
i. 400m people in China watch the Victoria Secret fashion show
ii. China is a highly fragmented market with no incumbent leader
iii. By YE 2017 will have 36 stores in 13 cities
1. 6 VSFA (2 already opened): Macau, Shanghai, Chengdu, Beijing, Suzhou,Nanjing
2. 30 VSBA: multiple cities
iv. T-Mall
1. 11/11 (Singles day) big launch – incredible signficiant promotional day
2. Super brand day (end of September)
v. Direct to consumer business
vi. Economics of China should be very similar to US
f. Other parts of globe being served by franchise players
i. Middle east business >> 4 brands available (BBW, VSBA, VSFA, Lecenza) biggest market in world; performance is mixed.
 
 
What is the bear case?
 
(1) VS is old fashioned and has not responded to change in times
• Sexy image has grown stale because of brand’s unwillingness to broaden how it
defines beauty vs. Aerie (challenging beauty standard by casting range of body types
in campaigns
• Millennials are more "body positive" and want to see real women and tired of trying
to live up to impossible ideals of Victoria secret models.
 
(2) Amazon 
a. Amazon has come up with their own line so question will be whether VS experiential stores will continue to be relevant
 
(3) Structured bras being competed away by bralettes and sports bras - modern woman wants comfort which is reducing AUR
 
(4) Continued exposure to B and C malls and shifts to online selling hurt long term profitability
 
 
 
PreMortem – What if we are wrong?
• Evidence brand is impaired
• Human behavior has it changed? The human need to be desirable
• Slowdown and negative SSS in BBW
• Inventory turns worsen
• Risk to cost structure and supply chain risks
• Consumer spending lower than expected
 
 
Key Indicators to Watch
Same store sales (particularly after anniversary of swim wear)
 
Sales per square foot,
 
Inventory per square foot
 
Gross and operating margins
 
Free cash flow
 
China launch and results
 
Other: Instagram/Twitter/Google Trends
 
Valuation
DCF gets to $71
 
MSD overall revenue growth driven by China and online; LSD annual operating income growth
 
Operating margins remain in mid teens with target of 16%.
 
Intrinsic value between $65-75 per share depending on FCF growth rate, discount rate and international growth rate and VS sales per avg square foot.
 
Summary
#1 lingerie brand with #1 dollar share for bras and panties, PINK is leading specialty collegiate brand that has doubled sales in last 5 years; 3 of top 10 fragrances; VS fashion show in nearly 200 countries; 100 billion media impressions worldwide.
 
 
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Management plan is executed, delivers and market re-rates realizing the quality of this franchise.

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