L Brands' Spin-Off Could Prove Lucrative

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.

Narrowed Moat, but Healthy ROICs The degradation of the Victoria's Secret business was the basis for our L Brands moat rating downgrade to narrow from wide in 2018. While total sales at Victoria's Secret have increased 7% cumulatively over the last five years, profitability has waned, with segment operating margin declining to 7% in 2018 from 17% in 2013. As e-commerce has sprouted endless opportunities for competition, winning and losing brick-and-mortar retailers have become more apparent. For L Brands, results have been a mixed bag. While Victoria's Secret sales (56% of revenue) have languished due to proliferating competition in the lingerie business, Bath & Body Works (35% of revenue) has continued to connect with customers, conveying its value proposition across its omnichannel platform.

In our opinion, languishing sales and profitability at Victoria’s Secret has been the aggravating factor holding L Brands’ market valuation down, as failed merchandising efforts pressured the company’s gross margin. With the inability to take pricing at the Victoria’s Secret brand as easily as in the past, the adjusted enterprise gross margin deteriorated to 37.8% in 2018 from 42.8% in 2015. In our forecast for the combined business, we expect gross and operating margin performance to stabilize as efforts to right the ship take hold but fail to increase materially, given price competitiveness and transparency that has become even more pervasive in retailing.

While profitability has deteriorated in recent periods, over the last 10 years L Brands has had a fairly durable gross margin (35% in 2009 versus 38% in 2018), highlighting its ability to maintain price over an economic cycle and drive traffic through a number of fashion cycles. We expect the long-term gross margin could remain stable in the high 30s for a multitude of reasons. First, we believe a mix shift will benefit the gross margin line as bralettes fade in favor and more women return to purchasing higher-margin structured bras--and Victoria’s Secret begins to incorporate products addressing such trends into its lineup. However, Victoria’s Secret has also begun to introduce its own lineup of unstructured bras to allow it to play the current trend. Second, we anticipate L Brands will embrace a higher proportion of e-commerce sales, providing wider reach and improved visibility to consumers and further stability to the operating margin. We forecast e-commerce sales rising to 25% of total sales in 2023 from an estimated 21% in 2020. Finally, we believe these gains will be offset by investments to support its competitive position (including advertising and promotions), with elevated selling, general, and administrative expenses at 27% of sales, above the 25% average over the past five years. All these impacts translate into a five-year explicit forecast of 5% operating margins for the segment.

L Brands’ lingerie segment has undergone a litany of business and management changes in recent years. And while not all steps taken have been proper, as evidenced by the resumption of swim product offerings in 2019, we still commend the team for attempting to determine what changes might work best to drive rising profitability at the brand and adjusting as its gains more insights.

Victoria’s Secret now has a leader who has experience with luxury brands, with John Mehas replacing Jan Singer in November 2018. We expect that Mehas, the former president at Tory Burch, will continue to position the Victoria’s Secret brand as premium and aspirational (something the Tory Burch brand does very well), and that we probably won’t see much in merchandising benefits until the third quarter, given the lead time required to bring product from design to delivery. While Singer had equally good experience, coming from Nike and Spanx, efforts to engage the consumer were failing under her leadership.

Weak pricing strategies from the lack of product relevance were evident in monthly commentaries from sales releases while Singer was running the segment. Victoria’s Secret has historically had a disproportionate weighting on the overall enterprise merchandise margin at L Brands. Over the last 12 months reported, Victoria’s Secret had been unable to achieve positive merchandise margin improvement in any single period, weighing on the total company average. On the flip side, over the same time frame, Bath & Body Works had bolted together nine periods of flat to higher merchandise margins, implying that product innovation at the fragrance brand is continuing to resonate with consumers.

The merchandise margin weakness hasn’t been surprising, given Victoria’s Secret’s lumpy same-store sales performance recently. The brand hasn’t been able to post positive same-store sales growth since the second quarter of 2016, representing 11 consecutive quarters of same-store sales declines. Given that the Victoria’s Secret segment represents more than half of the company’s revenue but around one third of the profit, this has acted as a drag on overall profitability, the stock price, and the outlook for the business. However, we believe that with proper merchandising the segment has the ability to sustain positive same-store sales growth, having reported more than four years of quarterly increases between 2012 and 2016. Given the company’s sustained leadership position in its categories and the fresh leadership perspective at Victoria’s Secret and Pink, we think the likelihood of refreshed merchandising tactics is rising. However, given the persistent struggles in merchandising, our existing long-term forecast is for just 1% same-store sales growth, as we account for the competitive landscape.

More important, we think Victoria’s Secret’s impact on the total enterprise could be changing, as Bath & Body Works grows faster and composes a larger part of the total sales and profit mix. The Victoria’s Secret segment represented 56% of the company’s revenue in 2018, down from 64% in 2013. With recent trends focusing on comfort and body positivity, smaller niche and nascent brands have been able to capitalize on new marketing opportunities to win share of the intimates and apparel category, stalling Victoria’s Secret top-line growth. But as Victoria’s Secret has shrunk as a percentage of total enterprise sales, Bath & Body Works has become a more significant contributor to the mix, a trend we expect will persist. While Bath & Body Works represented just 29% of sales in 2013, it made up 35% of sales in 2018, and we forecast it will be more than 40% of sales in 2023 (when Victoria’s Secret accounts for about 50% of sales). This alone should offer some natural operating margin lift, given the higher profit contribution of each Bath & Body sale.

Bath & Body Works is now the leading contributor to profit at L Brands, generating 75% of total operating profit (including international and other segments), and we expect it will continue to generate the majority share of profitability over the next five years. We forecast Bath & Body to represent about 70% of operating profit in 2023, even with gains from efforts at Victoria’s Secret to right the ship and stabilize its own segment operating profit.

We anticipate that even with modest operating margin expansion at Victoria’s Secret, the segment is only likely to generate high-single-digit operating margins over time, around the 7% it obtained in 2018 but still below the high teens it captured earlier in the decade.

While Victoria’s Secret margins have compressed, we don’t believe that Bath & Body Works will succumb to the same pressures. We think 19% average operating margins are sustainable for Bath & Body Works, as monthly sales commentaries and results offer support that the segment is not struggling to the same degree as Victoria’s Secret or weighing down profitability to the same magnitude. As long as Bath & Body Works continues to bring out new, innovative products (we estimate the floor sets change every four to six weeks), we think demand and pricing should hold up. Many consumers can feel compelled to stock up on their favorite fragrances, which may not resurface at the brand for a full year, making the perpetual resetting of the floor imperative to convey the appearance of scarcity to consumers who like particular offerings.

Furthermore, we believe the fragrance retailer is better connecting with consumer demands, as evidenced by the stability of merchandise margin increases over the last year. Over the past seven fiscal years, Bath & Body has generated average same-store sales of 4%, allowing for easy leverage of expense metrics; it delivered only two quarters of negative performance--a 1% shortfall caused by a merchandising/demand mismatch. When we look across the mall retailer universe, data supports Bath & Body’s success; anchor store same-store sales have struggled, with Macy’s averaging 1% declines and Nordstrom 1% increases, while companies like Gap (1% average shortfalls) and Tapestry (7% declines) have similarly suffered from less impactful merchandise choices over the last five years.

Healthy same-store sales performance implies that Bath & Body Works has remained a leading brand in North America for three-wick candles, fragrance diffusers for the home, moisturizers, fine fragrance mist, shower gel, hand sanitizer, and liquid hand soap. We think this business should capture low-single-digit same-store sales growth ahead, as it remains somewhat more defensible from e-commerce competitors, given that scented products are more difficult to sell online, unless on a replenishment basis. Bath & Body Works has been able to maintain its lead over its nearest competitor, The Body Shop, and we do not see evidence of this trend changing. For reference, The Body Shop had less than $450 million in revenue in 2017, and we estimate a single-digit operating margin for the brand, materially below the $4.6 billion in revenue and 20%-plus operating margin for Bath & Body Works.

L Brands’ profitability has not always suffered as it has in recent years, and we think some of the benefits the company has reaped over the years has stemmed from CEO Les Wexner’s ability to spot trends early. The company wisely moved away from its namesake business in 2007, before the recession and before e-commerce became the sizable threat it is today regarding substitute goods for apparel sellers. Even before that, the company trimmed its exposure to the apparel businesses under its umbrella, a category that has seen significant sales and margin deceleration as lower-price-point, faster-merchandise-turn competitors (like Zara and H&M) have entered the category domestically. For reference, Abercrombie & Fitch has delivered a sales decline of 13% and Express has generated a 5% sales decline cumulatively, while Victoria’s Secret sales have risen 7% and Bath & Body Works’ revenue has increased 49% over the past five years.

Tactical divestitures from the corporate portfolio allowed L Brands to generate returns on invested capital above its cost of capital (at a five-year average of 24% versus 8%), which it has been able to maintain despite the downdraft in profitability over the last few years. These ROIC results help support our thesis that the brand intangible asset--a pillar of our narrow moat rating--that L Brands has developed over the past few decades still has value, even with these headwinds. Victoria’s Secret and Bath & Body Works now account for all of L Brands’ sales, and both meet our threshold for a competitively differentiated intangible asset. 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%). In addition, it is the number-one millennial brand and fashion brand worldwide on Facebook, Twitter, and Instagram (according to the company’s 2018 investor relations slide deck), and it has 4 of the top 10 fragrances in the United States.

Breaking Up L Brands' Businesses Makes Strategic Sense With Gap announcing the spin-off of its better-performing Old Navy brand, we think a breakup of L Brands warrants evaluation, given the disparity in performance between L Brands' two key segments, Victoria's Secret (56% of sales and 7% operating margin in 2018) and Bath & Body Works (35% of sales and 23% operating margin).

The rationale for breaking a business into multiple parts can vary, but we think the four factors Gap highlighted also hold weight for L Brands. First, it creates two independent companies, each with its own focus and operating structure. With the stark differences in operating performance, it seems that the operating focus of Victoria’s Secret and Bath & Body Works should be different.

Second, Gap expects the breakup to enable each business to extract efficiencies from independent models (via new strategic initiatives), plans to grow (assess better ways to market and address the core customer), and customer cohorts (reach a wider audience). While we suspect there’s some overlap between the customer base at Victoria’s Secret and Bath & Body Works, given the predominantly female purchaser profile, we believe Bath & Body has significantly broader reach across all consumers, while Victoria’s Secret’s focus on young women (teens, early 20s) at Pink and young adults (20-40 years of age) at the namesake brand offers a significantly more narrow reach, particularly with limited sizes in some product categories. If Victoria’s Secret could focus on its niche demographic to better ascertain changing trends and customer needs to take further share, we believe operating margins would more easily rise. For Bath & Body, given a product line that can fit consumers of all types, building awareness (through targeted marketing campaigns of underpenetrated consumer bases) and expanding adjacent product lines could penetrate an even broader set of buyers than currently exist.

Third, Gap noted that breaking Old Navy off would result in different financial profiles and permit specific operating priorities and capital-allocation opportunities. For L Brands, we think this is where a breakup would be more complex, given the significant leverage on its balance sheet (nearly $6 billion) and the debt service that it requires (more than $300 million per year, versus operating income of around $500 million at Victoria’s Secret and $1 billion at Bath & Body Works). We expect some form of recapitalization could occur in a breakup of L Brands, which could possibly offer rates that are lower than on existing notes (which average more than 6%) or bring incremental equity onto the balance sheet, which could also help pay down some of the company’s pricier notes as they come due, with any remaining cash flow being reinvested in the respective brands. For reference, the company reduced its dividend in 2018 to $1.20 from $2.40 to provide further financial flexibility, freeing up about $300 million and leaving it offering a nearly 4.5% dividend yield.

L Brands already has a significantly higher debt/adjusted EBITDA metric than most of its competing mall retailers (at nearly 3 times at year-end), as many of these businesses run on a high operating lease, asset-light model, which ameliorates the need to carry high levels of debt. We’d expect the debt to be split accordingly by earnings power in a breakup, with more than half of the notes going to Bath & Body Works to maintain compliance with existing covenants and the remainder going to Victoria’s Secret. While we don’t explicitly value the international segment or the other segment (which has been shuttered and included La Senza and Henri Bendel) specifically in this analysis given the negligible impact on operating income, we’d expect they would most likely sit in the new Victoria’s Secret company.

Finally, Gap said the two separate companies could create value for customers and shareholders and provide incremental opportunities for employees within the organization. We agree with this as we would expect it would be a result of a more laser-focused business with double the opportunities for workers to ascend within each business. Overall, we think the logic behind Gap’s split works similarly for a breakup of L Brands. We support the concept as feasible and attractive, given the levels at which Victoria’s Secret and Bath & Body Works are operating today.

Spin-Off's Attractiveness Depends on Customer Traction and Cost Leverage Breaking up a business can lead to a jump in valuation, with companies generally experiencing a 6%-12% conglomerate discount historically relative to their stand-alone peers. Furthermore, a study published in the Journal of Financial Economics found a 13%-15% average value loss from diversification between 1986 and 1991. The Edge Consulting and Deloitte (2014) found that since 2000, spin-offs have generated 10 times the average gains of the MSCI World Index over the first 12 months after spin-off, with the parent company also outperforming the benchmark. These points warrant a look at what a sum-of-the-parts valuation might be for L Brands.

In our initial exercise, a breakup wouldn’t necessarily benefit the company, offering a valuation higher than the current market but lower than our combined enterprise value in a sum-of-the-parts analysis. Our initial sum-of-the-parts discounted cash flow model determined the valuation of the two companies independently, assuming the segments would perform similarly under a consolidated or independent scenario. We included historical revenue by brand and used our forward estimates for each segment on the revenue line. Similarly, we added our existing operating margin forecast to each independent brand outlook, with Victoria’s Secret averaging 6% and Bath & Body averaging 19% over the next decade. For capital expenditures and depreciation, we have allocated around 60% to Victoria’s Secret and 40% to Bath & Body, given the historical breakdown of those line items. For items such as working capital categories, which the company does not allocate between segments in its annual filing, we allocated the line items by the contribution of each segment to total sales.

For Victoria’s Secret, our sum-of-the-parts discounted cash flow model shows the segment worth about $7 per share as a stand-alone business. This valuation includes a narrow moat rating, a weighted average cost of capital of 8%, a return on new invested capital of 30%, and a stage 2 EBI growth rate of 3.5%, which are lower than the enterprise metrics of 35% and 4%, respectively. With about $1.8 billion, or one third, of the debt load allocated to the segment, the value of the common equity runs at about $2.5 billion. For Bath & Body Works, we arrived at a segment valued at around $26 per share. This segment valuation also includes a narrow moat rating, a weighted average cost of capital of 8%, a return on new invested capital of 40%, and a stage 2 EBI growth rate of 6%, higher than the enterprise levels of 40% and 4%, respectively. We assigned a greater proportion (around two thirds) of the existing debt load to Bath & Body, given the higher level of operating margin it generates, at about $3.9 billion. In our opinion, a corporate breakup without a plan for material operating improvement would not be competitive, and we’d prefer the two brands remain together.

However, we don’t believe that the company would pursue a breakup without a plan to improve the operating performance and merchandising prowess of each segment. We reran the above exercise with modest improvement in sales and operating margin and concluded that a spin-off of Bath & Body would then be accretive to existing shareholders. In this scenario, Victoria’s Secret and Bath & Body Works are able to focus on their own strategic innovation goals, leading to products that improve our existing growth rates for those businesses to 2% and 5%, respectively, on average as demand responds positively to new offerings. Here, we have terminal operating margin results that are 200 basis points higher than in our combined discounted cash flow model, with Victoria’s Secret around 10% and Bath & Body Works around 20% in 2028. In this case of a spin-off with improving profitability, Victoria’s Secret is worth about $15 per share (with $2 of dissynergies included). For Bath & Body Works in the same case, we arrived at a segment valued at around $35 per share (with $2 of dissynergies included).

We included about $4 in dissynergies in the breakup of the businesses (which, for simplicity’s purpose, we allocated by percentage of revenue between the two businesses) as some shared services would have to be replicated at one of the stand-alone companies. This represents around 2% of the $3 billion in selling, general, and administrative costs the company bills annually. Given that many of the sourcing products are different between Victoria’s Secret and Bath & Body Works (outside of the beauty category at Victoria’s Secret), we don’t believe that the negotiating leverage together will be materially different than the scale apart. Altogether, these three pieces of the business (Victoria’s Secret, Bath & Body Works, and dissynergies) lead us to a sum-of-the-parts valuation of around $50, which is above the $42 valuation offered by our discounted cash flow model. In this case, we’d prefer the company to break up, given that the intrinsic value of the two businesses would be higher apart, with a high teens premium to our existing fair value estimate, which already offers 60% upside to the current market valuation.

Even Without a Split, L Brands' Shares Are Compelling We are standing by our fair value estimate of $42 per share for the underlying business for now, given the uncertainty as to whether management will ultimately pursue a breakup. We meaningfully decreased our fair value estimate in 2018 (from $60) after reconsidering certain industry issues. First, with increased competition and Victoria's Secret using more promotions to drive traffic, we lowered our long-term gross margin assumption to 38% from 40%. Second, we downgraded the company's economic moat rating to narrow from wide, which reduced the duration of our stage 2 fade from 10 to 5 years (bringing the company to its steady-state earnings before interest). The gross margin adjustment accounted for about two thirds of the valuation change, while the moat change represented approximately one third. Our discounted cash flow model assumes an 8% cost of capital.

We believe L Brands can deliver 3%-4% average revenue growth over the next five years (beyond 2019, which is weighed down by the closure of Henri Bendel and the sale of La Senza), driven by continued strength at Bath & Body Works and expansion internationally (specifically in China) and online, with operating margins that average 10.5%, given continued investment in stores, the bralette mix shift, and North America mall exposure. Overall, our 10-year forecast for 3% average annual revenue growth is held down by 1% average comp performance, leading to mid-single-digit average annual operating income growth (post-2019) and a terminal operating margin target of 11%.

In 2019, we model a 1% revenue decline and a 60-basis-point decline in operating margin to 10.3% (the trough margin of our forward outlook) for the consolidated business. We see 1% comp-store sales, as we see struggles at Pink and continued promotional activity failing to alleviate as Victoria’s Secret attempts to right the ship, pressuring average unit retail.

We consider that much of our forecast includes a business as usual scenario for L Brands, with Victoria’s Secret slowly turning around, but we believe there are a few issues that could go better than we expect, surprising us on the upside from our steady state forecast. The primary gains L Brands could capture stem from the store base. First, we think as leases come due, L Brands could extract economic rents from rental contract renewals. Second, the company could prune the store base, shuttering underperforming locations. Third, these efforts together could help lower capital expenditures, freeing capital for incremental brand investment.

First, as store closures in the U.S. have escalated, retailers are in a solid negotiating position to request concessions from mall operators. Coresight Research noted more than 8,000 store closures in 2017 and 5,000 closures in 2018, leaving landlords in a less favorable position to hold rental pricing firm, given the rising vacancies. In turn, companies are extracting better economics from landlords. For example, RH now has some landlords financing 60%-100% of its leasehold improvements on certain locations, freeing up more cash flow to reinvest in its business and return to shareholders. We believe the mall operators will be amenable to such concessions for brands that drive foot traffic to their brick-and-mortar locations and expect L Brands will be a beneficiary. Any gains on rental concessions should benefit profitability, despite partial benefits in lower rent expense being reinvested in innovation at both brands.

Second, the company could decide to prune its store base, shuttering underperforming locations while keeping premier locations in operation. Given the higher productivity at remaining locations we’d anticipate with such a change, there should be a natural lift to operating margins as the mix of the fleet changes. Lower revenue from fewer stores should theoretically be more than offset by higher profitability of the remaining fleet. We think Victoria’s Secret is probably overstored in the U.S., with 957 locations at the end of fiscal 2018. Other longtime mall retailers have been closing stores to maximize the return of their fleet in recent years; for example, Macy’s shuttered nearly 150 of its Macy’s and Bloomingdale's locations between fiscal 2013 and fiscal 2018, reducing its count by 18%, while North America Gap locations went to 758 stores from 968 over the same period, a 22% reduction. We think that Victoria’s Secret could similarly shutter nearly 100 of its stores at natural lease expiration over the next few years, assuming around 10% of leases come due annually and the company renews leases in the half of the fleet staged in A and B malls, allowing it to benefit from higher productivity fleet mix.

Closing underperforming locations would help lower capital expenditures over time, freeing up capital to further reinvest into product innovation, marketing, and brand support, efforts that would fortify our narrow moat rating. L Brands still spends a significant proportion of its capital expenditures on its store base, which has left it slow to adapt to the changing industry dynamic relative to smaller, nimbler foes. In recent years, as much as 85% of L Brands’ spending was allocated to its store base, both opening new stores and remodeling its existing base. Even a 10% reduction in capital expenditures offset by half of the lower costs reallocated to higher marketing expenses would lead to no change in our intrinsic value.

Even on a multiples basis, L Brands’ shares appear compelling. Over the past 10 years, the company has traded at an 8.5 times average enterprise value/trailing 12-month multiple. The last time the shares traded at the existing multiple (about 7.8 times) was exiting the recession nearly a decade ago. Postrecession, the shares moved up to 12 times EV/TTM EBITDA before trending back down to current levels. At 7.8 times, L Brands’ shares remain at a more than 8% discount to the 10-year average of the multiple.

Assessing the company by sum of the parts (with the assumption that a performance improvement plan is undertaken if the company pursues a spin-off), discounted cash flow, or EV/EBITDA implies that L Brands’ shares remain undervalued and at an attractive discount to our valuation. We think the linchpin for sentiment turning around on the investment thesis will be Victoria’s Secret brand--which generates around one third of the company’s profits--stabilizing. We believe that with the resumption of swim and the introduction of less structured bras in stores already, the brand is attempting to cater to the demands of its core consumer. Rebuilding brand goodwill and awareness of the changes that it is making are the remaining factors that could bring Victoria’s Secret back into favorability with its target market.