L Brands Has More Upside

Summary

• October numbers look good.
• Stock will bring in momentum buyers once we surpass the 200-day moving average.
• Still well undervalued at under $50 a share.

After a difficult summer, L Brands (LB) looks like it is on the way back. Shares are now back up trading around the $47 mark, which means we are practically back to our entry price which we initiated a few months ago. The reason for the nice bump in the shares was the impressive October numbers which saw Victoria’s Secret's comps rising by 1%. This may not look that impressive on the surface, but remember that the same flagship brand actually slumped by 5% in September. The company's other flagship brand "Bath & Body Works" kept its momentum going by reporting 5% growth in comps in October on the back of 4% comps growth in September. Due to the strength of October's numbers, management now believes earnings will reach the top end of its previous guidance for the third quarter. If shares can stay above the 200-day moving average of just under $47 a share, then L Brands should take out $50 pretty soon due to the stock still being pretty undervalued compared to its historic valuations.

Even at $50 a share, we still see significant upside in shares. L Brands current earnings multiple (taking shares to be approximately $47) is 13.8, which means it is still around 7 points off its 5-year average. The company's price to sales ratio is still a good 40% below its 5-year average. As this is a company which relies heavily on the pricing power of its brands, its margins are imperative to the success of the company. Many brick and mortar retailers continue to the go to the wall due to the lack of a clear competitive advantage. Despite L Brands also having suffered from wholesale weakness especially in the US, this company clearly has competitive advantages which is why there remain bargains in many segments of the retail industry.

1. Gross and Operating Margins

L Brands' gross and operating margins on a trailing twelve-month average still look very healthy. In fact, the current numbers of 40% (gross) and 14.5% (operating) are still well above the company's 10-year average. Periodic and significant drops in turnover and earnings do not tell the whole story when researching a potential value play. Last year, L Brands still only brought in $1,158 billion in net income which was only a single digit percentage above the same metric of 2 years prior. Free cash flow levels fared even worse with only $900 million being generated as opposed to almost $1.1 billion of 2 years prior. Margins never though slumped to levels like they did in other retailers such as Guess (GES). Therefore, despite the weakness L Brands has clearly shown in recent quarters, underlined by a big shakeup in its Victoria Secret's brand, we never saw a big slump in the company's margins, which clearly placed an attractive potential value play on the table.

2. L Brands Dividend

The CEO Les Wexner has a clear history of rewarding both himself and shareholders of companies he has run. With a yield of still well over 5%, we felt the company was always going to find a bottom once value players came into the fray. The company's dividend has increased by a factor of four over the past decade, and with a current pay-out ratio of $2.40, we still are only dealing with a pay-out ratio of 70%. Investing in a value play with clear competitive advantages in the marketplace enables one to get paid while waiting for the stock to rebound. Even though the rebound is delayed, investors have the option of using the increasing dividend to double down on the stock. Moreover, the present interest coverage ratio of almost 5 and projected earnings growth of almost 11% annualized illustrate that despite the company's debt, its financials look sound, which should mean more aggressive dividend hikes to come.

3. Shares Still Almost 50% Off All-Time Highs

This final point is really the kicker. Why? Well, the stock has not been in a downtrend for years on end as the decline in essence only began 20 months ago. Now, the pace of the bounce back rally could easily mirror the speed at which shares declined over the past 20 months or so. When shares of a quality stock fall so steeply like they have done with L Brands, it means that resistance levels are few in number once the stock rises again. This is why I would be wary of taking too profits too early here. The rally here could be just beginning.

L Brands, as long as shares remain trading above the 200-day moving average, should now be able to participate fully in the rally in US equities. I'm betting it will outperform. Remaining long.

Analyst’s Disclosure: I am/we are long LB. 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.