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Francis Lynch
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I have deep passion for investments and understanding of how global markets function. I hold a Bachelors of Science in economics-finance from Bentley University and am scheduled for the CFA level 1 exam for June 2014. I consider myself a value investor.
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  • L Brands (LB): Larger Economic Moat, But Concerns Remain Within The Castle Walls 0 comments
    Jul 28, 2014 3:20 PM | about stocks: LB

    (click to enlarge)
    I am upgrading my outlook on L Brands (NYSE:LB) to accumulate from neutral on the basis of the company's strengthening market position (Larger economic moat), growing international presence, increasing sales and stable cash flow (albeit surrounded with retail uncertainty). My primary concerns remain warranted however as debt interest payments remain excessive and could affect net income and/or future dividends. Further pressure could result should consumer spending decline or if additional funds are needed for further capital expenditures. As a result I am reducing my 2014 share price target to $72 from $78 (26% increase from its current level) but slighty increasing expected earnings per share to the range of $3.40-$3.55, which would result in a more comfortable P/E multiple of 20-21, slightly above the historical average of 19 times earnings.

    An updated and in depth analysis will be provided later this week.

    L Brands is the parent company of Victoria's Secret, Body Shop, La Zensa and Henry Bandel. The company currently operates 3837 stores around the world with nearly 23% of these stores located overseas, primarily in Asia and Europe.

    Fundamental Case (Original Analysis Provided on June 2nd 2013):
    Earnings for the most recent quarter increased to 48 cents a share from .41 cents a year ago (A 17.7% increase). Revenue on the other hand increased 5.29% to $2.27 Billion. This beat Wall Street estimates on both the top and bottom line yet the stock has fallen 8.6% since its most recent earnings call, representing a great buying opportunity for long-term growth investors.

    A quick analysis of overall revenue reveals that it has not changed much since 2008. Profit on the other hand has stabilized to around $2.54 a share for all of 2012 (up from a low of .65 cents in 2009). Same store sale increases should drive both the top and bottom line going forward as VS and BBW should each achieve 8% increases in same store sales this year. I expect revenue to increase to $11.25 billion for the full year, with most of the gains coming in Q4, representing a 7.8% increase over 2012 totals (Average analyst estimates call for $11 billion).
    Despite strong earnings, there is one major concern for the company and that is the amount debt outstanding, which recently stood at $7 billion. While cash and cash equivalence stood at $547 million, any downturn in the economy could send shares south. Management unfortunately paid out a $3 a share dividend last December to avoid paying new capital gains taxes that kicked in this year.

    International Potential:
    Despite operating 1,019 Victoria Secret locations around the US, the company has a limited presence overseas. It operates 26 stores in Canada as well as "initiation" locations in England, Hong Kong and the Middle East. In the future most of the company's new revenue is likely to come from overseas markets. The brand is very well known around the world due in part to their models, annual fashion show and product appeal.

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    From L Brands International Website Section

    Margin pressure:
    As a retailer, the company commands extremely attractive profit and operating margins. In my analysis this is likely to continue as seasonal promotions end and existing inventory is cleared out. Though industry experts predict that "Same Store Sale" margins for VS stores are likely to contract to 17% over the next five years, they do not point out much that could cause this besides increasing competition. In my view as long as inventory management, strong product offering, a loyal and expanding customer base and falling commodity prices remain intact, margins for VS stores could potential increase by 2% over the next few years to 28.4%.

    Lets turn our attention to commodity costs. In particular cotton and polyester fibers, which are two important variables for garment makers. While the price of polyester fibers has not fluctuated much over the past few years, I am expecting prices to slump during 2013 and into 2014 as China's economy shows signs of slowing down (Currently China consumes over 65% of all polyester fibers). The price of cotton has fallen over the past two years and is likely to fall further as excess supply continues to hit global markets. These trends are extremely attractive for L Brands as operating and profit margins are likely to increase further driven by an effective and seasoned management team.
    Furthermore revenue per square foot, an important industry metric, has been steadily increasing. In 2009 rev per square foot increased from $580 to $860, and at BBW it went from $587 to $749. These trends are likely to continue as the company begins opens new stores.

    Over Valuation?
    While L brands commands a P/E ratio of 19.6 many of its competitors sport lower P/E's, and the industry overall stands at 33.13 (Yahoo Finance). Maiden Form Brands (NYSE:MFB) and Hanes Brands (HAN), two of L Brands most direct competitors, currently sport P/E's of 16.05 and 16.15 respectively. Yet the one question we have to ask is whether L Brands deserves to trade at a premium.

    While Maiden Form operates directly in the women's intimate segment, the company does not stack up to L Brands profit margins or brand recognition. Furthermore though the company operates 74 discount stores and distributes most of its goods through department stores, a big gamble as these distributors can decide to cut purchases or squeeze Maiden Form further if products are not selling well. Hanes Brands on the other hand does not operate in the "sexy" segment. Though Hanes Brands is a good bet on overall sales, there is no product differentiation between what Hanes sells and what generic brands sell. And a business with little product differentiation is not something I want to invest in. Comparable competition can also be seen at American Eagle (NYSE:AEO), which operates "Aries", a lingerie division catered towards teenagers. However it does not stack up against Victoria Secret's "Pink" division, which accounted for 15% of 2012 total revenue.

    CAPEX Plan:
    L Brands has one of the most ambitious expansion and remodeling plans set for 2013. Management has stated that they plan on spending between $575 and $675 million on opening 50 new stores and renovating 102 existing locations. Over the next 12 months this should boost existing same store sales as existing customers flock to these new stores and an increase in foot traffic is seen.

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    Strategy Going Forward:
    In addition to growing out its Victoria Secrets division, the company plans to capitalize on the success of Bath and Body Works, which accounted for 25% of 2012 revenue ($2.67 billion). With 1571 stores located primarily in the United States, BBW has international appeal. There are currently 35 BBW stores operating in Canada, which racked up 9% same store sales for the most recent quarter. While both VS and BBW serve as complementary brands, I would not rule out the sale or spin off of BBW to another firm. Trefis estimates that BBW accounts for 29.6% of L Brands stock price or $14.50 a share. Based on my calculations of free cash flow, annual sales, with no debt issuance, BBW could fetch $19-20 a share ($5.38 Billion market value). History may support my analysis as the firm divested itself of two unsuccessful apparel businesses, the Limited and Express (NYSE:EXPR) over the previous five years. While the sale of these two firms was made to focus exclusively on both the VS and BBW brands, management may want to take advantage of exuberant capital markets and raise capital in order to ramp up its international strategy and pay down its debt load. On a side note, L Brands, was formerly known as Limited Brands up until last month when management made the name change, the company was first started as The Limited.

    Is there a possibility that the whole company may be taken private or sold to another firm? At $30 share there was potential for a deal, however with a current market value of $14.1 billion (Almost $18 billion two weeks ago), this would be a fairly large acquisition for a private equity firm or global apparel company such as VF Corporation to digest. Management's best strategy would be to shore up its cash position, pay down debt, and continue to focus their attention on expanding the VS brand.

    Though I consider L Brands a growth stock, the company also distributes a quarterly dividend of .30 cents a share, or 2.45% at its current stock price. This handily beats the average S&P 500 dividend yield of 1.95%. I expect the company to maintain its .30 quarterly dividend until it has the ability to hike it in 2014 on stabilized cash flow from operations and increasing earnings.

    In Conclusion: As a retailer, L Brands will face potential headwinds including a sizable debt load, but as a segment leader with massive international growth potential, the company looks extremely promising. Furthermore with commodity costs expected to fall further this should help stabilize operating and profit margins.

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: LB
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