On the heels of Gap’s February announcement that it would separate into two businesses, activist hedge fund and shareholder Barington Capital called for a similar move at L Brands (LB). While investors sent Gap shares up more than 20% on the news that Old Navy would be a stand-alone business, we think such a breakup could be even more favorable for L Brands, given the lucrative 20%-plus operating margins of its Bath & Body Works segment and the upside that two distinctly focused businesses could create. Old Navy’s same-store sales growth has already begun to slow and enterprise operating margin has contracted more than 500 basis points since 2013, a trend that might put such a transaction at risk. On the flip side, Bath & Body Works continues to ink topnotch same-store sales growth on a mature fleet, with an 8% increase in 2018 on top of a 2% rise in 2017 and every year postrecession reporting positive same-store sales and stable segment operating margins.
In our opinion, valuing Bath & Body Works as a stand-alone business would render an equity value per share of $35; this is higher than the market capitalization of the whole enterprise today, assuming 1% sales and 2% operating margin improvements over our base case in the consolidated model for each segment. In a $50 sum-of-the-parts valuation, this implies those holding Bath & Body would receive Victoria’s Secret shares worth $15 (including $4 in dissynergies split between the two businesses). Given that operating problems at Victoria’s Secret haven’t leaked into the Bath & Body business, we expect value creation from leadership that is solely focused on the lingerie business, while the team at Bath & Body could work to maximize cash flow and pay down debt. We still view L Brands as undervalued, trading at a 38% discount to our $42 fair value estimate, and we believe that equity value could be unlocked more quickly if the business were to split into two.
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Jaime Katz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.