Victoria's Secret? Concealed Assets

| About: L Brands, (LB)


L Brands has a strong economic moat yet has fallen 50% since 2016.

Understanding the company's balance sheet requires an understanding of what it doesn't show.

I would be interested at $20.00.

A Bit of Background

The retail sector is a bit of a dump these days which is why I'm spending my time rummaging through the 10-Ks of companies found in that corner of the economy. The latest one to catch my eye is L Brands (LB). The stock has been in a pretty steady decline since the beginning of 2016 - falling from about $90.00 to around $44.00 today.

Source: Seeking Alpha

The L Brands company is comprised of two major brands with a couple of others tacked on. Its most iconic brand is Victoria's Secret: the women's wear and lingerie company. This division owns 1,200 stores in the US, Canada, the UK, and "Greater China" [1]. There are another 410 stores in 70 countries which operate under franchise, license, and wholesale arrangements [2]. There is also, of course, a website.

The second most important brand is Bath and Body Works, a company which specializes in retailing things that smell good: shower gels, candles, hand creams, etc. There are 1,600 stores across the US and Canada with another 159 stores being operated in 30 countries under franchise, license, and wholesale arrangements [3]. This too has a website.

The remaining companies are La Senza (Canada's homegrown version of Victoria's Secret) and Henri Bendel (a handbag company). Neither of these companies' divisions are terribly important to the company as a whole, so I'm not going to focus on them too much. They exist, and you should know that, but in the grand scheme of this company, they don't mean too much. In fact, I'm not going to focus too much on Bath and Body Works either.

Victoria's Secret Asset

Source: L Brands' 2017 10-K

If you take a look at the L Brands' balance sheet, you'll see a rather peculiar thing: under the "Shareholders' Equity" line, there's a negative number! In strict accounting terms, this means that the company has more liabilities than assets. More colloquially, the company has negative "book value".

This seems like an incredibly weird thing for a company whose stock currently trades for about $44.00. Would you be willing to pay $44.00 for a piece of paper that says you owe an additional $2.56? Hopefully not! And yet, that's exactly what's happening here. My belief that markets are stupid is the reason I end up reading all these damn 10-Ks, but paying $44.00 only to owe an additional $2.56? No way are markets that stupid. Even if the shareholders were out to lunch, surely the company's lenders would notice and refuse to provide more capital… but they don't seem to mind the situation either. All of this suggests one thing: there's something missing from the balance sheet! If you're an accounting nerd, you might have already guessed what it is. But for those who are still left scratching their heads, here's a clue: the missing assets are right in the company's name! It's the brands! More specifically, it's the brands which the company has built up from scratch (as opposed to purchased). A company is only allowed to show the value of brands on its balance sheet if it has paid for them in a transaction [4]. They're not allowed to show a value for a brand they've created from scratch. In L Brands' case, that's an important thing to understand. The "Victoria's Secret" brand is one of the most recognizable across the globe (it is, after all, synonymous with "sexy"), and yet the company gets no credit for it on the balance sheet.

Adding the Brand Value to the Balance Sheet

When I'm manipulating financial statements, I always like to keep my assumptions noticeably conservative. Generally, this results in using smaller numbers than what might be true: assuming less growth, using a smaller interest rate when discounting future lease obligations, setting my "buy" price below what I think the stock is worth, etc. You might assume that I would do the same thing here - set the value of the brand lower than what it might otherwise be. I am, after all, adding an asset to the balance sheet; underestimating seems more conservative than purposely overestimating. Well, you'd be wrong. Here's why: Adding a brand [5] asset to the balance sheet (and increasing the equity by an equal amount!) will change four of the metrics I normally use to measure a company's value:

  1. Return on Capital Employed (ROCE)
  2. Free Cash Flow Return on Capital Employed (FCFROCE)
  3. Growth in Book Value per Diluted Share
  4. Market Capitalization to Book Value

A change in those last two metrics won't really matter in this case: "Growth in Book Value per Diluted Share" and the "Market Capitalization to Book Value" were both very large negative numbers before I started messing around with the balance sheet… and that's an indication that measuring this company off of those metrics probably isn't a good idea. As such, I'm going to focus on the first two numbers.

By adding or subtracting an asset from the balance sheet, I'll be amending the value of "Capital Employed" which in turn will affect "Return on Capital Employed" and "Free Cash Flow Return on Capital Employed". Here's what those two metrics look like in equation form:

Since "Capital Employed" is in the denominator [6], increasing it will lower the metrics. Since the goal is to be conservative, I'm going to overestimate the value of the brand. Here's my thinking: it is much easier to hit my metrics if you assume less capital employed. If I gave the company a brand worth $6 billion, I would expect it to earn more than if I gave it one worth $3 billion: more valuable brands should be able to draw more purchases or higher prices from customers. So, if the brand is actually worth $6 billion, but I assume it's only worth $3 billion, then the company is going to look amazing! It is getting to use $6 billion worth of assets but is only being measured as if it is using half of that! As such, a conservative estimate here is to actually over-estimate the value of the brand. If I do that, and if the company still looks good, then I think we've got a winner!

So, what is the value of the brand? I'm hardly an expert on these things. In fact, I don't have a damn clue how you actually measure their value [7]. Luckily, I have a friend who comes across this issue from time to time for legal cases he works on. So, I asked him. He suggested using estimates from a few companies [8]. Only one of those companies has a figure listed for Victoria's Secret (which presumably doesn't include L Brands' other brands): $6.245 billion [9]. Another company produced a similar list of companies but didn't have Victoria's Secret listed [10]. There was, however, a lot of overlap for the two lists. Large brands like Apple (AAPL), Amazon (AMZN), Ikea, and McDonald's (MCD) showed up on both. As such, I was able to compare the valuations for the two lists to get an estimate of how far off they were from each other. Turns out my suspicions were right: estimating brand values is hard. The company which produced my $6.245 billion estimate seems to be valuing brands at twice the price of the other company's estimates [11]. That means my range of estimates is probably somewhere in the $3.125 to $6.245 billion range. Since we're being conservative, I'm going to go with $8.00 billion [12].

Now that we have the balance sheet all worked out, we can check the numbers.

The Numbers

As always, I'm striving to ensure that I use conservative assumptions across the board. I have, for example, capitalized the future lease obligations and treated the gift cards as part of the capital structure [13]. Using conservative assumptions gives me comfort in case I have to let something small slide in order to justify buying the stock - if the company looks okay under the darkest of assumptions, it's probably actually doing pretty good.

Return on Capital Employed

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

The ROCE numbers don't look amazing. This is pretty disappointing because, unlike my last writeup (see here), I was actually hoping this might be a "forever" company. The Victoria's Secret brand seems like the kind of thing that is a legitimate economic moat. Now, to be fair, I might have set up L Brands to fail. I'm looking for companies that can get at least an average of 15% ROCE over the long run. As previously mentioned, an important aspect of measuring this is to get the "capital employed" value correct. I chose to use $8 billion for the value of the brand, while my two best reference points (as questionable as they are) were $3.125 billion and $6.245 billion. If I had used the average of these two ($4.685 billion) the numbers would have looked like this:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

That's closer to my goal, which shows that maybe there is still some hope! I think this is also a good time to bring up another concern I had about the previous numbers: I suspect that the companies publishing them are incentivized to overestimate their value rather than underestimate them. That is, bigger numbers seem like they would be better for business (especially when the "true" value can't be determined). A headline which reads "Victoria's Secret brand is now valued at $10 billion" will get more responses than one that says "Victoria's Secret brand is now valued at $9 billion". So, in addition to using a conservative $8 billion estimate, I'm also considering that the original $3.125 billion to $6.245 billion range might have already been conservative for my purposes (which is to say they were liberal estimates on the part of the brand valuers). Here's what it looks like if we went with $3.125 billion:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

Those numbers certainly look like something which would satisfy my 15% requirement. Sometimes, it's a little below 15% and sometimes it's a bit over 15%, but it's in the 15% ballpark for sure.

Overall: okay, but not great.

Free Cash Flow Return on Capital Employed

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

Once again, the numbers are disappointing when assuming an $8 billion brand value. At no point does the company come close to beating my 8% goal. The average seems to be solidly within the 5% range.

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

If I go back and use the $4.685 billion estimate, the results increase but are still solidly below 8%.

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

Sadly, even with the most "liberal" of my conservative estimates, $3.125 billion, the FCFROCE isn't good. It falls obviously below my goal of 8%.

Overall: not good.

Growth Metrics

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

The growth metrics look pretty good. The book value metric should be viewed with some suspicion as they are influenced pretty heavily by my $8 billion brand value estimate. If I were to use the $3.125 billion estimate, the 5-year CAGR for Book Value Per Diluted Share falls to -0.96%. But then again, I wasn't giving it much credit to begin with. Operating Income and Free Cash Flow look pretty good though, and that's what I'm most interested in (and they aren't influenced by my brand estimates).

Leverage Metrics

The leverage metrics are also affected by the choice of brand value: the more you value the brand the less the company is leveraged (as that valuation also counts as equity in order to keep the balance sheet balanced). Here's the leverage under an $8 billion brand valuation:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

And now assuming $3.125:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

Wow! Things got pretty ugly pretty fast.

Overall: Bad. Historic leverage numbers aren't as important as current leverage numbers… and neither of those is under 2.00.

The Trade-Off

Perhaps you didn't catch it at first glance, but if you go back and look at the numbers above, you'll notice something important about the estimate of the brand value: it creates a tradeoff between good ROCE numbers and good leverage numbers! If you assume a brand value of $8 billion, the ROCE numbers look awful… but the leverage numbers look pretty good! However, if you use the $3.125 billion estimate, the opposite is true! Normally when you face these kinds of tradeoffs, you're forced to pick one or the other: good returns or good leverage. In this case, I'm going to suggest that you take a third option: don't pick either - just avoid the stock all together. It's become pretty clear that the company isn't going to look good under any of the assumptions I've made. Plus, there's a pretty good chance that my $3.125 billion to $6.245 is wrong. As such, I'm going to need a pretty steep price discount to make up for all of that… and unfortunately, that isn't currently being offered. Below are my valuation metrics assuming a $44.00 stock price for 2017 and historic stock prices for the other years [11]:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

The only good metric is the company's Market Capitalization to Book Value metric… and that's because I've assumed an $8 billion valuation for the brand! If I went with $3.125 billion, that metric would blow up to 5.32. I chose to disregard the negative Market Capitalization to Tangible Book Value metric due to the balance sheet being saturated with intangible assets that I think have real economic value [12].

So, after all this work, I don't have a stock to buy. How annoying! I might consider buying this at $20, so I'll set a price alert, but I won't be holding my breath on this one.

PS. Some of you might be wondering why I didn't add back the value of L Brands' other brands. Surely if I was going to do it for Victoria's Secret, I should have also done it for Bath and Body Works, La Senza, and Henri Bendel. There's one simple reason I didn't do it: it ultimately didn't matter. Increasing the value of assets only makes the ROCE and FCFROCE metrics uglier. As such, my bad situation could only get worse by adding more brands. Furthermore, my two most prominent valuation metrics (MCAP/FCF & EV/OI) aren't affected by the balance sheet. Lastly, getting a good estimate of the brand value for Victoria's Secret was tough... get one for the other brands might be impossible. If this ever trades around $20, I'll probably attempt it, but until then I'm going to move onto the next one.


[1] I think "Greater China" is how you say Hong Kong, Taiwan, and China without upsetting any side.

[2] L Brands' 2017 10-K

[3] L Brands' 2017 10-K

[4] Even then it has to continuously test the brand's value for impairment and then reduce the asset value accordingly. Under some conditions, you can bring the value back up to where it once was (but never beyond that value!), and under some other conditions, the impairments are permanent… which can lead to situations where brands are effectively not carried on the balance (just like Victoria's Secret!)

[5] The "brand" distinction is important here. Brands are intangible, and thus they will not affect my measures of "Tangible Book Value". If, however, I added a tangible asset (like a building or a piece of land), the number of metrics affected would grow to 6 with "Growth in Tangible Book Value per Diluted Share" and "Market Cap/Tangible Book Value" both being affected.

[6] aka "The Bottom" or "Da bottom" <-- Get it? Cause "Denom" kinda sounds like "Da bottom"! Anyway, that's how I remember it.

[7] Here's my guess: It's the value of the discounted cash flows that a company can produce without using the brand subtracted from the value of the discounted cash flows that a company can produce by using the brand. How do you measure that in real life, though? I have no idea.

[8] Those were: Interbrand, Brandz, and Millward Brown. Turns out Brandz and Millward Brown are the same people… so maybe my friend doesn't know what he's doing. Or maybe the courts don't. Maybe both?

[9] Brandz Top 100 Most Valuable Global Brands (PDF Warning)

[10] Interbrand Global Rankings

[11] This, by the way, is exactly the reason why companies aren't allowed to show homemade brands on the balance sheet. Their values are too inconsistent and subjective.

[12] $8.00 billion is the value I'm using for 2017. I've assumed that it has grown over the years at a rate equal to the growth in sales. Here's how that looks:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

[13] Gift cards are effectively interest-free loans from customers to the company. The customer has paid cash up front and will eventually want that cash "paid back" in the form of merchandise, but as you can see below, the company consistently has an outstanding value which acts like a semi-permanent loan:

Source: L Brand's 10-Ks from 2013 to 2017 & Author's Calculations

[14] The historic numbers are just a number I quickly picked from around the time that particular year's 10-K came out. They might be off by a week or so, but nothing major.

[15] If I thought the company's intangible assets were worthless or of questionable economic value I would most certainly be looking at this line.

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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