Victoria Hasn't Lost Her Secret

With an array of short-term challenges, falling comparable sales in go-forward categories at Victoria’s Secret, and significant exposure to the struggling mall distribution channel, it is no surprise that

Adding further concern to the story, management said just a year ago that it believed it could continue to increase North America square footage in the low- to mid-single-digit range annually despite falling levels of mall foot traffic.

That said, we believe the risks associated with the story are more than priced in at current trading levels and that near-term catalysts and long-term opportunities are underappreciated. In the near term, we think the anniversary of the bralette trend and the decision to exit swim and apparel categories will provide an inflection point in Victoria’s Secret’s same-store sales declines and operating margin.

Further, we believe that the decision to take China operations in-house provides the company with a significant long-term growth driver and that this market has the potential to reach the size of the U.S. market.

With the company’s strong brand intangible asset yielding a wide economic moat in a space where fit and quality are valued over price, we think the current 39% discount to our $69 fair value estimate is unjustified. We view L Brands’ shares as attractively priced.

Mall Exposure a Risk, but Concerns More Than Priced In We think one of the largest overhangs on this stock is L Brands' significant exposure to the foundering mall distribution channel and management's seeming lack of concern regarding this issue. We do not deny that this is a real concern. Management has relied on store growth in the United States as the primary means of driving revenue growth outside of comparable sales. As of the second quarter, L Brands has over 1,100 U.S. Victoria's Secret and Pink stores, almost 1,600 U.S. Bath & Body Works stores, and nearly 50% exposure to B and C malls. With North America Victoria's Secret contributing about 62% of revenue in fiscal 2016 and Bath & Body Works another 31%, this brick-and-mortar footprint is the bulk of the contribution to consolidated earnings.

More worrying is that management appears blind to this threat. At its November 2016 investor day, management issued guidance calling for accelerating North America square footage growth in the low- to mid-single-digit range (versus about 1% average net growth annually over 2011-15), a large component of its plan to achieve 7%-10% annual top-line growth. Management believed it could hit this target growth range by the second half of 2017. We were immediately skeptical, and this has already proven a more difficult target than management appreciated. Management’s most recent guidance implies only low-single-digit top-line growth in the back half of 2017, well below its planned 7%-10%. Management also missed second-quarter guidance calling for comparable sales declines in the midsingle digits versus the actual 8% decrease. We think these misses are leaving investors concerned that management is out of touch. In our opinion, part of the recent deceleration in comparable sales growth in go-forward categories probably points to a more permanent decline in demand in the mall channel, and as such, we are cautious about future store growth in North America.

However, we think concerns regarding management are overblown. Although its recent commentary leaves us a little concerned about management’s understanding of market trends, this has historically been a very strong team, with adjusted return on invested capital averaging about 26% over the past three years and 2017 the only year in over five years that management missed or did not exceed its original guidance target. Les Wexner founded the company in 1963 and remains CEO with about 16% of shares (through personal holdings and trusts), which we believe aligns his interests with those of minority shareholders. Stuart Burgdoerfer has served as executive vice president and CFO for about a decade with previous leadership positions at Home Depot, PepsiCo/Yum subsidiary Pizza Hut, and management consulting firm CSC Index. He has repeatedly been recognized as one of America’s best CFOs by Institutional Investor, which we think speaks to the level of excellence he has achieved.

Bolstering our confidence, this team already has a history of adjusting its strategy to respond to changing retail environments. In 2007, L Brands sold 67% of the Express brand and 75% of The Limited, realizing that returns on investment were higher in its beauty, intimate apparel, and candle businesses, and that these businesses were more defensible, with greater pricing power. In 2010 and 2011, L Brands sold its final stakes, ending its ownership of both The Limited and Express. This decision proved to be the right one with adjusted operating margin expanding from 11% in fiscal 2006 (according to Capital IQ) to 16.2% in fiscal 2016. We think the decision to exit swim and apparel--which lack the pricing power of undergarments--could be viewed in the same light. We have faith in this team and believe that it will course-correct given recent data, with a more muted and defensive view on the U.S. retail environment as well as new innovative products, and that the true value of the company will be realized. We look forward to the investor day in November for an update on the strategy.

We think both the management and real estate risk is more than priced into the stock. Current trading levels imply flat average annual comparable sales growth (including direct sales) over the next 10 years and adjusted operating margin declining to the low double digits, versus the flat comp sales (excluding the impact of swim and apparel exits) and 14% adjusted operating margin expected in fiscal 2017.

We think the market’s outlook represents a misunderstanding of the drivers of current weakness. In our opinion, new product introductions and the anniversary of mix shifts as well as the absence of the clearance of swim and apparel will cause an inflection in these metrics. First, the swim and apparel exit will be less of a headwind going forward, falling from about 9 comp points to the Victoria’s Secret segment in the first half of 2017 to about 2%-3% in the third quarter and 1% in the fourth. Additionally, management qualitatively cited that it was encouraged by the customer response to new product launches in the second quarter, and we look forward to more newness in the fall. Two of these launches, Body by Victoria and the Illusion bra, carry a significantly higher average unit retail, or AUR, than bralettes (with price points of $34.50-$54.50 versus bralettes at $20-$44.50), which should contribute to improved comparable sales and gross margin performance. Signs that headwinds are abating can already be seen. Consolidated revenue declines went from 7% in the first quarter to 5% in the second, and we expect only a 2% decline in the third despite similar comps in the prior year for each quarter. Meanwhile, adjusted operating margin declines fell from 510 basis points in the first quarter to 8.6% to 320 basis points in the second to 10.9%, and we expect 280 basis points in the third to 8.2%.

As L Brands laps these challenges, we think revenue and operating margin performance stands to improve further heading into 2018, albeit not recovering to historical levels and still well below management’s long-term guidance to reflect mall traffic headwinds and near-term product mix shifts. We model 2.6% average annual revenue growth over the next five years (versus 5% average annual revenue growth over the past three years) and adjusted operating margin recovering to 16% (in line with 2016 and below the 17% historical three-year average).

Poised for Improved Performance We believe L Brands possesses a wide economic moat. There is a limited amount of direct competition of Victoria's Secret's scale in women's lingerie retailing, with Gap GPS and Aerie at a lower price point ($16.50-$72.99) and brands like La Perla ($124-$720) at a much higher price point. Similarly, Bath & Body Works has been able to maintain its lead over its nearest competitor, The Body Shop; we don't see this changing as The Body Shop struggled under the ownership of L'Oreal, and we don't expect a quick fix as new owner Natura tries to right the ship. We think new entrants would be at a pricing disadvantage, given Victoria's Secret's economy of scale advantages, lower cost of marketing owing to word of mouth, massive store fleet, and social media strength as well as all of the press surrounding the Victoria's Secret fashion show and the Angels.

Supporting our stance on the firm’s competitive edge, Victoria’s Secret is the number-one brand in dollar share for bras and panties (IBISWorld estimates its share of the entire lingerie market at over 60%). It has 3 of the top 10 fragrances in the U.S. in the form of Bombshell, Heavenly, and Tease. The Victoria’s Secret fashion show is broadcast in nearly 200 countries and generates 100 billion measurable media impressions worldwide. Bath & Body Works had over 130 million transactions in 2016 and is the number-one brand in America for body lotion, shower gel, fragrance, liquid hand soap, hand sanitizer, and its spa collection. Seventy percent of capital expenditure is invested in stores, which we think should assist Victoria’s Secret in withstanding the erosion in mall traffic that is plaguing other retailers. Finally, research (as cited by Hanesbrands) shows that comfort, fit, and consistency are valued more than price by consumers in undergarments. We think this makes logical sense, as changing brands requires the switching cost of having to try on multiple other brands to find the right fit and size, a task most people consider unpleasant. As a result, we think returns on invested capital will outpace our 8% weighted average cost of capital over a significant period, with our explicit discounted cash flow model forecasting an average adjusted ROIC of 19% over a five-year time horizon.

An obvious conclusion to draw when presented with declining go-forward category comparable sales (categories excluding the apparel and swimwear exits) is that Victoria’s Secret could be losing market share, implying that its brand intangible asset is failing to deliver a competitive advantage. This fear has been compounded by media reports claiming that there has been a cultural rebellion against sexy and flirty styles. If this were true, we agree that it would imply further revenue declines. However, we do not think the data supports this.

First, the younger consumer enters the brand through Pink (with a college-age target market), and Pink performance has remained healthy. Sales at Pink have more than doubled in the past five years, and it is nearly a $3 billion business, representing just under 25% of consolidated sales. In the second quarter of fiscal 2017, total Pink sales increased in the mid-single-digit range, and in the first quarter, Pink comps were up by low single digits. We think this demonstrates that the company continues to attract consumers entering the category, as its marketing and product styles still resonate positively with younger consumers.

At $1,400 of sales per foot, Pink is a leader in productivity at teen retailers, further supporting our wide moat argument. We estimate that Abercrombie & Fitch ANF, Hollister, American Eagle AEO, and Aerie are all under the $1,000 sales per square foot productivity level. Pink even outpaces Zara at narrow-moat Inditex, which we estimate to have $626 sales per square foot.

Second, we disagree with the notion that Victoria’s Secret is ceding market share in its main brand. Instead, we think comparable-store sales declines in the lingerie category are due to product mix shifts (with pricing differentials) rather than market share losses. Core lingerie bra unit growth in the midteens in the first quarter and midsingle digits in the second supports this thesis. This unit growth implies that AUR fell 26% in the first quarter and 13% in the second (given that category sales were down 11% in the first quarter and 8% in the second) at Victoria’s Secret. Therefore, revenue pressure appears to be only due to mix shifts to lower-price-point sports bras and bralettes, not market share or pricing power losses.

Industry data supports the notion of mix shifts rather than market share losses. According to retail analytics company Edited, which sampled 80 lingerie retailers across the U.S., United Kingdom, and Europe, sellouts of pushup bras have fallen 50% over the past year while sellouts of bralettes or triangle bras have grown 120%. Padded bras fell 22%. According to Edited, bralettes are on average 26% less expensive in the industry than structured bras. Therefore, AUR pressure is an industrywide trend, not a Victoria’s Secret-specific problem.

Data from Google Trends further supports this argument. Searches for sports bras and bralettes have trended up significantly over the past five years, while sexy bra demand has declined. Given that the price range is $22.50-$49.50 for sports bras, $20-$44.50 for bralettes, and $34.50-$66.50 for sexy bras at Victoria’s Secret, this data again supports the notion of mix shifts as the cause of AUR declines rather than pricing power within a category or unit market share losses. In fact, using the mean prices in each category at Victoria’s Secret, we see that sports bra prices are about 29% lower than sexy bras and bralettes have a 36% price differential. This aligns with AUR declines (down 26% in the first quarter and 13% in the second) and further reassures us that market share is intact on a unit basis.

We think bralette penetration levels are stabilizing and will be less of a headwind. First, bralettes provide little in the way of support. Therefore, we think only women with smaller bust sizes can avail themselves of this product. According to TheAverageBody.com, almost 40% of American women wear cup sizes over B. As such, we see peak bralette penetration at 60% or less of women. We estimate that bralettes currently account for 10%-15% of bra sales at Victoria’s Secret. Although this implies significant room for further declines, we note that new structured bra products should also inflect AUR. Two of these launches, Body by Victoria and the Illusion bra, carry a significantly higher AUR than bralettes (with price points of $34.50-$54.50 versus bralettes at $20-$44.50), which should contribute to improved comparable sales and gross margin performance. We think the company will be successful in driving up AUR by providing some added support features and using higher-quality materials to create products that have the look of a bralette but more support like a structured bra. The easing of AUR pressure in the second quarter (down 13% per our estimates versus 26% in the first quarter) supports our thesis that AUR constraints are beginning to fade. We see AUR within Victoria’s Secret moderating to a low-single-digit decline next year and remaining at a more modest annual downtick each year through fiscal 2021, but we believe this will be offset by a low-single-digit uptick in units, resulting in about 2% annual comps between fiscal 2019 and fiscal 2021.

Even if we are wrong on this point, our bear-case analysis takes into account continued AUR pressure. Assuming that revenue growth averages only 1% annually through 2021 (roughly in line with 2017’s flat to slightly up performance in go-forward categories) and adjusted operating margin stagnates in the 13%-14% range (versus 16% in 2016), we arrive at our $51 bear-case fair value estimate, which is still north of where the stock is trading.

Finally, we note that North America Bath & Body Works performance (31% of fiscal 2016 sales) hasn’t faltered. We believe that this business has some defensibility to the e-commerce threat as scented products are more difficult to sell online, unless on a replenishment basis. In fact, sales productivity has increased 17% over the past five years, reaching $831 in sales per selling square foot by the end of 2016. This makes us more comfortable with the 1,693 stores at the end of fiscal 2016 and our belief that there is room for low-single-digit new store growth annually. Additionally, the segment has posted positive comparable-store sales growth every year since 2009. Although we model growth to moderate given the law of large numbers (and the comping of an extra week in 2018), we expect the business to sustain its market-leading position. Growth should be enhanced by e-commerce penetration. We see penetration, currently sitting in the low double digits, increasing to over 20% in the next five years on 20% average annual revenue growth (slightly below the 22% average over the past three years). Because Bath & Body Works is the market leader in body lotion, body cream, shower gel, fine fragrance mist, fragrance collection, fragrance diffuser for the home, liquid soap, hand sanitizer, spa collection, and specialty retailer for candles, we see segment annual revenue growth averaging almost 6% over the next five years, still accounting for a slight deceleration from 7% over the past three. At an almost 24% adjusted operating margin in fiscal 2016 (versus Victoria’s Secret’s 15%), mix shifts to this business line should be margin-constructive.

China an Enormous Long-Term Growth Opportunity Although we believe the U.S. businesses are nearing maturity, we think L Brands has a long runway for international growth. Historically, much of the business was conducted on a royalty sales basis, resulting in international sales accounting for only 3% of revenue in fiscal 2016, despite almost 580 franchise stores at the end of fiscal 2016 (versus the company's over 3,000 owned and operated store base). The U.K. was the first departure from this policy in 2012, now with 19 fully owned stores, but in our view, the most exciting opportunity is the fully owned China business. At only 2 Victoria's Secret stores and 30 VSBA stores as of the end of the second quarter (versus 1,174 North America Victoria's Secret stores), China represents only a tiny part of the business now. However, we see this market as having the potential to grow to the size of the U.S. market (about $7 billion in revenue). Scaling this business will take time, and we do not see China growth having much of an impact in the near term. That said, if stores are opened at a rate to support low to mid-20s growth in international markets, as management guided at its last investor day, we see international revenue growing to $2.6 billion in the next 10 years from $423 million at the end of fiscal 2016 and accounting for 14% of sales. In our opinion, this is sufficient to catapult total company revenue growth back to 4%-5% annually.

Early performance metrics confirm the strength of demand in the China market. L Brands recently opened a store in Chengdu, similar to that found in North America malls (9,000-10,000 square feet). The store is delivering about $1,000 in sales per square foot, putting store productivity north of that in the U.S. (about $800 per foot). Business on TMall (a Chinese e-commerce market with a 60% Internet penetration rate in the country) is also strong despite an original 13- to 14-day lead time (it was first fulfilled out of North America). Now that sales are on the local platform with next-day delivery and the brand will be more heavily advertised (there is a Super Brand Day at the end of September when Victoria’s Secret will be the title page on TMall and the brand will participate in Single’s Day on Nov. 11, a day during which online retail sales at Alibaba--TMall’s owner--totaled almost $18 billion in 2016, well above the $3 billion in online sales on Black Friday in the U.S.), we think online demand will also be strong.

In the long term, we do not see any structural differences in China and expect it to have profitability characteristics similar to the North America business. Management’s confidence in the region is supported by Morningstar’s own regional research, which projects consumption growth in China to average about 6% over the next 10 years, buoyed by falling saving rates and robust wage growth.

We expect Victoria’s Secret price points in China to be 100%-130% of U.S. pricing and thus see little risk to productivity shifts. In the near term, we expect management to remain focused on this large opportunity and do not expect additional countries to be moved to an owned and operated basis, as the management team prudently focuses its resources on this lucrative, fast-growing opportunity.

Attractive Wide-Moat Company in a Depressed Space We continue to believe that management's long-term guidance (provided at the last investor day) of 7%-10% annual growth is overly optimistic, entirely due to its more favorable stance on the challenging U.S. landscape, but we now think the market has more than priced in the actual downside. Our $69 fair value estimate is based on a discounted cash flow analysis.

We believe L Brands will return to 3%-4% revenue growth in the next two years, driven by improvements in beauty, comping swim and apparel exits, new product introductions, and online expansion (which we see moving to over 20% of sales in fiscal 2021 versus 16% currently), with operating margins remaining in the midteens thanks to the bralette mix shift and continued North America mall traffic pressure. Overall, we forecast 3% average annual revenue growth (on flat average store comp performance), 2% average annual operating income growth, and a five-year operating margin target of 15.9%. Although these are lofty goals--many apparel retailers possess operating margins in the low double digits or below--we think they are achievable, given the defensibility of the lingerie and beauty space. Supporting this notion, revenue declined only 5% in fiscal 2009 at L Brands and rebounded to 11% growth in fiscal 2010.

In 2017, we model a revenue decline of 1% and a 220-basis-point decline in operating margin to 14.0%. In go-forward categories, we see comp sales flat, with the exit of swim and apparel negatively affecting total company comparable sales by about 3-4 percentage points. The benefit of the 53rd week is assumed to be about $0.09 per share.

Our fair value estimate includes our assumption of a lower corporate tax rate (25%) through tax reform enacted in 2018, which contributes $6 to our fair value estimate. Our discounted cash flow model assumes an 8% cost of capital.