Summary
- Victoria's Secret is scheduled to report 4Q2022 results on 2 March 2023 after market close.
- Inventory levels and outlook for 2023 should be key focus areas.
- VSCO stock trades at an undemanding valuation, but this might be justified.
Investment Thesis
Victoria’s Secret ( VSCO ) is a brand that is trying to revitalize itself to ignite growth in sales. VSCO aims to do that by anchoring the brand in inclusivity to grow market share in intimates and elevating the omnichannel experience for customers. This attempt by the company to better connect with the customer and reach a wider audience in its revamped marketing strategy should enable it to grow sales and significantly increase the operating profit margin. However, the company has been seeing major headwinds in 2022 that are leading to declining sales and gross profit margin ((GPM)) erosion. A weak economic outlook is bad for discretionary products and could mean that VSCO needs to navigate another year of muted or negative growth in sales. The only solace for VSCO in 2023 might be the unwinding of the pressure on the GPM that emanated from rising supply chain costs; however, the risk of increased promotional activity offsetting this tailwind is high. The stock lacks major catalysts in the short term that could make it interesting. However, it may be a long-term play for believers in the brand revitalization story. Undemanding valuation multiples but a lack of short-term catalysts make me assign a “Hold” rating on the stock.
Figure 1 Trailing Twelve Months Sales and Gross Profit Margin
Key News Leading into the Earnings
VSCO continues to move ahead with its share buyback programs as it announced a new share repurchase program for FY2023 with a total value of $250 million on 11 January 2023 . This new program is equivalent in size to the program that was available in FY2022. VSCO’s management expects to generate around $300 million to $325 in free cash flow in FY2022, and the size of the repurchase program indicates that the company is funneling most of its free cash flow generation into share buybacks. Moreover, the size of the buyback represents around 8% of today's market of $3.2 billion, which makes it a very meaningful development for the stock.
This news was followed by an announcement for an accelerated share repurchase program for $125 million (which is part of the broader $250 million program) to be completed in 2Q2023.
Updated 4Q2022 Management Guidance
VSCO’s management updated guidance for 4Q2022 on 11 January 2023. The new guidance offered a much tighter range than the earlier guidance that was provided with the 3Q2022 earnings announcement. Moreover, the new guidance for 4Q2022 EPS came in the upper half of the previous guidance. Figure 2 illustrates the new guidance range and the implied YoY growth rates.
The new guidance still points to a large decline in sales. Moreover, the new guidance still points to a big contraction in operating profit that mostly indicates continued pressure on the gross profit margin stemming from continued promotional activity. Guidance for EPS decline appears softer than the decline in operating profit due to the reduction in the number of shares outstanding. The consensus EPS estimate for 4Q2022 stands at $2.34, a tad lower than the upper range of guidance. Also, the analysts’ 4Q2022 EPS forecast range is quite tight between $2.29 and $2.37.
Figure 2 Summary of 4Q2022 Guidance
Inventory Levels Are Likely to Set Tone for 2023
The story for VSCO in 9M2022 has been that of declining sales and rising inventory levels. Management attributed most of the rise in inventory to supply chain issues and indicated that inventory will normalize in 1H2023. There is also a seasonality aspect, as inventory in 3Q usually rises in anticipation of the holiday season. Thus, it is very important to monitor inventory levels in 4Q2022 and 1Q2023 to assess the health of the company’s working capital position. I believe that the way the company handles inventory in FY2023 will be a big test for management that would show their ability to adapt to changing economic conditions.
For 4Q2022, I expect to see early signs of an improvement in inventory levels. First, there should be a normal decline in inventory levels from a QoQ perspective due to normal seasonality patterns following the holiday shopping season. From a YoY perspective, I still expect to see growth in inventory levels but not in the same magnitude as the first three quarters of 2022 (likely in the high single digits or low double digits). There is a base effect at play, as 4Q2021 marked the first quarter where we saw a big YoY jump in inventory. In 2023, it is more likely that VSCO will get a better grip on inventory as the supply chain challenges are behind us and this would allow the company to put inventory orders that better match demand.
Figure 3 Rising Inventory
Valuation
VSCO stock trades at what could be deceptively cheap multiples. The TTM P/E multiple is 8.1x and the TTM EV/Sales is 0.9x and which is well below the sector median of 15.1x and 1.2x, respectively. In my opinion, this reflects the weak sales performance in 2022 and the pressure the company is facing on the gross profit margin. The company needs to show signs of reversing this trend for these multiples for the stock to become attractive. Economic headwinds could create a tougher operating environment in 2023 and it could mean that any meaningful recovery is still far ahead. The stock looks cheap but that may be justified, at least for the short term.
Key Risks
Pressure on sales could spell trouble for a retailer as it could lead to major contractions in operating margins. This in turn could lead to erosion in cash generation and a weaker balance sheet position. VSCO is also trying to revitalize its brand and make it more relevant for today’s consumers; however, there are no guarantees that the company may be successful in this endeavor. Given the uncertainties, this is a stock for investors with a very high tolerance for risks.
Final Thoughts
VSCO is a tricky stock to examine. There is scope to make the brand great again but that is a long and difficult road ahead. Macro headwinds will likely prove to be a key challenge in 2023. The company needs to show its ability to navigate this path while pursuing longer-term plans. This is why I am more interested in the outlook that management will be providing during the 4Q2022 earnings call than the results of the quarter—which are not likely to surprise given the recently updated guidance. A key focus area for me would be inventory levels and the plans to manage inventory in 2023.
For further details see:
Victoria's Secret Q4 2022 Preview: Updated Guidance Leaves Little Room For Earnings Surprise