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Morningstar | L Brands Cuts Dividend to Fuel Strategic Reset, but VS Continues to Struggle; Shares Undervalued

Narrow-moat L Brands’ third quarter was headlined by a dividend cut and leadership change at Victoria’s Secret. Despite the low-teens decline in shares, results were largely in line with the October sales results released on Nov. 8, calling for earnings per share of $0.15. While the firm outperformed our forecast on nearly all metrics, we don’t see a material change to our $43.50 fair value estimate as we expect our long-term outlook, including sales that rise 4% supported by VS and Bath and Body comp growth of 0% and 2%, respectively, underperforming VS store closures, and higher direct to consumer sales, to remain in place. We don’t, however, think the firm can boast meaningful gross margin expansion given the competitive landscape and hold gross margin around 38% over our forecast. Along with higher spend to protect its brand intangible asset, our long-term operating margin assumption reaches 11%, well below the five-year historical average of 16%.

Change appears widespread at L Brands, and the firm confirmed it would evaluate all options for the business and invest in its brands, following the recent announcement of Henri Bendel closures and ongoing assessment of LaSenza. We believe this played a factor in the board halving the dividend (to $1.20) beginning in March 2019. We see this as prudent given the dividend payout ratio was set to average 88% over the next three years, as it allows the firm to pay down debt and frees up capital to support brand investment. We believe digital investments such as re-platforming the VS digital business to facilitate buy online, pick up in store, and fulfilling from multiple distribution centers will drive the higher margin direct-to-consumer business (an estimated 20% EBIT margin), which we expect to rise to 29% of sales in 2027 versus 16% in 2017. Further spend on an expanded assortment (licensing opportunities in eyewear, footwear, and swimwear) could stand to restore some brand equity at the languishing VS brand.

Third-quarter sales of 6% surpassed our 3% estimate, as 10% comp sales at Bath and Body exceeded our 4% forecast, while the VS comp decline of 2% matched our outlook. In the quarter, merchandise margin was down significantly at VS, continuing to compress gross margin performance by 90 basis points, to 36.9%, outweighing the merchandise margin gains that Bath and Body claimed (representing just 34% of total sales versus 55% from VS) marking the 11th consecutive quarter of gross margin deceleration. Poor assortment at VS and PINK resulted in increased promotion that crimped gross margin, highlighting the issue were fashion errors in the PINK loungewear business (focused on jeweled products) which had a two-fold impact as the items were more expensive to produce and had to be discounted heavily to clear inventory. We believe this validates our thesis that L Brands will have difficulty returning to gross margin expansion as capitalizing on hard to predict fashion trends continues to drive performance.

On the leadership front, the firm noted Victoria’s Secret brand CEO Jan Singer was stepping down and would be replaced by John Mehas (currently serving as president of Tory Burch) in early 2019. Over the past two quarters, there has also been turnover at PINK brand with Denise Landman retiring and Amy Hauk (current president for merchandising and product development of Bath & Body Works) replacing her at the end of the year. We continue to believe the firm exhibits a standard stewardship rating and will avoid passing early judgment on the new brand CEOs as it usually takes at least six months for their creative direction to materialize in the product offerings.