Description

Quick Pitch / Variant View

I believe a long of L Brands, Inc. (“LB” or the “Company”) offers a compelling and asymmetric risk / reward profile for the patient investor as a result of (i) hidden asset value / earnings obfuscation from growth investments the Company is making internationally, (ii) sum of the parts (“SOTP”) margin of safety, (iii) alignment with a management team with a long track record of being competent stewards of capital, and (iv) significant upside potential should the Victoria’s Secret (“VS”) brand recover in North America (“VS NA”).

fogle42’s recent post provides background on the situation, the brands within the LB portfolio and why the opportunity exists, but I wanted to posit a variant view to the situation that I thought merited a new post (especially with the stock down an additional ~25%).

Specifically, I believe that at today’s price, an owner of LB is paying almost nothing to own VS NA and PINK while clipping a ~12% FCF yield  (excluding growth investments the Company is making in China), not to mention a safe ~8.5% dividend yield. While much of the Street’s focus and short thesis has concentrated on the well-publicized struggles of VS NA (and more recently PINK), I believe Mr. Market is creating these assets at ~30% of FY ‘18 Revenue and 2.6x FY ‘18E EBITDA.

As a whole, LB currently trades at an undemanding <11x FY ‘18E EPS (<9x excluding International losses) on VS NA EBIT margins that are ~970bps lower than their ‘15 peak. Sentiment (and multiples) in retail can change very quickly. One needs to look no further than URBN, which is up ~160% from its August ‘17 lows as it has seen ~5 turns of ‘18E P/E multiple expansion as comps and margins have snapped back. While Core VS NA has unquestionably struggled to adjust to recent changes in consumer tastes, these are still strong brands that have the potential for recovery. While I do not have any special insight as to when that may happen, I believe LB represents a downside protected option on VS NA figuring how to serve today’s woman (as it has successfully done for the past ~30 years). Were it to do so, I don’t think it’s inconceivable for LB to trade at a high teens EPS multiple on expanded margins that would result in a double (or better) from current levels on top of the fat dividend yield.

Thesis

1. Hidden Asset Value / Earnings Obfuscation

Between FY ‘15 and FY ‘18E, International EBIT declined from $88mm to effectively nil despite ~35% international franchise store growth (ex La Senza which falls under “Other” revenue). What happened? The Company has made significant investments in China (and to a lesser extent, the UK) with international owned store count growth of ~5x over the same period.

Thus while, the extremely high margin (~66% EBIT) franchise revenue has not gone away (and in fact, has increased), it has been obfuscated by investments in growing the China and UK retail businesses that could be turned off if the Company wanted to. Thus, when thinking about the true earnings potential of LB, I think one must recognize the ~$160mm investment being made in those operations. For those less familiar with the structure of LB’s international operations, I encourage you to listen to Martin Water’s 9/7/17 presentation at the GS conference, where he lays out the margin profile for each line of business in some detail.

Additionally, while China and the UK currently lose money, they offer significant upside potential (though mgmt’s persistent inability to right the ship in the UK is concerning), it seems silly to me to capitalize these losses in perpetuity. Consequently, I estimate the value of the International and Other segments using a SOTP methodology:

Franchise operations account for the vast majority of value here and I feel like 10x EBITDA is reasonable, if not conservative, based on where other franchisors trade. I value retail at 1x revenue, though think it could potentially be worth a lot more if the investments in China come to fruition. External MAST operations are definitely saleable as evidenced by the Company’s prior transaction with Sycamore, but have less visibility into them.

Bringing it all together, I think these two segments, which account for over ~$200mm of losses, are worth ~$1.6bn.

2. SOTP Margin of Safety

Bath & Body Works (“BBW”) is a somewhat divisive asset but its growth and margin profile speaks for itself as it continues to generate extremely high ROICs. Between FY ‘11 and FY ‘17, EBIT increased by $439mm vs ~$700mm of capex (not inclusive of FY ‘17 capex) for a pre-tax ROIC of ~62%. While it lacks a “perfect comp” URBN, PRTY and MIK trade at ~9x, ~8x and ~7x ‘18E EBITDA, respectively. Personally, I think BBW is superior to all of these businesses but for conservatism, I value BBW in the middle of the range at 8x.

While it is tough to value VS NA, I think if given the opportunity, private equity would happily pay 6x EBITDA or ~75% of revenue for a chance to turn around an iconic brand. Adding, the $1.6BN of International + Other value discussed above and subtracting net debt (using LTM average cash given the seasonality in cash balances), I get to a SOTP value of just under $40 or ~41% above current prices.

3. Alignment with Competent Stewards of Capital

SOTP valuations can prove illusory if it is not combined with someone incented to realize that value. Luckily, in this case we have an “owner / operator” that owns ~17% of the Company and has an extremely long track record of shareholder value creation. Ignoring the fact that Les Wexner effectively created VS and BBW from scratch while ejecting from Express and the Limited at the right times, more recently, the Company returned ~$11.8bn to shareholders (~1.5x the current market cap) between ‘10 - 17 in dividends and buybacks.

While I would prefer that the Company use its FCF to affect a significant one time dutch tender / repurchase as it did in ‘96, ‘04, ‘07 and ‘11 rather than paying nearly all of it out as dividends (even if it resulted in a near term dislocation as dividend investors turned over), management has clearly proven that it will not light shareholder’s capital on fire. Regarding the dividend, while many might look at an 8%+ dividend yield and wonder when the cut is coming, management has shown that it is willing to flex capex spending (see ‘09 and ‘10) in order to maintain the dividend. With a $2.40 dividend per share and ~280mm shares outstanding, the dividend requires ~$670mm of cash flow vs the Company’s ‘18 FCF guide of $800mm. As discussed above, I believe LB is investing $150mm+ of EBIT in its international retail growth along with $625 - 650mm of capex despite not needing to grow its core NA store base, which gives the Company flexibility to maintain the dividend even if VS NA choppiness remains. Regarding store count, I think many underestimate the power that LB has as a tenant. As one of the few concepts that still draws shoppers to malls (as opposed to the Express’s of the world that you just happen to shop while there), I understand that LB generally has extremely favorable rental agreements (particularly in lower tier malls), which has enabled it to continue to make money across the mall quality spectrum.

Most importantly, I think that the significant insider ownership coupled with the SOTP discount to intrinsic value puts a floor on the stock since at some level (and I don’t think we’re too far away from it), I have to believe Wexner would rather just take this private and realize that upside for himself rather than report to an increasingly disenchanted set of public investors. While some would point to its relatively high leverage for a public company (~2.5x) as an impediment to a buyout, I believe that despite ‘retail’ being a dirty word in the credit markets, LB could comfortably get total leverage to 4 - 4.5x in a buyout. At a 25% premium to current prices, 4.5x total leverage and assuming Wexner rolls his stake, a buyout would require ~$4bn of incremental equity, which I believe is eminently doable to a KKR or BX in tandem with a Sycamore. To be clear, I do not think LB ends up going this way and certainly am playing for more than 25% from here, but just want to illustrate the downside protection I believe exists at current levels.

4. Upside Option on VS North America

On my FY ‘18 estimates, VS NA (including PINK) EBIT margins will have declined ~970 bps since peaking at 18.1% in FY ‘15 on a ~(1.5%) decline in total revenue.

I estimate that each 100 bps of margin improvement represents ~20 cents of EPS or $3 / share capitalized at 15x (I think the LB multiple would start to revert to historical norms should margins or SSS show any signs of improvement).

While I doubt that getting back to ~18% is a realistic near term goal, LB has been able to adapt the VS brand to changing tastes and market conditions in the past (see the early ‘00s) and a shareholder is paying nothing for this optionality at current prices.

It must also not be forgotten, that unlike most retailers going through tumultuous times, Amazon is not the primary (or even secondary) cause of the issues at VS NA as it has struggled to gain traction in a category where fit is paramount. Additionally, one must keep in mind that ~20% of the VS NA business is online and growing LDD and that while the online business is gross margin dilutive, it its EBIT margin accretive.

Risks

1. BBW margins

With ~25% EBITDA margins, there is likely more downside than upside to BBW margins should the business slip. It is also a bit concerning that BBW has barely been able to leverage its 9% 1H 18 comp (20 bps of YoY improvement) due to the telegraphed investments in store labor.

2. PINK collapse

I believe, the recent move in the stock from 30s into the high 20s is primarily related to PINK weakness, whose “deceleration” management called out as the primary reason for the guidance cut. Until ‘18, PINK had been a juggernaut over the last decade as it became a ~$3bn revenue behemoth that had been largely responsible for VS NA’s growth over the last several years. Comps turned this year and with margins that are currently higher than Core VS, it’s possible a sustained period of comps weakness could take overall VS NA even lower.

3. Q4 / Seasonality

While I think that the guide has been largely de-risked after the recent cut, bears will point to tougher 2H comps. Q3 and FY guidance implies that 75-80% of FY ‘18E EPS will be generated in Q4. That being said, even with a (1%) Q4 SSS comp (both VS NA and BBW), 100 bps of YoY gross margin erosion, and SG&A increases consistent with 1H ‘18, I believe LB would still hit its guidance (keep in mind that it ‘only’ needs ~$820mm of Q4 EBIT to hit its guidance vs $987mm in ‘17).

Catalyst

1. Any signs of improvement in VS NA business performance

2. Inflection in China / UK profitability

3. Monetization of any parts of the business