In January 2021, one of my fellow contributors published an article called “I was wrong about L Brands”. Although I was not wrong about L Brands (LB) with my last article, I have a similar feeling: I was right about L Brands, but did not do the right thing back then.
Interestingly, it seems like we are seeing these turnaround stories quite often (or at least, I have this feeling). In the last few months, companies like GameStop (GME), Bed Bath & Beyond (BBBY) or Owens & Minor (OMI) had an impressive performance and L Brands would be another example. But it certainly seems to be difficult to determine which rally is sustainable. It is also difficult to determine, which rally is driven by a fundamental improvement of the business, which rally is the correction of a former misjudgment of market participants and which rally is pure speculation and euphoria.
In the following article I will provide an update about L Brands and I will also include some lessons learned from L Brands (and other companies I covered in the past). Let’s start by looking at the last results.
Results
When looking at the results for fiscal 2020, we see more or less solid numbers. In fiscal 2020, L Brands generated total sales of $11,847 million, which is reflecting a sales decline of 8.3% compared to fiscal 2019. While revenue declined in fiscal 2020, operating income could increase from $258 million in fiscal 2019 to $1,580 million in fiscal 2020. And in fiscal 2019, the company had to report a loss of $366 million, which could be improved to a net income of $844 million in fiscal 2020 resulting in earnings per share of $3.00.
L Brands is basically reporting in two different segments – Victoria’s Secret and Bath & Body Works. Victoria’s Secret results are still rather disappointing and sales in fiscal 2020 declined 27.9% YoY. But at least Victoria’s Secret Direct sales increased 31.3% in fiscal 2020. Bath & Body Works on the other hand could increase its sales 20.1% YoY to $6,434 million and Bath & Body Works Direct sales could increase even 109.1% YoY.
(Source: L Brands Investor Handout)
Victoria’s Secret – once the flagship – remains to be the “problem child”. Not only revenue declined pretty steep in 2020, the segment is hardly contributing any operating income to the overall results. But while Victoria’s Secret is struggling, Bath & Body Works is still performing with a very stable pace and reporting great results.
(Source: L Brands Investor Handout)
Balance Sheet
In my first article about L Brands, I saw the company’s balance sheet as huge problem. In the meantime, L Brands could improve its balance sheet. Nevertheless, we start with some negative aspects. On January 31, 2021, the company still had $6,366 million in long-term debt on its balance sheet and compared to one year earlier, the debt is about $880 million higher, which is not great. And L Brands still has a total deficit on its balance sheet as the liabilities are still exceeding the assets, which is also not great. But the total deficit decreased from $1,495 million a year ago to $661 million right now.
Usually, we calculate a debt-equity-ratio to get a feeling how high the debt levels are. In this case, we can only compare the total outstanding debt to the companies operating income to determine how long it would take to repay the debt. During fiscal 2020, the company generated an operating income of $1,580 million and it would therefore take about four years of operating income to repay the outstanding debt, which is still rather high. But we should not neglect the $3,903 million in cash and cash equivalents L Brands has on its balance sheet. This is enough to repay more than 60% of the outstanding debt and when subtracting this is would take only about 1.5 years to repay the outstanding debt, which is more than acceptable.
(Source: L Brands Investor Handout)
The balance sheet is still not perfect, but we should not be worried about solvency or liquidity at this point. When looking at the maturity profile, L brands also has to repay rather small amounts in the next few years, which is also good if the company should run in troubles again in the next few quarters.
Dividend and Buybacks
The dividend was also an important aspect in my last article about L Brands. I wrote:
And even if the stock should drop lower, investors can lock in a 7% dividend yield in the meantime as the dividend can be considered as reasonably safe.
And while I considered the dividend as reasonably safe, Mr. Market was mocking me only a few months later as L Brands cut its dividend completely after the dividend was already cut about one year earlier – from $0.60 before to $0.30. In 2019 the lower profitability forced L Brands to cut its dividend in half. In February 2020, the company paid a dividend for the last time so far.
During the last few decades, L Brands also bought back shares. During the last decade, the pace of share buybacks was rather slow, and the number of outstanding shares was reduced from 327 million in 2010 to 281 million right now. But in 1995, the number of outstanding shares was still about 720 million and especially in the second half of the 1990s, the number of outstanding shares was reduced in an impressive manner.
(Source: Seeking Alpha Charting)
Right now, L Brands is paying neither a dividend nor is the company repurchasing shares. But during the last earnings call, management said its main focus was to reduce the outstanding debt. Management is also thinking about buying back stocks again and resuming a dividend in the coming quarters.
Intrinsic Value Calculation
Since the lows in March 2020, L Brands gained more than 600% in value and after such a rally, it is quite natural to ask if the stock can still be a good investment. And right now, L Brands is trading for a P/E ratio of 20 and is therefore not really cheap. However, when looking at the much more important price-cash-flow ratio, we see single digit numbers indicating, that L Brands might still be undervalued. And while this P/FCF ratio is the highest in the last three years, it is one of the lower ratios during the last two decades.
(Source: Seeking Alpha Charting)
I usually include the simple valuation metrics in my articles, but I also point out, that a discount cash flow analysis is leading to better results (in my opinion). In the last four quarters, L Brands generated a free cash flow of $1,811 million, but this number seems like an extreme outlier. First of all, capital expenditures in fiscal 2020 were only $228 million and this was the lowest number in the last decade. In the other years, capital expenditures were between $426 million and $990 million. And the operating cash flow was also the highest in the last decade. Instead of using these numbers, I would rather use the average of the last decade - $931 million – as basis for my calculation.
A second difficult question to answer is what growth rates we should use as realistic numbers. We can look at past growth rates to get a feeling what growth rates might seem realistic.
CAGR Since 1982 Since 2000 Since 2010 Since 2015 Revenue 9.33% 0.95% 2.92% 0.57% Net Income 9.80% 2.92% 5.93% -3.42%
While we can clearly state, the L Brands could not report similar growth rates in the years since 2000 as in the two decades before, the picture is looking a bit diffuse. When looking at revenue, we can see an upward path – interrupted by several years of declining revenue. Net income however can only be described as choppy.
(Source: Author’s work)
And due to this choppy performance in the past, we should not expect extremely high growth rates at this point. During the last decades, L Brands has always been profitable (except in fiscal 2019), but when looking at net income we don’t see any patterns or consistency. In such scenarios, I would take an average free cash flow number and I would also calculate with rather low growth rates.
When taking the average free cash flow of the last decade as basis and assume a growth rate of 5% from now till perpetuity, L Brands would be fairly valued right now (assuming a 10% discount rate). In my last article, I calculated an intrinsic value of $50. Analysts also seem quite positive, that L Brands can return on the path of growth and for fiscal 2022 till 2024 they expect earnings per share to be around $5.00. When considering these numbers, 5% growth till perpetuity and the average free cash flow of the last decade seem like realistic numbers we can work with. It is not overly optimistic and includes a margin of safety on the one hand and it assumes also a growing business on the other hand.
L Brands is certainly not the bargain it once was, but the stock also does not seem extremely expensive. It is also worth mentioning, that the stock is still trading almost 40% below its former highs.
The Opposite of FOMO?
I will end with a rather personal note and a lesson, that seems to get more and more important for myself. In times of FOMO many people probably will not understand where the problem lies, but I sometimes am too cautious executing a trade and might actually miss out on a great opportunity. I’ll try to explain.
As I have already mentioned above, I wrote two articles about L Brands in the past. In my first article, I was rather bearish about L Brands, but not so much for the long run. I rather expected L Brands to decline further in the short term (and I was right as the stock continued to decline from $27 to below $10). In my second article, I was bullish. This was in November 2019 and the stock price at publication was $17.74. In these 1.5 years the investment would have returned 250%. In retrospect it is always easy to look at the performance and claim one was right – but the point is: I did not buy.
And I already mentioned above that this seems to be a pattern. We saw similar patterns with the stocks of GameStop, Bed Bath & Beyond or Owens & Minor. When identifying these extremely cheap stocks, we often are looking at discounts of 30% or 40% and sometimes these stocks trade even 50% below the intrinsic value. And one has to be very confident about the analysis, when the stock market is apparently seeing the fair value of the stock at a completely different level. One can assume to be much smarter than the market (and in retrospect, I was smarter than the market about L Brands), but one should not be overconfident: it is quite easy, that one might have overlooked something, and the market knows more than the individual and the stock price is therefore justified. And right now, we also have to be careful to distinguish between those stocks, that rally due to undervaluation and based on fundamental aspects and the stocks, that rally due to Elon Musk tweets, FOMO and euphoria.
I have to learn to pull the trigger when I identified these bargains. Investing is not just about identifying companies, analyzing these companies and determining an intrinsic value for these companies. It is also about pulling the trigger and resist sentiment – that is one way how money is made in the stock market. And it certainly pays off to stay humble, still question everything and assume from time to time that one could be wrong. And it also pays off to stay skeptical – especially right now, when the stock market is in complete euphoria. Right now, everybody is a genius, but that won’t last.
I am holding back cash for better buying opportunities, that will come again. But it might take some time (maybe even two or three years) before these great buying opportunities emerge. And while it certainly makes sense to sit on “dry powder” when that happens, I probably should invest more in the meantime. I can identify companies, that seems extremely cheap, but often don’t invest in these companies. And it still goes without saying, that about 90% of the stocks are neither bargains nor are they trading at a fair and reasonable price. We are still looking at one of the most “expensive” stock markets ever. But as it is often pointed out: it is a market of stocks and not a stock market.
L Brands Turnaround
L Brands for example could improve its business again and it seems like the company will manage the turnaround. In case of L Brands, we are also talking about a company with a solid business model and also an economic moat due to the brand name. This is leading a solid business, which can also run into trouble or even go broke, but usually the structural advantages enable these companies to survive even challenging times.
And L Brands has Bath & Body Works, which is performing with high consistency and has the ability to offset problems by Victoria’s Secret. Since 2009, Bath & Body Works could report positive comparable sales almost every single quarter and, in most quarters, we were looking at high single digit or even double-digit numbers.
(Source: L Brands Investor Handout)
And while Victoria’s Secret continues to be struggling, we should not underestimate the business, the brand name or the digital engagement of the brand, that has high value. Up to this point, many metrics are still declining (like sales of Victoria’s Secret or the sales per average square foot), but if management can stop the decline of Victoria’s Secret, the growth of Bath & Body Works is enough to make the total business profitable and growing.
(Source: L Brands Investor Handout)
About two weeks ago, L Brands also increased its first quarter earnings guidance again due to improved sales trends. Instead of $0.55 to $0.65 in earnings per share, the company is now forecasting earnings per share being in the range between $0.85 and $1.00. And although L Brands is pointing out, that the environment remains uncertain and that there is no assurance, that these improved trends will continue, we can be optimistic.
Conclusion
L Brands is yet another company that I have identified as extremely cheap in the past and as a great bargain, but in which I did not invest. Now it is probably a little bit too late. L Brands might be fairly valued at this point, but it is definitely not a bargain anymore. But for those, who had invested about a year ago, big profits could have been made as the stock increased from $10 to over $60 since March 2020.
Daniel Schönberger
My analysis is focused on high-quality companies, that can outperform the market over the long-run due to a competitive advantage (economic moat) and high levels of defensibility. Focused on European and North American companies, but without constraints regarding market capitalization (from large cap to small cap companies).My academic background is in sociology and I hold a Master’s Degree in Sociology (with main emphasis on organizational and economic sociology) and a Bachelor’s Degree in Sociology and History.I also write about investing, economy and similar topics on Medium: https://medium.com/@danielschonberger
Analyst’s Disclosure: I am/we are long BBBY. 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.
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