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Limited Brands, Inc. (LTD)

Q1 2007 Earnings Call

May 24, 2007 9:00 am ET

Executives

Sharen Turney - CEO, Victoria's Secret

Neil Fiske - CEO, Bath & Body Works

Stuart Burgdoerfer - CFO

Martyn Redgrave – CAO

Tom Katzenmeyer - IR

Analysts

John Morris - Wachovia Securities

Lorraine Maikis - Merrill Lynch

Dana Cohen - Banc of America Securities

Randall Konik - Bear Stearns

Lauren Levitan - Cowen

Neely Tamminga - Piper Jaffray

Brian Tunick – JP Morgan

Richard Jaffe - Stifel Nicolaus

Todd Slater - Lazard Capital Markets

Jennifer Black - Jennifer Black & Associates

Barbara Wyckoff - Buckingham Research

Paul Lejuez - Credit Suisse

Howard Tubin - RBC Capital Markets

Dana Telsey - Telsey Advisory Group

Presentation

Operator

Good morning and welcome to the Limited Brands first quarter 2007 earnings conference call. (Operator Instructions) Now I would like to introduce Mr. Tom Katzenmeyer, Senior Vice President Investor, Media and Community Relations. Sir, you may begin.

Tom Katzenmeyer

Thank you. Good morning, everyone. This is Limited Brands first quarter earnings conference call for the period ending Saturday May 5, 2007. As a matter of formality I need to remind you that any forward-looking statements that we may make today are subject to our Safe Harbor statements found in our SEC filings. Our first quarter earnings release and related financial information are available on our web site, Limitedbrands.com, and as always this call is being taped. It can be replayed by dialing 1-800-337-6551, followed by the pass code 583. You can also listen to an audio replay from our web site.

Martyn Redgrave, EVP and Chief Administrative Officer; Stuart Burgdoerfer, EVP and Chief Financial Officer; Sharen Turney, CEO of the Victoria's Secret brand and Neil Fiske, CEO of Bath & Body Works are with me this morning as is Amy Preston, our Vice President of Investor Relations.

After our prepared comments we will be available to take your questions for as long as time permits. I'll remind you about this again later, but so that we can talk to as many callers as possible, please limit yourself to one question.

With that I'll turn the call over to Martyn Redgrave.

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Martyn Redgrave

Thanks, John, and good morning, everyone. As you know, last week we announced the sale of a 67% interest in Express and our intention to explore the strategic options for Limited Stores. In light of this news and also our announcement yesterday that our board has authorized a new $500 million share repurchase program, I'd like to just make a few comments to help to put all of that into strategic context and try to link that back to our strategic plan that we discussed publicly at our investor update meeting last November. Then I'll turn over the review to Stuart who will take us through the first quarter results and our future earnings guidance.

As you know, for some time we've been communicating our strategic agenda of focusing on growth in our intimate apparel as well as our personal care and beauty businesses. We've also consistently said that our priority for 2006 was to turn around the negative performance of Express and that we remained open to explore other strategic options in the future as we have consistently for all of our other businesses in the past. Our actions over the past ten years have demonstrated this shift in focus. In 2006 over 70% of our revenues were generated from our intimate apparel and our personal care and beauty categories, as we have grown these businesses and also reduced our involvement in apparel through various transactions.

The actions announced last week with respect to both Express and Limited Stores reflect our continuing commitment to our strategic agenda as well as to creating shareholder value. With Victoria's Secret and Bath & Body Works we operate the leading brands in intimate apparel and personal care and beauty. With our acquisition of La Senza earlier this year, we've added the number one intimate apparel brand in Canada, and with it, a platform for international growth. We are now the largest North American intimate apparel retailer and we also have over 370 stores operating under license agreements in 36 countries outside of North America.

We remain very confident in our strategic agenda which we presented at our investor meeting last November and we believe we're taking all the right steps to execute against that agenda and deliver the long-term growth that we have targeted in that plan.

At that meeting we reviewed our mission to build a family of the world's best fashion retail brands whose well-told stories create loyal customers and deliver sustained growth for our shareholders. I'd like to take a minute to highlight a few of the key initiatives that we're executing against.

First, we are on track to expand the average size of our Victoria's Secret store footprint by roughly 50% over the next five years. This year that activity will result in square footage growth for the brand of 8% to 10%, and we have a five-year plan that encompasses about 80% of our total store locations.

The success and growth opportunities in PINK, Intimissimi and Beauty, as well as the ideas that are still in the early stages of developments like Victoria's Secret sport, accessories and swim, give us confidence that we can continue industry-leading sales productivity in these larger store formats. In fact, the stores that we've remodeled as tests in the last few years have produced internal rates of return in excess of 30%. Now as Sharen will report, the initial ramp-up of this expansion plan is having a short-term negative impact on earnings, but we remain confident that this initiative will deliver very positive returns over time.

In November we also discussed the opportunity for international expansion. Since then we've acquired La Senza which is even more dominant in Canada than Victoria's Secret is in the United States. We now own and operate the three dominant intimate apparel brands in North America, Victoria's Secret, PINK and La Senza. Importantly, as I said, La Senza also provides us with a platform to explore international growth for our other brands.

Now turning to our personal care and beauty categories, with Bath & Body Works and Victoria's Secret Beauty, we are the largest personal care and beauty specialty retailer in North America. In fact, over the last five years we've become the fifth largest beauty company in the United States. We have the number one position in the prestige fragrance, fragrant body care, aroma therapy, spa, dermatological skin care and personal care for girls categories.

In addition to the square footage growth through opening new Bath & Body Works stores in off-mall locations, we have significant growth opportunities in BBW's new Internet and catalog businesses. We are also investing in new technology and distribution center capacities to support the growth of both our existing Victoria's Secret direct business and our new Bath & Body Works direct business.

In addition, as we've talked about consistently, we are continuing to invest in our enterprise-wide technology initiatives in the areas of supply chain, shared services and customer relationship marketing. As Stuart will report, these capacity and technology enhancing investments are also having a short-term negative impact on earnings, but again, we remain confident they will deliver future positive returns.

Finally, we are continuing to invest in new concepts in both personal care and the accessories categories like Bigelows, White Barn Candle Company, Diva London and Henri Bendel, all in order to incubate and grow these new concepts to scale.

As Les said last week, we believe we are better positioned for growth than we ever have been before. This competence is evidenced by the announcement yesterday of our new $500 million share repurchase program. We intend to aggressively pursue the purchase of our shares in the open market.

In connection with our plans to sell 67% of Express and explore strategic options for Limited Stores, we are at the beginning of a process to review our overall expense structure with a view to realignment and resizing that is appropriate to the size and the nature of the new Limited Brands portfolio structure. We believe there's an opportunity for significant reductions and we're very focused on it.

In addition, we are continuing to review and evaluate additional aspects of our overall capital structure. Specifically we're evaluating the amount of leverage that is appropriate for our business given our new structure, our cash positions and the impact on our cost to capital and credit ratings.

All of these actions will obviously impact our financial results. We know that you're all very anxious to estimate and model the impact, however, there are a number of things that remain open that make this very difficult for us to give you guidance on, including the closing of the Express sale, which we anticipate before July 6th; the finalization of our transition services arrangements between us and Express; the outcome of the exploration of the strategic options for Limited Stores, and finally, the review of our expense and capital structures.

At this point in time we can reasonably estimate that we expect to record a second quarter pretax gain of approximately $330 million related to the sale of the sale of the 67% interest in Express, and that's subject to closing adjustments. We also expect that the net effect of the Express transaction and the new share repurchase program will be a flat to slightly dilutive impact on our full year earnings per share results.

While we're very encouraged by all the strategic initiatives that I've discussed, let me be clear: our first and most important responsibility is to grow our core businesses and to execute well on all of the fundamentals of being an outstanding fashion retail brand operator. We are very focused in getting the right balance between our comp stores sales growth expectations and the inventory and marketing investments to support this expected growth.

So with that, thanks and I'll now turn it over to Stuart.

Stuart Burgdoerfer

Thanks, Martyn, and good morning, everyone. We are obviously disappointed with our first quarter results. Earnings per share were $0.13 versus $0.25 per share last year. Comps increased 4% on the low side of our initial expectations and total sales increased 11% to $2.311 billion. Gross margin decreased 320 basis points to 34.8%, significantly below plan, driven by a decline in merchandise margin, particularly at Victoria's Secret. Sharen will cover this in more detail.

Buying and occupancy expense was roughly flat as a percent of sales. Total SG&A dollar spending increased by 15%, roughly in line with our initial expectations, deleveraging by 110 basis points. This incremental spending was driven primarily by the following:

About 30% of the dollar increase is attributable to the addition of La Senza's SG&A costs.

Roughly half of the dollar increase is attributable to store selling costs which deleveraged by 110 basis points. This increase was related to additional payroll hours to support sales growth in the quarter which was driven by a high single-digit growth in transactions and mid single growth in units per transactions.

The remainder of the increase relates to an increase in marketing costs primarily at Victoria's Secret. Marketing expense deleveraged by 60 basis points.

Additionally, we continue to invest in infrastructure and technology initiatives that Martyn mentioned. As Sharen and Neil will discuss further, beginning with this quarter, the allocation of a portion of these costs to their businesses impacted their segment results.

First quarter operating income decreased by $77.4 million. By segment the results were: Victoria's Secret operating income decreased by $72 million, Bath & Body Works decreased by $17.5 million, Apparel increased by $2 million, and the other segment net expense decreased by $10.1 million.

Retail inventories ended the quarter up 27% per foot at cost versus up 47% per square foot at the end of the fourth quarter last year. Apparel inventories end of the quarter up 17% per square foot at cost. Our growth in inventory has moderated and is consistent with where we thought we'd be at the end of the quarter. The drivers of the increase are also generally consistent with what we described in detail on February's fourth quarter earnings conference call with the majority of the increase in core, seasonless basics.

While we missed our first quarter sales plans, we were able to manage our inventory to planned levels by implementing promotions which negatively impacted merchandise margin in the quarter and also adjusting our go-forward receipt flow.

We are very focused on striking the appropriate balance between responding to the challenging retail environment and our sales trends, while at the same time providing the right level of newness and in-stock positions for our customers. Achieving this balance may result in further pressure on merchandise margin and adjustments to our receipt flow through the remainder of 2007. We expect that our year-over-year increases in inventory will continue to moderate to the point where we are at a low double-digit increase by the end of the second quarter and we are targeting to be roughly flat to 2006 levels by year-end.

Now turning to our outlook for 2007. Mall traffic remains a challenge and is down 7% month to date in May. While we had initially forecast a positive low single-digit comp for May, we are now estimating a comp in the negative low single-digit range. Our current view of May is reflected in our Q2 earnings guidance. In the second quarter we are projecting earnings per share of $0.20 to $0.24 versus $0.28 per share last year. This estimate is predicated on low to mid single-digit comps, a decline in the gross margin rate and an increase in the SG&A rate. We expect the total increase in SG&A on a dollar basis, including the impact of La Senza, to approximate the percentage growth of the first quarter.

For the full year, we are projecting earnings per share of $1.55 to $1.65. This estimate is predicated on mid single-digit comps, a decrease in the gross margin rate, and an increase in the SG&A rate. The second quarter and full year guidance does not yet include any impact from the Express transaction, potential strategic options for Limited Stores or share repurchase announced today.

We continue to estimate the 2007 capital expenditures will be between 790 and $815 million. Over 60% of our capital expenditures relate to the investments in remodeling and expanding existing stores, as well as opening new stores. This investment is driving three quarters of the incremental capital spending versus last year and relates to the real estate growth for Victoria's Secret and BBW, that Martyn discussed earlier, as well as the capital spending of La Senza which is incremental for 2007.

About 20% of our Cap Ex budget relates to investments in the two technology initiatives and the expansion of our direct distribution center. This investment level is roughly flat year over year. The remainder of our Cap Ex budget relates to home office and other investments including the consolidation of the majority of our New York offices to one location.

Before I turn it over to Sharen, I'd like to make a few comments about La Senza's performance in the first quarter. La Senza's first quarter sales were $91.7 million and comps increased 5% slightly below expectations. Sales growth was supported by key promotions and as a result merchandise margins were down to last year. As expected, La Senza's results were about a penny dilutive to our earnings per share in the quarter and reflect the impact of the purchase accounting adjustments. We continue to expect that the La Senza acquisition will be modestly accretive in 2007. Lingerie sales were driven by bras and panties and La Senza Girl sales were driven by knit tops, pants and underwear.

Thanks. Now I'll turn the discussion over to Sharen.

Sharen Turney

Thank you, Stuart, and good morning. Total Victoria's Secret segment sales including La Senza, increased 15% in the first quarter to $1.2 billion. Comp store sales increased 2%. Total segment operating income declined $72 million to $146 million, a decline of 33%.

Several anticipated non-comparable items negatively impacted the Victoria's Secret segment results in the first quarter. Of the operating income decline, slightly more than 10% related to the expenses associated with our new distribution center and upgraded technology. These investments support the future growth of our direct business. Another 10% related to expenses associated with our real estate initiative. As we ramp up the number of expansion projects, we begin to accelerate depreciation on our store assets at the same time we make a decision to remodel the store. This results in the recognition of a significant expense prior to the realization of the benefits associated with the expanded store. This negative impact will continue through the remainder of 2007.

Lastly, the inclusion of La Senza's results represent not quite 10% of the operating income decline. We expect that the investments in direct and our real estate initiative will impact the second quarter by roughly the same dollar magnitude as the first. La Senza's results should be relatively neutral to slightly positive in the second quarter.

Now turning to the individual business results within the segment. Victoria's Secret store's first quarter performance was disappointing. Comp stores of 2% and 10% on a two-year basis did not meet our planned sales growth. The gross margin rate declined significantly, driven primarily by a decline in merchandise margin which was down significantly to last year and to plan. Buying and occupancy expanse deleveraged, driven by the impact of the real estate activity that I discussed earlier.

The SG&A rate increase to last year was primarily driven by an increase in marketing and store selling expense. We planned for an aggressive growth on top of the very strong performance last year, supported with planned additional marketing activities and the inventory to support our planned sales growth. The quarter began with a weak Valentine's Day holiday performance and the environment continued to be challenging throughout the first quarter. Mall traffic was down 6% in the quarter.

In response to softness in the sales trend, we implemented promotions during our bra launches, we were more aggressive on a multiple pricing strategy for PINK panties, and we took markdowns on certain sleepwear merchandise in order to drive traffic and move through inventory that was bought to a more aggressive plan. These actions contribute to do a decline in our merchandise margin rate. Adding to this decline was a shift in our sales mix as a higher percent of our overall sales came from PINK, which operates at a lower margin than some of our other categories.

We missed sales expectation across all segments of the business including, bras, panties, PINK and Beauty. We supported our bra launches with national media and strong customer relationship marketing campaigns, however, in hindsight, our bra launches lacked enough differentiation and newness to drive the planned growth in our bra and panty business. In PINK, sales growth was driven by loungewear but the overall assortment did not deliver on aggressive sales plan. In Beauty, the successful Beauty Rush body launch was offset by a disappointing performance in other categories.

The results for Q1 clearly highlights some near-term areas of opportunities for our business. We have a relatively new senior leadership team that is actively repositioning the business to deliver low to mid single-digit comp growth, square footage growth of 8% to 10% and predictable bottom line growth.

This repositioning activity includes balancing sales growth with marketing and inventory investments, growing market share through critical bra launches, capitalizing on cross-channels and cross-category efficiencies, executing a real estate strategy. The results of these actions will not be seen immediately. We expect the second quarter to remain challenging.

I'd like to highlight some of this activity. We've reviewed our planned marketing expense and have eliminated less productive marketing activities while focusing on opportunities for integrated messaging. We will reduce our marketing spend in the remainder of the year, while providing the appropriate level of support to our key launches. In addition, we are aggressively managing our inventory position while still providing the required level of product newness for our customer. Maintaining a level of newness will enable us to continue to grow market share through critical bra launches and focusing on floor-set execution.

For the balance of the season, we are planning the following:

This week we introduced a Very Sexy 100-Way Bra, a strapless convertible bra that can be worn in a variety of ways, supported by a direct marketing campaign to drive awareness, trial and loyalty, and it's off to a good start.

Our semi-annual sale event is planned to run from June 19th to July 9th, the same length and timing as last year and will be supported with national media. In July, we will anniversary last year's very successful back-to-school PINK floor-set, focus on PINK's loungewear, accessories, bras and panties.

In the fall, we are placing a larger emphasis on critical bra launches with the greatest potential for success resulting in fewer but more effective bra launches. We also plan to continue growing the PINK brand through products and targeted support of critical themes.

In Beauty, we will launch new products while continuing to grow our proven winners including Dream Angels, Garden and Beauty Rush.

The Intimissimi line of intimate apparel, which represents a strong opening price point proposition and an escalated frequency of fashion, continues to expand in additional store in store locations. Intimissimi is now 155 stores with plans to expand to roughly 230 stores by the end of this year.

Finally, we continue to be excited and optimistic about our real estate strategy. In the first quarter we opened five new stores and remodeled two stores, with the plans to open or remodel a total of 140 stores by year-end. The increased square footage, and additional locations, will provide for long-term growth, but will present short-term challenges as we absorb the additional investment expense.

Turning our attention to the direct channel, the catalog and the Internet channels continue to be an important part of the 360-degree access we provide our customers, and we maintained momentum throughout the first quarter in the direct channel. Victoria's Secret direct achieved first quarter sales growth of 9%, still below our aggressive expectation.

The 12-month buyer file grew in line with sales as the business distorted to key spring categories, expanded the use of successful tested gift with purchase, and invested in additional Internet marketing efforts. Sales growth in the quarter was driven by swimwear, dresses, casual woven separates and knit tops, partially offset by a declined in bras.

Swimwear growth was primarily focused in our Beach Sexy sub brand, bra tops and matte jersey dresses drove the increase in dresses during the quarter. Direct merchandising margin rank declined in the quarter, principally due to the impact of the sales mix shift to apparel from bras and the higher clearance price selling in the early part of the quarter.

As expected, operating income dollars were down to last year, as we make the investments to support the growth of our direct business that I had mentioned earlier. The focus for the balance of Q2 will be on optimizing growth via our diverse merchandising portfolio and leveraging the strength of the semi-annual sale. Marketing focus will continue to be on reducing less productive circulation and reinvesting in web banner advertising to not only drive sales, but to continue to build our customer file.

In closing, during the first quarter we identified and began to address areas of opportunity. We also experienced positive traffic in our stores and realized a double-digit increase in unit velocity. Victoria's Secret is a fundamentally strong business and a brand with a very compelling growth opportunity.

Thank you. Now I will turn it over to Neil.

Neil Fiske

Thank you, Sharen, and good morning. Bath & Body Works comps increased 5% in the first quarter against a 4% increase last year. Sales for the quarter were below our expectations. Total sales for the quarter increased by $35 million over last year. Operating income, however, declined $17 million to $7 million. The operating margin decline was driven by a significant increase in the SG&A rate as the gross margin rate was down slightly.

As Stuart mentioned earlier, Bath & Body Works incurred substantial costs this quarter related to our supply chain systems implementation. Roughly half of the decline in operating income dollars is attributable to these costs. In fall 2006 we undertook a large-scale systems implementation encompassing the majority of our technical infrastructure including planning, finance and replenishment. Beginning this quarter we began recognizing these costs related to these systems which were previously recognized as an expense in the other segment.

In addition, we have spent considerable time and incurred incremental costs working through the technical and process issues, which often occur with a large-scale implementation of this magnitude. We remain confident that our new supply chain systems and associated processes will result in long-term benefits through higher in-stock levels, better inventory turn and faster response to selling trends. The other half of the decline in operating income dollars relates to the incremental investments in the brand, primarily related to real estate and marketing.

The quarter began with soft sales performance in our Valentine's Day theme which was partially due to inclement weather. In mid February we had a strong Presidents Day weekend driven by the launch of our new aroma therapy fragrances in Tranquil Mint and Mandarin Lime as well as additional promotional activity.

Our combined March and April comps were plus 7% driven by a solid Easter and a strong launch for our new Honeysuckle fragrance in March. However, our Mother's Day theme, which began in mid April, performed below expectations, driven by softness in the gifting category. Our gifting collection for Mother's Day was not as well received this year as it was last year, as our customers did not respond as favorably to a direction that was more trend and fashion-forward. We have applied our learnings and made appropriate course corrections from Mother's Day for this holiday, re-emphasizing the more traditional elements of our collection.

During the quarter momentum continued to build in our direct business. We saw positive performance of our multi-channel strategy with the distribution of 3 million copies of our spring catalog as well as the continued success of our e-commerce business. We view the direct channel as both a revenue and profit generator as well as a marketing vehicle for our brand and our collection of powerful sub brands.

Looking ahead, we have a cautious outlook for the second quarter driven by top line sales performance and the ongoing nature of a portion of the costs that impacted the first quarter. We are currently in our bronze bombshell theme featuring bronzing and tanning products from our True Blue Spa line. Also features, our fun new summer fragrances in the Signature Collection, Fresh Pineapple and in our Temptations line, Sunset Mango and Island Coconut.

Beginning the first week of June we launch our semi-annual sale, which like last year, is planned to run for five weeks. We wrap up the season with our post semi-annual sales theme featuring the launch of a new fresh, cool, clean collection under the Signature Collection line. Looking forward to the fall season, we are cautiously optimistic in the fundamental underpinnings of the brand to deliver a successful fall and holiday.

With that, I'll turn the discussion back to Tom.

Tom Katzenmeyer

Thanks, Neil. Given the announcements about our apparel brands last week we wanted to focus our time on this call on Victoria's Secret, Bath & Body Works and the growth opportunities in our business. So I'll make just a few comments about apparel before we begin to take your questions.

For the first quarter, total apparel segment comps were up 5% and sales increased 2% to $499.2 million. Total segment operating income increased by $2 million to $18.4 million. Express comps increased 5% in the first quarter with sales exceeding expectations. Operating income was roughly flat on a dollar and rate basis and was negatively impacted by an increase in shrink realized during March physical inventory and incremental investments in customer relationship marketing.

In February, Express kicked off the season with strong performance of their early spring assortment that featured the launch of the new wide-leg pant which was complemented by compelling in-store and targeted direct mail offers. The wide-leg launch is an outstanding example of Express' ability to bring fashion from the runway to their doorway quickly and successfully and has certainly created momentum in early spring.

In March, Express continued to focus on spring merchandise and new product launch activity with the introduction of the new deluxe premium denim. As many competitors moved to sale with softer than expected March sales trends, Express remains focused on the late March dresses floor set, which produced strong results and was on fashion trend.

The sale event in the first part of April drove significant traffic and was successful. April finished the quarter strong with positive momentum being generated in both the men's and women's businesses and featured a highly integrated Life is Shorts campaign both in-store and through direct mail. Throughout spring Express continued to work to improve traffic trends through focused, segmented and integrated messaging to the customer. Express traffic was above mall traffic trends ten of the 13 weeks during the first quarter. A more focused, consistent approach to the assortment and communication of the brand store has built a positive response to the summer assortment. We are confident in the plan to keep customers engaged in the brand through the balance of the season and beyond.

At Limited Stores, first quarter comps increased 4% and the operating results improved to a breakeven result. The improvement in operating margin was driven by an expansion in the gross margin rate, a result of both improved merchandise margins and leverage in buying and occupancy costs. Comp growth was driven by the wear to work category and dresses.

That concludes our prepared comments. At this time we'd like to begin to take your questions. Again, I want to remind everyone we'd like to get to as many people as possible, so please limit yourselves to one question.

Operator, I'll turn it back to you, and I will help you moderate the questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Morris - Wachovia.

John Morris - Wachovia

Neil, remind us a little bit about the opportunity you had for holiday. I know it's way out there on the horizon but obviously it's a very critical period for you and the BBW division. What have you got on tap for holiday? Where's the opportunity this year versus last year?

Sharen, maybe if you can delve a little bit deeper at Vicki's on the bra category, why the launches have lacked differentiation, and how you plan to address that? Also, your initiatives for sleepwear as well. Thanks.

Neil Fiske

As you may recall, we made some adjustments in 2006 responding to our learnings from the prior year in our holiday strategy that were quite effective this year. We moved to a more transitional floor-set to kick off the holiday season called Happy Fallidays. We had a terrific October and a terrific November as we moved into our Aspen theme and picked up a lot of ground this year early in the holiday season relative to the prior year.

Where we believed we had opportunity coming out of holiday was really in the closing ten days or so, where we didn't have sufficient inventory of our best-selling seasonal items because they had sold through, nor did we have specifically targeted programs to go after traffic and conversion in those last ten days. So the biggest adjustment we will be making in holiday 2007 is to go after the final stretch of holiday with a different assortment strategy and a different set of programs to go after the last-minute shopper.

Sharen Turney

When we talk about the bra category, I think that one of the things that we did this year that I think that we weren't differentiated enough is that we built upon the technology that we launched last year and I think we started talking to ourselves a little bit internally. So when you think about Secret Embrace, it is the most fabulous one-piece bra, we actually took that to our different sub brands. Last year we focused on that in one sub brand so this year we took it as a collection. I think that what we ended up doing was confusing the customer about is Secret Embrace a technology, is it a sub brand? We weren't clear within our messaging. That's the number 1.

Number 2 is last year when we owned a bigger share of our market in truly push-up bras and last year we really focused on some of the market share like the wireless or full coverage that we did not own. This year we did not, we weren't as aggressive about that. We really put too many launches in place that were targeted just to the push-up category.

Number 3, I think in terms of as we talked to our customers and navigation within the stores, that as we have launch ideas, whether it be new or improved technology, that we have to be much sharper in terms of what our message. We have done a lot of hindsighting and what we have also found out is that really the customer is not as much about the technology, but the technology is a driver to the benefit of the bra and so understanding the balance between those two. So we have taken all of these learnings as we go forward into the fall season.

In terms of the sleepwear category, and it's really a category that really builds in terms of holiday and we did a lot of learnings last year as we looked at tying back into some of the Victoria's Secret Direct and Victoria's Secret store sleepwear, it is something that we learned a great deal about. We think that we have taken those learnings and affected the assortments as we go into the holiday timeframe and have really some aggressive, exciting plans for this holiday around sleepwear.

Operator

Your next question comes from Lorraine Maikis - Merrill Lynch.

Lorraine Maikis - Merrill Lynch

Thank you. Good morning.

Can you just give us a little bit more information on your outlook for Victoria's Secret and what's included in your full year guidance as far as the second half? Also have you considered monetizing some of the investments on your balance sheet in order to return more cash to shareholders?

Stuart Burgdoerfer

We don't provide segment specific guidance in detail but what we can reiterate is that for the enterprise in total for the second quarter our comp expectation is low to mid single-digits, that we expect a decline in gross margin rates, an increase in the SG&A rates and again for the full year we're expecting mid single-digit comps, a decline in gross margin rate and an increase in the SG&A rate.

Many of the factors that Sharen described in terms of affecting the first quarter in terms of some of the incremental costs, I think, as she described it's the case, obviously, that some of those costs will continue and that's reflected in our total company guidance.

Martyn Redgrave

Lorraine, you said investments, so I assume you mean investments in joint ventures and other businesses. If that's the case, we're always evaluating the net present value versus market value of various other investments that we have, and wherever we find the right timing and the right opportunity, we will monetize those investments. We've been pretty aggressive about that in the past and we would continue to be aggressive in the future. It is explicitly something that we will look at in connection with the overall evaluation of our capital structure.

Operator

Your next question comes from Dana Cohen - Banc of America.

Dana Cohen - Banc of America Securities

I just wanted to go back on the operating margin decline at VSS. Of the 900 basis points can we slice it into SG&A and merchandising margin? Looking at the merchandising margin, what were the biggest chunks of the pressure? Just so that we can have a better sense of what is hitting this quarter and what is go-forward. Both for the VSS and BBW, how much of this expense is going to continue for the rest of the year?

Stuart Burgdoerfer

Dana, in terms of the breakdown of the operating margin decline in the VS segment, the impact of merchandise margin and gross margin as well is a bit greater than the impact of SG&A, so we're not going to, you know, get more specific than that. But in terms of magnitude, the gross margin decline on a rate basis was greater than the SG&A decline. In terms of the ongoing effects of the real estate initiatives, you know, as Sharen indicated, those will continue through 2007 but will not rate a bit towards the end of the year.

Dana Cohen - Banc of America Securities

And the BBW?

Stuart Burgdoerfer

At BB,W in terms of magnitude, the SG&A impacts that Neil outlined were substantially greater than the slight decline in gross margin rate. Again, a fair portion of those will continue through the balance of the year given that they're related to the costs associated with the new systems.

Operator

Your next question comes from Randall Konik - Bear Stearns.

Randall Konik - Bear Stearns

Sharen, can you just give us some color on what your thoughts are on how Victoria's Secret is positioned in the competitive landscape? It sounds like a lot of items you talked about are self-inflicted issues on the business in the first quarter and maybe the last quarter. Can you just give us your thoughts on issues in the business that are self-inflicted versus competitive related? Thank you.

Sharen Turney

Sure. As I stated, I do believe that our bra launches and some of even our fashion misses were totally self-inflicted. There is no doubt and we're quite aware of the competition, and it is something that obviously that we are quite aware of. We know where JCPenney is positioned, we know they went to InnerBrand, as a consulting firm to help them. We know from the InnerBrand folks that they actually patterned us and have tried to emulate how our sub brand positioning is. And in knowing that, it is our job and our duty to continue to push forward because you're always going to have followers and we're very sensitive to that.

We also know that there are opportunities within the segments that we are not serving today, whether we think that we've covered some of the younger segment but not all of the younger segment and there is a different pricing structure that has to be applied to that. We definitely understand where aria is in Penney’s stores and what they're moving and how they're moving and are watching that. Especially as you think about the panty business and how you really continue to win at panties which is a focus of ours.

We're also very aware of the fact that A&F is looking at opening up their 10,000 to 12,000 square-foot stores and we understand those real estate initiatives and we feel like that more of what happened to us in the first quarter is self-inflicted versus competition. But in no way are we thinking that competition is not important and it's something that we are ready to compete with.

Operator

Your next question comes from Lauren Levitan - Cowen & Co.

Lauren Levitan - Cowen

I'm curious if Sharen and Neil could comment on operating income targets both in the near term and long term for their brands? Is it realistic to think that historical levels can be achieved? Neil, maybe you can give us a specific sense of what would the apples-to-apples comparisons had been if you'd been allocating expenses on a comparable basis to the way you are now versus having some of those expenses allocated to other?

Sharen, on the operating income side, if you do see more competition and more need to be marketing, what implications does that have for the long-term operating income potential of the brand? Thank you.

Tom Katzenmeyer

Lauren, just to clarify, are you asking about the whole year? A whole year operating income rate?

Lauren Levitan - Cowen

Yes, that would be helpful. Selling on a near term and long term maybe this year and then over multiple years.

Tom Katzenmeyer

Why don't we go to Neil first. We won't obviously go out that far but why don't we just go to Neil first for an observation of that data.

Neil Fiske

I think that the apples-to-apples question is kind of a tough one to answer because of where we are in the stage of implementation of the supply chain system. So obviously there were a lot of costs that we have this year that we just simply didn't have last year, having gone through this in fall of '06 and having ramp-up and transitional issues and implementation issues, some of which we foresaw, some of which we didn't foresee. There is really no comparable to that. As Stuart indicated, that was the single biggest driver of our year-over-year change in SG&A rate.

So I know we're not getting specific on those numbers, but directionally that should give you a sense of where it was this year versus last year and the transitional nature of those implementation costs.

Sharen Turney

For Victoria's Secret, we are really investing for growth, both in the direct channel and in the store channel for top line and bottom line growth. When you think about the investments that we are making, the operating rate to maintain itself in historic rates over the near horizon as we are talking about touching 80% of the fleet, will be much more difficult.

I think, though, that the investment in the real estate, the investments in technology, the investments in the merchandise categories and also balancing out the merchandise categories I think will give us the opportunity to grow, not necessarily on the rate basis.

Martyn Redgrave

I'm going to just add something. This may be helpful, but I will state it in the context of our expectations. We recognize that there are cost impacts occurring because of real state initiatives and technology initiatives. When we look at the overall financial architecture of these two core business segments, intimate apparel and BBW, we expect them to get back to and sustain the level of overall operating income margin that they have historically been at.

Lauren Levitan - Cowen

On a rate basis.

Martyn Redgrave

I said operating income margin, rate, percentage of sales.

Operator

Your next question comes from Neely Tamminga - Piper Jaffray.

Neely Tamminga - Piper Jaffray

I wonder if you guys can give us a little insight as to how we should be thinking about mass with respect to this transaction as well as, you know, give us a sense of how much mass is supporting, what total percentage of mass is supporting the intimate apparel brands versus the Limited apparel versus non-Limited brands. That would be really helpful.

Martyn Redgrave

Mass, is I think you know, is our sourcing and production business arm that serves all of our apparel, intimate apparel businesses, so its biggest customer by far is the Victoria's Secret and Victoria's Secret direct businesses and obviously will continue to serve those businesses as they always have before.

In connection with the Express transaction, we have agreements with our new partners, Golden Gate, to have Mass to continue to serve the Express business. We would expect that any agreement we would reach or any option we would choose for Limited Stores would also include a similar agreement for continued services from Mass. So we continue to see it as a fundamental part of our strategic business portfolio in terms of operating, it's the sourcing and production arm of our core business, the core businesses. We also have another one called Beauty Avenues, it's in the same category for Neil and his team.

Mass does serve third-party clients and has a relatively significant business in that, but that is secondary, if you will, from the overall portfolio management perspective to its core position as the sourcing and production arm of our businesses.

Operator

Your next question comes from Brian Tunick – JP Morgan.

Brian Tunick - JP Morgan

I guess trying to reconcile why you expect comps for the second quarter to be up low to mid single-digits? Why the acceleration over the next two months? And then maybe if you could talk about the capital structure review that's ongoing, maybe what kind of leverage or debt to equity levels does the board feel comfortable with now given the fact that the fashion risky apparel businesses are gone? Thank you.

Stuart Burgdoerfer

Brian, as you would imagine, what we do in terms of estimating comps is we look at our comparisons, obviously. We look at the trends of our business and historic and expected builds, given prior launch and marketing activity and what we have in the hopper for the current period. Based on that work, despite our comments about May, we're comfortable that based on what we know that we would realize a low to mid single-digit comps in the second quarter.

Martyn Redgrave

Brian, in terms of our overall capital structure, the framework that we're looking at it within, is the following and I think I've been very clear about this and consistent over the last 18 months that I've been on these calls.

First and foremost, we want to make sure we have the cash flow to support the operating businesses and the capital for growth initiatives, as I've described at the beginning of our call, as well as the technology initiatives that we've been describing consistently for the last 18 to 24 months. We also want to be able to support a strong quarterly dividend and we've defined that as a high-yield dividend position. We will always be looking to support that kind of a quarterly dividend. We have consistently said to the extent that we have excess free cash flow, that we would return those to shareholders and the $500 million that we've announced yesterday is a consistent signal along those lines.

In terms of overall capital structure, what we continue to believe and our advisors continue to recommend most strongly, is that we want to remain investment-grade in terms of our overall capital structure. We believe that's very important given the aggressive growth ambitions that we have in terms of capital flexibility and availability.

Tom Katzenmeyer

Thanks, Martyn. I realize it's right at about 10:00 and there are other calls this morning but we would like to continue to take your questions. So operator, if we can get another question.

Operator

Your next question comes from Richard Jaffe - Stifel Nicolaus.

Richard Jaffe - Stifel Nicolaus

I'm going back to the operating margin opportunity over the next couple of years and the potential to return to either historical levels or near historical levels at both Victoria's Secret and Bath & Body. I guess obviously at Bath & Body they get the new systems in place things should get close to rebounding with positive comps to where they were in the past, but at Victoria's Secret it seems more challenging. There seems to be some issues that are longer term that will keep margins below historical levels. Could you help us understand if it's realistic to expect operating margins to back to historical levels or if the initiatives, the additional depreciation attached to real estate, the lower margin businesses of PINK and Intimissimi all contributing to perhaps a lower operating margin going forward?

Stuart Burgdoerfer

A lot of this depends on the timeframe that you're looking at, obviously. So in the near-term the investments that we're making I think are clear, we've described what they are and they certainly put pressure on the operating margins rate. As we begin to realize the benefits and the leverage that comes from those investments in a mid to longer term horizon, we certainly expect to approach, if not reach, the historic operating margin in both of these businesses.

So it's a tough question at the end of the day to answer it. It's one that involves a lot of judgment and investment of competition and the other factors that we've been discussing and certainly that we evaluate, but certainly we expect to get leverage and benefit from the investments that we're making and we would expect a significant improvement in the rate and in the mid to longer term basis approaching, if not being at the historic rates for the segments.

Operator

Your next question comes from Todd Slater - Lazard Capital Markets.

Todd Slater - Lazard Capital Markets

Just a question on PINK if you could talk about your PINK standalone strategy in malls where you expanded or plan to expand Victoria's Secret stores by 50%. Thank you.

Sharen Turney

The PINK freestanding stores is really a task that we have within three markets in this timeframe. We do have plans for two more coming up within the near-term. The strategic intent is for PINK to be a part of the total Victoria's Secret as well as the other sub-brands. We see it as an integral part of the growth as well as an entryway into Victoria's Secret. So I think that as we continue to learn about the freestanding stores as we go into larger square-foot stores, and one of the reasons we're moving into larger square-foot stores is that we have more ideas than what we can accommodate today within our average 6,000 square feet stores.

Operator

Your next question comes from Jennifer Black - Jennifer Black & Associates.

Jennifer Black - Jennifer Black & Associates

I wondered if you could talk a little bit about BBW? Do you feel that you have the right assortment in your flagship stores, and, or if you could narrow the assortment? I was surprised to see Frederick Fekkai in Target and the Jonathan brand at Costco. I just wondered how you feel the industry is going?

Neil Fiske

I think the short answer to your question is, yes, we can narrow the assortment in our flagship stores. We've been, as you know, on a little bit of a journey over the past couple of years to figure out what the right mix of breadth and depth is. Clearly, in the beauty landscape there are a lot of different ways to slice it and to compete. Some of our competitors are kind of a beauty supermarket and have tremendous breadth. Others are much more narrowly focused and traditionally we have been fairly narrowly focused.

Where we are now in our flagship group, and I think in principal overall for Bath & Body Works is moving to a narrower assortment where we're concentrating on building fewer, bigger, better brands that have the potential to be number one or number two in their category. We're really using that as a filter for what we develop, what we put into our stores, and so I think you would expect to see the assortment not just in flagships but in core stores as well continue to narrow in its breadth and at the same time the brands that we have, we feel very strongly about.

In the girl's segment we have the number one girl brand in America. In the Bigelow brand we have the oldest apothecary in America and the potential to be the largest apothecary brand in the U.S. very shortly. We have the world's largest aroma therapy brand, the world's largest spa brand, the world's largest fragrant and body care brand with Pat Wexler. Depending on how you keep score, we will be number two or potentially number one in that category very shortly and our focus is really to continue to build those few brands that can dominate their segment.

Operator

Your next question comes from Barbara Wyckoff - Buckingham Research Group.

Barbara Wyckoff - Buckingham Research

A question for Sharen about color and bras. You know, in the spring season you had a lot of color. What percentage of the business was in color versus last year? Were the sales in line with your ownership, and then could you just comment on sort of your thoughts on color and its importance going forward--now and going forward?

Sharen Turney

The color selling in bras this year actually increased by about 20 points over last year as a percent of total. The color initiative and expanding the fashion colors was very beneficial to us. In fact, where you saw the slower selling were in the basic colors. I think that as we look at the fashion trends that are going on in the market today, as well as what we predict for his holiday and into next spring, we believe that this still is a very important opportunity for us. We also think that we can do a better job in terms of balancing color distortion between the different sub brands to actually have clear identification between our sub brands.

Operator

Your next question comes from Paul Lejuez - Credit Suisse.

Paul Lejuez - Credit Suisse Securities

Sharen, can you maybe talk a little bit more about the swim, accessories and sport opportunity? What's going on now and what are you thinking longer term? And then just quickly could you, Stuart, maybe remind us what the minority interest is on the balance sheet?

Sharen Turney

Sure, Paul. Basically in terms of where we have the predominant swim categories in the direct business and that business has continued to grow over the last couple of years, each year compounding over high double-digit increases. We did take a position this year to test swim within our retail stores and really evaluating that opportunity. Swim is a difficult business in the retail sector because of the narrow selling time. I think that as you start to prioritize all of the different growth opportunities you have to stack up where could swim be, but to get that information and to have that, also, is a good thing.

I think when you think about the sport business, is that, you know, we believe that we've been experimenting with sport learning. We think it's a natural adjacency to our core business. We did a lot of consumer testing around this. There's a great connectivity from the customers that say, you know what you guys can do it, we believe you can do it, and it's an initiative that we have been working on. It has a small test that we'll continue to rollout testing that concept as we go into fall and then, obviously, into spring.

The accessory business is really a good opportunity when you think about the PINK business or it's another opportunity for us to be in what you might call the gifting business on a year-round basis, and it's something that we are playing with. Obviously you'll see some other more exciting things from us around holiday. PINK has got a focus on that and it is just another layer of getting a piece of the brand.

Stuart Burgdoerfer

Paul, the key item in that line is last fall we established a venture with an independent technology provider and the amount you're seeing in that line is related to that venture.

Paul Lejuez - Credit Suisse Securities

And so that's all fully consolidated?

Stuart Burgdoerfer

It is.

Paul Lejuez - Credit Suisse Securities

And it's losing money?

Stuart Burgdoerfer

It's an investment position given that it focuses on technology.

Paul Lejuez - Credit Suisse Securities

But it's an add-back, right?

Stuart Burgdoerfer

That's right.

Martyn Redgrave

Just to be more specific, as it is a matter of public record, we are a joint venture partner with a private equity firm that is engaged in building technology solutions for direct channel businesses and specifically for Victoria's Secret Direct. And so they are an investment or a start-up phase where everything is expensed through the P&L and we're consolidating that because of our minority interest position and the fact they're specifically focused in their first phase on delivering technology to Victoria's Secret direct.

The reason I call that out is because that will be a continuing impact on our financials in 2007 while we're recognizing the expenses from that venture without recognizing any benefits for the technology because the technology won't be delivered until the end of the year.

Paul Lejuez - Credit Suisse Securities

Can you quantify that impact?

Martyn Redgrave

Let us think about how much detail we want to go into that. Right now I would say no.

Operator

Your next question comes from Howard Tubin - RBC Capital Markets.

Howard Tubin - RBC Capital Markets

Sharen, just a question for you on the upcoming launches for the second half of the year at Victoria's Secret. Will the launches represent complete newness to the customer or will they be a continuation of expanding technology through existing lines?

Sharen Turney

We actually repositioned our whole entire launch strategy for the fall season and now what you'll be seeing is newness that will come into play. As we think about the launches as we go into it, they will have benefits of some of the existing technology that we have, but they actually are going to be more new than not.

Operator

Your final question comes from Dana Telsey - Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

As you look at the business in the context of Victoria's Secret and Bath & Body Works, has there been a time in the past that both businesses have faced these challenges? Is there anything from history that can be used potentially as a guidepost to map out the recovery? Thank you.

Tom Katzenmeyer

Neil and Sharen, you both want to give an observation about that?

Sharen Turney

Yes, we have seen this animal before in terms of, as you guys have been with us a while, of when we've had great launch years, tough launch years and great launch years, and I think that we've been able to learn a lot from that and we gain momentum when we've gone through soft launch years. So I think that the obvious complexity of the business is probably continuing to be there and as we're learning our way through that, might be a difference from the past. But we have definitely seen this animal before.

Neil Fiske

My perspective on it would be the year that we're in, I would describe somewhat as an anomaly relative to our history. This isn't like it was back in 2001or 2002 when the business was really heading in the wrong direction from comps and income. We are undertaking a very ambitious agenda right now to build an infrastructure for our business that will support its growth and it's an all-consuming endeavor and it takes a lot of management attention, it takes a lot of resources, and as much as we'd like to hope that it doesn't impact the business from top line sales or innovation, a project of that magnitude, obviously, ends up taking a lot of time and attention.

So my perspective on it would be as we get through the implementation and we really get this thing humming, the business should pick back up in its momentum.

I'm very optimistic about what this can do for us in moving to a much more of a pull-based business system, where we have much faster inventory turns, much higher in-stock levels, the right product in the right stores at the right time, is an enormous opportunity for us. I think when we get the infrastructure, the processes and people in place, it should kick-start the business with a new set of growth.

Tom Katzenmeyer

Thanks, Neil. Thanks, everyone for all the time you have spent with us this morning and we appreciate your continuing interest in Limited Brands.

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Source: Limited Brands Q1 2007 Earnings Call Transcript
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