A much anticipated deal for L Brands’ (NYSE:LB) troubled Victoria’s Secret business has finally taken place, although at terms (mostly pricing of course) which is a bit of a disappointment to investors. The “bit” part of the previous sentence is a massive understatement as the deal might be helpful to reduce debt (and mostly lease liabilities) as Victoria’s Secret is on the verge of losing money. It marks a truly devastating outcome compared to realistic values which could be attached to the business just a few years ago.
L Brands has reached a deal with Sycamore Partners to separate its Victoria’s Secret business from the profitable Bath & Body Works business. The shock to investors is that Victoria’s Secret is valued at merely $1.1 billion, with Sycamore paying $525 million for a 55% stake, while the company will hold the remainder 45% of the shares in its possession. That price tag is of course very disappointing given that the namesake brand and PINK just a few years ago was a very dominant and profitable business, worth multiple times more at the time. Furthermore, important to note about $2.5 billion in lease liabilities will disappear from the balance sheet as well.
To put the $1.1 billion valuation into perspective, Victoria’s Secret has seen sales range around $8 billion between 2015 and 2018, with sales seen around $7.5 billion in 2019. Operating earnings have fallen from $1.5 billion to essentially an adjusted operating profit of $95 million last year, although the company reported a large loss due to charges. Based on the deal tag, the activities are valued at just over 0.1 times sales and roughly 11-12 times adjusted earnings. That latter seems like a fair multiple, yet is based on operating margins just above a percent, while this was nearly a 20% operating margin business just a few years ago. Quite frankly, I would have not had any doubts that this business would have been valued at $15-$20 billion just a few years ago, indicating how much value has gone up into smoke.
Some other news was announced that half a billion in proceeds will be used to retire debt. Furthermore, longtime standing CEO and Chairman Leslie Wexner will resign and an update was given on the fourth-quarter developments. Overall fourth-quarter comps are seen down 2%, with Bath & Body Works reporting 10% growth, while Victoria’s Secret posted a similar decline.
What Is Left?
Going forward, L Brands is a pure play on Bath & Body Works, the business which has grown from $3.7 billion in sales in 2015 to $5.4 billion in 2019. Of course, the company holds a 45% stake in Victoria’s Secret, yet this has now become a passive investment. BBW is a very profitable business with over $1.1 billion in operating earnings, although some unallocated corporate expenses might put some pressure on that number, pushing it more towards the billion mark.
L Brands has not yet reported a consolidated balance sheet for the end of 2019. At the end of the third quarter, cash holdings amounted to $340 million. Total debt amounted to $5.55 billion for a $5.2 billion net debt load as this will fall to $4.7 billion following the closure of the deal, while most of the lease liabilities will disappear as well. With BBW posting adjusted EBITDA at around $1.3 billion, leverage ratios remain on the higher side at 3.6 times, although the company still holds a stake in Victoria’s Secret valued at nearly half a billion, hopefully having potential to appreciate over time as well.
The 276 million shares now represent a $6.5 billion equity valuation, which values the entire company at a little over $11 billion. To put this into perspective, this values BBW at roughly 2 times sales and 10 times operating earnings, as the low-margin Victoria’s Secret business gets valued at a similar operating earnings multiple, yet at just over 0.1 times sales!
Assuming that interest expenses might fall sooner to $300 million a year and assuming EBIT (including some stranded corporate allocation expenses) of a billion, I see earnings before taxes of $700 million. A 20% tax rate would result in $540 million of earnings, or nearly $2 per share. This indicates that the remaining business is valued at around 12 times earnings, low multiples given the growth, although the company remains quite indebted.
Nonetheless, I am truly disappointed. As recent as the start of this year, multiple rumours put even a deal tag at $2-$3 billion, as a $1.1 billion valuation is utterly low. Remember that every billion is equal to nearly $4 per share in case of the L Brands stock as the PR rumours surrounding the brand and utter mismanagement have really taken a toll on the valuation and appeal of private equity buyers.
My last thesis actually dates back from November of 2018 when the company cut its dividend in half. I liked that move, yet saw more headwinds ahead with a split/spin-off as the only real possibility to create value.
Ironically enough, I pegged the valuation of BBW at $11-12 billion at the time, which valued shares at $22 per share if I accounted for the net debt load of the company at the time. With regards to the Victoria’s Secret business, I was a bit too upbeat as I believed a buyer would be found at around 1 times sales of $7.5 billion, as that would result in a break-up value of $50 per share. In fact, the $1.1 billion valuation is really a great shock if we see how quick the brand and its value have gone up into smoke in recent years.
Fortunately, I was awaiting stabilisation and was not buying the dip at $30 in November of 2018 as shares actually hit the $15 mark this autumn, now having recovered to $23 in anticipation of the deal. With the deal terms disappointing a lot, I am a bit cautious to buy the shares although a 12 times multiple for BBW looks cheap given the 10% comparable growth. Uncertainties relate to the high debt load and potential larger stranded costs, although this is an interesting story to keep watching. A fresh and incentivised management team and potential for the remaining 45% stake in Victoria’s Secret to appreciate over time make that this is a story to keep watching.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.