Summary

• At below $40/share, L Brands is trading at about current earnings power value.

• There are real risks, including a permanent impairment of the Victoria's Secret brand.

• There are also ample opportunities for earnings growth: continued strength at Bath & Body Works (the main contributor to earnings in 2017), a "back-to-normality" at Victoria's Secret and international expansion.

• Investors seem to be putting all the focus on the negatives while disregarding the positives.

• This has created a compelling entry point that we are buying into.

We added L Brands (LB) to our first-class stock portfolio mid last year, and are now adding to our long position at below $40/share.

The long investment thesis is rather simple: L Brands, the owner of Victoria's Secret (VS) and Bath & Body Works (BBW), is one of the world's finest specialty retailers, as we shall see.

At a stock price below $40/share, you are paying the value of current earnings power. That is using 8% as discount rate and with current balance sheet leverage.

And you are getting 6% of that as dividend yield, and another cut as share buybacks.

Up to here, solid value for money. But there is more.

As we shall see in the remainder of this piece, there are ample opportunities for earnings power growth within the current capital expense budget of $750 million a year. Continuous growth in BBW, a "back-to-normality" of VS in North America and UK, and a successful execution of the international expansion initiatives (particularly of VS in China) would all result in significant upside relative to today's earnings power value.

There are also risks, the biggest of them, a permanent value impairment of the Victoria's Secret brand. But it is our impression that the financial community is putting all the focus on the negatives while disregarding the positives.

In short, we believe that at below $40/share, you can pay current (depressed) earnings power value in one of the finest retailers in America, and get three options to likely and significant profitable growth as margin of safety.

Bath & Body Works

Bath & Body Works is one of the most profitable retailers in North America. As a favorite producer and marketer of consumables, it is also a dependable source of cash flow for the company.

Store remodels and DTC (direct-to-consumer, or "online") initiatives have resulted in significant growth in the last few years. DTC has been growing at over 20% CAGR in recent years, and for the full fiscal year 2017, comparable sales came in at 5% (+2% excluding DTC).

Sales at VS are some 78% larger than at BBW. So investors tend to focus on Victoria's Secret when looking at L Brands. But the strength of the BBW franchise, together with weakness at VS, have resulted in the former's contribution to fiscal 2017 adjusted operating income  ($952.5 million) exceeding the latter's ($932.3 million) for the first time.

The bottom line here is that the best performing business segment is already the biggest contributor to earnings, and that is a big positive going forward.

Bath & Body Works is one of the finest world retailers, and the main contributor to L Brands operating income (image: L Brands IR)

Victoria's Secret

There is no question that VS is going through tough times.

VS comparable sales have been in mostly negative territory since end 2016, and operating margins are down 500 basis points from 2015/2016 levels, due both to sales deleverage and merchandise margin declines, as the company resorts to price cuts to fight foot traffic declines. For full fiscal year 2017, comparable store sales fell 8%, both with and without DTC. Management attributes 3% of the fall to discontinuation of VS swim and apparel categories while avoiding any mention to the positive impact of the decision in go-forward category comps. We see net adjusted annual comps in the -6% to -7% ballpark.

Three scenarios: back to normal, new normal and worst-to-come

The key question at VS is whether the current state of affairs is temporary and investors can expect a return to "normality", or whether THIS is the new normal. There is even the possibility that the value of the VS brand is permanently impaired, and the worst is yet to come.

A continuation of 2017 business performance would be sufficient to justify a $40/share price.

On the other hand, a return to 2015-2016 business performance would bring about significant stock appreciation, driven by both earnings growth and price multiple upwards revisions. This back-to-normal scenario would easily double the current stock price. 

The gloomiest worst-yet-to-come scenario would result in further stock price declines, but certainly well below 100%, since most of the operating profit comes already from BBW.

So even if the three scenarios were equally likely, the relative scenario returns are already bullish. Besides, we are not even considering the credible case of VS not only coming back but exceeding 2015-2016 performance in years to come.

Now, what of these three scenarios is the likeliest?

Risks

At the present time, there are several doom and gloom stories vividly imprinted in the financial community imaginary.

One relates the traffic shift trends from malls to online, and how Amazon (AMZN) is going to eat away the business of incumbent brick-and-mortar retailers. Another is the trend away from "sexy" and towards "athleisure", comfort and natural beauty, the latter epitomized by Aerie, from American Eagle Outfitters (AEO).

Starting with the traffic shifts from malls to online, and the Amazon threat.

There is some merit to the argument that VS's would lose some of its competitive advantages in a mostly-online retail world, assuming that day ever comes (which we consider likely). For example, "real estate" is somewhat more differentiated in the physical than in the online world.

But grossly speaking, there is no reason to expect that brands that manage to navigate the transition will be any less relevant than they are today. And it is our impression, that L Brands is already at the forefront of digital. The PINK Nation app (a fidelity program of the PINK brand of VS) is the #9 iOS app in Lifestyle, with 4.8/5 ratings based on 292K ratings. The VS app is #24 in Shopping, ahead of almost all other apparel retailers. And DTC is growing much faster than store-sales at both VS and PINK.

As for Amazon, it represents low prices and convenience, all fundamental features in the sale of books or office staples. What it does not represent is quality, distinction or sexiness. Hence, we lose little sleep over the most profitable customers of VS and PINK shifting their lingerie and beauty purchases to Amazon white-label products. And although VS may one day elect to start selling through Amazon (as it does though TMall, owned by BABA, in China), such move will only take place if and when it is accretive to L Brands' bottom line.

Regarding the trend away from "sexy", an attribute built over the years into the main association to the VS brand: the trend is a real one.

Aware of the athleisure movement, the company introduced sportswear lines at VS and PINK a couple of years ago. It has also responded, albeit late, to the (lower priced) bralette movement, which seems to finally start receding. And while we are of the opinion that the "natural" advertising campaigns by Aerie will not go much beyond curiosity, we see a need for VS to transition from the "just sexy cute" girl attributes to those of a more sophisticated and charismatic woman, more fitting of current times. But we believe such transition can be implemented in a rather seamless way, preserving the relevance of the VS Fashion Show, and the marketing-scale competitive advantage it provides to the company, along the way.

Of one thing we are certain: models, as "examples to be imitated", will continue to inspire shoppers. And when you are dealing with cosmetics and lingerie, beauty will always be a prime model quality, be it of the "sexy cute" or of a more "sophisticated charismatic" nature.

All in all, we see the return-to-normal scenario as more likely than the worst-to-come one.

A last word on VS

Despite the business weakness, reported 2017 operating margins came in at 12.6%. That number may pale in comparison to 2015 margins. And it is lower after adjustment to allocate some of the "Other segment" losses to it. (That segment includes Mast Global, the production, sourcing, and logistics arm of the group, which seems to be producing an operating loss year after year.) But even after adjustment, VS operating margins remain strongly on the green.

And while comparable sales have been weak, units sold have hold up for the most part, with no evidence of significant market share loss. The lower comps have been mostly due to lower AUR, as shoppers have shifted away from higher-priced constructed bras and towards lower-priced bralettes. If bralettes prove to be a fad as search trends may start to suggest, VS stands to benefit immensely on grounds of AUR gains alone.

International

The international reporting segment encompasses store-based sales outside US and Canada, through both company-owned and partner locations, as well as TMall online sales in China. The segment had a negligible contribution to operating income in 2017. Part of that weakness comes from investments in China, reported under GAAP as current expenses, but most is due to continuous underperformance in UK.

Based on Q4 management commentary, the international franchised businesses are doing well, with good operating income growth and at high operating income rate. In China, VSBA (VS Beauty and Accessories) stores and e-commerce through the Tmall platform are also performing well, and the seven full assortment stores, five of which were opened in Q4 2017, are progressing roughly as expected.

In 2018, the company expects to open another 10 or 11 full assortment stores in China.

The negative note on China was an answer during the Q4 earnings Q&A session, in which management shared expectations for a similar operating loss in China for 2018 as in 2017, below previous expectations for YoY improvement.

In any case, it is way to early to put a precise number to the likely contribution to value from the expansion in China.

The best way to look at it is as a low-risk high reward play: an option, if you will. Given the difficulties of the Chinese market for western companies, it may be seen as a long shot, and yet one with a significant expected value, given the size of the opportunity.

Takeaways and future coverage

L Brands has been and continues to be one of the world's finest retailing businesses. The last piece of evidence came in the 2017 ACSI retail report published last month, with L Brands emerging as the sole leader in customer satisfaction after a 5% YoY gain, setting a record high score for the company and the category, and catching up to the almighty Amazon.

At below $40/share, L Brands is trading at about Earnings Power Value, considering 2018 guidance for about $900 million of earnings and FCF, 282 million shares outstanding, today's corporate leverage and a 8% discount rate.

While there are risks, there are also ample opportunities for earnings growth, mainly continued strength at Bath & Body Works (the main contributor to earnings in 2017), a "back-to-normal" at Victoria's Secret, and international expansion. 

We believe that at this point, chances are on the upside. More importantly, the potential size of the upside (100%+ on back-to-normal North American VS business alone, plus the possibility of continuous expansion at BBW and a successful VS entry into China) handily exceed the maximum downside.

Investors seem to be putting all the focus on the negatives while disregarding the positives, which has created a compelling entry point that we are buying into.

This research piece was originally published in invworks.com.