The stock of L Brands (LB), the parent of Victoria Secret's and Bath & Body Works, was trading sharply lower after a disappointing April sales release.

Reported sales were in line with 2018 full year guidance, with net sales up 4% YoY and comparable sales up 3% YoY after adjustment for the earlier Easter holiday.

By brands, and after a 3% adjustment for the earlier Easter holiday, comparable sales were up 1% at  Victoria Secret's (VS), and up 9% at Bath & Body Works (BBW). For Q1, comparable sales were up 1% at VS and 8% at BBW.

The killer sentence in the sales report was:

THE MERCHANDISE MARGIN RATE [at Victoria's Secret] WAS DOWN SIGNIFICANTLY TO LAST YEAR DRIVEN BY ADDITIONAL PROMOTIONAL ACTIVITY IN ORDER TO DRIVE TRAFFIC.

Lower merchandise margins lead to lower gross margins, which forced the company to guide Q1 EPS at the lower end of the previous guidance of $0.15 to $0.20. 

Despite the guide down, we were surprised by the steep selloff, which brought the stock close to $30/share. Historically, Q1 contribution to earnings is about 10%, which renders the guide-down relatively unimportant.

Indeed, the selloff was rather the result of ever more investors throwing the towel on Victoria Secret's, as exemplified by Buckingham Research calling the company "dead money".

In their gloominess, investors seem to be ignoring the strength of the Bath & Body Works business, which was the biggest contributor to operating earnings in 2017, and is bound to be an even more important contributor this year.

On what follows, we estimate the value of Bath & Body Works at a standalone business, and argue that widespread investor pessimism has taken L Brands stock to a price not far from that substantiated on the BBW business alone.

We close with our views on the investment opportunity and a recommendation to management regarding capital allocation.

Before moving on to valuation, we want to remind investors that L Brands is part of the market-beating IW Portfolio since August 2017. Our original long thesis on L Brands is available here.

Leslie Wexner, Founder, Chairman and CEO of L Brands, has been a shareholder champion (photo: Art Market Monitor)

Valuing Bath & Body Works as a stand-alone business

Adjusted operating income after tax

L Brands reports results in four segments:

• Victoria Secret's
• Bath & Body Works
• VS & BBW International (outside US and Canada)
• Other, which includes La Senza, Henri Bendel, Mast Global (production, sourcing, logistics and IT functions) and Corporate 

In 2017, BBW was the main contributor to operating income with $953 million.

Operating income from the International segment, which includes BBW operations outside the US and Canada, was about break-even, mainly due to softness in UK and investments in China.

On the other hand, the Other segment reported a whooping $162 million operating loss, with operating margins of -27%! In 2016, the loss amounted to $117 million, with operating margins of -23%.

Some of the losses can probably be traced to weakness at La Senza and Henri Bendel. But there is evidently more to it, since these are relatively small business components. In fact, it seems that the company is burying significant recurrent production and logistic costs associated to its main VS and BBW businesses in the Other segment.

To arrive at a conservative valuation of BBW as a stand-alone business, we are going to assign ALL the operating losses of the Other segment to the VS and BBW segments, in proportion to each segment revenues.

In 2017, BBW was responsible for 33% of L Brand revenues. 33% of $162 million is $53.5 million, so we revise BBW operating income down to $900 million.

A 35% tax rate puts BBW 2017 after-tax operating income (NOPAT) at $585 million, or $2.1/share.

Enterprise value

At $30/share and with 282 million shares outstanding, L Brands has a market capitalization of $8,460 million. Adding to that the $4,200 million of net debt as of February 2018 puts enterprise value at $12,660 million, or $44.9/share.

Valuation

All in all, at $30/share, we estimate that the entire L Brands group is selling at 21.4x 2017 after-tax earnings from Bath & Body Works in North America.

BBW is a formidable business. Comparable sales are growing at high single digits, and have experienced consistent growth in recent years. Merchandise margin rates are stable.

In 2017, direct-to-consumer (DTC, or "online") sales grew 25%. Sales per average selling square foot in BBW US were an impressive $844, well above the sales efficiency of most US retailers.

As the largest specialty retailer of body care, home fragrance products, soaps and sanitizers, BBW enjoys economies of scale in a recurrent business with high consumer captivity.

For all these reasons, we believe Bath & Body Works has better business quality than the average US corporation. And yet, the S&P 500 is trading at 24.8x TTM earnings, well above the 21.4 ratio at which BBW North America can be bought today.

And that's assigning zero value to Victoria's Secret (a business segment with 13% operating margin in 2017) and business operations outside of US and Canada.

A call to action to Les Wexner... and a present

In 2017, L Brands distributed $686 million in regular dividends and devoted $445 million to share repurchases, for a total distribution to shareholders of $1,131 million, well above 2017 FCF and guidance for 2018 FCF.

With the current economics at VS, that level of distributions is unsustainable.

Even worse, management has stubbornly maintained the annual ordinary dividend at $2.40/share, presumably in an attempt to retain its current shareholder clientele.

The approach has obviously failed to maintain the stock price anywhere close to the company's intrinsic value.

In view of the above, and in the interest of the shareholder base, we ask founder, Chairman and CEO Les Wexner, whom we hold in high esteem:

1. To significantly reduce or suspend dividend payments for the time being.
2. To accelerate share repurchases, allocating up to 100% of the FCF to buyback stock at prices well below intrinsic value.

"Dividend investors" who demand regular cash distributions from their equity investments can achieve that end through homemade dividends.

Quite frankly, Les Wexner is one of the reasons we invested in the company in the first place. He has never shied away from unconventionality, from zigging when others are zagging, to produce immense value for his shareholders (20%+ compounded annual return since The Limited went public in 1969).

He has achieved those returns by alternating periods of aggressive investment in organic expansion with periods of brand divestiture, opportunistically navigating the demand and supply nuances of women apparel retailing.

We ask him now for another act of boldness, sacrificing the dividend streak to accelerate share repurchases and protect his shareholders.

For what is worth: we will be sending him a book to Corporate Headquarters, at Three Limited Parkway, Columbus, Ohio:

The Outsiders - Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William N. Thorndike, Jr.

Our modest contribution to the cause.

We hope he enjoys it as much as we did, and use it as an inspiration. In fact, we wouldn't be surprised to see his name in the next edition of the book.

If he steps up and does the right thing, he will have very much deserved a place among Henry Singleton and John Malone

We'll let you know when he replies.

Front cover of The Outsiders, by William N. Thorndike, Jr., "an outstanding book about CEOs who excelled at capital allocation", per Warren Buffett words

Takeaways and future coverage

Month after month, Victoria's Secret continues to disappoint.

So far, VS Lingerie CEO Jan Singer has been incapable of turning that core business around and bringing it back to its glorious days. And the market has overreacted.

In fact, we have argued that the $30 stock price can almost be substantiated on the value of the Bath & Body Works North American business alone.

The multi-billion value of Victoria's Secret -even if impaired, and the value of "call options" to successful international expansion in China and elsewhere provide for a hefty margin of safety.

To be clear: we are not calling for a sale or spin-off of VS. Even at significantly lower margins, it is still one of the most profitable apparel businesses in North America. And there are obvious and increasing synergies between VS and BBW, with Beauty being an ever more important part of VS.

Instead, the steep undervaluation provides opportunities:

• to management, to create shareholder value by accelerating share repurchases,

• and to current and prospective shareholders, to add to their long positions.

We know we will be adding to ours while Les Wexner finds his place among The Outsiders.

This piece of research was originally published in invworks.com