2023-03-06 09:14:24 ET
Summary
- Victoria's Secret's guidance points for flat organic sales growth in FY2023.
- VSCO did a great job at managing inventory levels in 4Q2022.
- Rising SG&A costs to offset the benefits of unwinding supply chain costs.
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 pressure on sales and this is likely to continue in FY2023. 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 (on an organic basis). Moreover, rising SG&A costs are likely to offset the benefits of unwinding supply chain costs in FY2023. Thus, 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.
4Q2022 Showed Smallest Comparable Sales Decline in FY2022
VSCO's comparable sales levels were hit hard in FY2022. This is due to pressure on the consumers' wallets that led to an increase in promotional activity across the sector. According to management , VSCO maintained its leading market position in intimates in FY2022 by seeing a slight increase in market share. In the fourth quarter, VSCO posted the smallest YoY decline in comparable sales in FY2022. During the 4Q2022 earnings call management highlighted that PINK apparel was a key underperformer in 4Q2022 and indicated that plans are in place to revamp the product line by 2Q2023. However, the company did not provide an encouraging outlook , as it is guiding for a mid-single-digit decline in sales in 1Q2023. It seems this bleak guidance is stemming from the weakness in PINK apparel, as management seemed more confident about sales growth once the revamped products hit the store.
Figure 1 YoY Change in Sales in FY2022
Source: Calculated by Author using data from the company
Pressure on Gross Profit Margin Starts to Ease
The second pain point for VSCO in FY2022 has been the contraction in the Gross Profit Margin ((GPM)). Promotional activity and higher supply chain costs were key sources of this pressure. However, 4Q2022 marked the start of the reversal of rising supply chain costs and accordingly we saw the lowest YoY contraction in the GPM during the year (even though VSCO was big on promotions during the holiday season). Though this is good news for the GPM, the company provided guidance for an increase in SG&A as a percentage of sales that offsets this tailwind for the GPM. The reason for the rise in SG&A is the resetting of the incentive programs for the sales associates and the increase in spending to support the technology separation activities from Bath & Body Works ( BBWI ). It looks like FY2023 will be another challenging year for VSCO with muted sales growth coupled with an uptick in SG&A expenses.
Figure 2 The YoY Contraction in GPM
Source: Calculated by Author using data from the company
Inventory Improvement is a Big Positive
I am pleased with VSCO's inventory management in 4Q2022 (I had this as a key concern in my previous article ). I believe that the market is not paying enough attention to this matter. The company had attributed the inventory spike in 3Q2022 to the buildup for the holiday season; however, the decline in sales in 9M2022 made me concerned that VSCO might have overstocked. Moreover, it is also important to exclude the impact of the Adore Me acquisition to better assess the movement in inventory in 4Q2022. Excluding Adore Me's inventory, inventory was flat YoY (but around 90 bps higher as a percentage of TTM sales). This is a major improvement over the trend in 9M2022 and sets up the company well to deal with the challenges of 2023. A lighter inventory would allow the company to tilt more towards products that have better traction without being overly burdened with old stock that moves slowly. This is very important in today's environment.
Figure 3 VSCO Inventory Ends the Year on a Positive Note
Source: Calculated by Author using data from the company
Leverage Reduces QoQ but Remains Higher YoY Due to the Adore Me Acquisition
VSCO's net debt declined by $274 million QoQ in the fourth quarter (from $1.1 billion in 3Q2022 to $848 million in 4Q2022). The increase in net debt in 9M2022 was largely used to help to finance working capital and share buybacks. The working capital position had an excellent unwinding process in 4Q2022 and helped boost the company's cash generation. However, the acquisition of Adore Me in 4Q2022 (approximately $400 million) meant that net debt levels remained elevated from a YoY perspective. Moreover, with the 36% decline in EBITDA in 2022, VSCO's leverage (measured by net debt-to-EBITDA) almost tripled from 0.4x in 4Q2021 to 1.1x in 4Q2022. I believe that this level of leverage is easy to manage for the company but it puts some restraints on its ability to buy back shares. This is likely why management indicated that the second portion of the $250 million buyback program will come late in FY2023.
Figure 4 Net Debt Rises YoY Due to Adore Me Acquisition
Source: Calculated by Author using data from the company
Most of the FCF Generation is Used to Fund Share Buybacks
VSCO's FCF generation in FY2022 was somewhat underwhelming at $273 million-a 60% drop from the level in the previous year and below the lower end of management guidance of $300 million. This still is above the company's annual share buyback levels, as it indicates that buybacks are still funded from internal sources. For FY2023, the company is guiding for FCF to be in the range of $300 million to $350 million. Given the current trends in sales and working capital, I forecast the FCF generation in FY2023 to be closer to the top range of management's guidance at $336 million. This should be enough to cover buybacks but does not leave much room for major debt reductions.
Figure 5 FCF and Share Buybacks
Source: Calculated by Author using data from the company
Outlook for FY2023
VSCO's management is guiding for mid-single-digit growth in sales in FY2023 compared to the previous year. However, this is not an indication of an improved operating outlook. This is largely a reflection of a flat outlook for the business, as the growth is due to the addition of Adore Me and an additional week of operation. I have built a 4% growth in sales in my forecast (which points to slightly negative organic growth), as I am still concerned that the pressure on sales might remain in FY2023. As previously discussed, though the GPM is likely to see some relief from lower supply chain costs, the anticipated rise in SG&A will likely offset this improvement at the operating profit level. I point at a slight operating profit margin contraction, as the supply chain relief started flowing in 4Q2022, while the higher SG&A costs will start in 1Q2023. Thus, my operating profit margin assumption of 8.6% is lower than the management guidance of 8.9%. Finally, my forecast for FY2023 EPS is $4.67 and which is lower than the management guidance of $4.90 mostly due to the lower operating profit margin assumption.
Figure 6 FY2023 Forecasts and Implied Multiples
Source: Calculated by Author using data from the company
Valuation
VSCO shares fell more than 5% post the announcement of the results. In my view, this is putting unreasonable pressure on valuation multiples. VSCO is trading at an EV/Sales of just 0.6x and a P/E of 7.7x (forward multiples based on my FY2023 forecasts). This is well below the sector median of 1.2x and 15.3x , respectively. The outlook for sales is not great and there is some cost pressure in the short term, but the discount seems harsh given the company is not losing market share.
Key Risks
Pressure on sales could spell trouble for retailers 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 FY2023. The company needs to show its ability to navigate this path while pursuing longer-term plans. VSCO showed good controls over inventory levels in 4Q2022 and that puts it in a good place in a challenging environment. I believe that VSCO needs to show signs of sales recovery for valuation multiples to significantly rerate upwards. Given the weakness in PINK apparel, this might not come before 2Q2023 results (unless retail market conditions improve in general).
For further details see:
Victoria's Secret Q4 2022 Results Commentary: Lacking Short-Term Catalysts