L Brands Inc.: She's Beautiful... And Complicated

Summary

• LB generates big, beautiful stable cash flows but key revenue metrics are trending lower.
• The enterprise valuation is well below retailers in general but well above more direct comps.
• The debt is also complicated as it runs either rich or cheap depending on the tenor.
• Here's a review of why and how investors might best position themselves within the capital structure.

L Brands, Inc. (LB) is hugely successful marketing lingerie with Victoria's Secret models dressed up as angels, but away from the runway, investors haven't had much to cheer about lately. Over the past five years, while the S&P 500 provided a total return (including dividends) of 92.4%, LB shareholders received a 31.2% total return. And if you're thinking that performance is similar to most other retailers given all the comments about the death of traditional retail, think again. The S&P 500 Apparel Retailer sub-index (which includes both internet and store-based operators with an internet presence) actually returned 100.9% over the same period. True, that broader sector performance has recently tapered off, but LB's shares have suffered more.

This wasn't always the case, as shown in the price graph below. The graph compares LB common to both the S&P 500 and the Apparel Retailer indices. Until the second half of FY'16, LB was generating sector-beating returns at least during four of the past five years. Moreover, the Company's shares were also generating the broader market for three of those years. However, at least since the middle of last year, if LB Common Stock still has wings, it has unfortunately been attached to Icarus rather than a Victoria's Secret model:

At $12.6 billion revenue, LB remains several orders of magnitude larger than its women's apparel retail comparables. By comparison, Ascena Retail Group, Inc. (ASNA) runs $6.9 billion sales, Chico's FAS, Inc. (CHS), $2.5 billion and Cato Corp. (CATO) just under $1 billion. The Company's valuation reflects its size and better metrics. While LB's Enterprise Value to EBITDA multiple of 7.3x and P/E multiple of 14.3x for this year are 21% and 24% discounts, respectively, to the S&P 500 Apparel Retail Index, they are also 34% and 5% premiums to the average for the most directly comparable women's specialty apparel retailers taken as a group.

Over much of the past three years, it was possible for investors in L Brands to believe they owned one of the few women's clothing store operators that was successfully parrying the threat from lower cost, discount-driven e-tailer competition. The Company's stores - Victoria's Secret (62% of FY'16 revenue, 59% of operating income) and Bath & Body Works (31% of revenue and 45% of operating income) - were successfully handling the declines in foot traffic and intense internet discounting that damaged results at other store-based retailers.

In FY'14, FY'15, and through the first half of FY'16, LB's same-store sales growth frequently exceeded results at those other women's apparel store operators. Moreover, same-store sales were mostly trending higher. The Company appeared to have broken away from the declining pattern elsewhere in the segment.

Alas, that previous perception of LB holding an advantaged to invulnerable position within its segment has been proven false. The graph below compares in a single frame the same-store sales at LB and the comparables over the past five years. Note that in FY'11 and into FY'13, LB was basically following the pack, with same-store sales trending south. They were higher on average but still trending in the same direction as the rest of the group. Then, during the period stretching from Q4'13 through the end of Q3'16, it looked like the Company had separated itself out. Same-store sales tacked higher even as results at the comps were more mixed:

The Company is hardly doomed to fail despite the challenges created by a changing retail landscape. However, recent trends and changes in the Company's metrics do call for a fundamental re-evaluation of what it means to be an investor in LB. Investors need to re-think positions within LB's capital structure with an eye toward finding better ways to extract consistent value from the Company's securities. The implication is that just going long the LB common stock and hoping the metrics improve from here will not suffice. What follows is an argument for what to do about it.

It doesn't take much sleuthing to see LB's strengths and weaknesses. The strengths are obvious. Per the Financial Summary below, despite moderating or uneven revenue growth, LB ended FY'16 with $1.9 billion cash and net leverage of just 1.5x its $2.4 billion EBITDA. Free cash flow this past year ran $900 million even as the Company continued to spend more on its expanding store base:

LB is more than a big balance sheet and cash flow generator. The Company remains a powerhouse international retailer which, as management says, doesn't just sell lingerie. It markets experiences. These are sold by the Victoria's Secret, PINK, Bath & Body Works, La Senza, and Henri Bendel trade names. Yes, L Brands sells lingerie, but it also offers personal care and beauty products, apparel, and accessories using aspirational life-style brands that are intended to make its customers "feel sexy, bold, and powerful." The Company manages 3,074 company-owned specialty stores in the US, Canada, the UK, and China, and its brands are sold in more than 700 franchised stores across the globe.

LB's retailing efforts are geared toward the aspirational. But LB's leadership is undoubtedly inspirational. CEO Leslie Wexner founded the business with one store called The Limited in 1963 and, over the ensuing decades, created an enterprise which was not just a collection of domestic specialty apparel shops but a global marketer of major brands and their extended product lines. Anyone who can build a segment leader from virtually nothing is a phenomenon. Yet Wexner's success also carries within it an ironic weakness. The CEO is a retailing savant but he is also 79 years old. Who will succeed him …?

The other weaknesses become fairly obvious when you compare same-store sales at Victoria's Secret and at Bath & Body Works and compare them for both the in-store and online versions. First, the in-store perspective, shown in the graph below. By the end of FY'16, Victoria's Secret in-store same-store sales were running negative 3%. Given the preponderance of Victoria's Secret in-store sales within the Company, the 5% growth in same-store sales as Bath & Body Works wasn't enough and in-store same-store sales overall went to zero. The graph below presents a more granular, monthly view of what's happened at the store level during the past five years:

In January, the final month of the Company's FY'16, overall comp store sales were -4% while Victoria's Secret same-store sales were down 10% and it didn't get better after year-end. In February, Victoria's Secret comp store revenue was down 16% compared to February of 2016. That included certain categories of merchandise that Victoria's Secret will no longer stock going forward, namely swimwear and apparel. Comp sales, excluding swimwear and apparel, were down 8%. The drop-off, blamed on "challenging mall traffic levels" also led to a significant reduction in merchandise margin rates. Management increased promotional events in an attempt to drive foot traffic back up.

The damage at Bath & Body Works was less severe. In January '17, the final month of FY'16, Bath & Body Works comp store sales results were actually up 11% but fell to negative 4% in February '17. Keep in mind, Bath & Body Works has 1,591 stores in the US, more than half of the Company's total store count. Unfortunately, it's not just lower foot traffic at Victoria's Secret stores that's been hurting LB's top line recently. LB's overall annual net sales increased 1% in FY'16 with the biggest change coming from a 25% hike in online Bath & Body Works sales, but in Q4'16, online same-store sales at both Victoria's Secret and Bath & Body Works took a nosedive. This is clear from the graph below of the quarterly changes by segment during the past five years:

LB expects Q1'17 same-store sales to be down by high single to low double digits. Management assumes there will be a 6-point negative impact from exiting swimwear and apparel in the quarter. This equates to a forecast of down low to mid-single digits for the March, April time period combined. Easter is three weeks later than last year, and Easter Sunday shifts out of March and into April. Management believes the shift into April will have a negative impact to March comps of 2-3 percentage points.

One gets the impression from studying LB's two main segments that the Company likely peaked around Q2'16, at least in terms of how much more revenue growth it can extract from the store base. The more recent drop in internet sales could prove temporary. It's hard to take management to task for the recent misses. Taking a somewhat longer view of LB's metrics puts the recent same-store sales fall off in better perspective. Management has actually done a very good job of keeping profitability high even as same-store sales declined.

A significant contributor to that success has been inventory control. As shown in the top part of the graph below, over the past five years, LB has kept other metrics like revenue per square foot, gross profit per square foot, and EBITDA per square foot at the same or higher seasonal levels. As shown in the bottom part of the graph below, that higher profitability was maintained even as LB's store count increased. Management succeeded in that effort by consistently reducing the Company's inventory per square foot:

What should investors do with this information…? Keep in mind, we started off looking at the equity and saw just how cheap it's gotten relative to the apparel retail sector and to the broader equity market. We examined the Company's business strengths and weaknesses and reviewed key financial metrics and were left with the impression that LB is still a major retail presence. However, we also can see that the Company was transitioning from a consistent growth story to more of a steady cash flow generator as its sector restructured toward internet sales and away from the physical stores LB excels at managing. LB's saving grace has been its ability to market an experience while selling beauty products at physical stores. That's a type of entertainment that can't be easily replicated online.

The LB Common Stock trades at a 12.7x LTM P/E multiple and 14.8x Estimated FY'17 P/E multiple while the S&P 500 Apparel Retailer Index averages 19.4x. Since the other women's apparel retailers are also trading at about the same discount to the rest of the apparel retailer space, that only becomes a good argument for buying the LB shares if you believe LB is a potential acquisition target. It's hard to make that case. There have been 175 acquisitions of privately owned US apparel companies in the past five years. However, there have been very few acquisitions of publicly owned US apparel retail companies during the same time period. I located only eight completed deals of that type and none pending. Despite its relatively low valuation viz the broader apparel retail segment, the argument that LB is about to be acquired doesn't have much to support it. The aggregate $3.9 billion cash paid for all of the US public apparel companies cited above is just a fraction of LB's $20.7 billion enterprise valuation:

One might alternatively make an argument for the Common Stock based on the cash flow yield. That could conceivably attract greater interest from parties looking to take a significant or minority position. However, LB's ability to generate more cash from less inventory isn't a great argument for additional investors to buy the Common Stock unless, of course, that cash will be consistently diverted toward buying back their shares. If the Company's revenue growth has peaked and there's only so much additional cash flow to be generated from inventory management, there's effectively a lid on the upside to the equity and how much in the way of cash flow that can be diverted toward repurchasing it.

There is evidence that LB will not be hiking the size of its share buyback programs significantly going forward based on how much cash LB has devoted to repurchasing Common Stock over the last five years. Yes, there have been consistent repurchase announcements but some of them, such as the most recent one in February, include a commitment to buy the remainder of the shares not purchased under the previous repurchase announcement. These are all promises to repurchase shares "from time to time" on the open market, not commitments to repurchase shares immediately. And, as the market value of the equity has declined, so has the value paid in these repurchases. The total value of LB Common Stock bought back over the last 12 months was only 3.2% of the outstanding $13.6 billion equity market cap, per the graph below:

That leaves a possible argument for buying the LB Common Stock based on its dividend payment rate. The regular quarterly dividend payment was raised from the $0.50 per share paid through 12/4/15 to $0.60 per share starting 3/4/16. The Company also paid a $2 per share special cash dividend that same day. LB shares have an indicated dividend yield of 5.04% at current prices. The dividend yield is high relative to the broader equity market (the S&P 500 averages 1.96%) and to the Apparel Retailer index (1.74%).

Does a 5% dividend yield with questionable equity upside beat alternative investments carrying either higher yields or greater and more easily obtainable upside…? It is highly unlikely that LB Common Stock will trade in a narrow range and allow holders to sleep calmly in their Victoria's Secret pajamas as they collect a 5.04% yield. The 30-day historical volatility for LB Common Stock is up near 59% versus the 8% rate at which the S&P 500 has been running, regardless of the political environment. The implication is that owning the shares for the dividend yield will require ignoring the roller-coaster ride that's likely to come with it.

LB's $5.7 billion of long and short-term debt is mostly comprised of senior unsecured notes. The Ba1/BB+ rated front end notes due within six years carry yields ranging from 2.94% (the LB 8½ Senior Notes due '19) to 4.81% (the LB 5 ⅝ Senior Notes due '23). The long dated Ba2/BB- rated Senior Notes have yields between 7.22% (the LB 6 ⅞ Senior Notes due '35) and 7.60% (the LB 7.60% Senior Notes due '37). The long dated LB Senior Notes - like LB Common Stock with a maturity of never - have gotten too cheap to relevant indices since the end of last year. Per the graph below, the option adjusted spread on BB rated US high yield bonds is 256 basis points. The LB five-year CDS is priced around 10 basis points through that and the front-end LB 5 ⅝ Senior Notes due '23 are also not cheap to that spread at a +228 Z-spread:

The long dated LB 6⅞ Senior Notes due '35 at a 7.22% yield and +467 Z-spread are quite wide to the BB high yield index's average yield of 4.59% and +256 option adjusted spread. Comparable bonds in the retail space trade with average yields of 6.02%, Z-spreads of 366 basis points, or option adjusted spreads of 361 basis points. The 6⅞s are higher ranking and higher yielding than the LB common. The bonds are correlated with the common (r-squared on value is 65% over the past six months). However, they are significantly lower volatility than the common. The historical 30-day volatility for these bonds runs 16%, twice the S&P 500, but about a quarter of the LB common's 30-day volatility.

If the 6⅞s moved to a Z-spread of 366 basis points, they would be priced at 107.35, a roughly 10-point increase from where they are priced today (97.25). That's 10.4% of potential upside. If the same bonds traded more in line with the BB US high yield index's option adjusted spread of +256, they'd be worth about 120.5 (i.e., 23.25 points higher and a potential increase of 23.9%).

As LB heads toward a future in which revenue gains and margin improvements are more difficult to achieve, its securities present investors with a complicated choice about the best way to obtain a steady yield, position for upside and still limit risk. Investors can own the lower yield/higher volatility equity, which might either continue to trade at the same premium to its direct peers or suddenly break away from those other women's apparel retailers to trade up at the 21% higher retail sector average valuation multiple. Or, instead, investors can own the higher yield/lower volatility long dated bonds with a more certain potential to tighten back toward a retail sector average spread that's at least 100 basis points richer.

The equity alternative is a 5.04% yield with 59% volatility for 0% to 21% upside. The long-dated bond alternative is a 7.22% yield with 8% volatility for 10% to 24% upside. Looking at these two alternatives from this mathematical perspective, the yield, volatility, and range of potential upside favor owning the long-dated bonds over the Common Stock.

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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.