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Short Case on L Brands – Published March 2017

L Brands (LB)

L Brands (ticker LB) is the owner and operator of Victoria’s Secret and Bath & Body Works. Other businesses account for less than 5% of revenue and no operating profit so will not be addressed here. Victoria’s Secret is now about 60% of the $13B US lingerie industry. Bath & Body Works sells candles, soaps, and other bath products. Both brands are primarily mall-based.

Investors who short stocks love to find evidence of management malfeasance or accounting chicanery. We have no reason to take issue with L Brands management or the company accounting. We believe the company is caught on the wrong end of several larger trends.

Declining Mall Traffic:
Most Victoria’s Secret and Bath & Body Works locations are in malls, and mall traffic has been weak. While overall holiday retail sales last season were up a little, online sales have been taking share from physical locations and leading to decreased mall traffic. Several teen retailers have declared bankruptcy (Pacific Sunwear, Delia’s, Aeropostale, Quicksilver, and Wet Seal). Mall anchors are closing stores (Macy’s, Sears, and J.C. Penney). And earnings estimates for mall REITS have been decreasing (CBL & Associates, The Macerich Company, Pennsylvania Real Estate Investment Trust, and Taubman Centers).

Shift from Underwire Bras to Bralettes:
More than anything else, this is the key issue. The typical underwire bra is a complicated garment. Many designers take specific courses to learn to design them and due to the level of complication and number of parts, bras can’t be machine-produced. For many years, Victoria’s Secret has been the leading seller in this market and is well-known for its structured push-up and other cleavage-enhancing bras. The market has been trending away from complicated support garments and towards bralettes. Bralettes are more casual less structured garments that don’t include an underwire. Something that looks more like a sports bra or a tightly fitted cropped t-shirt with a little elastic support would be examples.

Victoria’s Secret is facing two problems due to the shift to bralettes. First, bralettes are sold at a much lower price point than typical bras. While you can find bras at almost any price point, Victoria’s Secret tended to sell a lot in the $50 – $60 range. Bralettes are closer to a $20 item, and American Eagle’s Aerie has sold at $15 several times. Victoria’s Secret tried to sell bralettes at $25 – $30, but eventually gave up and went to $20 pricing. A recent sale lowered the unit price to $12.50 (2 for $25).

The second issue is that bralettes are easy to produce and fit. They can be made by machine, and are sold in small, medium, large sizing. Simplified construction and sizing means more competition. Traditional competitors are selling bralettes at lower prices including Maidenform at $12 and Calvin Klein at $9 – $21. New competitors like Aerie are taking share. Of even greater concern is that Amazon is about to start selling bralettes at less than $10 under its Iris & Lilly brand. The easy sizing decisions for bralettes vs bras is a big help for online sales as it removes many fitting complications requiring a trip to a physical store.

Changing Social Sensibilities:
Sometimes what a company does to become successful can become a hindrance later. We saw this a few years ago with Abercrombie & Fitch. The company built a brand name as something the “cool” kids would wear. Mike Jefferies, the CEO, talked about how the brand was for attractive people, and how the company wouldn’t make clothing in large sizes because he didn’t want to see out-of-shape people in Abercrombie clothing. It worked for a long time, and then all of a sudden, it seemed out of step. Publicly, the company began to look like a body-shaming bully. Sales plummeted.

Victoria’s Secret grew to 60% market share by defining sexy. The company featured beautiful models with perfect bodies that were made more perfect in photographic advertisements by airbrushing. The annual fashion show became a big televised event, and the models became celebrities and were marketed as “Angels”. Like Abercrombie, it worked beautifully, but we’re now seeing a counter-trend.

Dove soap is advertising “real beauty” and featuring models with a variety of body types. The company is encouraging women to stop feeling body-related anxiety. Lane Bryant is aggressively taking direct aim at Victoria’s Secret by running ads featuring larger women in their underwear with the tag line “We’re No Angels”. Aerie is successfully connecting with a younger generation by telling them that they’re attractive as they are and promising not to airbrush modeling photos.

Abercrombie succeeded in selling a lot of clothing at high margins by branding themselves as cool. Victoria’s Secret dominated the lingerie market by defining sexy as perfection. These approaches worked for a long time, but when public sensibilities change, the upstarts took aim at the leaders.

We’ve heard from the mothers of teenage girls, and it makes the significance of this trend clear. While these mothers hesitate to take their daughters shopping at Victoria’s Secret which focuses on sex-appeal or its younger brand Pink, they feel more comfortable taking their girls to Aerie which seems more casual, clean-cut, sporty, and less sexy. It won’t take many more years of that before Victoria’s Secret becomes the brand that “older” women wear. That’s not the branding you want when trying to sell lingerie.

Price Reductions and Competition:
We’ve already noted that not only is bralette pricing below bra pricing; but also, that Victoria’s Secret has taken pricing on bralettes down from almost $30 to $12.50. For years, Victoria’s Secret took price increases on bundles of 5 or 7 panties. Pricing had gone from $25 to $28 over the last 6 years. Those gains stopped in the 4th quarter last year when the price of the bundle fell from $28 to $27.50. Pricing just ticked back up to $28 on the website, but selling core merchandise at lower prices during the holiday season wasn’t an encouraging sign. The Victoria’s Secret brand for younger women, Pink, prices its panties and bralettes about the same as Victoria’s Secret.

We expect the recent price cut won’t be the last one. While pricing on individual items will vary, in general, Aerie, Maidenform, Calvin Klein, Gap Body, and Urban Outfitters sell at lower prices than Victoria’s Secret. In general Soma is higher priced, but with increasing low-priced competition and Amazon entering the market with a discount digital brand, there won’t be much of a pricing umbrella in this segment of the market.

How Has This Affected the Financials?
We’ve outlined the competitive pressures facing Victoria’s Secret, and it’s starting to show in the numbers. Same store sales fell from 5% in fiscal 2015 to -1% last year, and have been negative for the last 6 months. Growth in sales per square foot has been negative for the last 4 quarters and the rate of change is accelerating (negative 4.5% last quarter). Operating margin for the owned stores fell 300bp last year. We noted earlier that mall traffic has been weak, and Victoria’s Secret’s online sales were only up 1% last year consistent with retail sales.

So, that amounts to a 1% increase in revenue on a 3.7% increase in square footage and decreasing margins.

Bath & Body Works Losing Strength:
Bath & Body Works has performed well, but is now starting to show signs of slowing. Same store sales have fallen from 6% to 5% to 3% over the past 3 years, and last quarter was 2%. Growth in sales per square foot have fallen from 4% to 3% last year. Operating margins were down 30bp for the year, but about 110bp last quarter. This isn’t terrible performance, but this division does about half the revenue of Victoria’s Secret.

We think Bath & Body Works is facing two problems. This first is characterized by this comment directly from L Brand’s quarterly commentary: “We realize that her acceptance of our body care products, while strong, is not growing with the speed that we would like. Therefore, we will flow more newness throughout the quarter and year in order to broaden the offerings of different body care forms and uses that we carry.” Our translation of this is that the customer doesn’t like the product as much as she used to like it. This issue may be fixable with some innovation or a product refresh.

The second problem is more serious. One of the reasons Bath & Body Works became successful was it featured a great store experience. Customers were encouraged to browse the store and sample many tester products. Reduced mall traffic limits the appeal of this approach. Bath & Body Works may have a great customer experience, but fewer people walking through the mall means fewer people will experience it. People shopping online won’t have that customer experience, will be less susceptible to add-on products, and may just be looking for the lowest price.

Like Victoria’s Secret, Bath & Body Works has become more promotional. Last week, the company was giving away a free full-priced item with any purchase of $10 or more. That’s a discount of up to 50% for anyone buying as little as 1-2 items. It’s worth noting that this promotion was available both in the stores and online meaning that customers didn’t have to walk into a store to benefit.

The Dividend May be a Problem:
L Brands has declining same store sales, declining sales per square foot, declining gross and operating margins, and declining EPS (down 6% last year and expected to be down 14% this year). It has such a large share of the lingerie market that it’s going to be difficult to grow share, and is facing growing competition from lower priced competitors. Despite that, the company still trades at 15x this year’s earnings.

The high dividend at $2.40 (almost 5% yield) may be a large reason for this valuation. In addition, LB has paid out a $2.00 special dividend in each of the last 2 years and has consistently raised the regular dividend. These increases may need to stop. Two years ago, free cash flow for the company was $1,142MM. Last year, it was $900MM. And company projections for this year are $650 – $750MM. Last year, total dividends paid were $1,268MM. The regular dividend assuming no increase and no special dividend will be about $700MM this year. It’s unlikely that there will be an increase in the dividend this year, or that there will be a special dividend. Another year of weaker free cash flow generation, and L Brands may need to cut the dividend.

Are EPS Estimates Too High?:
EPS for the year ended January 2016 was $3.99. EPS for the year ended January 2017 was $3.74. The company is projecting $3.05 – $3.35 for the year ending January 2018. We think those numbers may be aggressive. Assuming EPS of $3.25, that’s a reduction of approximately $.50 from last year. L Brands is expecting to do $.20 – $.25 in 1Q which would be a decrease of $.35 – $.40 from the year earlier. So, despite decreasing sales, decreasing sales productivity, weaker same store sales, lower gross margin, and SG&A deleveraging, the company is basically saying that 1Q will be bad, but the last 9 months of this year will only trail the prior year by about $.10 – $.15. We’re skeptical that this quarter will be the bottom (or close to it) and the business will stabilize from here.

The company is trying to remodel stores and reduce capital expenditures a bit. That makes sense, but SG&A isn’t declining. Mall-based retail tends not to have high net margins, so a loss of a couple of percentage points in gross margin and a little SG&A deleveraging can hit the bottom line hard.

Again, we point out that L Brands is well-managed and that we are not aware of any deceptive or questionable accounting. There is a long-term trend away from mall shopping and another social trend toward body-positivity and away from advertising angelic airbrushed perfection. Finally, where Victoria’s Secret had the best positioning in structured bras, the trend towards cheaper more casual bralettes is reducing pricing and increasing competition. These are issues that will both take a long time to solve and may be resolved at permanently lower levels of profitability.

We see two primary risks to our short thesis. The first is that the negative trend we’ve outlined in this piece may be temporary. It’s possible that women will reverse the trend towards cheaper, less-structured, more-casual undergarments, and go back to $50 push-up bras marketed by airbrushed Angels. The same management that grew the company to 60% market share may be able to manage through the current environment. If guidance is correct, this quarter would mark the worst of the decline, and the stock would be inexpensive at 14x next year’s analyst estimates with a 5% dividend yield. Our belief is that the lingerie market is becoming lower-priced, more-casual, and more-competitive, but we acknowledge that there is always risk in taking current fashion trends and social attitudes and projecting them into the future.

The second risk is the dividend. A 5% dividend yield may keep the stock up even in the face of declines in sales, margins, and earnings. The current dividend would use up approximately 100% of management’s estimate for free cash flow; however, the company does have some financial flexibility. Debt to EBITDA should be under 2x this year and last year interest expense was less than 20% of operating income. That means that even if free cash flow continues to decline, the company can maintain its dividend for a while with additional borrowing. Again, our view is that L Brands is facing long-term secular declines in both mall traffic and in the lingerie market. Increasing debt may allow the company to maintain the high dividend for a while, but this would only buy time while the underlying business is eroding.

EPS for the year ended January 2016 was $3.99. That fell to $3.74 for the year ended January 2017. Company guidance for this fiscal year is $3.05 to $3.35 based on improving same store sales (excluding the swim and apparel business the company abandoned last year) and lower gross margin. Analysts are taking the middle of the range for this year at $3.20 and projecting improvement to $3.47 for next year.

We think the company and the analysts are too optimistic. Same store sales for Victoria’s Secret have been negative for the past two quarters, and have declined to 2% at Bath & Body Works. Sales per square foot has shown negative growth for the past two quarters, and gross margin has declined year over year in each of the past four quarters. Said simply: L Brands is lowering prices and is still selling less merchandise.

Gross margin fell 200bp last year. Assuming a small reduction in sales over the next two years, continued small decreases in gross margin, and relatively consistent SG&A would get us to EPS around $2.50 for next year (FYE Jan ’19). That would be the third consecutive year of declining EPS and would either force the company to reduce the dividend or take on debt to pay the current dividend. Keeping the current 14 multiple on the stock would get us a price target of $35. If the market reduces the multiple on multi-year declining performance to 12x, that would get us a target price of $30.

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