L Brands, Inc.: Overvalued

| About: L Brands, (LB)


L Brands' last several years' performance was outstanding, not even taking into account its spin-offs.

However, last year's results show that the growth machine is starting to slow down, as inventory level has increased significantly as a percentage of revenues.

The current valuation represents the market's hope for high dividends and strong revenue growth in the future. My analysis shows the market is too optimistic.

I recommend risk-averse investors not to buy this stock and not to get lured by the attractive dividend figures.

However, risk lovers may look into the put options. My target price range is $47-58 per share.

L Brands, Inc. (NYSE:LB) is a platform retail company for international brands like Victoria's Secret, Bath & Body Works, Pink, Henri Bendel, and La Senza. Its revenues are among the highest in the fashion apparel industry - $11B and counting. The company has been growing its revenues by an average of 5% annually for the past several years. Its net income figures have increased even more significantly - by about 7% per year, on average. Moreover, due to the buyback program, which has been growing, L Brands' diluted EPS has increased by more than 45% - totaling 10% CAGR for the same time period. The rich dividends paid out during the last 5 years are the result of the company's strong earnings' record (see Diagram 1). However, the dividends reached such a high percentage of cash flows that they have caused L Brands' retained earnings account to turn negative. Only during the last year has its total equity reversed to being positive again.

Diagram 1

Source: Data - Morningstar.com, infographics by author

Over the years, the company developed brands that it later sold or spun off. The Limited, Express, Structure, and Galyan's are only the most famous examples. These activities were a nice bonus for investors who bought the stock before 2010. However, the last 5 years were focused on core business operations. The company did very well in core activities.

Despite the lower-than-average revenue growth rate in the past few years, the three-year average net income growth rate was at a 7% level, which is three times higher than the industry average. The strong net income growth was the result of decent operating metrics, to a large extent. Its operating margin of 17.5% (75% higher than the industry's average) and net profit margin of 10% (again, significantly higher than the industry's mean) are key growth drivers for the bottom line. The return of assets has been at about 15.6%. It is difficult to calculate ROE and the D/E ratio due to the series of buybacks made during the last year. However, the high level of ROA and the interest coverage ratio of circa 7x are the main reasons why the company is profitable (see Diagram 2).

Diagram 2

Source: Morningstar.com

There is only one point of concern as regards L Brands, Inc. - its current valuation level. As you can see from Diagram 3, the company had a fantastic performance during the last five years. $10K invested at the beginning of 2010 would have grown to $80K at the moment. The company has outperformed both the Apparel Stocks and the S&P 500 indexes. The most significant portion of the company's value was created in the period from mid-2014 to mid-2015. The main reason for that is the excellent EPS performance and the fantastic dividend payments, which resulted in a 2% dividend yield at the date of paying dividends. (If you bought the stock earlier, the yield on cost would be 4%.)

This exciting performance does not go in tandem with the declining revenue growth trend. Moreover, during the year, the inventory level has grown by 9% year over year - a lot higher than the revenue increase by 5% (9-month results). I see a dangerous sign of overvaluation for L Brands.

Diagram 3

Source: Morningstar.com

DCF Analysis

My DCF model is presented in Diagram 4. In Diagram 5, you can see how different metrics of L Brands, Inc. are expected to change during this period. I have made several assumptions, which can be easily seen in the "Assumptions" tab of my Excel file. My model shows that after subtracting the market value of debt, minority interest and adding back cash and investments, the market value of equity is about $15B in the base-case scenario. Consequently, the fair value per share is approximately $50.5 per share. This is 48% lower than the current price ($97 per share).

Diagram 4

Source: Data - Morningstar.com, model by author

Diagram 5

Source: Data - Morningstar.com, infographics by author

Sensitivity Analysis

The sensitivity analysis is presented in Diagram 6. According to the base-case scenario and assumptions for the EV/EBITDA multiple and WACC, the fair value price range is calculated to be in the range of $47-58 per share. This price range represents a 30-60% downside risk for the stock at current price levels.

Diagram 6

Source: Data - Morningstar.com, model by author

Zero-growth Analysis

The Zero-growth analysis has been described in one of my articles. You can read more about it here.

According to this analysis, the current market price shows no margin of safety for the stock. The valuation gives a fair market value of equity of $18.25B, which translates into a fair price of $61.4 per share. This price is more than 36% lower than the current level. However, if we only use net income in the calculations, the result will be a share price of only $44.6, which is about 54% lower than the current price. Therefore, there is no margin of safety in the current market price.

Comparative Analysis

My comparative analysis is based on three key ratios: P/E, P/S, and P/BV (see Diagram 7). The P/BV ratio does not fit here, as the book value of equity is negative. The industry's top 25% multiples show that the stock price is 15-20% undervalued. However, all other multiples show that the stock price is vastly overvalued. The current EV/EBITDA is 12.8x, which is slightly above the industry's average of 12.4x (according to Damodaran, here). So, the stock price looks overvalued in terms of the comparative analysis.

Diagram 7

Source: Data - Morningstar.com, infographics by author


According to the analyses, it is clear that the current valuation for L Brands, Inc. is too optimistic. Hence, it is dangerous to buy this stock now. I recommend risk-averse investors to HOLD this stock and stay away from it. Risk lovers can utilize put options. I set the target price range at $47-58 per share. This price range can be translated into a 40-50% downside opportunity.

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.

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