2024-01-07 23:49:27 ET
Summary
- I reiterate my hold rating for Victoria's Secret.
- VSCO's growth initiatives, such as the loyalty program and digital strategy, are driving brand improvement and increasing online sales.
- Management guides for strong growth in 4Q24, but I am concerned about FY25 growth and the weak performance of PINK.
Investment action
I recommended a hold rating for Victoria’s Secret ( VSCO ) when I wrote about it the last time , as the business performance has not fully recovered yet. That said, I was positive about the progress with regard to management’s growth initiatives. Based on my current outlook and analysis of VSCO, I recommend a hold rating. I still think the business is not done with its turnaround situation yet, and there is still more to prove. Valuation today appears to imply success in turning around the business, which I view as a risk as 1Q25 might be a weak quarter, causing expectations to reset.
Review
For performance update, VSCO reported 3Q24 revenue of $1.26 billion, a sequential improvement in revenue decline from -6% in 2Q24 to -4% in 3Q24. Gross margin also saw a sharp recovery from the -10% in 2Q24 and -9% in 3Q23 to -5% in 3Q24. At the bottom line, VSCO reported adj EPS of -$0.86, missing consensus estimate of $0.79. The miss was largely due to the increase in marketing investment for the Victoria’s Secret World Tour. From a headline results perspective, VSCO has certainly shown improvements, and, importantly, management cited North America sales trends improved each month sequentially throughout 3Q24. Management highlighted October as the best month year-to-date in the current quarter and said that momentum was continuing into the holiday season (4Q). This gives me a positive impression of 4Q performance and confirms that the growth initiatives are still bearing fruit, in my opinion. As an example, initiatives like the multi-tender loyalty program saw good progress; VSCO now boasts 22 million members who generate approximately ¾ of sales every week. This means two important things:
- VSCO has managed to drive brand image improvement and improve consumer awareness (which is driving recurring customers).
- VSCO now has direct marketing capabilities for 75% of its customers (on a weekly sales basis). This should have a positive impact on marketing expenses over the long term.
VSCO's digital strategy is also complementing the larger pool of members, as it is seeing higher conversions in its digital channel. It proved that VSCO is seeing success in pivoting from its traditional retail format to e-commerce. In North America, which represents ~90% of sales, while store sales declined 11% (-16% SSS), digital sales grew 12% y/y, an improvement from the 5% we saw in 2Q24 and 10% in 1Q24. Digital sales now represent ~1/3 of total North America sales. Aside from helping with growth, I also think that the success that VSCO is seeing online helps to relieve some pressure from the high cost of operating its brick-and-mortar model. My logic is that the more VSCO penetrates the online market, the more it is able to reduce its footprint over time. The cost savings could be reinvested into its marketing campaign, which I think is something that VSCO has to constantly invest in to maintain its brand image.
Looking into 4Q24, management guided growth in the range of 2% to 4%. This is a strong update that significantly outperforms the consensus estimate for -2.4% growth (~440 bps delta at the midpoint). I think there is a high chance that VSCO will meet this guide, as around 1/3 of 4Q24 sales volumes are already in the books due to Cyber Monday. Importantly, management cited trends that were positive in November in North America. The problem is whether VSCO can sustain this growth into FY25. While I am very encouraged by recent improvements, I am holding my horses back and believe that VSCO has yet to meet its inflection point and that VSCO still has a lot to show with regard to its turnaround strategy. Take PINK as an example. According to management, net sales were hit hard by 3–4 percentage points during the quarter and November due to apparel challenges at the PINK banner. This aspect of the business continues to be weak, and management seems to have no immediate solution (they mentioned it will take time to turn around the business, which is not a healthy comment in my view). I expect investors to continue monitoring VSCO and are unlikely to pour in capital at this point.
Valuation
In my previous model, I valued VSCO with the assumption that VSCO can achieve its FY19 performance in FY26. If so, I thought the company shares would be worth $29. In this post, I look to explore the bull case multiple that VSCO deserves to trade at. Ever since VSCO came into the public market in FY22, it faced multiple challenges that stemmed from covid, rising rates, and high inflation. As I continue to monitor VSCO's share price, it made me wonder if the historical valuation multiple (forward PE) is representative of where VSCO should trade at. Previously, I noted that other specialty apparel stores' peers were trading at ~7.6x forward PE, and I took that to benchmark against VSCO. The aspect that I missed out on was that these peers used to trade in the low-teens forward PE range and that the 7.6x forward PE was an industry-wide downward revision. As of today, all of these peers have re-rated upwards back to the low-teens level.
From a relative perspective, using the same historical discount that VSCO uses to trade against peers, VSCO should trade at 10x (~20% discount over the past 2 years). I would put forth the argument that VSCO could possibly trade at 12x forward PE, in the bull case, as its expected earnings growth (suppose the turnaround works) is much higher than peers’ median.
From a post-downcycle perspective, VSCO is going to be a much better business than it was in FY22 because of all the strategic updates (like the global marketing campaign and digital strategy that had little presence back then) that it had made, so it can be argued that VSCO should trade higher multiple.
Author's work
As such, if VSCO's actual normalized forward multiple is 10x, the upside remains very attractive at this level. I remind readers that this is the way I am framing the bull case for VSCO. Personally, I am more conservative, as such, I am still recommending a neutral rating as I want to observe the next few quarters before coming to the conclusion that VSCO growth trends are on an acceleration path. That said, for the risk takers who believe the turnaround would work, a small pilot position could be rewarding.
Risk and final thoughts
Regarding the FY25 growth outlook, management mentioned that both December and January are likely to be down on a y/y basis as consumers pull back spending after the big promotional days and that January will have lower levels of inventory (to prep for the semi-annual sale). This means that 1Q25 might be very weak, which could turn the stock narrative negative (remember that VSCO is trading at 10x PE today, which means expectations are really high).
Overall, VSCO has shown progress in its turnaround efforts. However, I remain neutral rated as I think the business still has a lot of challenges to fix. For instance, the issue at PINK. While management cites positive trends leading into 4Q24, I worry about 1Q25 performance which might cause a negative reaction to expectation, especially with the stock trading at 10x forward PE. There's a need for sustained performance to validate a successful turnaround, and the next quarters will be crucial in determining VSCO's growth trajectory.
For further details see:
Victoria's Secret: Progress Made But Business Not At Inflection Point Yet