L Brands' Spin-Off Could Prove Lucrative
We think the company's strength in fragrance more than offsets weakness in lingerie.
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.
Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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