EUR 850.00 For Business Accounts Only

Morningstar | Bath & Body Provides the Silver Lining on L Brands’ Performance; Shares Undervalued

Narrow-moat L Brands' segments continue to offer mixed results, with Bath & Body Works delivering another stellar quarter of 13% comp growth, while Victoria’s Secret’s 5% comp decline continues to languish. But with management no longer distracted by margin-dilutive brands like Henri Bendel and LaSenza, we expect a renewed focus on restoring brand equity at the lingerie business, which in turn should drive improving comp-store sales and profitability at the VS segment over the rest of 2019. For reference, first-quarter comps at VS have sequentially improved over a 7% decline in the fourth quarter, and the second half of 2019 is set to lap mid-single-digit comp declines, setting the firm up for easy comparisons ahead. Robust competition is pervasive across the lingerie landscape, constraining our moat rating to narrow and our midcycle operating margin target to 7% for the segment. The profit profile of BBW, with operating margin of 17.8% in the quarter (up 150 basis points), continues to support overall profitability, and helped L Brands exceed both the firm’s EPS around break-even guidance, and our $0.00 estimate, by $0.14.

In turn, L Brands raised the low end of its full-year EPS guidance to $2.30-$2.60 (from $2.20). Despite the $0.14 beat, the raise at the midpoint represents just a $0.05 hike, which in our model should be offset by lower-than-anticipated second-quarter earnings power (our forecast called for $0.26 versus L Brands outlook for $0.15-$0.20). We don’t plan to materially alter our 2019 EPS estimate of $2.36 or our $42 fair value, which is supported by five-year average sales growth of 2% and EPS growth of 5%, and operating margin of around 11%. We view the shares as undervalued, even after the high-single-digit pop after the report, with sentiment weighed down by weak performance at the VS brand (56% of 2018 sales). However, we contend that shares should reflect greater promise of the lucrative Bath & Body business (75% of 2018 operating profit.)

We published a report discussing segment performance opportunities in April, “Breaking Up Is Hard to Do, but L Brands’ Spin Could Prove Lucrative,” on the heels of no-moat Gap’s February 2019 announcement that it would carve into two separate businesses. While investors sent Gap shares up more than 20% on the news that Old Navy would be a stand-alone business, such a breakup could be even more favorable for L Brands, given the lucrative 20%-plus long-term operating margin performance its Bath & Body Works segment generates and the upside two distinctly focused businesses could create. Bath & Body Works continues to bring top-notch same-store sales growth on a mature fleet, printing an 8% increase in 2018 on top of a 2% rise in 2017, with every year after the recession tying up positive same-store sales marks and stable segment operating margin performance. In our opinion, valuing Bath & Body Works as a stand-alone business would render an equity value per share ($35) that is higher than the market capitalization of the whole enterprise today, assuming a 1% sales and 2% operating margin improvement over our base case in the consolidated model for each segment. In a $50 sum-of-the-parts valuation, this implies those holding Bath & Body shareholders would receive Victoria's Secret shares worth $15 (including $4 in dis-synergies split between the two businesses). Given that operating problems at Victoria's Secret haven’t yet leaked into the Bath & Body business, we’d expect value creation should stem from the focus of leadership that is solely exposed to the lingerie business, while the team at Bath & Body could work to maximize cash flow and pay down debt.