Seeking Alpha

L Brands Offers 7% Dividend Yield And Further Upside Potential

|
About: L Brands, Inc. (LB)
by: Daniel Schönberger
Daniel Schönberger
Value, long-term horizon, dividend investing, long only
Summary

While Bath & Body Works could report stable growth for several years, Victoria’s Secret is facing problems with stagnating sales as well as declining margins and declining comparable sales.

But the high brand awareness and the leading position in the intimates market are still valuable assets for the company and management is presenting strategies for a turnaround.

The stock could be a real bargain as a lot of negativity is priced in right now and even without any future growth, the stock is deeply undervalued.

Finally, the stock is especially interesting for dividend investors with a yield close to 7% and a dividend that can be seen as safe right now.

My investing philosophy is focused on long-term investing and therefore I am searching for companies with a wide economic moat surrounding the business and for a very long time, Morningstar (MORN) assigned L Brands, Inc. (LB) a wide moat rating and only about a year ago, the company was downgraded to a narrow moat. But analysts are still convinced that L Brands has a competitive advantage over its peers.

ChartData by YCharts

However, when looking at the stock price in the last few years, we can’t see much of the mentioned competitive advantage. In 2016, the stock was trading as high as $100 and was declining in the last few years to a low of $15.82 a few weeks ago. About one year ago, in September 2018, I covered L Brands. Back then, the stock was trading at $27.70 and declined another 38% since then (about 35.7% negative return when we include dividends). I ended my last article with the following quote:

L Brands definitely deserves a top spot at your personal watchlist, but I currently see the risk that the stock might sink even lower particularly with the imminent danger of a dividend cut. In this case, patience could be rewarded and I would advise to keep a close eye on L Brands, but wouldn’t pull the trigger yet.

In the following article we will look at the fundamental business again – the development of Victoria’s Secret as well as Bath & Body Works. We will look at revenue, margins and comparable sales to get a clear picture. We will also look at the company’s balance sheet, the dividend and management’s growth strategy before we are trying to decide if L Brands is a good investment right now.

Bath & Body Works vs. Victoria's Secret

L Brands was founded in 1963 and owns Victoria’s Secret, PINK and Bath & Body Works. In total, the company operates nearly 3,000 company-owned specialty stores in the United States, the United Kingdom, Ireland, Canada and Greater China. Victoria’s Secret could be called the flagship of L Brands and is still contributing the biggest part of revenue. In the second quarter of 2019, Victoria’s Secret was responsible for 55% of total revenue, but the brand seems to be in trouble and facing some serious headwinds. Not only is revenue stagnating since 2015 or even declining (especially in the last few quarters), operating income as well as operating margin declined sharply between 2015 and 2018.

Victoria

(Source: L Brands Investor Relations)

Aside from Victoria’s Secret, Bath & Body Works (BBW) is the second important segment, which was responsible for 36.5% of total revenue in the last quarter. Bath & Body Works has 1,700 company-operated stores as well as 230 stores in more than 30 countries operating under franchise, license and wholesale agreements. It sells body care, home fragrance products, soaps and sanitizers. And the picture of Bath & Body Works is totally different. Not only could BBW increase revenue constantly during the last decade, it could also increase operating income in every single year and since 2015 operating margin is stagnating at a high level.

Bath & Body Works: Revenue and operating income during the last decade

(Source: L Brands Investor Relations)

When putting the picture together, L Brands could still increase its revenue every single year for the last decade, although growth was slow and revenue grew only in the low single-digits. On average, revenue could grow 4.87% during the last decade, which is a solid growth rate. Since 2015 however, growth slowed down and in the last three years, the average revenue growth was only 2.89%. But when not only looking at revenue, but at the operating income, the picture gets worse. Since 2015, operating income as well as gross margin and operating margin are constantly declining. Gross margin declined from 42.8% in 2015 to 37.0% in 2018. Operating margin decreased from 18.0% in 2015 to only 10.1% in 2018.

L Brands: Gross margin, operating margin, return on assets

(Source: Own work)

When looking at comparable sales, the picture gets really grim. While Bath & Body Works could report good comparable sales in the recent quarters, the numbers for Victoria’s Secret were terrible. In the first and second quarters, Victoria’s Secret had to report 14% comparable sales decline for two quarters in a row. And the following quarters it looked like sales could stabilize again and it was even positive in Q1/18 (1% comparable sales growth), but since then the number constantly declined again.

L Brands: Comparable sales of Bath & Body Works and Victoria

(Source: Own work)

Debt Levels

Another problem is the company’s balance sheet, which is far away from being perfect. The first problem is the negative total equity. For quite some time, total equity has been negative and while treasury stock was at almost $2 billion a few quarters back – which would be a good explanation for the negative equity – it is currently only $358 million while total equity sums up to a negative amount of $929 million. A second problem is the company’s long-term and short-term debt. In total, L Brands has about $5.5 billion in debt on its balance sheet. Due to the negative equity, we can’t calculate a meaningful D/E ratio. But we can compare the debt on the balance sheet to the operating income to get a feeling of how long it would take L Brands to repay the outstanding debt. When using the highest annual operating income the company could generate during the last decade, it would take about 2.5 years to repay the debt, but when using the operating income of 2018 (which was only $1,440 million), it would take almost four years. Of course, we also have to mention the $853 million in cash and cash equivalents the company currently has.

L Brands: Debt maturity profile

(Source: L Brands Investor Relations)

When looking at the maturity profile, we see that about $800 million are due in 2027 and 2028 and $1,450 million are not due before 2033, making the risk of L Brands running in liquidity problems really low. The debt itself is no reason for concern and as almost half of the company’s debt is not due within the next few years, L Brands won’t run into any major troubles. But in combination with the above-mentioned aspects, the balance sheet is another rather negative aspect.

Looking Into The Future

When looking at the past few years, the picture of L Brands is far away from being great. L Brands is basically a retailer and is facing similar problems as most other retailers. The pressure has increased on many brick-and-mortar stores and L Brands is also facing these problems. Additionally, management made some strategic mistakes regarding Victoria’s Secret, but that doesn’t mean the company is on its way to extinction (as some people already wrote).

One of the positive aspects is the brand awareness, which might get more and more important in the years to come. Victoria’s Secret alone has more than 100 million followers on Twitter (TWTR), Facebook (FB) and Instagram combined. Victoria’s Secret has more followers than the next 50 companies operating in that segment combined. PINK also has about 20 million followers on Twitter, Facebook and Instagram.

Victoria

(Source: L Brands Investor Relations)

A second important positive aspect is Victoria’s Secret’s market share. It still has the largest share of the “intimates market” and maintains a large lead over the closest competitor. Although the market share was declining a little bit, Victoria’s Secret still has a market share of 24%, while the closest competitor Walmart (WMT) has only a market share of 11%. Over the last few years, market shares of its competitors were pretty stable. Only Amazon (AMZN) – currently on the fourth spot – could gain market share and is now at 7% market share.

Victoria

(Source: L Brands Investor Relations)

L Brands is also trying to restructure its business and turn the ship around. In January 2019, the sale of La Senza was completed and the company also closed all of the Henri Bendel stores as well as the e-commerce website. Additionally, management expects to close about 55 Victoria’s Secret stores in North America in 2019 and about 40-60 stores again in 2020 (but management expects that about 40% of sales will transfer from closed stores to nearby centers and the digital business).

Although we don’t have much evidence that management will be able to turn the ship for Victoria’s Secret around (the comparable sales decline even accelerated in the last quarters), the same management team is confident that L Brands will return on the path of growth. For Bath & Body Works, management is expecting consistent sales and operating income growth in the mid-to-high single-digit percentage, which seems very realistic and like a goal that could be achieved. For Victoria’s Secret, management is expecting stabilization and improvement with a long-term goal of 10-15% operating margin, which seems to be very ambitious considering the current performance (and an operating margin of 6.9% in 2018). However, a few years ago, Victoria’s Secret had an operating margin between 17% and 18%, so management’s goals are definitely achievable.

Management is especially confident about the growth potential in China and expects to open between 50 and 75 stores outside North America in 2019. In the last few years, L Brands could increase its store count as well as the retail sales between 16% and 18% on average and management expects growth to be in the low twenties in the coming years. Management will also focus on direct channel growth as this is a very profitable business with much higher margins. Currently, the sales are about $2.5 billion with an operating margin above 20% and management is expecting growth in the mid-teens going forward. For 2020, the company also plans to update the digital business to enable greater capability in terms of inventory SKUs and delivery. In total, management is expecting sales to grow between 5% and 10% in the years to come.

It could very well be that Victoria’s Secret and L Brands will return on the path of growth, but we have to be careful right now not to be too optimistic. Bath & Body Works will probably continue to grow at high rates, but Victoria’s Secret is still declining and the decline accelerated in the last few quarters. And it is also difficult to see any wide economic moat for Victoria’s Secret right now as eleven out of 12 quarters with declining comparable sales are not indicating pricing power. But if Victoria’s Secret is able to deliver the promised evolution of the brand and stabilize sales, this would already be a big step in the right direction.

Intrinsic Value Calculation

When trying to determine if a company could be a good investment, we have to consider fundamental aspects about the business, but also the current stock price in relation to a price we consider to be a fair value for the stock. And in order to get a fair value for the stock we use a discounted cash flow analysis, which is reflecting the estimated cash flows in the years to come. When using the free cash flow of the last four quarters and assuming that L Brands will only be able to generate the same free cash flow from here to perpetuity, the intrinsic value would be almost $28 for the stock (using a 10% discount rate). It is quite obvious that L Brands is currently valued for a scenario where the free cash flow will decline in the years to come and L Brands not being able to grow ever again.

When taking management’s own expectations of 5-10% sales growth and assuming a mid-single-digit free cash flow growth in the years to come, L Brands would be a real bargain. And even if management is not able to achieve a mid-to-high single-digit growth rate in the years to come, the stock could still be a good investment right now as a lot of negativity is priced into the stock and when the business could be able to grow only in the low single-digits, an investment could easily yield 15% annually.

Dividend

A final aspect that is worth considering is the company’s dividend. The rather stagnating revenue as well as the lower profitability forced L Brands to cut its dividend in half at the beginning of 2019. In 2018, L Brands paid a quarterly dividend of $0.60, but in 2019, L Brands had to cut the dividend in half to $0.30 quarterly dividend right now. And a dividend cut usually has to be seen as negative, but cutting the dividend was probably the right decision as management can use more than $300 million annually in a different way (for example, reducing the debt or investing in its business).

And despite the dividend cut, L Brands still has a dividend yield close to 7%. The payout ratio is currently around 58%, which is a rather high payout ratio, but low enough to consider the dividend being safe for now. L Brands has been paying a dividend at least since 1985, which should make investors confident at some level that L Brands will continue to pay a dividend and if management is not forced to cut the dividend again, the stock is interesting for every dividend investor. In the past, the company also paid special dividends on several occasions. Additionally, the company also decreased the number of outstanding shares. In 2010, the company had 327 million outstanding shares and over time the number decreased to 278 million outstanding shares.

Conclusion

The dividend was cut a short time after I wrote my last article about L Brands and it was probably a wise decision not to invest as the stock continued to decline in the following months. But right now, we have to ask again if L Brands could be a good pick and the stock seems to be valued really cheap and for any dividend investor the dividend yield seems to be interesting.

It is difficult to tell if the stock has found rock bottom yet. But the current stock price is definitely reflecting a lot of negativity and fear and the sentiment really seems to be at a low point right now. If management is only able to stabilize free cash flow (which has already been increasing in the recent past) and we don’t see further declines, the stock is already deeply undervalued. And even if the stock should drop lower, investors can lock in a 7% dividend yield in the meantime as the dividend can be considered as reasonably safe.

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.