In today's inflated market there are few opportunities to find value. Many people are in the market not because they want to be, per se, but because banks don't pay anything and people are afraid of losing purchasing power. But L Brands (NYSE:LB) could be an interesting choice for long-term investors. The stock has retreated slightly in recent days, and there might be better entry points in the near future if the weakness in retail persists, which we think it will.
L Brands is a great business with strong competitive advantages. The company is the industry leader in the women's intimate apparel and beauty market and faces limited competition. According to Morningstar, Victoria's Secret is the market leader in bras and panties in the US, and has 3 of the top 10 fragrances. Bath & Body Works is the market leader in a variety of categories, including body lotions, fragrances, and shower gels, and the combination of brand strength and loyal customer bases give LB pricing power. In addition, we believe that consumer preferences for comfort make buyers less sensitive to price. LB also has important advantages on the cost side that raise barriers to entry and success. The firm's large scale allows it to operate at lower unit costs, and LB can spend less on marketing than less developed rivals thanks to the reputation of its Victoria's Secret and Bath & Body Works brands. Finally, we believe that switch costs make it difficult for rivals to take share from LB (customers tend to stick to familiar brands in order to avoid trying on a bunch of different clothes).
Thanks to its powerful brand intangible assets, LB can generate economic profits and high returns without expending a lot of capital. Free cash flow has averaged almost 10% of sales during the past three years, and the company pays out nearly 50% of earnings in the form of dividends. The dividend yield of 3.1% is safe, in our view, thanks to strong profitability, cash flows, and entrenched advantages that minimize business risk.
LB has grown revenues at a 5-year CAGR of 4.8%, averaging 4% comps growth in the past three years that reflects a mix of pricing and market share gains. This is vastly superior to the 1.6% average growth for the women's clothing store industry, and LB has room for more growth in international markets (which account for just 4% of total revenues), and through new product introductions.
LB's stock price declined slightly the other day after the company reported results for August. Total sales increased 3%, and comps came in better-than-expected at +2%. However LB sacrificed margins in order to achieve these top-line results, and slashed prices on sports bras to take market share. Industry conditions have become more competitive for retailers as economic growth has slowed and consumption has shifted to e-commerce, but we don't think LB's powerful brand advantages have eroded. There is a risk that consumption will continue to slow, which would lead to a more promotional pricing environment and possibly cause consumers to trade down to cheaper brands. However we think this would just lead to a better buying opportunity, and that there are plenty of reasons to be optimistic about the long-term outlook for LB. LB's strong advantages put the company in a better position than most retailers to deal with the growing threat of Amazon. And, even if product margins start to decline, LB can still improve net profit margins by leveraging fixed costs across greater scale and by franchising more of its stores (which would reduce overhead).
There is little value to be found in today's market, but investors with a buy-and-hold focus should keep their eyes on L Brands. With a forward P/E of 18 and a cash flow yield of 8.7% (compared to its 5-year average of 7.2%) the stock trades at a reasonable price, and it could fall to an ever better entry point in the near future if economic growth continues to stagnate. The dividend yield is compelling at 3.1%, and we think it will become even more compelling in the coming months as more investors realize that the Fed won't raise rates significantly anytime soon.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.