2023-07-03 23:47:56 ET
Summary
- Victoria's Secret & Co is undervalued by almost 70% due to mixed fiscal results since its spinoff souring investor sentiment in the firm.
- The firm continuous to remain profitable and exhibit healthy FCF despite short-term headwinds and decreasing sales figures.
- Despite the undervaluation, the company's significant debt and uncertainty about meeting growth and profitability targets limits my ability to rate the company a strong buy.
Investment Thesis
Victoria's Secret & Co ( VSCO ) is the market leader when it comes to mid- to high-end intimate apparel and lingerie. The firm has an extensive product portfolio that allows for significant organic cross-selling opportunities and holistically drives multiple operational synergies for the firm.
However, since the firm's spinoff and IPO investors have been met by a mixed bag of fiscal results that have resulted in market sentiment souring against the firm.
The ensuing market selloff has left shares trading at a historical low with the company being materially undervalued by almost 70%.
Nonetheless, the significant uncertainty present in the firm's ability to meet their lofty growth and profitability targets limits my ability to rate the company a strong buy, despite the huge undervaluation present in shares.
Company Background
Victoria's Secret | Investor Relations
Victoria’s Secret & Co (hereinafter “VS&Co”) is a specialty retailer of women’s intimate and other apparel products. Their portfolio is diverse and spread across multiple different product categories which the firm markets under their “Victoria’s Secret”, “PINK” and “Adore Me” brand names.
VS&Co has also achieved significant geographic diversification by selling their products in more than 70 different countries. This has allowed VS&Co to become a global brand name which further generates popularity and a robust reputation for the firm.
The most recent merger agreement to acquire 100% of Adore Me, Inc (a digitally-native intimates brand) has further expanded the firm’s extensive and commanding presence in the market segment.
Nonetheless, relatively poor performance since VS&Co’s spinoff from L Brands and subsequent IPO has left shares reeling with significant negative market sentiment surrounding the company. However, the company’s turnaround plan seems to be gaining traction with fundamentals improving accordingly.
Economic Moat -In Depth Analysis
VS&Co has a relatively narrow economic moat which is primarily built upon their brand image along with the economies of scale derived from their global presence in the intimate apparel market.
The extensive portfolio of brands operated by VS&Co harbors some economic moat for the firm thanks to the image these banners provide the company’s products.
In a majority of markets, “Victoria’s Secret” branded products are viewed as upper-mid range lingerie and intimate apparel. This has been mostly achieved by creating attractively designed products which are accompanied by significant marketing materials.
The extensive marketing associated with “Victoria’s Secret” apparel creates a luxurious and alluring image which promotes the brand’s appeal in potential customers eyes. It is this image that has allowed the brand to become a globally renowned lingerie icon which has an established history of 45 years.
VS&Co has further expanded the “Victoria’s Secret” brand to include a “beauty” segment which specializes in complementing the apparel lineup with fragrances, body mists and other beauty-oriented products.
The luxurious image developed for the “Victoria’s Secret” line of apparel also creates tangible differentiation from a majority of competitors by positioning the brand up-market. This reduces the number of competitors VS&Co must contend with in the market segment while also allowing for a larger mark-up to be commended for their products.
By creating a wide portfolio of high-end products which complement one another well, VS&Co is able to create a sales environment that promotes cross-selling. This combined with their pricing power helps VS&Co increase their revenue per customer which ultimately helps expand gross margins through increased sales volumes.
Victoria's secret.ie | PINK
A similar approach to product differentiation has been accomplished by VS&Co for their “PINK” lineup of activewear. The PINK active lifestyle brand focuses on celebrating diversity, equity and inclusion with their products by offering a wide-variety of fits and sizes to suit a greater demographic of customers.
The attention VS&Co devotes to ensuring their marketing material and products are catering to a variety of customers once more creates a tangible level of differentiation for their products compared to those of competing brands. I believe the honest, transparent and inclusive approach to building the PINK brand helps create a more trustworthy and reliable relationship between the company and its customers which should help bolster repeat sales.
PINK also complements the core “Victoria’s Secret” intimate apparel lineup perfectly by offering customers an even wider range of VS&Co products to enjoy. This once more helps drive cross-selling and organic sales growth.
Adore Me Homepage
The latest addition of Adore Me to the VS&Co line of products brings a digitally native lingerie and intimate apparel brand to the VS&Co portfolio. Adore Me operates primarily by offering customers a home-try-on service whereby customers can order items to try on at home at no additional cost should they decide to return them.
While this new segment is a novel addition to the VS&Co portfolio, it will take sometime to understand what level of moatiness this business will bring to the table. Nonetheless, Adore Me targets a younger customer who is more digitally-oriented when it comes to shopping experiences. This could help ensure the whole range of VS&Co brands remain relevant and popular in the eyes of consumers thus avoiding a stagnation point in brand appeal.
When considering VS&Co’s entire portfolio of brands, it is clear that there exists a narrow yet robust economic moat which is primarily derived from the synergies these brands provide one another and the organic cross-selling this business model promotes.
The ultimate scale of their operations also helps create some moatiness to the firm’s operations. By operating over 1200 stores worldwide with over 843 in North America alone, VS&Co is able to offer customers an immersive shopping experience across the globe.
Victoria's Secret | Investor Relations
While in-store sales still account for around 70% of VS&Co’s sales as a percentage of revenue, management is acutely aware of the rapidly growing importance of high-quality digital sales channels. In 2022, digital sales accounted for the remaining 30% of sales with further growth expected in years to come. The addition of Adore Me to the portfolio will no doubt further boost these figures.
VS&Co complements their online website sales with a variety of social media campaigns including an extensive presence on many such media platforms. This helps create a true omnichannel business which targets the attention of customers using a variety of mediums and platforms.
Victoria's Secret | Investor Relations
A significant development over the last couple months has been the announcement by VS&Co regarding their new collaboration for cross-category sales on the Amazon ( AMZN ) Fashion platform. This agreement will see VS&Co products across their “Victoria’s Secret” and “PINK” lineups become available for purchase on the Amazon Fashion Storefront.
This should help boost the sales volumes of over 4000 items while simultaneously enhancing the ease at which potential customers can purchase VS&Co products. While it is difficult to definitively derive what sort of margins VS&Co will be achieving with partnered sales through Amazon, I suspect they will be slightly contracted compared to their D2C sales.
While gross margins for their products may decrease slightly in this sales medium, I believe the ultimate increase in volume should help further diminish the relative size of fixed COGS thus helping to expand net margins for the firm.
Even without considering the new Amazon deal, the huge volume of items sold allows VS&Co to negotiate with their suppliers over discounted bulk-purchasing contracts which ultimately help grow the firm’s gross margins compared to smaller competitors.
VS&Co has also ensured that their supply chain is agile in its ability to cater for changing tastes, sales-mediums and consumer demands. This allows VS&Co to bring new products to market incredibly quickly which provides the company an upper hand when it comes to developing and reacting to new fashion trends.
Overall, I believe VS&Co harbors a narrow yet tangible economic moat which should see the brand remain at the forefront of mid- to high-end intimate and activewear for at least the next seven years.
While any such fashion brand is always subject to the often irrational and rapidly changing tastes and preferences of consumers, the customer-centric approach to product design combined with a strong set of brands to offer places VS&Co in the prime position to harness the attention of consumers.
Financial Situation
VS&Co has had a mixed-bag when it comes to their financial performance since their IPO back in 2019. Without considering the significant deviance present in their FY20 results due to the coronavirus pandemic, VS&Co seems to be improving the consistency and profitability of their business.
Average ROIC for the past four years (without considering FY20) has been 10% which while not stellar, is quite impressive for a fashion brand such as VS&Co. Gross, operating and net margins for the same period were 32%, 7% and 6% respectively.
While these core operating performance metrics are perhaps slightly lower than I would like to see in a potential investment opportunity, I believe VS&Co has the potential to see significant margin expansion in the near future.
When considering the firm’s FY22 , VS&Co clearly suffered from the difficult conditions created by unrelenting macroeconomic headwinds.
Net sales decreased 6% YoY due to weakened instore and digital sales. Gross profits fell 16% accordingly due to the decrease in % relative to total sales. Operating income also decreased 35% YoY.
Nonetheless, it must be noted that these falling sales and profitability figures still concluded in operating income and adjusted diluted EPS in FY22 Q4 exceeding the firm’s most recent guidance. VS&Co’s EPS of $2.47 beat guidance by $0.13 while revenues for the final quarter of $2.02B beat by $6.72M.
Furthermore, VS&Co was able to very slightly decrease their COGS for 2022 from 27.9% to just 27.5% as a percentage of sales. Considering the hugely difficult macroeconomic environment defined by record-high inflation, labor shortages, lingering supply-chain disruptions and falling consumer discretionary income, the ability for VS&Co to control these costs of production is impressive.
Full-year gross margins fell 430 basis points YoY to 36.4% due to the necessity for increased promotional activity to be conducted in order to retain sustainable sales figures.
Ultimately, VS&Co saw their full year adjusted EPS fall to just $4.95 compared to 2021 figures of $7.18. This significant worsening in profitability and sales performance has created significant negative investor sentiment regarding the company.
Similar poor performance was repeated in Q1 FY23 with net sales still decreasing 5%. Operating income continued to contract 53% YoY which ultimately resulted in net income falling a whopping 73% compared to Q1 FY22.
VS&Co management’s updated guidance for 2023 (updated in May 2023) shows expectations are that net sales will flatline or decrease in the low-single digits compared to 2022. FCF is forecast around the $175M mark with no guidance being offered for adjusted EPS.
Seeking Alpha | VSCO | Profitability
Seeking Alpha’s Quant assigns VS&Co with a “ B ” profitability rating which I believe to be a largely accurate representation of the firm’s current situation.
From a balance sheet perspective, VS&Co looks to be quite heavily indebted. In the short-term, VS&Co faces no real liquidity threat as the firm has $1.435B in current assets while total current liabilities amount to just $1.369.
However, VS&Co has a relatively significant long-term debt position of over $1.27B.
While the majority of these debentures are due after 2027 some maturities are expected over the coming few years including a significant $299M in 2026. The majority of this almost $300M due in 2026 is based on a revolving credit facility which no-doubt is tied to a variable interest rate.
This could place significant pressure on the firm should the Fed continue to drive-up interest rates in the second half of 2023. In the long-term, a higher interest-rate environment could lead to greater interest rate expenses for the firm should they choose to withdraw further funds.
Nonetheless, the majority of VS&Co’s debt is in term loans which guarantee the firm a fixed interest rate.
When analyzed alongside the firm’s future lease and purchase obligations, it is clear that VS&Co will have to source a significant amount of cash over the coming year to cover the $1.235B in payment obligations.
This most likely means that VS&Co must further utilize their variable interest rate revolving credit facilities to facilitate the payment of these obligations. In turn, this increases the exposure VS&Co has towards unfavorable rate hikes which could impact the firm’s overall debt schedule in a negative manner.
VS&Co has a quick ratio (current assets minus inventory divided by current liabilities) of 0.19x which supports my thesis that VS&Co will most likely need to utilize their revolving credit facilities to meet their payment obligations.
The firm’s overall debt/equity ratio is 10.54x which helps illustrate the significant debt burden the company has. I believe this debt burden could continue to loom over VS&Co shares especially in the minds of many potential investors.
When it comes to VS&Co’s credit ratings, we are once again met with a mixed bag. Moody’s and S&P rate their “Corporate” credit rating as Ba3 and BB- respectively. Both agencies believe the outlook is stable.
For context, Ba3 is classified as credit obligations which are “judged to be speculative and are subject to substantial credit risk”.
Considering everything discussed above, it does seem like VS&Co is facing a difficult and worsening fiscal situation which surely indicates poor share performance to come. However, I believe this less than desirable performance could actually be a blessing in disguise for a deep-value oriented investor who understands the intricacies of the current situation…
Fundamentally, I believe VS&Co still remains a high-quality business which is merely suffering from a more wide-spread decline in economic activity rather than a busted product or sales strategy.
VS&Co remains laser focused on a three-pillar strategy to ensuring future growth and margin expansion is achieved. This strategy revolves around strengthening their core range of products, igniting growth through international growth and transforming the foundations of the company to remain relevant with the current generation of customers.
At the very core of their business, VS&Co remains a bra and panties company. Therefore, the firm is continuing to develop and grow their core range of products through the development of new and exciting lineups along with the acquisition of Adore Me.
The recent launch of their customer loyalty program should also help drive repeat sales for the firm and further strengthen the relationship the firm holds with their core customers.
Furthermore, VS&Co has significant international expansion planned through franchised store openings scheduled for 2023. With more than 100 stores planned to open in multiple different international markets over the next two years, significant sales growth can reasonably be expected. This should also help increase the brand's global market penetration which should further drive increased sales for the firm.
Finally, the company has identified $250M in cost savings to be achieved throughout 2023-2024 thanks to organizational restructurings designed to enable increased efficiency and drive operating margins expansion. The focused and process-oriented changes management is applying towards achieving margin expansion seem sensible and relevant.
Valuation
Seeking Alpha | VSCO | Valuation
Seeking Alpha’s Quant assigns VS&Co with a “ B ” Valuation rating. I believe this is an excessively pessimistic evaluation of the current value present in VS&Co shares.
The firm currently trades at a P/E GAAP FWD ratio of just 7.61x along with a P/CF TTM of just 2.83x. Their FWD EV/EBITDA of 6.62x is quite reasonable especially when considering their EV/Sales TTM and FWD of 0.64x and 0.65x respectively.
To put this into perspective, VS&Co is only valued at around 2/3 of their total sales for the past TTM.
While these metrics seem to already suggest that VS&Co could be trading at a relatively attractive valuation, it's important to always delve further than just the basic valuation metrics.
Seeking Alpha | VSCO | Summary Chart
From an absolute perspective, VS&Co is trading at historically low prices. Shares have fallen around 60% since their highs of almost $75.00 in late 2021 to just $17.00 today.
The significant market selloff has primarily been caused by the mixed fiscal performance achieved by the company post IPO.
However, I believe this negative sentiment is excessive especially given the intrinsic value present at the firm.
The Value Corner
By utilizing The Value Corner’s Intrinsic Valuation Calculation, one can better understand what value exists in the company from a more objective perspective.
Using VS&Co’s current share price of $17.43, an estimated 2024 EPS of $2.43, a conservative “r” value of 0.08 (8%) and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 4.67x, I derive a base-case IV of $56.10. This represents a whopping 67% undervaluation in shares.
When using a more pessimistic bear case CAGR value for r of 0.03 (3%), VS&Co still appears to be undervalued by around 48% with an intrinsic value of $33.20.
Therefore, I believe VS&Co is absolutely trading in deep-value territory.
In the short term (3-7 months), I believe shares could continue to tumble as a difficult FY23 unfolds and further tarnishes VS&Co’s reputation among investors. Equally, given the generally irrational behavior of investors as a group, almost anything could occur in the short-term.
Short-term performance is also undoubtedly tied to the greater levels (or lack thereof) of economic activity occurring in the economy. A recessionary period in H2 of 2023 could definitely lead to further price drops in VS&Co shares.
In the long-term (1-3 years), I see a much more positive future on the horizon for VS&Co. Their position as a market leader in the intimate wear market combined with a clear growth strategy support a thesis that significant future returns are possible.
When combined with a huge undervaluation present in shares even at current levels, I believe the pricing error by Mr. Market has opened the door for a lucrative value play to be made in VS&Co shares.
Risks Facing VS&Co
VS&Co faces a multitude of risks most of which stem from the firm’s significant exposure and sensitivity to the prevailing macroeconomic conditions.
Fundamentally, VS&Co and their sales of intimate apparel are directly reliant on consumers having sufficient discretionary income and confidence to spend on non-essential items. This places a significant portion of VS&Co’s sales at the mercy of the prevailing macroeconomic conditions. Therefore poor economic performance on a national or global scale could and have significantly hurt VS&Co’s performance in the past.
Given the very high probability of a recession in the second half of 2023, the possibility for VS&Co to underperform this year is relatively high.
Furthermore, VS&Co faces the longer-term risk of their brands failing to capture the attention of shoppers in the same manner in which they have previously done so. This could lead to a stagnating brand image which would undoubtedly harm their net sales.
A similar risk of failed execution is present in their acquisition of Adore Me. Given the digitally-native presence of Adore Me, changing consumer tastes and preferences when it comes to shopping for intimate wear could hurt the businesses overall profitability. This could lead to a lack of synergies being achieved between the new business segment and their existing brands which has the potential to decrease operating and net margins significantly.
The significant debt burden also present exposes VS&Co to the risk of increased interest payments hampering profitability. Given that it is almost certain VS&Co will extend their debt position through the withdrawal of more funds from their revolving credit, any further significant increases in debt could lead to worsening fiscal results in the mid-term future.
From an ESG perspective, VS&Co has a very positive outlook. The firm’s strategy of addressing people, purpose and the planet is well though-out and excellently executed. The company has recently been voted as one of the best North American establishments to work at from a diversity perspective.
Furthermore, 88% of the Board of Directors is made up of women. This is the highest percentage of any company in the Fortune 500. VS&Co maintains that this structure is organic and simply a representation of their workforce and customer base.
VS&Co’s creation of a dedicated ESG Steering Committee allows for cross-functional oversight of material ESG issues which helps prioritize and better integrate ESG management into the fundamental workings of the firm.
Therefore, I believe VS&Co could be a suitable pick for more ESG conscious investors.
Summary
VS&Co has not achieved fiscal excellence in the years following their IPO. The rapidly souring macroeconomic conditions have resulted in lack lustered results which have tarnished the firm’s reputation in the eyes of many investors.
The resulting market selloff has left shares trading at a significant discount compared to the intrinsic value present at the firm. Furthermore, fundamentally the firm’s business model remains sound.
This creates a very difficult and complex situation that makes evaluating what opportunity lies in VS&Co incredibly hard. While the firm is trading soundly in deep-value territory, the potential for further short-term headwinds to hamper 2023/2024 results is real.
Therefore, I rate VS&Co a “Buy”. While the firm materially undervalued by almost 70%, the high-levels of debt and exposure to prevailing macroeconomic conditions creates significant risk and uncertainty in the firm’s ability to meet profitability and growth targets.
For further details see:
Victoria's Secret: Deep-Value, But Not Without Risk