L Brands: Giving Away The Store

Summary

• L Brands is selling a 55% stake in Victoria's Secret to Sycamore Partners in a deal valuing the business at $1.1 billion.
• This sale price is less than the business' annual operating profit just a few years ago and reflects a stunning lack of confidence in Victoria's Secret's turnaround potential.
• The Victoria's Secret deal will leave Bath & Body Works as a standalone business with a high growth rate and incredible profit margin, but also a heavy debt load.
• The stunning collapse of Victoria's Secret's profitability is a warning sign of what could happen to Bath & Body Works sometime in the future.
• Avoid L Brands stock.

On February 20, L Brands (LB) announced that it had reached a deal to sell a majority stake in its once-mighty Victoria's Secret business to retail-focused private equity firm Sycamore Partners. Victoria's Secret, including its PINK sister brand, generated $7.5 billion of revenue last year: 58% of the total for L Brands. However, for the past couple of years, Bath & Body Works has been bringing in the vast majority of L Brands' profit.

The potential deal had been rumored for weeks. However, the price was shocking. Sycamore is buying a 55% stake in Victoria's Secret at a valuation of just $1.1 billion. After purchase adjustments, it will pay about $525 million. As recently as fiscal 2016, Victoria's Secret was producing more than $1.1 billion of operating income annually.

Most investors had expected a significantly higher purchase price. In early February, Seeking Alpha contributor Robbe Delaet estimated $2 billion as a bear-case valuation for Victoria's Secret.

Given Victoria's Secret's well-chronicled problems, it's not surprising that potential buyers were only interested at fire-sale prices. However, the company's decision to sell at this fire-sale price is more troubling. Investors would be wise to avoid L Brands stock, which now represents a risky, heavily-leveraged bet on Bath & Body Works.

Dumping Victoria's Secret

Victoria's Secret has been in an accelerating downward spiral for several years. In fiscal 2015, the Victoria's Secret segment (consisting of the Victoria's Secret and PINK brands in North America) produced $7.67 billion of sales and an incredible $1.39 billion of operating income, putting its operating margin at 18.1%. However, sales growth slowed in fiscal 2016 and then went into reverse a year later, while operating margin has been plunging since 2016.

(Image source: Victoria's Secret)

In the recently-ended 2019 fiscal year, comparable sales fell 9% for the Victoria's Secret segment, following a 6% decline a year earlier. Segment revenue for Victoria's Secret dropped to $6.8 billion, while adjusted segment operating income (excluding various impairment charges) was just $114.6 million: down 92% from four years earlier. Adding in its loss-making international business, Victoria's Secret produced full-year operating income of $95 million.

The sale price works out to a little less than 12 times Victoria's Secret's fiscal 2019 operating income. However, the price is significantly cheaper based on cash flow, as Victoria's Secret has cut back on CapEx (relative to depreciation and amortization expense) in recent years. Furthermore, just two years earlier, Victoria's Secret earned $900 million of operating income, including its international business, highlighting Victoria's Secret's profit potential if it can reverse some of its recent margin erosion.

In short, if Sycamore Partners can stabilize Victoria's Secret's profitability, it got a great deal. And if Sycamore can make the business even half as profitable as it was four or five years ago, the acquisition will turn out to be an absolute steal.

L Brands' management has emphasized that the company maintains upside exposure to Victoria's Secret through its 45% stake in the business. However, giving up 55% of the upside plus incurring inevitable one-time separation costs and dis-synergies for a very small cash infusion seems like a desperation move.

Assessing Bath & Body Works' valuation

L Brands expects to use the sale proceeds plus $500 million of excess balance sheet cash to pay down about $1 billion of debt after the Victoria's Secret divestiture closes. That will leave the standalone Bath & Body Works business with about $4.5 billion of long-term debt.

As of the end of last week, L Brands' market cap was approximately $6 billion. Assuming a constant share price, the company's post-divestiture enterprise value would be a little over $10 billion. Assuming that L Brands' 45% stake in Victoria's Secret is worth around $500 million (in line with the sale price), Bath & Body Works is being valued at nearly 8 times its 2019 EBITDA of $1.3 billion. That's a fairly rich valuation for a retailer.

(Image source: Author)

The valuation looks more attractive based on L Brands' forward P/E ratio. Analysts currently expect EPS of $2.20 this year, including the Victoria's Secret business. Adjusted EPS could still exceed $2 after the divestiture, given that Victoria's Secret has been barely profitable recently. That would put the forward P/E ratio at roughly 10x. However, the company doesn't have an investment-grade balance sheet, so a low P/E ratio is to be expected.

Of course, while Bath & Body Works carries a premium valuation, it's a fast-growing business. Comparable sales rose 10% last year, on top of 11% growth in fiscal 2018 and a 5% increase the year before that. Furthermore, operating income has risen at a double-digit compound annual growth rate over the past decade.

There's too much risk

If Bath & Body Works continues to grow at the pace seen over the past decade, L Brands shareholders should achieve huge gains in the years ahead. Unfortunately, while Bath & Body Works is a well-run retailer with a strong position in its niche, its extraordinary run of success may not be sustainable.

Since 2012, the Bath & Body Works segment margin has consistently exceeded 20%. That enviable margin profile could entice new competitors to enter the market. Bath & Body Works is a low-moat business: its brand name and established customer base are its main competitive advantages. There are a number of other potential pitfalls. Falling traffic to low- and mid-tier malls, changing consumer tastes, and/or an economic downturn could all hurt sales and significantly reduce the chain's profitability.

(Source: L Brands 2019 Investor Update Meeting Presentation, slide 13)

Of course, these risks may not come to pass. However, it's important to remember that from 2001 to 2015, Victoria's Secret was growing just as quickly as Bath & Body Works, tripling its operating income from $454 million to $1.4 billion. It looked like a dominant business with ample room for growth right up until when profit started plunging. Its earnings then fell more than 90% in four years.

Had Victoria's Secret been a standalone company with similar leverage to what Bath & Body Works will have after the divestiture, it might already be bankrupt. Luckily, Bath & Body Works has been producing more than enough income to service the full company's debts and fund its dividend.

I don't expect Bath & Body Works to experience an epic collapse like Victoria's Secret. But if sales stagnated and its operating margin receded to 10%-12% (still quite strong for the retail industry), the stock would plunge due to the highly-levered balance sheet.

In the mid-1990s, L Brands was a diversified conglomerate operating nearly a dozen different specialty retail banners, giving it lots of options for growth. One by one, it has divested or shut down all of those brands except for Bath & Body Works. This shift towards a concentrated bet on one growth brand increases both upside and downside potential for shareholders.

If it had a conservative balance sheet, the new Bath & Body Works might be a worthy investment. However, it simply has too much leverage for a single-brand specialty retailer. Barring a change to the company's leverage profile, investors should avoid L Brands stock.

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Analyst’s 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.