Description

Background

The two primary contributors to L Brands’ sales and operating income are Victoria’s Secret VS (VS) and BB (BB) brands.  Although VS provides nearly 60% of sales and BB provides about 33% of sales, VS and BB each provide roughly half of operating income.  Almost 90% of sales are US-based (the focus of this writeup) and over 80% of sales are retail (as opposed to online).

VS is a retailer that sells women’s underwear, perfume, and accessories. BB is a retailer that sells shower gels, lotions, fragrance mists, perfumes, candles, and home fragrances.

The performance at VS has been weak of late, with a 5% YOY sales decline in FY18 after 1% growth the preceding year.  Longer-term, VS has seen slow growth (2% top line CAGR from 2013-2018) but an erosion (5% annual decline) in operating profit over the same 5-year period.  Discounting has hurt VS’ gross margin and operating profit—LB’s gross margin declined from a high of ~42% in Q1 2015 to 35.9% for the latest quarter (Q1 2018), primarily driven by VS. VS has been discounting merchandise in order to drive sales in recent years, and this has been especially prominent at sub-brand Pink, which comprises 40% of VS sales.

BB results have been better, with mid-to-high single increases in sales and EBIT for both 2017 and 2018, and a 5-year annualized sales growth of nearly 6% and operating profit growth of nearly 10%.  Even in 1Q18, amidst weak mall traffic, BB store sales were up 5% YOY (excluding ecommerce, which also grew).

Key Issues

The two big issues facing L Brands are:

1. Mall traffic decline (should hurt both VS and BB, although BB results have been more resilient) and the fixed costs of its large store base (for both VS and BB)
2. VS segment: Shifting consumer preferences, especially among younger consumers, away from the traditional push-up bra towards more comfortable, casual, and sometimes lower-priced styles such as bralettes and sports bras.

How can L Brands respond?

• Issue #1 (mall traffic) is largely out of LB’s control.  LB stores are heavily tied to malls (71% of stores). The primary “fix” is to gradually shift the footprint away from malls by closing underperforming stores, which they’ve been doing for a few years now.  It’s worth pointing out that some malls are quite healthy; not all malls will close (VS and BB have stores in healthier “A” and “B” malls, as well as less-healthy “C” and “D” malls). But its fair to expect long-term mall store closures, offset by some new stores in hypermarkets and contemporary urban locations.

Overall, the decline in malls have been ongoing for years, and LB has been able to slightly grow sales over that time, as they close some underperforming locations and open new ones. The company expects go forward square footage to be flat to up low-single digits (we’ll assume flat; even that may be aggressive).

The good news for BB is that they’ve done quite well over the past 5 years amidst declining retail traffic.  And although VS has struggled, a good portion of the struggles may be related to the “consumer preferences” issue rather than store traffic alone.  Some good news for VS is that it appears to be finally turning the corner on e-commerce sales, which are higher-margin than store sales (20% EBIT margin vs. 13% for stores).  After years of struggling with e-commerce (with flattish results in 2011), VS has had more success in recent months (e.g. growing online sales 23% in 1Q18 ($354mm vs. $286mm in 1Q17).  The company continues to invest in its online abilities, rolling out a ‘re-platforming’ of their technology foundation.

• Issue #2 (shift in consumer preferences) is a much more manageable issues for VS.  The company was slow to react to the shift away from high-end bras, but the answer is relatively straightforward.  Don’t cannibalize your key product with low-price substitutes but do adjust your product mix to meet changing consumer demand (e.g. offering high-end sports bras and athletic wear.)  Initially, VS discounted traditional products such as push-up bras in an attempt to gain share, but now they’ve adjusted their mix and introduced a full line of sports bras and other sportswear.  Consumer willingness to pay for high-end athletic wear remains alive and well. (Underwear share of sales is now roughly 40%, down from 45% in 2017, and bralettes are ~5% of sales.

Overall, LB has the tools to manage both issues, thanks in-part to the strong brands of BB and VS.

Brands

• VS is the 2nd-most followed brand on Instagram, surpassed only by Nike.  VS shoppers are rated among the most loyal consumers by industry observers (e.g. NPD Group, who notes that their loyalty cards and merchandising are highly effective, with VS shoppers spending more on lingerie and making more frequent purchases than the average lingerie consumer).  (Other marketing efforts, like the VS Fashion Show, have struggled in recent years.)

• VS still has very high market share—news articles report 60-70% of bras in the US are sold by VS.  That statistic seems questionably high, but the broader point is that VS has a massive lead in terms of market share and name recognition vs. other brand names (like American Eagle and GAP’s bralette-focused brands).  

Valuation:

• Assume that VS continues to grow their e-commerce share and continues to shift their product mix toward high-margin items (rather than discounting bras or pushing bralettes).

• Assume that a stabilizing VS and a growing BB contribute to 3-4% growth in the next two years, with operating margins settling around 15%

• The result is roughly $2b in 2020 EBIT, which after $450mm in interest and a 25% tax rate produces $1.2b in net income or ~$4.25/share of EPS.  Applying a 13x multiple to the now-growing business produces a target price of $59-60 in 2020 or discounted to today, roughly $49 – still a significant premium to the current share price.

Management

The CEO of L Brands, Leslie Wexner, founded the company in 1963 and currently owns 17% of the company. I believe his interests are fully aligned with shareholders’ interests. His compensation has been in line with shareholder returns. From 2016 to 2017, his compensation was down 61% compared to a -15% shareholder return.

Risks

The following risks and their mitigants are generally addressed in the writeup, but they’re repeated below for clarity:

• VS’s lower-priced brand, Pink, may be cannibalizing some VS sales.

• Continuing declines in mall traffic could lead to lower same store sales for VS and BB.

• Some commentators believe that VS’s brand has not adapted to well to societal trends towards female empowerment and acceptance of different body types. Many of these commentators point to American Eagle’s Aerie as an example of more contemporary brand; many of Aerie’s models are plus-size and Aerie says their photographs are not photoshopped.

• There is a plethora of online women’s lingerie startups, and Amazon also has plans to enter the space. If these startups are successful, they could take market share away from VS.

Catalyst

• Return to sales growth as bralette market penetration levels out and VS adjusts product mix.  
• Improvement in operating margin as online sales continue to grow.