6% Yielding L Brands Shares Are Too Risky For Income Investors

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L Brands shares (LB) are underpriced, after losing more than 75% of its value since November 5, 2015. The decrease in the share price is attributable to poor performance in the company’s Victoria’s Secret (VS) segment, which sells lingerie and other women apparel. In 2017 and 2018, for example, the segment recorded store comps decline of 5% and 2%, respectively. In contrast, Bath & Body Works (BBW), the other major segment of the firm, had store comps growth of 5% and 8% in the same periods. The VS segment sales are expected to continue falling until the company changes the segment’s brand image and products to match shifting consumer preferences. Since implementing the changes will take a considerable time period, the firm’s stock price is likely to fall further over the next few years.

The financial performance has been lackluster recently but the balance sheet doesn’t look as bad as it sounds

Despite the problems in the VS segment, L Brands reported a 6% growth in net sales for 2018 as sales increase in the BBW segment more than offset the decline in sales in Victoria’s Secret. In 2019, however, the company is expected to report a 1-2% decrease in net sales.

To boost sales, L Brands has resorted to aggressive promotion and discounting of merchandise in the VS segment. These measures have resulted in a decline in the company’s gross and operating margins. Additionally, they have caused the company’s adjusted earnings per share to fall from $3.99 in 2015 to $2.82 in 2018. Further, according to the company’s latest guidance, earnings per share will decrease to $2.40 in 2019.

The company has also taken measures to strengthen its financial condition following the operating problems in the VS segment. In 2018, the board announced a reduction of the full-year dividend from $2.40 per share to $1.20. The proceeds from the dividend cut will be used to reduce the amount of debt.  Currently, the company’s long-term debt to EBITDA ratio is 3.14. This level of debt can be comfortably paid from the company’s BBW segment’s earnings. The focus on debt reduction indicates that the company favors turning around the VS segment rather than spinning it off.

2014 2015 2016 2017 2018
Revenue Growth 6% 6% 3% 0% 5%
Gross margin 41% 42% 43% 41% 39%
Operating margin 16% 17% 18% 16% 14%
Adjusted EPS $3.50 $3.99 $3.74 $3.20 $2.82
Debt/EBITDA 0.90 1.01 1.01 1.03 3.14
Dividend per share $2.36 $4.00 $4.40 $2.40 $2.40

Source: Company annual reports

The Challenges Facing the Company

Like its peer Abercrombie & Fitch, L Brands has failed to change with the times in its VS Segment. A few years before its sales decline began, Abercrombie had been criticized for excluding plus-sized women in its product offering and perpetuating unrealistic standards of beauty. The same criticism preceded the operating problems in L Brands’ VS segment, which started in 2016.

A recent study by the international research organization Euromonitor shows that the major factor in Victoria’s Secret sales decline is changing attitudes among American women. According to the research, an increase in feminism and body-positive messaging through various media has caused American women to opt more for brands that promote female empowerment. In contrast, VS advertising campaigns’ portrayal of women implies that they need male approval. Its product offering also suggests that women should have certain body types.

Apart from the lack of inclusivity, L Brands has not embraced the functional and “comfort wear” trend in the apparel industry. A 2018 study by the research group NPD indicated that 40% of millennials have what they term as comfort wear in their wardrobe.  Moreover, a third of millennials’ bra budget is spent on sports bras. Although L Brands has invested in sports bras, the company is yet to prioritize comfort and function in its core products.

According to the NPD Group, millennials represent the largest share of the intimate apparel market. Further, plus-sized women are now responsible for about 43% of non-sport bra sales, up from 29% in 2013. Both groups have positive attitudes toward inclusivity. Therefore, L Brands can stem the sales decline in the VS segment without catering to the preferences of the two markets.

Recent Strategic Changes

In 2016, L Brands decided to remove swimsuits from its VS segment lingerie business. The company also eliminated some apparel and accessories that it sold through the direct channel but not stores. In addition, it dropped the circulation of the catalog, which the company was used to mail to customers. In total, the discontinued items would cost the company $500 million in sales, meaning that the current sales decline is partly attributable to the removal of the items. The company, however, announced the return of swimsuits to its stores in February 2019.

The company’s VS segment has also had a flurry of leadership changes from 2016. After the resignation of Sharen Jester Turney in February 2016, Les Wexner, L Brands CEO, become the acting head of the segment. Jan Singer, the former CEO of Spanx, then took the role in May 2016 until her resignation in November 2018. Currently, the segment is headed by John Mehas, the former president of Tory Burch.

On an annual investor day on September 11, 2019, John Mehas suggested that the company is prepared to change. Mehas told investors that the VS segment’s products need to be seen as “by her for her.” He also played a video featuring models of no specific body type, implying that the company could embrace inclusivity. The CEO, however, offered no specific details on the segment’s turnaround strategy.

Industry Overview

Victoria’s Secret still holds 24% of the dollar market share in the intimate apparel market even after the sales decline in the business over the last three years. The other companies with sizeable market shares are Walmart (11%), Kohl’s (7%), Amazon.com (7%), and Target Corp (6%).  However, has been losing VS market share from 2015, when it accounted for 32% of the market according to Euromonitor data.

Source: The NPD Group, Inc.

The VS Segment is also the most popular brand on social media. For example, VS is the most followed fashion brand on Instagram with 68.7 million followers, and second overall after NIKE. The fashion brand is also the most popular on Facebook with 29 million followers. In contrast, Aerie, one of the current popular lingerie brands in America, has 1.2 million followers on Instagram and 1.9 million on Facebook.

The main beneficiaries of Victoria Secret’s decline have been the fashion companies that have embraced inclusivity, functionality, and comfort in their product offerings, such as the American Outfitter’s Aerie, Third Love, and Lively. Aerie, for example, now accounts for 3% of the intimate apparel market, up from 1.6% in 2013. The company has also recorded store comps growth over the last 16 quarters. In the latest quarter, for instance, the company reported a store comp growth of 32%.

Valuation based on earnings multiples

At the current share price of $18.50, L Brands has a P/E ratio of 7.71 based on the projected 2019 EPS of $2.40. The average P/E for the company’s competitors, on the other hand, is 12.69. Using the average P/E, the company’s market value per share is $30.45. Consequently, the stock is undervalued under the P/E ratio approach. 

The undervaluation of the company is likely to persist for some years until sales in Victoria’s Secret stop decreasing. If the management does not make major changes to the VS brand image and product offering, the segment is likely to lose between 30% and 40% of its 2016 peak sales before the sales decline stops. Implementation of the required changes is likely to be slow given that the company will have to abandon a brand image that it has communicated for many years.

Takeaway for investors

L Brands stock is undervalued. The undervaluation is, however, likely to continue because of the comp sales decline affecting the company’s Victoria’s Secret segment. The sales decrease is also reducing earnings per share as the company increases promotions and discounts to attract customers back to its stores.

The VS segment’s challenges arise as a result of changing consumer preferences in the intimate apparel market. Consumer attitudes, particularly in the millennials category, are shifting towards products that are more functional and comfortable as opposed to merely depicting a certain look. Additionally, an increasing number of consumers prefer brands that are more inclusive and that promote women empowerment.

L Brands has the strongest brand and the largest market share in the industry. Moreover, the company is in a strong financial position due to its low debt to EBITDA ratio and the operating cash flows from the strongly performing BBW segment. These features will allow the company to make the necessary branding and product changes in the VS segment in time.

Although the company is prepared to make the changes required to turnaround the VS Segment, the transformation is only likely to happen gradually. The company could also spin off the segment, but this option is unlikely to be exercised going by the company’s current focus on reducing debt. With low debt, the company will have more time to turnaround VS.

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