L Brands Net Sales and Comparables Trending Positively
L Brands (NYSE:LB) recently announced that its net sales in September were 6% higher than they were a year ago, with comparable store sales picking up 3%. With this report, the fiscal third quarter (which ends this October) is trending positively for the owner of global brands like Victoria's Secret, Bath and Body Works and PINK.
Previously, L Brands had reported that net sales in August had risen by 3% compared to a year earlier while its comparable store sales had grown by 2%. Consequently, there is a high likelihood that L Brands will achieve its third quarter earnings forecast of between $0.40 to $0.45 per share.
While L Brands had strong August and September results, its stock has fallen by close to 24% in the year to date - despite the fact that it has beaten Wall Street expectations in each of the last four quarters.
This is unsurprising given that L Brands is currently forecasting anywhere from a 3.5% to 7.2% decline in its earnings per share in fiscal 2016 compared to its fiscal 2015. Indeed, while L Brands' current earnings guidance of between $3.70 and $3.85 is an improvement over the range of $3.60 to $3.80 per share that it forecasted in May, it is still short of its February guidance of $3.90 to $4.10 per share.
However, L Brands' decline is still somewhat odd considering that the S&P 500, of which L Brands is a component, is also in the midst of what could be six straight quarters of negative earnings growth - yet is up by 4.4% in the year-to-date.
Considering this, and the fact that L Brands carries a very healthy dividend yield of 3.3%, which happens to be more than 100 basis-points better than both the S&P 500's and its sector's dividend yields, should investors be looking the stock as a potentially undervalued play? Let's take a look:
Restructuring Clouds Creating Opportunity for the Optimists
L Brands has indicated that its earnings this year are expected to come between $3.70 and $3.85 per share compared to the $3.99 it earned a year earlier. While L Brands' net sales are expected to grow by 3% to 4% compared to 2015, it anticipates various restructuring charges associated with leadership and operating personnel changes and layoffs, shifts in its promotional strategy, product exits and "incremental cost(s) related to (L Brands') plans to develop China as a company owned business" to depress its earnings.
L Brands' management has indicated that it is making these changes "proactively" - essentially saying that they're taking on some short-term pain - a year after delivering record results - in order to strengthen the company going forward. At this stage, we have no reason to doubt L Brands' strategy, particularly since it has actually delivered better-than-expected results in the last two quarters.
Presumably, the changes that L Brands is implementing will simplify its business by enabling its teams to focus on a narrower selection of (more profitable) products. This, in turn, will permit it to get new products within its bras, panties and beauty segments to market sooner, thereby preserving the competitive position of Victoria's Secret and Bath and Body Works against competition from cheaper or niche alternatives.
What's more, L Brands is now making its China venture company-owned rather than a partnership with local partners. We suspect that L Brands is concerned with the slowdown in the Chinese Beauty Market and wishes to exact greater agency over its branding and market positioning as the Chinese market continues to falter. This sort of strategy could take years to generate a significant payoff and investors should consider the possibility that L Brands could exit China altogether as other companies have.
Overall, if there's anything that L Brands recent strong sales reports have shown investors, it's that its core businesses remain strong and that investors can accept the narrative that the current year's dip in its earnings isn't an indication of a larger secular decline. Moreover, investors should note that L Brands' comparable sales are actually tracking better than they have been at any time in the last four years so there is cause for optimism.
Leveraging Cheap Debt
Meanwhile, investors who are concerned about L Brands' ability to return capital to investors shouldn't be. The company has generated over $1 billion in free cash flow in each of the past two years and it appears that it will generate between $400 to $600 million in free cash flow this year. This is adequate to cover its annual dividend when coupled with its existing resources. The company also has strong liquidity - $1.63 in working capital for each dollar of its liabilities so there is no "hard" choice for management - L Brands can elect to continue returning capital to shareholders while pursuing other strategies.
If anything, the main concern in terms of L Brands' balance sheet is its high degree of leverage, which exceeds that of its industry. For this reason, L Brands is considered a sub-investment grade credit. Its history of share repurchases and special dividends have effectively siphoned-off its earnings and the company has recapitalized itself through debt. In that sense, L Brands will continue to be dependent on leverage to finance its operations and it is likely that its $5.7 billion in long-term debt will grow in the coming years.
On net, however, L Brands' world-renowned brands will continue to generate robust sales that, in turn, will generate significant free cash flow. This will enable to the company to continue paying dividends for the foreseeable future.
A Slight Discount
L Brands is currently trading at just 18-times its trailing earnings, which is below the multiples of large-cap stocks and its peer group. On a forward basis, L Brands is trading roughly on par with the SP&500 at 17.9-times earnings.
Considering L Brands' third quarter performance thus far and the expectations for the retail sector this coming holiday season, we anticipate that its 2016 earnings will come in at the upper end of its forecast, or $3.85 per share. Further, we expect that with the company having worked off its restructuring efforts in 2016, 2017 will see "cleaner" results and the company will report earnings growth of 7.5%, for earnings per share of $4.14. This implies a target price of $75.53 per share, which is just slightly below the consensus target of $78.38 per share.
2016 hasn't been kind to L Brands' stock, even though the company itself has remained healthy. In our view, this has permitted the stock to come down to more reasonable levels and it's now just slightly undervalued.
Considering this, we believe that investors should begin to accumulate the stock, particularly since we expect it to report better-than-expected results for the third quarter and like the healthy 3.3% dividend yield. Note that we said "accumulate" rather than "buy." This is because we see the stock as only slightly undervalued. We need to see confirmation that restructuring won't dilute its earnings further in the form of strong 2017 earnings guidance before recommending that investors take a meaningful position in L Brands.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LB over 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.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.