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Morningstar | Downgrading L Brands to Narrow Moat From Wide After Taking Fresh Look; Shares Remain Undervalued

After taking a fresh look at L Brands, we are adjusting our moat rating to narrow from wide and reducing our fair value estimate to $43.50 (from $60 previously), incorporating an outlook that has sales growth returning to the 3%-4% range, but pricing headwinds that will keep gross margins in the high-30% range over time, crimping profitability.

Our more pessimistic view stems from the increased competition in the intimates and apparel industry, driving the rising need for L Brands to use promotions and discounts to drive traffic. These two factors do not give us confidence that excess economic returns can persist over the 20 years required for a wide moat rating. Recent trends focusing on comfort and body positivity have allowed smaller niche and nascent brands (American Eagle’s Aerie, for example) to capitalize on new marketing opportunities to win share of the intimates and apparel category, hindering L Brands' ability to take pricing as easily as in the past. Deteriorating gross margin (from 42.8% in 2015 to 39.3% in 2017) supports this thesis.

However, we still see value in L Brands’ intangible assets. Victoria's Secret is the number-one brand in dollar share for bras and panties, and it has four of the top 10 fragrances in the U.S. Furthermore, we surmise new entrants will be at a pricing disadvantage due to Victoria’s Secret’s economy of scale advantages and word-of-mouth marketing, especially regarding the press surrounding the VS fashion show (which is broadcast in nearly 200 countries and generates 100 billion in measurable media impressions). Additionally, North American Bath & Body Works performance hasn’t faltered. It is the number-one brand in North America for three-wick candles, fragrance diffusers for the home, moisturizers, fine fragrance mist, shower gel, hand sanitizer, and liquid hand soap, generating 130 million transactions in 2016. Given this success, the segment was able to earn an EBIT margin exceeding 23% in 2017.

While we have adjusted the duration of our expectations for L Brands to earn returns on invested capital in excess of cost of capital, we expect most of the headwinds facing the brand to be behind the firm. As a result, we are maintaining our stable moat trend. We think brand strength is indicated by the still-lower spend utilized by L Brands relative to some of its narrow-moat competitors, while maintaining its visibility. In this vein, advertising spend as a percentage of sales decreased from 5% of sales in 2009 to 2.6% in 2016 (while sales continued to grow at a low- to mid-single-digit clip annually), compared with competitors that have been forced to maintain or increase brand spend to withstand competitive angst. However, this trend reversed in 2017 (with ad spend up to 3% of sales), and we believe L Brands will continue to invest money into its brands through advertising to bolster awareness and protect the brand intangible asset that underlies our narrow moat rating, which is embedded in our assumption for long-term operating margins of 11% (versus an average of 16% over the past five years). Additionally, while profitability has deteriorated of late, looking over the past 10 years, L Brands has had a fairly durable gross margin (35% in 2009 versus 39% in 2017), highlighting its ability to maintain price and drive traffic through several fashion cycles, despite expanding and eliminating categories like swimwear. Moreover, we expect the long-term gross margin could remain stable in the high 30s for a multitude of reasons. Most importantly, we believe mix shift will benefit the gross margin line as the trend in bralettes fades and more women return to purchasing higher-margin structured bras. Additionally, we anticipate L Brands will embrace more efficient e-commerce sales in the future, providing wider reach and improved visibility to consumers, offering further stability to the operating margin line. Finally, we believe these gains will be offset by investments to support its competitive position (including advertising and promotions). In culmination, all these impacts translate to a five-year explicit forecast of 11% operating margins. This is in line with other narrow-moat apparel operators/specialty retailers, such as Ralph Lauren and Hanesbrands, which we expect to generate margins around 11% and 15%, respectively, over the same horizon.