2023-11-14 17:25:23 ET
Summary
- Victoria's Secret & Co. shares have proved a disappointing investment since the company's IPO in 2019.
- VSCO operates as the #1 U.S. intimates brand but has faced recent challenges due to brand image issues and stiff competition.
- Despite a market-leading position, VSCO has low profit margins and experienced weak financial performance since going public.
- The company has implemented an aggressive transformation plan which has shown some signs of success but has yet to lead to a financial turnaround.
- I am initiating the stock with a hold rating and would consider upgrading the stock if the company is able to show further signs of improvement related to its transformation plan.
Victoria's Secret & Co. ( VSCO ) made its public debut on August 3, 2021, after completing a spin-off from L Brands (now Bath & Body Works, Inc. ( BBWI )). On its public market debut, VSCO shares rose by nearly 30%.
However, despite this strong showing on its first day of trading VSCO shares have failed to deliver solid results since going public.
Since becoming a public company, VSCO has delivered a total return of -54% compared to a total return of 4.9% delivered by the S&P 500.
By nearly any metric VSCO is a cheap stock. VSCO trades at just 8x trailing earnings, 7.8x forward earnings, and 7.2x forward EV / EBITDA. However, the stock is cheap for a reason and further analysis is required to determine if VSCO is a value play or value trap.
Company Overview
VSCO is a specialty retailer of women's intimate and other apparel and beauty products. The company is the #1 U.S. intimates brand and has 20% share in the U.S. intimates market.
VSCO operates more than 910 stores in the U.S., Canada and China. Additionally, VSCO has ~450 stores in 70 countries operating under franchise, license and wholesale arrangements. VSCO owns 51% of its China business which is operated via a joint venture with Regina Miracle.
The company operates two primary brands: Victoria's Secret and PINK. VSCO also operates a smaller brand, Adore Me, which is a technology-led digital-first innovative brand serving women.
VSCO has a strong online business and 35% of total sales are generated through e-commerce platforms.
Highly Competitive Business Resulting in a Thin Moat
The women's intimates, apparel, and personal products business is highly competitive. VSCO competes with players such as Calvin Klein (owned by PVH Corp. ( PVH ), Skims (co-founded and owned by Kim Kardashian), and many other smaller players. VSCO also competes with private label brands offered through department stores such as Macy's, Inc. ( M ), Nordstrom ( JWN ), Saks, and others.
In addition to having a high degree of competition, the barriers to entry in the women's intimates business are fairly low. The emergence of Skims, which was founded in 2019 by Kim Kardashian and Jens Grede, and is now estimated to be worth over $4 billion is an example of how quickly new companies can enter the market.
Despite, VSCO's market-leading position and strong brand the company still has only been able to generate low-single digits profit margins.
Recent Financial Performance & Guidance
Since going public, VSCO has experienced weak financial performance. The company reported strong growth in FY 2021 with sales rising by 25% compared to FY 2020 as sales rebounded due to the COVID drop. FY 2022 was more challenging as sales dropped by ~6.5% compared to FY 2021. In addition to revenue volatility, VSCO has also experienced significant margin-related volatility as operating margins rose to ~12.8% in FY 2021 before falling back to ~6.7% on a trailing 12-month basis as of Q2 2023.
Trailing 12-month revenue of $6.17 billion remains well below a pre-pandemic high of $8.1 billion in 2018.
In the most recent quarter announced on August 30th, Q2 2023 VSCO reported a 6% decline in sales on a year-over-year basis. Operating income plunged 62% compared to the same period a year ago as margins declined to 3.4% compared to 8.3% during the same period in 2022. EPS came in at $0.24 compared to $1.09 during the same period a year ago.
The company has experienced challenges due to a lack of model diversity and controversial comments regarding transgender models made by an executive in 2019.
VSCO CEO Martin Waters added color on the results during the Q3 2023 earnings call:
In the second quarter, we delivered sales, adjusted operating income and adjusted diluted earnings per share within our guidance range while the macro environment continues to put pressure on our customer base and on our core intimates categories. As anticipated, and what was a continuation of first quarter trends, sales performance in the second quarter was particularly challenging in the overall stores and digital intimates market in North America. and this impacted both Victoria's Secret and PINK businesses. External market data indicates that overall stores and digital intimates market in North America remained challenged and was down mid-single digits in the quarter compared to last year.
We continue to be pleased with our international business, which experienced growth in excess of 25% and strong profit flow through in the quarter, and our recently acquired Adore Me brand also grew sales during the quarter, highlighting the strength of their business model and unique digital strategies.
For FY 2023 the company expects sales to decrease in the low-single digits on a year-over-year basis and operating income margins to be in a range of 5%-6%.
I expect the company to deliver on these estimates and analyst estimates are in line with the company's projection. However, I do believe the odds are higher of a downside miss in regards to these targets given that quarterly revenue declined by 6% over the past quarter and operating margins came in at 3.4%. The company expects margin improvement due to lower costs resulting from operational improvements as well as lower raw material prices. I believe these drivers are reasonable and thus expect some margin improvement from Q2 levels.
Turnaround Efforts & Growth Initiatives
In late 2022, VSCO announced a major transformation plan. The plan calls for the company to strengthen its core by improving the customer experience and revitalizing existing brands. Additionally, the plan calls for the company to improve operational efficiency and grow its international business by expanding its omnichannel operations.
Thus far, VSCO has made some important progress including creating ~$80 million in annual cost savings and achieving strong international growth (FY 2023 international sales are expected to be up 16% YoY).
International remains a key growth opportunity for the company as VSCO currently has just 1% non-U.S. Lingerie market share. VSCO has been able to deliver solid growth from its international segment over the past few years which suggests the company may be successful in driving future growth from the international segment going forward. Moreover, the international market is much larger than the U.S. market and thus the growth potential is very significant.
Another potential driver of growth is the Adore Me business which is a digital-based brand focused on size inclusivity and affordable sustainability. Adore Me posted 2022 sales of ~$250 million which represented 20% growth on a year-over-year business.
VSCO's transformation plans call for the company to grow from ~$6.2 billion in annual sales today to $7.4 billion in 2026. The company believes that North America core sales can increase by ~$600 million and international & Adore Me sales can also increase by ~$600 million.
VSCO believes it can double its operating margin rate by 2026 due to sales growth, gross margin expansion, and cost controls. As a result of revenue growth and margin improvement, VSCO believes it can grow operating income at a 25%+ CAGR by 2026.
While I believe VSCO has a solid plan to transform the company, I believe the goals are very lofty. I believe the company is likely to succeed in growing its international business and improving its margins. However, I am more skeptical regarding the ability for the company to return to sales growth in the U.S. market given the high degree of competition and brand damage related to controversial comments made by executives in 2019.
Valuation
VSCO trades at 9x consensus FY 2023 estimated earnings and 7.8x consensus FY 2024 earnings. Comparably, the S&P 500 is trading at ~18x consensus 2024 earnings. Thus, on a relative basis, VSCO appears to be cheap.
However, the earnings outlook for the company over the next few years is highly uncertain given the recent performance challenges and growth potential under the transformation plan.
In regards to trading levels vs comps, VSCO trades in line with other similar retailers based on key metrics such as P/E ratios and EV / EBITDA. VSCO, PVH, and CPRI all trade at high-single digit P/E multiples while faster-growing AEO and ANF trade at a premium.
VSCO is currently trading at the very low end of its own historical valuation range. While the stock appears cheap relative to its historic norm further analysis is required to understand why this is the case.
Over the past few years, the company had traded at a higher valuation as investors were hopeful that the company would be able to deliver meaningful earnings growth. However, that has not been the case and that is why VSCO's valuation has reset lower.
I believe VSCO is close to fair value currently given that it is trading in line with its peer group and towards the lower end of its own historical valuation range. I believe VSCO was previously overvalued and thus the stock should not be trading at its historical average. Thus, the current discount to its historical average valuation is appropriate.
Conclusion
VSCO is a cheap stock but it is cheap for a reason. The company faces stiff competition from a number of strong players in the women's intimate business. For this reason, it has struggled to generate strong profit margins.
Moreover, despite being the market leader in the U.S. VSCO has experienced declining revenues over the past few years as competitors have gained ground. VSCO revenue remains well below highs reached prior to the COVID-19 pandemic market disruption.
In an attempt to kickstart growth and improve profitability, the company unveiled an aggressive transformation and growth plan in late 2022. While the company has made progress in a few key areas such as cost-cutting and growth of the international business, it remains to be seen if the company can deliver on its aggressive 2026 growth and profitability targets.
VSCO reported declining year-over-year revenue and operating profit margins in Q3 and has guided towards similar year-over-year declines in Q4. This suggests the transformation plan is yet to fully take hold.
VSCO trades cheaply to the S&P 500 but this is due to the highly uncertain earnings outlook for the company. VSCO trades at an attractive valuation relative to its historical averages but this is due in part to the fact that the company has failed to deliver the financial results which investors had been hoping for. Moreover, VSCO does not appear to be trading at a highly attractive valuation relative to peers.
I am initiating VSCO with a hold rating but would consider upgrading the stock if the company shows further proof that its transformation strategy is taking hold. Specifically, I would like to see revenue growth in the North America business as well as improvement in operating margins.
For further details see:
Victoria's Secret: Wait For Proof Of Turnaround Progress