Analyst Note 07/27/2018
After taking a fresh look at L Brands, we are adjusting our moat rating to narrow from wide and reducing our fair value estimate to $43.50 (from $60 previously), incorporating an outlook that has sales growth returning to the 3%-4% range, but pricing headwinds that will keep gross margins in the high-30% range over time, crimping profitability.
Our more pessimistic view stems from the increased competition in the intimates and apparel industry, driving the rising need for L Brands to use promotions and discounts to drive traffic. These two factors do not give us confidence that excess economic returns can persist over the 20 years required for a wide moat rating. Recent trends focusing on comfort and body positivity have allowed smaller niche and nascent brands (American Eagle’s Aerie, for example) to capitalize on new marketing opportunities to win share of the intimates and apparel category, hindering L Brands’ ability to take pricing as easily as in the past. Deteriorating gross margin (from 42.8% in 2015 to 39.3% in 2017) supports this thesis.
However, we still see value in L Brands’ intangible assets. Victoria’s Secret is the number-one brand in dollar share for bras and panties, and it has four of the top 10 fragrances in the U.S. Furthermore, we surmise new entrants will be at a pricing disadvantage due to Victoria’s Secret’s economy of scale advantages and word-of-mouth marketing, especially regarding the press surrounding the VS fashion show (which is broadcast in nearly 200 countries and generates 100 billion in measurable media impressions). Additionally, North American Bath & Body Works performance hasn’t faltered. It is the number-one 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, generating 130 million transactions in 2016. Given this success, the segment was able to earn an EBIT margin exceeding 23% in 2017.
Investment Thesis 07/27/2018
We recently lowered our moat rating for L Brands to narrow from wide, as recent consumer trends have opened the door for competition to materialize. These recent increases in competition have tempered our forecasts for gross and operating margin potential (averaging 38% and 11% over the next decade versus 39% and 14% in 2017), as we expect L Brands to drive in-store traffic with pricing and promotion in future periods. In our opinion, the firm’s economic moat stems from its brand intangible asset in an industry characterized by prioritization of quality and fit, along with a rising global awareness that has the ability to continue expanding as the company perpetuates its footprint growth overseas (we believe the firm has a good long-run growth opportunity in China). In the near term, we see multiple catalysts for an inflection point in sales and margin performance with discontinued categories being comped, bralette penetration likely stabilizing, Victoria’s Secret Beauty improving, and new structured bra introductions.
L Brands believes it can sustain mid-single-digit annual growth driven by low-single-digit North America comp-store growth, flat to low-single-digit North America square-footage growth, mid- to high-teen direct sales growth, and low- to mid-20s international growth. Our outlook is slightly more tepid, calling for 0%-1% comps and less than 4% top-line growth. Additionally, management still plans to invest in expanding the store base, which concerns us, particularly since the company still has material exposure to B and C malls (50% of locations). We acknowledge that 99% of the store fleet is cash flow positive on an aftertax cash basis and that the company has flexibility with leases, given co-tenancy and occupancy changes. However, as more of L Brands’ own sales shift online and as mall traffic is likely to further suffer as online players gain share, we think store profitability could be pressured in the long run. This is reflected in our estimates calling for operating margins to continue falling to 11% over the next three years versus a 16% adjusted three-year historical average.
Economic Moat 07/27/2018
We are changing our moat rating to narrow from wide for L Brands. While we still believe the strong brands of Victoria’s Secret and Bath & Body Works command relative pricing power, the evolving industry competitive dynamics do not give us confidence these returns can persist over the next 20 years. Our change of opinion surrounds the Victoria’s Secret segment of the business, which represented nearly 60% of the company’s revenue in 2017. Recent trends focusing on comfort and body positivity have allowed smaller niche and nascent brands (American Eagle’s Aerie, for example) to capitalize on new marketing opportunities to win share of the intimates and apparel category, hindering L Brands’ ability to take pricing as easily as in the past. Deteriorating gross margin (to 39.3% in 2017 from 42.8% in 2015) supports this thesis, indicating the firm’s pricing power has come under pressure.
While we contend most of L Brands’ margin pressure is from the mix shift due to the increased demand for bralettes (typically a much lower average unit retail compared with a more structured bra), L Brands has needed to utilize storewide discounts to drive traffic, as seen in the recent extension of its semi-annual sale in Spring 2018 (exacerbating the pressure on merchandise margins), further warranting our concern about the sustainability of the firm’s ability to generate returns on invested capital in excess of the weighted average cost of capital, or WACC, over a 20 year horizon. Research (as cited by Hanesbrands) shows that comfort, fit, and consistency are valued more than price by consumers in undergarments. This puts Victoria’s Secret (with price points of $34.50-$54.50) in a difficult spot to materially expand its market share position, given the influx of competition, with higher-priced bras from Soma ($40-$80) most likely to win customers on fit, while value-conscious consumers can look to Aerie ($11.50-$30).
Compounding its gross margin headwinds, L Brands still spends a significant proportion of its capital expenditures on its store base, which we believe has left it slow to adapt to the changing industry dynamic relative to smaller, nimbler foes, and could put it at risk of further profit degradation. In 2017, approximately 85% of L Brands’ spend was allocated towards its store base, both opening new stores and remodeling its existing base. This runs in contrast to peers. For example, Aerie operates 225 domestic locations compared with Victoria Secret/Pink’s U.S. base of 1,124 stores, which has allowed Aerie to capitalize on consumer preference trends and grow at a rate (approximately 30% in 2017) far greater than the low to midsingle digits chalked up by VS/Pink. Further, an Accenture study noted that in fashion apparel, online or direct-to-consumer sales have a gross margin rate 10% higher than physical store sales. L Brands’ business model supports this thesis, with Victoria’s Secret’s e-commerce business delivering a 20% operating margin, compared with the total Victoria’s Secret segment margin of around 13%.
However, even with these headwinds, we believe that the brand intangible asset L Brands has developed over the past few decades still has value. Victoria’s Secret and Bath & Body Works account for over 90% of total L Brands sales, and both brands meet our threshold for a competitively differentiated intangible asset. 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%). In addition, it is the number-one millennial brand and fashion brand worldwide on Facebook, Twitter, and Instagram, and it has four of the top 10 fragrances in the U.S. in the form of Bombshell, Heavenly, Very Sexy, and Tease.
Furthermore, we surmise new entrants will be at a pricing disadvantage due to Victoria’s Secret’s economy of scale advantages and word of mouth marketing, especially in light of all of the press surrounding the Victoria’s Secret fashion show (which is broadcast in nearly 200 countries and generates 100 billion in measurable media impressions) and the “Angels.” Additionally, at $1,400 of sales per square foot, Pink is a leader in productivity among teen retailers, further supporting our narrow moat argument. We estimate that Abercrombie & Fitch, Hollister, American Eagle, 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 sales per square foot of $626.
Additionally, North American Bath & Body Works performance (33% of fiscal 2017 sales and 55% of EBIT) hasn’t faltered. Bath & Body Works is the number-one 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, generating 130 million transactions in 2016. Through this success, the business was able to earn an EBIT margin of 23% in 2017. We also contend this business is more defensible against the e-commerce threat, as scented products are more difficult to sell online, unless on a replenishment basis. Highlighting this advantage, Bath & Body Works has maintained its lead over its nearest competitor, The Body Shop, and we do not see evidence of this trend changing. In this vein, The Body Shop’s sales fell by 5% and operating profit fell by 38% in 2016, placing its 4% operating margin materially below the mid-20s margin touted by Bath & Body Works.
Finally, we believe returns on invested capital will outpace our 8% weighted average cost of capital over a 10-year period. Our model forecasts an average adjusted ROIC of 16% during a five-year time horizon, supporting our contention that its brand intangible asset should remain intact. Additionally, even in our bear case scenario, we estimate L Brands will still be able to earn an economic profit, with an average adjusted ROIC of 14.5% over a five-year forecast.
We are lowering our fair value estimate to $43.50 from $60 per share. This change is driven primarily by two factors: First, with increased competition in the industry and Victoria’s Secret utilizing more promotions to drive traffic, we have lowered our long-term gross margin assumption to 38% versus 40% previously; and second, our recent rerating of the company’s economic moat to narrow from wide reduced the duration of our stage two fade from 10 to five years. The gross margin adjustment accounts for about two thirds of the valuation change, while the moat change represents approximately one third. Our discounted cash flow model assumes an 8% cost of capital. We still believe L Brands will return to 3%-4% revenue growth in the next two years, driven by continued strength at Bath and Body Works and expansion internationally (specifically in China) and online, with operating margins around 11% (versus a high-teens management goal), given continued investment in stores, the bralette mix shift, and North America mall exposure. Overall, we forecast 3.5% average annual revenue growth (on negative 1% average comp performance), modest average annual operating income growth (after 2018), and a five-year operating margin target of 11%. In 2018, we model 2% revenue growth and a 240-basis-point decline in adjusted operating margin to 11.3%. We see comp sales declining in the low single digits (below guidance for low-single-digit growth), as we see struggles at Pink and continuing promotional activity pressuring average unit retail.
In our opinion, L Brands faces all of the typical risks of consumer discretionary retailers, including unemployment levels, wage growth, increasing labor and freight costs, low barriers to entry, and a global presence. Changes such as the possibility of trade renegotiations could hurt both top-line growth and margins. Additionally, our forward estimates are based on selling, general, and administrative expenses leveling as a percentage of sales and gross margin expanding on merchandise margin, 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, pricing power diminishes, or that consumer spending is lower than expected and the model faces less leverage. Brand positioning makes this a premium expenditure targeted at a young demographic, yielding risk that consumers may trade down in an economic downturn. 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. Finally, there is risk in CEO succession, with no potential successor having Leslie Wexner’s depth of retailing knowledge and experience.
We are maintaining L Brands’ Standard stewardship rating. Leslie Wexner has been CEO since he founded the company in 1963 and has been chairman of the board for more than 50 years. We think he has had an impressive record running the company, with decisions to shed fashion brands such as Express and The Limited and to buy Victoria’s Secret contributing to strong top-line growth and corresponding margins. He is also the largest stockholder of the company (through personal holdings and trusts giving him almost 17% of class), which we think well aligns his interest to other shareholders. Wexner earned a total compensation package of $5.7 million in 2017, down significantly from $14.8 million in the year prior. We think this package is well aligned with those of other apparel retail CEO packages and adequately reflects performance. In 2017, total shareholder return was down 15% and CEO pay was down 61%, indicating that performance-based compensation for L Brands is a focus. The board has 12 members, eight of whom are independent, with three-year staggered terms.
Overall, we think management has done an excellent job maximizing shareholder returns. The dividend payout ratio reached 70% in 2017, which we think shows a high commitment to returning excess cash to shareholders.
L Brands is a women’s intimate, personal care, and beauty retailer operating under the Victoria’s Secret, Pink, Bath & Body Works, La Senza, and Henri Bendel brands. The company generates the majority of its business in North America, with only about 4% of sales coming from international markets in fiscal 2017. Distribution channels include about 3,070 stores and online.