Wide-Moat L Brands Is Undervalued

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Second-quarter revenue grew 3% to $2.765 billion on comparable sales growth of 4%. Victoria's Secret comps were up 3%, in line with last year. Bath & Body Works' comparable sales grew 5% in the quarter, ahead of last year's 3% increase. As second-quarter earnings guidance was increased, we now expect operating margins to increase slightly from 14.1% in the prior year's second quarter, putting the company on track to deliver our estimated full-year 30-basis-point expansion to 17.4%. The company expects to report full second-quarter results Aug. 19, and we look forward to further insight from the subsequent conference call.

Growth Not Tapped Out Yet L Brands is the leader in the intimate apparel and beauty space, with strong brand assets yielding pricing power and brand loyalty--the basis for our wide moat rating. We think opportunities exist to drive mid-single-digit average annual revenue growth, including further North America growth, international expansion, new product introductions, and productivity improvements. We also believe that margins can further improve through scale, expense management, and inventory discipline. At the right price, L Brands offers investors the opportunity to own a leading company in remarkably uncrowded categories and one with a strong record of delivering shareholder returns and solid strategic execution.

Although L Brands has about 3,000 stores in North America, we do not think growth in this region is tapped out yet. More than 800 stores do not carry the full Victoria's Secret lingerie assortment, and more than 650 stores do not have the full Pink assortment. Adjacent categories including Victoria's Secret sport, loungewear/sleepwear, and swim are also likely to drive further square footage needs. Additionally, international markets are in the very early stages. The company has just over 300 Victoria's Secret and Bath & Body Works stores worldwide and only about 10 international company-owned stores. In the long run, we believe international opportunities will be key to driving sustainable growth as the North American market matures.

Historically, operating income growth has significantly outpaced sales growth, with adjusted sales up about 45% over the past five years and adjusted operating income up 132%. We see no reason why this trend won't persist. In addition to leveraging the selling, general, and administrative line, we also think franchise expansion will provide mix shift benefits and supply chain initiatives will result in improved full-price sell-through. On average, lead times have been reduced 50%, and we think there is an opportunity for a similar reduction in the future. As a result of these drivers, we think operating margins will increase to 20%-plus levels from the midteens and be competitive with those of fast-fashion retailers.

Brand Strength Digs a Wide Moat We believe the strong Victoria's Secret and Bath & Body Works brands can command relatively sustainable consistent pricing power. There is a limited amount of direct competition with Victoria's Secret's scale in women's lingerie retailing, with Gap's and Aerie's offering at a lower price point and brands like La Perla at a much higher price point. Similarly, Bath & Body Works has been able to maintain its lead over its nearest competitor, The Body Shop, and we don't see this changing. We think new entrants would be at a pricing disadvantage, given Victoria Secret's economy of scale advantages, lower cost of marketing thanks to word of mouth, massive well-positioned store fleet, and social media strength as well as all of the press surrounding the Victoria's Secret fashion show and the "Angels." 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. Our explicit model forecasts an average adjusted ROIC of 23% over a five-year time horizon.

Victoria's Secret and Bath & Body Works account for more than 90% of total L Brand sales, and both brands meet our threshold for a competitively differentiated intangible asset. Victoria's Secret is the number-one brand in dollar share for bras and panties. It has 3 of the top 10 fragrances in the United States in the form of Bombshell, Heavenly, and Tease. The Victoria's Secret fashion show is broadcast in more than 200 countries and has generated 45 billion measurable media impressions worldwide. Bath & Body Works generated more than 120 million transactions in 2014 and is the number-one brand in America for body lotion, shower gel, fragrance, liquid hand soap, hand sanitizer, its spa collection, and its aromatherapy collection. Strategic investments in brands have yielded a consistent improvement in ROIC, with 70% of capital expenditures invested in stores.

We think one of the most important metrics that reflects brand strength is gross margin, as this value conveys not only pricing strength but the ability to sell at full price. L Brands' gross margin averaged 42% over the last year, and we expect this to grow to 45% over the next five years on improved lead times. This is roughly in line with other high-quality companies, including narrow-moat Gap GPS (38% gross margin average over the past three years), no-moat Urban Outfitters URBN (36% gross margin average over the past three years), and wide-moat VF VFC (47% gross margin average over the past three years). Additionally, the company is gaining market share, with comparable-store sales growth averaging 4% over the past three years, well ahead of average women's clothing stores' retail growth of 2.7% and health- and personal-care growth of 3.0% (based on average retail sales growth reported by U.S. Census Bureau from January 2012 through November 2014).

We also believe the company has significant cost advantages versus its competitors. Investments in its supply chain have yielded impressive levels of inventory discipline. On average, lead times have been reduced by 50%, and we think there is an opportunity for a further similar reduction. The company has also developed capabilities in open to buy with in-season agility and test, read, react, and chase. We estimate an average dollar inventory turn of 3.9 in fiscal 2014 versus 2.1 at Hanesbrands HBI and 2.5 at Gildan GIL. All of these achievements probably support sales growth and margin expansion through reduced markdowns. Over the past five years, operating income grew 132% on 45% sales growth. During the same period, inventory increased only 2%. Cost advantages are apparent in industry-leading margins. With an operating margin averaging in the midteens over the past three years, it is close to the high-teens average of fast-fashion retailers and ahead of most its U.S. counterparts, including Gap at 12%, Urban Outfitters at 13%, and Abercrombie & Fitch ANF at 7%.

Pricing Power Offsets Some Risk In our opinion, L Brands faces all of the typical risks of consumer discretionary retailers, including unemployment levels, wage growth, increasing labor costs, low barriers to entry, and a global presence. Additionally, our forward estimates are based on selling, general, and administrative expense growing in line with sales and gross margin expanding on top-line leverage and decreased lead times. Therefore, there is an inherent risk that the cost structure increases more than expected, further changes to the supply chain are more difficult to achieve, or that consumer spending is lower than expected and the model faces less leverage. However, some of these risks are offset by the pricing power achieved through strong brands and exposure to the more resilient intimate and beauty categories.