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3 Reasons to Buy Kraft Heinz Stock, 1 Reason to Sell

What to do about Kraft-Heinz (NASDAQ:KHC)? One of Berkshire Hathaway’slarger holdings (Berkshire owns roughly 26.7% of shares outstanding, controlling the company in tandem with Brazilian investment firm 3G Capital),Kraft’s stock has tumbled roughly 28% in 2018, as the consumer packaged foods industry (“CPG”) has come under pressure.

In addition, the market is growing increasingly skeptical of Kraft’s ability to make a transformative aquisition, which had been the main upside thesis in Kraft-Heinz ever since the two companies merged three years ago.

Now near 52-week lows, is it time for holders to cut bait on the fallen darling, or is the stock now a screaming deal?

Reason to sell: disruption

I always like to get bad news out of the way first. Ironically, Kraft’s bad news was recently articulated not by short-sellers or bearish sell-side analysts, but rather by its very own largest stakeholder!

At a recent conference, 3G Capital CEO Jorge Paulo Lemann admitted, “I’ve been living in this cozy world of old brands and big volumes… We bought brands that we thought could last forever… You could just focus on being very efficient… All of a sudden we are being disrupted.”

a man sits at a desk with Oscar Meyer meats and a laptop and funny glasses.

Can innovatinve marketing like “Bacoin” save Kraft-Heinz? Image source: Kraft-Heinz.

Lehmann founded 3G, and was instrumental in the acquisition-of-big-brands strategy behind Kraft-Heinz, AB InBev (NYSE: BUD) and Restaurant Brands (NYSE: QSR). For him to admit his company was “caught by surprise” after deploying billions of dollars toward the large consumer brand strategy was quite an admission.

The disruption has come from the confluence of several factors, including the rise of craft/natural foods, low-cost private label brands, and the advent of e-commerce. The new generation of more health-conscious, yet budget-constrained consumers, has put traditional consumer packaged goods brands in a tough spot. On the high-end, these brands are being crowded out by healthier, more natural alternatives, while huge retailers have come out with high-quality private label brands, such as Costco’s (NASDAQ: COST) Kirkland brand and Kroger’s (NYSE: KR) Simple Truth, which are often priced below CPG rivals.

These factors have challenged Kraft-Heinz’s top-line, which fell 1.5% (in constant currency) in the first quarter. That being said, Lehmann also said, “I’m not going to lie down and go away,” and Kraft’s executives have been working hard to adapt to the times. Here are three reasons why you may want to buy the stock today.

Reason to buy: it’s a bargain

While the “safety” of consumer packaged goods companies traditionally earned these stocks relatively high price-to-earnings multiples, even with low growth, that has changed in a hurry very recently. Lackluster growth as well as concerns about high freight cost inflation have taken a toll on the industry, and especially Kraft-Heinz:

KHC PE Ratio (Forward) Chart

KHC PE Ratio (Forward) data by YCharts

Currently, you are not only buying into a low-priced sector, you are arguably buying the best-run company of the lot, at a valuation on par with its industry peers, and receiving a 4.5% dividend as well.

Of course, buying a cheap stock doesn’t necessarily turn out well, unless management is on its way to improving. On that front, there are two ways in which Kraft-Heinz is attacking this new age of disruption.

Reason to buy: product innovation

Kraft-Heinz isn’t resting on its laurels, but is quickly innovating its products.These innovations fall primarily into two camps. One is around renovating “powerhouse” brands ($1 billion+ in sales) such as Kraft, Heinz, Oscar Mayer, Planters, and Philadelphia to make them more relevant (like taking out artificial ingredients from Kraft Mac ‘n Cheese), and well as extending them to horizontal products (such as Kraft mayonnaise).

The second type of innovation is for entirely new products. On that front, Kraft-Heinz is moving quickly, aiming for 60% more innovations in 2018 versus 2016. Recent successes include Devour frozen meals, as well as the new, “Just Crack an Egg,” which, on the recent call with analysts, CEO Bernardo Hees said was “selling faster than we can make it.” Kraft also recently started its Springboard platform, a start-up accelerator to find the next big food innovation. Management has emphasized the need to provide incremental sales, not just the replacement of declining or outdated products.

Obviously, new brands such as these are not going to move the needle in the near-term — new innovations only made up 7% of sales over the past three years. Still, there are hints at least some are making a difference. In its recent post-integration update, management credited the new Devour line with returning the company’s frozen food category to growth after serval years of mid-teens declines.

Reason to buy: new marketing

Behind all of this product innovation will also be a revamped marketing strategy.One of the more interesting things Kraft Heinz is doing is doubling down on its own salespeople inside supermarkets, rather than pulling back or using third-party merchandisers. By bringing everything in-house, the company believes it can be more effective, as well as use big data analytics to further target marketing campaigns to the modern age. Hees said, “We started doing this in 2017. I can guarantee you that it’s paying off and we’re actually doubling down on this.”

Kraft is also investing in its people, with employees completing 60,000 hours of custom-made courses just in the first quarter alone. These courses keep employees up to speed on the latest innovations in R&D, marketing, and industry knowledge.

Get hungry

Down severely in 2018 while possessing the most dynamic management team in the industry, I’d be a buyer of Kraft-Heinz here here rather than a seller. It’s time to be hungry when others are fearful!

L Brands: So Much More Than Victoria’s Secret

Things are looking good if you are a fan of the Victoria’s Secret brand. While the world’s most renowned women’s lingerie brand usually sells its good at a hefty price tag, consumers now get the opportunity to buy these articles at a large discount as new promotions and limited time offerings are being featured in the stores and on the website on a daily basis. While this is great news for the Victoria’s Secret consumer, it is a thorn in the eye of the investors who have placed their money in L Brands, the mother company behind Victoria’s Secret. L Brands shares are down 46% YTD, and some sell-side analysts are convinced that L Brands shares still face more downside.

The question one has to ask however is, whether or not Victoria’s Secret is really the most important entity within the L Brands consortium. Surely, it is undeniable that Victoria’s Secret is the most famous brand within the group, and in terms of revenues, it towers over the other brands. When shifting the focus to operating income, however, it becomes clear that there are other brands in the portfolio that are contributing more to the bottom line than Victoria’s Secret. While most bullish pitches about L brands argue that the problems at Victoria’s Secret are short-term related and that it is a strong brand that is set to make a turnaround, I look at L Brands in a different way. I do not deny the potential of a Victoria’s Secret turnaround, nor do I question the strong brand. The numbers however prove that Victoria’s Secret is in a severely troubled state, and I am of the opinion that actions chosen by management are insufficient. I however believe the case can be made that the Bath & Body Works brand is severely undervalued within the L Brands group and that the market does not fully appreciate the optionality that L Brands has in creating value by spinning off or discontinuing certain parts within the group.

An introduction

L Brands was founded in 1963 when founder and current CEO Les Wexner opened his first “The Limited” store. In 1969, Wexner took the company public and in 1982 Wexner acquired the Victoria’s Secret brand for USD 1 million. After acquiring and spinning of several brands such as Abercrombie & Fitch (ANF) and the sale of its oldest brand “The Limited”, the current L Brands group looks as follows:

Victoria’s Secret: L Brands’ flagship brand and world renowned lingerie brand. Pink: Separate store concept from Victoria’s Secret but grouped under the latter, Pink is a women’s lingerie retailer focused on teenagers, college students and young professionals. Bath & Body Works: Market leading speciality retailer in home fragrances, candles, soaps, La Senza: Women Lingerie retailer, focusing on a younger target audience than Victoria’s Secret. Henri Bendel: Upscale retailer of handbags, accessories, women clothing and fragrances.

I will go in more detail on these segments, but first, let us have a look at the revenue and operating profit contribution of these segments.

As stated in the prologue of this analysis, the Victoria’s Secret brand takes the largest part of the revenue contribution for its account. While revenue contribution declined from 63% of total sales in FY15 to 58% in FY17, the brand still contributes significantly more than the second largest contributor Bath & Body Works. La Senza & Henri Bendel are grouped under the “Other” segment.

Revenues

L Brands revenue distribution – Source: Author calculations/L Brands financial statements

While Victoria’s Secret is the main revenue contributor, it is not the main contributor towards the operating income line. While it historically generated more operating income than Bath & Body Works, the latter has overtaken Victoria’s Secret as main source of operating income. Interesting to note is the negative contribution of the other segment.

operating profit
L Brands operating profit distribution – Source: Author calculations/L Brands financial statements

Let’s take a closer look at the different segments.

Victoria’s Secret

Victoria’s Secret is the iconic women’s underwear brand that is sold globally. It is known for its yearly fashion show that is watched by millions of people in more than 200 countries and for its lingerie models, the “Victoria’s Secret Angels”.

Within L Brands, Victoria’s Secret represents three subgroups: Victoria’s Secret Lingerie, Victoria’s Secret Beauty, and Pink. One could easily assume that Victoria’s Secret Lingerie overshadows the other two in value, but it is important to understand that Victoria’s Secret Beauty features 4 of the top 20 fragrances in the US and that Pink represents a USD 3bn+ sales base with a sales/square feet ratio above the Victoria’s Secret’s shops.

As stated above, Victoria’s Secret is not doing too well at the moment due to a number of factors. The problems started when previous VS CEO Sharen Turney decided to leave the company in February 2016. Founder Lex Wesner took over the CEO role again and decided to restructure the business. The business was split up in the three aforementioned segments and each received its own leader. Denise Landman who has over 15 years of tenure at Pink would resume leading the Pink segment. Jan Singer, who worked for more than a decade at Nike (NKE) was hired to lead the lingerie segment and Greg Unis came over from Coach (TPR) to lead the beauty segment.

A more radical decision was the choice to exit the swimwear industry and other product categories, thereby giving up 1bn USD in sales in order to be able to focus on the core products, bras and panties. VS management was convinced that they could offset the operational deleveraging from the swimwear exit by accelerating the growth in underwear sales. Unfortunately, for the management, the restructuring coincided with the surge of new fashion trends. Bralettes, a more fashion inspired type of bra which offers less support than a structured bra quickly gained popularity. The lack of differentiating power within bralettes and the significantly lower average selling price created the additional problem of negative same store sales.

Some of the promotions on a random day – Source: Victoria’s Secret website

This brought Victoria’s Secret in the position where it is being forced to offer discounts after discount in order to keep its topline up. These promotions include lower prices, free items such as panties and totes, large discounts on combinations, reduced basket size to qualify for free shipping or a combination of those things. While this allows Victoria’s Secret to grow its revenues lines, it is putting significant pressure on the margins and the profitability of the brand.

Just have a look at the operating profit contribution of Victoria’s Secret over the past years

Victoria Secret Operating Profit

Victoria’s Secret operating profit – Source: Author calculations/L Brands financial statements

Furthermore the market seems to be worried about increased competition, the high exposure to B- and C-class malls and the promotional environment.

There is no denying that we are in a promotional environment and Victoria’s Secret is not the only one offering large discounts. In a way, this is related to the aforementioned surge in popularity of bralettes. While constructed bras require some sort of design expertise in order to design bras that are both fashionable and offer the necessary support, bralettes target women with an A- or B-cup size and thus require less support. This handicaps Victoria’s Secret as they cannot really leverage their manufacturing expertise within this segment and are left to compete on the fashion aspect. Needless to say, the amount of players that can compete on fashion is far larger than those that can compete on design. This has allowed players such as American Eagle Outfitters’ Aerie (NYSE:AEO) to enter the market. With no clear differentiating aspects other than brand and fashion, it is impossible for Victoria’s Secret to warrant the same premium pricing that it has for constructed bras. The lack of product differentiation has turned the bralettes market in a market that competes on price and promotions. Whether or not bralettes are here to stay is a topic on which I will not comment. If it turns out that bralettes are more fad than fashion then Victoria’s Secret will be a prime benefactor of the return to constructed bras.

As to the exposure to the B- & C-class malls, I think the market may be overreacting a bit. I think the problems that Victoria’s Secret is facing have much more to do with the promotional environment and current fashion trends than with their mall exposure. Obviously, the fall in mall foot traffic is negatively impacting Victoria’s Secret sales but L Brands has repeatedly stated that their B- and C-class malls are actually the most profitable stores that they have. While the performance between these A-malls and C-malls is almost similar, the rent expense of the latter category is far below the level of the A-malls making these stores more profitable. With 99% of the store base cash flow positive, there is no immediate issue. On the long term, it will be interesting to see how the company will position itself. In recent years, Les Wexner has voiced his belief that the mall environment will remain viable several times. According to him, this is just a phase in which the out of favour chains get replaced by more attractive brands. He stated that he would be indifferent or even happy to see the Nordstrom (NYSE:JWN) and Macy’s (NYSE:M) stores get replaced by Tesla (NASDAQ:TSLA) dealerships, restaurants and other places that attract people (source: 2017 Investor Conference). The company has therefore increased investments in its employees in order to maintain the best associates (which have a tenure of more than 10 years on average) . I have found L Brands’ focus on the digital channels to be insufficient in the recent past but I am pleased to hear that the company is now investing more in the e-commerce segment. Especially since management confirmed that online sales are more profitable than in-store sales.

Performance comparison A-malls vs C-malls – Source: Investor Handout L Brands

Some bears also claim that Victoria’s Secret fails to inspire the younger generation shoppers but a recent study by Goldman Sachs actually reveals Victoria’s Secret as one of the most loved brands for Generation Z members and Millennials.

Bath & Body Works

Bath & Body Works is the leading U.S. speciality retailer for home fragrances, candles, hand sanitzers, soaps and moisturizers. While the total revenue number generated within this segment is much smaller than that of the Victoria’s Secret segment, the B&BW operating margin that is nearly twice as high as the one of VS has resulted in Bath & Body works becoming the main contributor to the operating income line.

B&BW Operating profit
Bath & Body Works operating profit – Source: Author calculations/L Brands financial statements

The thing that attracted my attention within this segment is the continuous strong growth in topline. In the first quarter of 2017, B&BW reported $678m in revenue. Now that the total first quarter sales of 2018 are revealed, we can see that the B&BW segment generated $760m in sales, a 12% increase compared to the previous year. I checked the monthly sales calls for all three months included in this quarter and noticed that unlike the Victoria’s Secret segment, the merchandise margin remained flat compared to the previous year in all three months. The increase in revenue is thus fuelled by market share gains and increased demand instead of additional discounting.

It is clear that the recent store remodels with a White Barn integrated in the Bath & Body Works store is paying off its dividends.

When looking at the high price paid by Natura cosmetics (OTC:OTC:NUACF) for the much lower margin struggling Bodyshop, one could start to wonder how much a high margin, fast growing market leader within this segment could be worth. This is something that will be discussed in the valuation section further down in this analysis.

One could argue that B&BW brand name is less valuable than that of Victoria’s Secret and that this segment has less of a moat than the lingerie division but it is also the case that this segment is higher margin and that it is less fashion-dependable. In all cases, it is clear that Bath & Body Works is a very valuable business.

The international segment

The international segment covers those Victoria’s Secret and Bath & Body Works stores outside North America.

The division can be split up in three sub-segments: the wholly owned stores, the franchise partners and the travel retail stores.

L Brands has chosen to own and operate its own stores in the same way as it does in North America in only two foreign markets, the United Kingdom and China. The margins and other financial metrics for these stores are similar to those in the United States. The wholly owned stores represent 20% of the revenues generated in the international segment.

Travel retail represents 20-25% of the international segment’s revenues. The stores within this sub-segment are those that you can find in the various airports all over the world. The stores operate on a wholesale model that generates above company average margins of around 30%. Management believes that revenues within travel retail can increase by factor 2.5 in 5 years’ time (Source: L Brands Investor Meeting 2016).

The majority of the revenue originates from the franchise partners that operate on a royalty basis. L Brands wishes to cooperate with a limited number of partners that can each manage a large geographical area. Currently 33% of the royalties received are used to support the international sales team while 66% ends up in the operating profit line. The interesting aspect here is that there is significant operating leverage potential as you have a certain fixed cost base within the international sales team expense base.

A lot of the international market is still untapped for L Brands. The company stated that Western Europe has the same potential as the United States, yet is it is mainly untapped. As a European, I would agree with this statement. A quick check with my female colleagues confirmed that which I already discovered on my credit card after my partner takes the liberty to use it: women love the Victoria’s Secret brand and its products. Belgians who wish to order Victoria’s Secret goods however have to order it online, pay international shipping fees if they order for less than $120 and then wait for 10-14days before it arrives. It is also impossible to return goods to a store, which creates additional costs if one wishes to return the goods. Therefore I can’t grasp why L Brands hasn’t looked more aggressively for a partner that can serve these high income Western European markets. One can only imagine how much more Europeans would purchase if they actually had the opportunity to visit a store or to order it from a local distribution centre that provides free one-day shipping and returns.

While the profitability of the international segment is currently depressed due to a rapid store build-out in China and due to Brexit-related problems, it must be noted that the operating margin of this segment was in the low twenties before the China expansion. While it may take 2-3 years before start-up costs fade off and the new stores reach maturity, it should be expected that the international segment will be a large contributor to L Brands operating profit growth.

The ‘Other’-segment

This segment features all of L Brands other ventures, which mainly consist of intimates brand La Senza and high end handbag maker Henri Bendel.

These ventures have a combined revenue base of nearly $600m but sadly for L Brands, have a negative operating income of over $160m. This operating loss is not a one off result due to a one time restructuring or anything like that. The past four years, this segment has posted an operating loss with negative mid twenty operating margins.

Other segment Operating Profit
‘Other Segment’ operating profit – Source: Author calculations/L Brands financial statements

While Les Wexner, who has build out the Victoria’s Secret and Bath & Body Works segments almost from scratch, probably believes that he can also turn these brands in billion dollar ventures, the question remains if Victoria’s Secret can afford to continue to invest in these brands. Not only in terms of time and attention but also in terms of financial resources.

While it is probably impossible to eliminate the entire operating loss as the other divisions would have to take over certain overhead costs, let’s assume that the company can reduce the operating loss by $130m by shutting down Henri Bendel and La Senza. This would have lifted FY2017 operating income from $1,728m to $1,858m, thereby raising the operating margin to 14.7% from the actual 13.7%.

Moreover, shutting down these brands is a very unlikely scenario. While these brands are loss making, they do have value for private equity players. Assuming just a 0.25 EV/sales ratio would bring in $150m for L Brands if one assumes that all debt stays with L brands. A sale would also prevent the company from having to take on any restructuring costs.

Afbeeldingsresultaat voor taylor swift henri bendel

Henri Bendel add – Source: Henri Bendel Twitter Page

The question remains whether or not, CEO Wexner will be open to divesting these brands. Without the pressure of an activist investor, I would not count on an early departure from these brands.

Management

Let us have a closer look at management. As stated earlier, the founder Les Wexner currently serves as CEO and he has a 16% stake in the company. This should align his interest with that of the long term shareholders. It could however also be the case that this large stake is preventing activist investors from coming in and pushing for value creation. Elliott Management Corp’s recent win over Vivendi (OTC:OTCPK:VIVEF) in the Telecom Italia (BIT:TIT) case however shows that a large stake from an opposing shareholder does not have to prevent shareholder activism.

I believe there are both good things and bad things to say about Wexner’s management. It is clear that Les Wexner has delivered outstanding results in the past decades and that he has build one of the most renowned apparel brands in the world. Wexner has bought and sold brands at exactly the right time and he has always been on top in regarding to changes in the retail environment. It can be argued however that ever since he took back the reigns in 2016, he made some questionable decisions. Discontinuing the swimwear division to reignite growth in the lingerie division would probably have awarded Wexner with a lot of credit if it had worked out but things turned out quite differently. Victoria’s Secret discontinued its profitable swimwear line but actually saw lingerie sales declining and the company had to resort to aggressive promotions in order to maintain the top line. I am by no means a retail expert but even I know that continued promotions are very harmful for a premium brand on the long term. Let’s face it, when have you seen significant discounting on top luxury brands such as Hermes (OTC:OTCPK:HESAY)?

It is also quite clear that the almost 81-year old Wexner is not the greatest fan of e-commerce and that he has not awarded enough attention to the digital channel. His view on the mall environment may very well be correct but it does bear some risk.

An important question to ask is how long the almost 81-year old Wexner seeks to continue leading the company. His children are in their late teens and early twenties and it is well possible that Wexner wishes to spend more time with his family now that he has reached a more advanced age. Does this mean that he would be more open to a restructuring of the company, including the divestment of La Senza and Henri Bendel as well as a spinoff of Bath & Body Works? Would he be open to a sale of either Victoria’s Secret or B&BW to a private equity player? Given Wexner’s age, these may become very relevant questions in the coming years.

CFO Stuart Burgdoerfer has an excellent reputation as CFO and he has held leadership roles at some of the world’s top companies such as The home Depot (NYSE:HD), PepsiCo (NASDAQ:PEP) and Pizza Hut (NYSE:QSR).

Interesting to note is that Burgdoerfer recently sold a large amount of shares in an open market sale. He sold his shares at around $39 and $42 per share. While insider selling does not necessarily mean that the management is expecting more bad results, we should certainly assume that this is a possibility. The big question however is whether or not we should expect more bad news in the coming months. Was his open market sale triggered by his knowledge of quarterly results coming in at the lower end of the guidance or does he have knowledge of something more severe, such as a dividend cut coming up? I personally expect no large dividend cuts and I would actually prefer if the dividend was lowered in exchange for more share buybacks.

Insider Open Market Activity- Source Bloomberg Portal

Then there are also the CEOs of the various divisions:

Denise Landman: Pink

While Pink has comped negative comparable sales in the last two months, it is undeniable that she has build out a strong brand with many loyal followers. I am confident that she can continue to grow the brand in the coming years.

Greg Unis: Victoria’s Secret Beauty

Victoria’s Secret Beauty has been one of the strongest performing sections within VS ever since the restructuring. Unis has significantly reduced the number of SKUs within the beauty segment and he is well underway to growing the beauty business.

Jan Singer: Victoria’s Secret Lingerie

If I was Les Wexner, I would be starting to doubt Ms. Singer’s management of the brand. While the swimwear division was cut in order to reignite growth in the lingerie division, the performance of the latter division has been lacklustre with no clear sign of improvement. As an investor, I am particularly annoyed by Ms. Singer’s evasion of any and all questions regarding the turnaround. Regardless on whether the question is about average selling prices, margins, volumes, bralette penetration or any other subject, the answer is nearly always the same. According to Jan Singer, it is all a matter of having that customer connection, having the goods that the client needs in every part of her life, having goods that inspire her. Either Singer does not have any answers on these various questions and she herself is struggling to find solutions or she knows the answers but doesn’t wish to reveal them as they don’t paint a pretty picture about Victoria’s Secret’s future. In both cases, her evasive answers are not exactly inspiring any investors to start buying L Brands stock.

Nick Coe: Bath & Body Works

By now, it should be clear that I consider Bath & Body Works to be the gem within the L Brands group. Coe is doing a wonderful job on expanding the business and the recent results have been better than I expected.

Martin Waters: International division

Good old Martin, the chap with the fancy British accent for those who listen to the calls, is the person in charge of the international division of Victoria’s Secret and Bath & Body Works. While I would like to see a more rapid roll-out of the brands in areas such as Europe, I find Waters to be more knowledgeable and open on all investor calls than Ms. Singer. I would give Martin Waters the benefit of the doubt.

Positive to note is that all the management members are very aligned with the long term shareholders as all executives need to hold three time times their base salary in L Brands stock and the compensation committee has shown to significantly reduce compensation when the results are disappointing.

The financial picture

One of the main questions that investors have at this point is whether or not the dividend is safe. It will be hard to answer before we get more financial details when the Q1 results come out.

Free Cash Flow Overview – Source; L Brands Investor Presentation

As you can see in the table above, the dividend is covered but it was only barely covered in 2017. For 2018, L brands guided slightly higher capex spending of around $750m but it also guided towards $900 million in free cash flow (L_Brands_Q4_2017.pdf) which is more than enough to cover the $686m in dividends. One could start to wonder on whether the Q1 results coming in towards the lower end of the guidance will have any impact on the free cash flow guidance. In any case, it would require a major adjustment for the free cash flow to fall to a level that would require a large dividend cut.

It should also be taken into account that free cash flow will rapidly rise again once the international segment stops its aggressive China expansion.

Let us also have a quick look at the financial leverage

Debt Leverage Overview – Source; L Brands Investor Presentation

When looking at the pure financial net debt, you can calculate that it will come in at around 2.05 times net debt/EBITDA assuming net debt of $4,280m and a 2018E consensus EBITDA of $2,085m.

At the beginning of 2018 lease adjusted net debt/EBITDAR was 3.44x or 4.0x if you use adjusted debt/EBITDAR.

Valuation

Now it’s time to try and put a price on the stock.

In my model I have opted to assume that Victoria’s Secret only makes a minor recovery. I am sure that L Brands bulls will consider my growth numbers far too conservative but if I can prove that L Brands is undervalued using very conservative estimates, then readers should be able to imagine where the stock price could go on a larger recovery.

I assume Victoria’s Secret store sales decline by 4% each year while direct sales grow by 20% in FY18, 15% in FY19, 12.5% in FY20 and then 10% in the outer years. L Brands guides for mid- to high teens direct sales growth in their multi-year plan and VS direct sales grew by 23.4% in Q1 2018.

I expect that operating margins for the segment take a nosedive to a multi-year low of 9.5%. and then steadily recover to 12.5% in FY22. This would assume that VS operating margins never reach the 12.6% operating margin that VS had in its horrible FY17 year, let alone the 18% realized in FY15. I thus consider my estimates to be very conservative.

For B&BW I assume that stores basically grow sales by 3% each year while online sales grow at around 10%. I model slight operating margin pressure to incorporate the possibility of more discounts in this segment. In reality the operating leverage on the higher sales number could easily offset this.

Management guides the international segment to grow low- to mid-twenties percent but I choose to be a bit more conservative in the outer years. I take operating margins of 13.5% in the outer years regardless of the fact that this segment had low twenties operating margins before the China expansion. This should more than offset any bear argument that VS margins have significantly declined since then.

In my model I assume that the other segment does not get divested and that it remains loss making over the entire forecasted period.

I forecast less stock buybacks than guided by the company and less than historically bought by the company as I assume that the company will not want to raise the financial leverage and that there may not be as much cash available after maintaining the dividend.

Then comes the tricky part, what multiple should a company like L Brands be trading at? Looking at trading levels in the past years a 18x-20x multiple should be warranted. Retailers with less known brands and lower margins such as American Eagle Outfitters (NYSE:AEO) trade at 17.8 times the actual earnings. Therefore I believe that a 15x multiple for L Brands is a conservative pick.

Applying that 15x earnings multiple on the $4.37 earnings expected in FY22 brings us to a $65 in 5 years time (I assume that L Brands bulls would actually be very disappointed if L brands only reaches $65 in 5 years time). Together with the assumption that the dividend remains stable at $2.4/share, this would result in a 20% IRR based on Friday’s closing price of $32.33.

Valuation
L Brands Valution – Source: Author’s Own Calculations

Another way to look at the valuation is by looking at the value of Bath & Body Works within L Brands.

Natura Cosmetics bought The Body Shop for 18 times EBIT (Bloomberg displays The Body Shop’s EBIT at 54.8m as last reported result) . Applying that same multiple on B&BW’s FY18E EBIT would value it at an enterprise value greater than the entire L Brands enterprise value.

Valuation 2
Bath & Body Works Valution – Source: Author’s Own Calculations

Using a more conservative EV/EBIT multiple of 10x, in line with American Eagle Outfitters’ 10.64x, followed by subtracting half of L Brands net debt results in an implied share price of $26.63. One could make the case that B&BW should trade at a higher multiple than AEO as B&BW is growing faster, has much higher margins and is the clear leader in its segment, but once again I prefer to use the necessary level of conservatism.

Now that we have the conservative value of Bath & Body Works, let us see what that implies about the value of Victoria’s Secret.

L Brands Equity Value

$9,014m

B&BW Equity Value

$7,510m

Implied VS Equity Value

$1,504m

Remaining Net Debt

$2,150m

Implied VS Enterprise Value

$3,654m

Victoria’s Secret FY18E EBIT

$708m

Implied VS EV/EBIT multiple

5.16

Implied Victoria’s Secret EV/EBIT multiple – Source: Author’s Own Calculations

Even when using my very bearish Victoria’s Secret FY18E operating profit forecast, it becomes clear that given the value of B&BW, Victoria’s Secret would be trading at a mere 5.16x EV/EBIT multiple. Additionally, it assumes that the La Senza and Henri Bendel brands are worth nothing as otherwise you would still have to subtract their value from this already insanely low valuation. I also did not include the operating profit of the international division for both VS and B&BW as this is currently near break-even level but in 1-2 years this will be an asset that is significantly contributing to L brand’s bottom line.

Applying a very conservative 8x EV/EBIT multiple on my very depressed VS EBIT forecast, would still indicate a share price of $12.46 when excluding the international sales.

Valuation 3
Implied Victoria’s Secret Share Price – Source: Author’s Own Calculations

Combining the derived share prices of B&BW and VS results in a $39.09 combined share price, more than 20% above Friday’s close. This is also neglecting any value in the La Senza and Henri Bendel brands as well assuming no recovery in the VS brand and excluding the entire international division for both Victoria’s Secret and Bath & Body Works.

So why would anyone invest in L Brands? The true value of Bath & Body Works is not reflected within L brands market cap. A spin-off or sale could realise this value. L Brands has the optionality to divest its La Senza and Henri Bendel brands, thereby bringing in extra cash in addition to boosting its operating profit. The company currently pays a covered 7.42% dividend. A performance turnaround in the Victoria’s Secret brand due to either a shift back to constructed bras or due to a reduction in discounting by competitors could result in a major upswing for the L Brands stock (just see American Eagle Outfitters price graph). The International segment has significant growth prospects. Victoria’s Secret may opt to re-enter the swimwear market. What are the main risks to this investment case? Margin pressure at Victoria’s Secret may get worse, resulting from additional discounting. Continued promotions may dilute the Victoria’s Secret brand name and the company may never be able to return to the position of the undisputed leader in intimate’s apparel. The case stands and falls with the performance of Bath & Body Works. If performance at B&BW worsens significantly then the dividend may no longer be sustainable. The company may maintain its mall exposure, increasing its vulnerability to decreasing mall foot traffic. Catalysts

On the 24th of May, L Brands will reports its Q1 number. It will be interesting to see the operating margins of the different segments. In the April sales report, L Brands stated that earnings per share would come in towards the lower end of the previous guidance. It will be important to see if management gives any further details. Was it due to lower share repurchases or higher start up costs in China or was it due decreasing profitability within the Victoria’s Secrets segment? The most important question that the investment community will have is whether or not L Brands will change its full year guidance. The stock price is bound to show strong movement, whether it be increasing or decreasing. Therefore it may be optimal for real bargain hunters or for those who want to play it safe, to wait till the earnings release before starting a position.

Conclusion

L Brands is often considered as a synonym of Victoria’s Secret and things aren’t going that well for Victoria’s Secret. Therefore, the L Brands stock has taken a dive of nearly 50% this year. While a recovery of the Victoria’s Secret segment would be the fastest way back up from this point, I don’t feel comfortable predicting such a recovery any time soon. I am convinced that the potential is there but in a world where retailers are struggling, it is impossible to say when exactly the promotional environment will ease. I however believe that L Brands has multiple other levers to value creation. First of all, the value of Bath & Body Works, a fast growing higher margin segment is not reflected in the stock price. Then there is the possibility to divest the loss making La Senza and Henri Bendel brands which could help strengthen the balance sheet and significantly raise the group’s operating income. Another long term contributor will be the International division that is currently not contributing much to the bottom line due to large expenses made in the build-out of the China division. As soon as these new stores start generating revenues, the company will get a large boost from the international division. While a lot of these initiatives are 2-3 years away from being delivered or may not be realised at all depending on the choices that management makes, I believe that we are currently at a price level that doesn’t take any of the aforementioned catalysts into account. L Brands is owner operated with all executives owning a large amount of stock in comparison to their base salary and compensation schemes are focused on long term results. Nevertheless, I would welcome an activist investor that could encourage more value creation at L Brands. In the meantime, Investors can collect a 7.4% dividend yield and wait till the situation plays out. There is a small chance that the dividend gets a small cut but I do not expect a large slash in the dividend.

While this is not the usual type of investment that I make, I have decided to start a small position in L Brands after last Thursday’s correction. I will eagerly wait on the quarterly results and earnings call in order to decide on whether I want to build this up to a full position.

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.