Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: Though shares of L Brands Inc are up year-to-date, they remain down significantly over the past five years as of this writing (before taking dividend considerations into account).

By Callum Turcan

The owner of the Victoria’s Secret, PINK, and Bath & Body Works retail brands L Brands Inc (LB) reported second quarter fiscal 2020 earnings (period ended August 1, 2020) on August 19 that smashed past both consensus top- and bottom-line estimates. However, those estimates were a low bar to beat as analysts had already factored in the significant headwinds the coronavirus (‘COVID-19’) pandemic created for its business.

Last fiscal quarter, L Brands reopened most of its stores and leaned on e-commerce sales channels to meet customer demand as best it could. For reference, Victoria’s Secret and PINK (collectively referred to as Victoria’s Secret by L Brands) sell lingerie and similar apparel/accessories while Bath & Body Works sells fragrances, soaps, hygiene products, and similar offerings.

Quarterly Update and Strategic Changes

L Brands’ GAAP revenues were down 20% year-over-year while its GAAP net income turned negative in the second fiscal quarter. The closure of some of its stores combined with changing consumer spending habits/trends pressured L Brands’ top-line performance and its e-commerce sales channels only offered so much reprieve. Its GAAP operating income dropped by 75% year-over-year last fiscal quarter, largely due to diminished economies of scale and meaningful restructuring and impairment charges (we will cover that in just a moment).

However, on an adjusted non-GAAP basis, L Brands noted it posted $0.25 in diluted EPS last fiscal quarter (up 4% year-over-year), aided by the removal of major impairment and restructuring charges. We like to take a large pinch of salt when it comes to non-GAAP figures, especially as L Brands’ restructuring program is expected to last for at least a couple of years.

In late-July, L Brands announced it was shaking up its corporate operations in a big way. For starters, Victoria’s Secret and PINK are expected to be separated from Bath & Body Works by creating a new standalone company. Last fiscal quarter, Victoria’s Secret posted a 39% decline in net sales while Bath & Body Works reported a 13% increase in net sales year-over-year. Consumers continued to stockpile soap and hygiene products during the pandemic, though lingerie sales faced significant headwinds. The idea behind the separation largely seems to rest on Bath & Body Works’ long-term outlook being much more promising than that of Victoria’s Secret, as the latter has not done a good job updating its offerings in the face of changing consumer trends and social norms.

L Brands seeks to generate $400 million in annualized cost reductions by reducing its corporate headcount by ~15% (equal to about 850 jobs), better managing its inventory, seeking rent relief from landlords, closing stores (250 Victoria’s Secret locations are expected to be closed in 2020), and restructuring its international business in the UK and the Greater China region.

As it concerns L Brands’ UK operations, the firm is actively seeking to restructure its lease agreements while “explor[ing] the sale of the business to a joint venture or franchise partner” with exclusive negotiations currently ongoing with “a major fashion retailer” after a Heads of Terms agreement was signed. Pivoting to L Brands’ Greater China operations, the firm recently closed its unprofitable flagship store in Hong Kong while attempting to restructure its lease agreements elsewhere (this could involve additional store closures).

Financial Update

As of this writing, L Brands has not yet published its 10-Q SEC filing covering the second quarter of fiscal 2020. The company has not provided full-year guidance for fiscal 2020 given the uncertainties created by COVID-19, though during L Brands’ latest earnings call, management noted that “we have a cautious outlook for the second half of the [fiscal year]” as its performance is expected to “moderate” going forward.

In a presentation covering its performance last fiscal quarter, L Brands noted it exited the fiscal second quarter with $2.6 billion in cash and cash equivalents on hand versus $0.5 billion in short-term debt and $6.3 billion in long-term debt. An update of L Brands’ cash flow performance was not made readily available, though we appreciate that the company has ample liquidity to ride out the storm. We caution that L Brands’ large net debt load poses a long-term problem for the firm, and likely played a key role in prompting the company to aggressively pursue expense reductions.

During prepared remarks covering L Brands’ fiscal second quarter, management noted that the firm recently converted its revolving credit facility into an asset-backed one that was undrawn at the end of its last fiscal quarter. That facility matures in August 2024 and has $1.0 billion in aggregate commitments. However, please note that one of the covenants of its asset-backed credit line stipulates that should L Brands’ consolidated cash balance exceed $0.35 billion, the firm must use the excess to pay down any borrowings on that asset-backed credit facility.

In early-June, L Brands issued out $0.75 billion in 6.875% senior secured notes due 2025 and $0.5 billion in 9.375% senior notes due 2025. Management noted during the firm’s prepared remarks that some of those proceeds would go towards retiring L Brands’ $0.45 billion in 6.625% notes due April 2021. We caution that L Brands’ cost of debt is quite high as investors are apparently worried over its ability to navigate the pandemic.

On a positive note, L Brands’ management noted the firm generated a little less than $0.6 billion in free cash flow during the first half of fiscal 2020, though we would like to see its cash flow statement to get a better idea of its performance on this front. L Brands suspended its dividend program starting last fiscal quarter to preserve cash and better position itself to ride out the storm.

Operations Update and Outlook

As it concerns L Brands’ e-commerce performance, direct sales at its Victoria’s Secret brand grew by 65% year-over-year while its Bath & Body Works brand posted an 87% year-over-year increase in direct sales last fiscal quarter. Though meaningful, the reduction in foot traffic more than offset rising e-commerce sales on a company-wide basis. Management is wary that L Brands may not be able to meet elevated e-commerce demand during the second half of its current fiscal year, and had this to say during prepared remarks (emphasis added):

“…[T]he majority of our sales and profits for the year occur in the fourth quarter. Given the traffic constraints imposed by social distancing protocols in stores and capacity restraints in our direct channel distribution centers, we have a very cautious outlook about our ability to manage our typical Holiday volumes, which are about three times larger per week than the average week in the second quarter historically.

We are evaluating and testing ideas to spread our Holiday volume out over a broader time period, and to pull some volume out of the fourth quarter and into the third. We also expect to return to a more typical promotional approach.

We are forecasting meaningful expense pressure driven by increased store costs, including payroll and supplies, as a result of the new labor model imposed by social distancing protocols, wage rate inflation in the domestic supply chain and increased direct channel fulfillment and shipping costs.”

We caution that the road ahead for L Brands is full of potholes. Capacity constraints are expected to hold back its ability to meet e-commerce demand during this upcoming holiday shopping season, which we see as a major hurdle given rising e-commerce demand overall during the pandemic (as households seek to avoid large crowds, especially indoors).

Concluding Thoughts

L Brands has enough liquidity and access to liquidity ride out the storm as things stand today, especially now that most of its stores have reopened, though we caution its net debt load and lack of confidence in its near-term performance is discouraging. We are not interested in shares of L Brands at this time, and we would like to see how L Brands’ Bath & Body Works unit performs as a standalone company before taking a second look at the name. Additionally, we want to see how effective L Brands is at reducing the cost structure at all its brands.

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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.