Limited Brands is a compelling investment that offers significant upside potential with minimal downside risk.  Using a conservative sum of the parts analysis we believe that Victoria’s Secret and Bath & Body Works alone are worth almost 30% more than the current Enterprise Value and that the Apparel division is worth an additional $1.50 - $4.00/share.  In addition, investors at the current price get a $3 billion sourcing agent (Mast Industries), a free call option on the potential for International expansion of Victoria’s Secret and/or Bath & Body Works (not included in anyone’s numbers), success of any one of several incubator concepts, and any future value created by one of the most innovative merchants and top value creators in the specialty retail industry.

     Victoria’s Secret and Bath & Body Works are dominant franchises whose attractive economic characteristics are masked by the underperforming Apparel segment. 

 

o        Each has dominant market share in its category with no significant number 2 competitor

o        High-teens operating margins and very good pre-tax ROAs (40% for VS and 25% for BBW)

o        Each had double digit comp growth in 2006 and will see accelerated sq. footage growth  

o        These businesses alone are worth significantly more than the enterprise value of the company

 

     Wholly-owned sourcing agent Mast Industries is a very valuable asset that is completely ignored by investors because of poor company disclosure. 

 

o        $3 billion of revenues (~$700mm to 3^rd parties) with ~$120mm of operating profit

o        Minimal capital requirements results in very high ROIC

o        Recent push to grow third party sales will result in significant growth at high incremental returns

o        Closest public company peer earns 20% ROICs and trades at 25x EBITDA

o        This business is ignored because results are lumped into “Other” category with corporate overhead

o        Could be sold or spun off once it has sufficiently built up its 3^rd Party sales

 

      Significant opportunity to improve returns and create shareholder value through the sale of the low-return Apparel segment. 

o        This division has been a drag on growth, margins, and returns for many years

o        Conversations with management and industry contacts indicate that a sale may occur in near future

o        With proper investment and attention this business should have 5%+ operating margins (1% now)

o        Proceeds from a sale could be used to buy back more stock

 

      Abundant cash flow generation and strong balance sheet enable further value creation through acquisitions, increased dividends, and continued share buybacks. 

o        Management has a long history of creating value from intelligent capital allocation decisions

o        Over $6 billion of stock repurchased in the last 10 years; over $1 billion in dividends last 3 years

 

     CEO with an impressive track record of building and monetizing new retail concepts gives investors a nice call option.

o        The Limited, Limited Too, Express and Bath & Body Works were all started from scratch

o        Victoria’s Secret purchased for $1 million (1 store); Abercrombie acquired for $46mm (25 stores)

o        Current “incubator” concepts include C.O. Bigelow, Diva London, and White Barn Candle Co.

 

      Investor confusion surrounding inventory build, margin compression, square footage growth, investment spending, and competitive threats has created an attractive investment opportunity.

 

      Attractive valuation and high dividend yield limits downside and provides significant upside potential

 

o        Less than 14x 2007 EPS or 7.5x 2007 EBITDA

o        2.4% dividend yield

 

 

On a sum-of-the-parts basis we value Victoria’s Secret at ~$28.00/share (which equates to about 16x 2008 EPS or 8x 2008 EBITDA) and Bath & Body Works at ~$10.00/share (14x 2008 EPS or 7x 2008 EBITDA).  Subtracting forecasted net debt of $3.80/share gets to a target equity value of $34/share by the end of 2007 just for these two businesses – almost a 30% premium to the current stock price.  In addition, we believe that the Apparel business could be worth $1.50 - $4.00/share (10x-14x EPS on a turnaround margin of 4% - 8%). 

 

There are also several other opportunities that, while very difficult to quantify, clearly provide upside potential.  We do not need to give any value to these pieces to justify our investment but it is an interesting exercise to try and see what they may be

 

Limited Brands consists of three reportable business segments – Victoria’s Secret, Bath & Body Works, and Apparel (which consists of Express and Limited Stores).  The company also owns Mast Industries (an apparel sourcing agent that sources primarily for current and former Limited Brands subsidiaries) and a few incubator concepts including C.O. Bigelow, Henri Bendel, White Barn Candle Company, and Diva London.  Former brands owned by Limited include Abercrombie & Fitch (acquired in 1988 and spun off in 1996), Lane Bryant (sold in 2002), Tween Brands (formerly Limited Too – spun off in 1999), and New York & Company (formerly Lerner New York – sold in 2002).

 

The value of Victoria’s Secret and Bath & Body Works is generally understood by investors who are familiar with these businesses (though greatly underappreciated by those who have only looked at the aggregate returns of LTD).  We believe, however, that despite historical performance there is unrecognized value in the Apparel division given the well-known brands, attractive real estate portfolio, sourcing competencies, and well-developed systems infrastructure.  These businesses could be worth much more than the value implied by the stock price if they were sold to a private equity buyer willing to invest in the stores and in a good merchandising team. 

 

Furthermore, we do not believe investors ascribe any value to wholly-owned Mast Industries, a $3 billion apparel sourcing agent that generates very high-returns and is undergoing a fundamental shift in strategy that should result in significant growth over the next several years.  Mast has historically sourced only for Limited companies or former Limited companies (e.g., Abercrombie) but we have heard from several former employees and other industry contacts that Mast has recently made significant investments in building up a sales and marketing team to grow their non-Limited business.  Disclosure of this business is very poor and thus is universally ignored by investors (it is lumped into an “Other” category that includes corporate overhead and the money-losing Henri Bendel division).  For reference, the closest public company comp for Mast is Li & Fung, a Hong Kong-based company that generates returns on capital exceeding 20% and trades at 25x EBITDA.

 

Investors have been focused on several issues, none of which impact the long-term value of this company:

 

Increase in Inventory: In the most recent quarter inventories were up 47% y/y on a cost per square foot basis.  This has led investors and analysts to believe that sales were significantly below plan and that there is a lot of markdown risk over the next couple quarters.  In fact, as management made clear at an investor day last week, the inventory build was planned for strategic reasons (at a strategic meeting held last year management estimated an increase in inventories of 40%-50%).  Inventory build was needed to (a) reduce out-of-stocks (they were unnecessarily losing a lot of core bra sales) and (b) provide safety stock at BBW as they went through their systems upgrade.  The current inventory is primarily core, seasonless basics (all fashion-based inventory that was not sold in the semi-annual sale was destroyed) and will be sold through at full price over the next couple quarters.  Inventory levels will fall in the back half of 2007.

Increased Competition for Victoria’s Secret: There has been concern over increased competition from JC Penney, Chico’s, The Gap, etc. but management has been very clear that they are seeing no impact from any of these entrants.  The higher promotional levels at VS are part of a strategy to (a) induce trial and develop loyalty among younger customers and (b) proactively discourage competitors.  The increased promotional expenditures are largely discretionary and can be reduced if they are not happy with the returns.

 

Margin Compression at Victoria’s Secret: Margins were down 330 bps at VS last quarter, primarily due to (1) increased promotional spending and (2) higher mix of lower-margin PINK sales.  As mentioned above, the promotional spending has been largely discretionary and can be reigned in if it does not produce adequate returns.  The mix shift is more structural, but management hopes to offset that impact through greater leverage of fixed costs.  We are modeling a slightly lower margin for VS going forward.

 

Misunderstanding of Square Footage Growth: Management recently announced a plan to expand VS stores by an average 50%, resulting in 8%-10% square footage growth in 2007.  Some analysts have misunderstood this to be a one-year initiative limited to 140 stores, but management made clear at an investor day last week that this is a multi-year plan to increase total square footage at VS by 50%-100%.  They are currently getting 30%+ IRRs on these projects so this will result in substantial growth at very high returns.  In addition, BBW will see accelerated square footage growth due to the success it is having in off-mall stores (sq. footage growth of 3% in 2007 vs. 1% in 2006).  Although net square footage growth will be flattish for the company (due to a 12% decline in apparel), this will change going forward as VS/BBW become a bigger part of the mix.

 

 

 

Victoria’s Secret uses a multi-channel approach to sell women’s intimate apparel and beauty products.  With approximately 1,000 stores, a very successful catalogue business and a growing online presence, Victoria’s Secret is the dominant player in the intimate apparel category, generating approximately $5 billion of sales and almost $1 billion of pre-overhead operating income in 2006.   

 

We are expecting substantial growth and improving returns on capital in this business over the next several years due to a material ramp up in square footage growth and continued growth of the Beauty, Direct, and PINK segments.  The longer-term opportunity comes from expansion into International markets, which the company seems to be positioning itself for with the recent acquisition of Canadian-based La Senza.  CEO Les Wexner has stated publicly that he believes the Victoria’s Secret could be a $10 billion business without any international expansion or introduction of any new categories.  Wexner has been very cautious about international growth but the brand has very high international awareness and it seems logical to assume that at some point they find a way to make money there. 

 

 

LTD has recently embarked on an aggressive initiative to grow square footage by expanding the size of its current stores.  The company believes that these store expansions can drive annual square footage growth of 8%-10% for the next 5-7 years (compared to total square footage growth of 8% over the last 3 years).  A typical expansion increases store square footage by 50% and generates an IRR of 36%.

 

 

PINK: In July, 2004 VS launched PINK, a sub-brand targeted at the high-school and college-aged girl with lower price points and more of an emphasis on cotton intimates and loungewear.  The concept has been a runaway success with sales going from zero to $700 million in a little over 2 years.  Industry contacts who we have spoken to indicate that this could eventually be a multi-billion dollar business supporting 400-500 stand-alone stores (the company currently sells PINK in the Victoria’s Secret stores but is experimenting with stand-alone PINK stores). 

 

International:We are not modeling any international growth but this does represent a significant opportunity given the potential size of the market and the strong brand awareness that Victoria’s Secret already has outside of the U.S.  LTD has been very cautious about expanding beyond the U.S. but the recent acquisition of La Senza gives VS a foothold in several international markets.  Management indicated that a main objective of this acquisition was to learn from La Senza’s international growth strategy and to share best practices.

Beauty: Victoria’s Secret’s Beauty business (selling fragrances, cosmetics, etc.) is currently a $1 billion business that the company believes can grow to $2 billion by increasing its current 2% market share.

 

Direct: VS currently does about $1.5 billion of business through its catalogues and online operations.  This piece of the business is growing at a double digit rate and at higher margins and returns than the core business given the low costs and limited capital required to operate the website.  It also helps to increase international awareness for the Victoria’s Secret brand as a significant portion of the direct sales (we estimate 10%-15%) are outside of the U.S.

 

Intimissimi: Victoria’s Secret is the exclusive U.S. licensee of Intimissimi, a very successful Italian lingerie brand targeting 20-25 year olds with lower price points lower than the core Victoria’s Secret brand.  The Intimissimi brand is currently carried in 160 VS stores and there is one free-standing store.  Plans are in the works to launch Intimissimi Beauty, which would be sold in U.S. stores as well as the 800+ Intimissimi stores across Europe.  It is far too early to evaluate the potential of this brand in the U.S. but given the success of the PINK concept, there is certainly upside potential here.  It is also worth noting that Grace Nichols, the long-time CEO of Victoria’s Secret, has been put in charge of leading the Intimissimi expansion.    

 

Sexy Sport: VS is currently launching their brand of sports apparel/lingerie.  This is a big market that VS should be well-positioned to compete in.  Management indicated that early results are actually ahead of where PINK was at this stage.    

 

 

 

With almost 1,600 stores and over $2 billion in sales, Bath & Body Works is by far the leading specialty retailer of personal care, beauty and home fragrance products.   The business was founded in 1990 and within 10 years had grown to over 1,400 stores with almost $1.8 billion in sales.  But the company experienced problems in the early 2000s as its marginal brand and lack of a truly differentiated product offering made it susceptible to increasing competition from drug stores and discount chains.  By 2002 sales per square foot had declined to $506, down from $668 in 2000, and operating margins fell to 17% from a peak of 26%.  BBW’s re-emergence coincided with a change in leadership in 2003, when Neil Fiske was brought in as CEO to replace Beth Pritchard.  Fiske, a former BCG consultant and co-author of the book “Trading Up,” has been focused on offering more differentiated products at significantly higher-price points to capitalize on the American consumer’s obsession with “affordable luxury” – essentially taking BBW from being the “McDonald’s of Toiletries” to the “Starbucks of Cold Creams.”  Results since Fiske took over have been very impressive – sales per square foot are back above $650 and operating margins are improving.

 

We are modeling only minimal square footage growth but believe there is a lot of room for continued growth in sales/square foot and further margin improvement as the company continues to move consumers up to higher price points.  Square footage growth assumptions could prove to be conservative if the company has success with its non-mall based store initiative.  The company is also in the very early stages of launching its Direct business, which should be a significant driver of growth over the coming years.                   

 

 

 

 

The Apparel segment consists of Express (658 stores, $1.75Bn revs) and Limited Stores (260 stores, $493mm revs).  Operating margins for this segment were 4% in 2002 but are currently running at a little better than break-even after incurring a $92mm loss in 2005.  The company has spent the last several years downsizing the apparel business, closing over a third of the stores in the last 4 years.  Although this business has shown signs of turning the corner (including a 12% comp in January) it is our sense that management is losing patience and will look to sell or spin this business in the near future.  Management has explicitly stated that its future lies with VS and BBW and at an investor day last week emphasized its track record of making portfolio decisions that create value for shareholders and stated that it is always evaluating its portfolio for further opportunities to create value.  We believe that the current stock price weakness will provide an impetus for management to take action sooner rather than later, and that the recent turn of the business will make a sale viable.   

 

Our conversations with industry contacts lead us to believe that there is a decent amount of value in these businesses (particularly Express) given the well-known brands, great real estate portfolio, sourcing competency, and well-developed IT systems.  With the right merchandising team and some much-needed store-level investments there is no reason why this business should not be able to have at least mid-to-high single-digit operating margins.

 

 

 

Limited also owns Mast Industries, an apparel importer that sources merchandise for Victoria’s Secret, Express, and Limited Stores, as well as other third-party retailers (primarily former Limited-owned companies like Abercrombie & Fitch).  According to the Mast website (www.mast.com) sales in 2005 (including external sales and sales to LTD divisions) were $2.9 billion, up 80% from 2003.  Operating profit for this segment is not broken out but management has stated that it is approximately $120mm (including internal allocation of profit).    

 

Despite being universally ignored by investors, we feel that Mast is an outstanding business and a very valuable (and growing) asset for Limited.  Its $3 billion in sales make it probably the second largest player in the industry (after Li & Fung) and it has a great reputation within the industry for quality and customer service.  Mast does not own any factories but has very strong relationships with factories all across the Far East, Europe, and Central America.  The returns on capital are very high and cash flows are very durable.

     

The real opportunity for LTD comes from Mast’s ability to grow third-party sales.  Historically, Mast has supplied primarily Limited subsidiaries and its third-party sales (over $700mm in 2006) were largely from companies that were formally owned by Limited (e.g., Abercrombie).  We have heard from numerous industry contacts (including Mast customers, competitors, and former employees) that Mast has recently begun a major initiative to grow sales outside of the Limited family and is beginning to get traction with companies like Chico’s and Pacific Sunwear.  Mast grew third party sales approximately 17% in 2006 and we believe that a significant portion of that growth came from unrelated companies such as Chico’s, Pacific Sunwear, and Diesel.  Given the exceptionally high returns on capital generated by Mast, this type of growth will positively impact overall returns for LTD.

 

Mast would also benefit from a sale of the Apparel business.  First, it would help diversify away from LTD, which would give it a higher multiple as a stand-alone company (according to Mast’s website, only 40% of sales are from intimate apparel).  Also, it would enable Mast to do business with a lot more customers who up to now would not work with them because they are affiliated with Limited, whom they view as a competitor.      

 

We value these two businesses on a multiple of 2008 EPS and subtract forecasted net debt to get a 12-month target price of $34, without giving any value to Apparel, Mast, or many of the growth initiatives.

For this business we are looking at the value to a potential buyer assuming no growth but a return to something closer to a normal margin for this type of business.  Assuming operating margins can return to somewhere in the range of 4% to 8% and using a multiple range of 10x to 14x on that level of earnings, we see an additional $1.40 to $3.92 in value.