Summary

We added L Brands (LB) to our first-class stock portfolio mid last year, and are now adding to our long position at below $40/share.

The long investment thesis is rather simple: L Brands, the owner of Victoria’s Secret (VS) and Bath & Body Works (BBW), is one of the world’s finest specialty retailers, as we shall see.

At a stock price below $40/share, you are paying the value of current earnings power. That is using 8% as discount rate and with current balance sheet leverage.

And you are getting 6% of that as dividend yield, and another cut as share buybacks.

Up to here, solid value for money. But there is more.

As we shall see in the remainder of this piece, there are ample opportunities for earnings power growth within the current capital expense budget of $750 million a year. Continuous growth in BBW, a “back-to-normality” of VS in North America and UK, and a successful execution of the international expansion initiatives (particularly of VS in China) would all result in significant upside relative to today’s earnings power value.

There are also risks, the biggest of them, a permanent value impairment of the Victoria’s Secret brand. But it is our impression that the financial community is putting all the focus on the negatives while disregarding the positives.

In short, we believe that at below $40/share, you can pay current (depressed) earnings power value in one of the finest retailers in America, and get three options to likely and significant profitable growth as margin of safety.

Bath & Body Works

Bath & Body Works is one of the most profitable retailers in North America. As a favorite producer and marketer of consumables, it is also a dependable source of cash flow for the company.

Store remodels and DTC (direct-to-consumer, or “online”) initiatives have resulted in significant growth in the last few years. DTC has been growing at over 20% CAGR in recent years, and for the full fiscal year 2017, comparable sales came in at 5% (+2% excluding DTC).

Sales at VS are some 78% larger than at BBW. So investors tend to focus on Victoria’s Secret when looking at L Brands. But the strength of the BBW franchise, together with weakness at VS, have resulted in the former’s contribution to fiscal 2017 adjusted operating income  ($952.5 million) exceeding the latter’s ($932.3 million) for the first time.

The bottom line here is that the best performing business segment is already the biggest contributor to earnings, and that is a big positive going forward.