Analysis

The next retailer on the chopping block may have a stronger position than the credit market realizes

November 11, 2020

The brick-and-mortar retail industry has been one of the most prominent impacted by the pandemic. However, not every company in this industry has been totally crushed.

Today’s firm is an upscale retailer that has the credit markets concerned, despite having stronger operations than first appearance.

Below, we show how Uniform Accounting restates financials for a clear credit profile. We also provide the equity tearsheet showing Uniform Accounting-based Performance and Valuation analysis of the company.

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The pandemic has been devastating for well known retail brands across different industries. JCPenney, Lord & Taylor, Neiman Marcus, Brooks Brothers, and Modell’s have all filed for bankruptcy in 2020.

Many of these brands have been cornerstones of malls across the country.

The reality is the retail industry has been under pressure for years before the pandemic. The rise of e-commerce has pushed brick-and-mortar stores to the brink of bankruptcy.

Some brands bearing the brunt have traditionally been found in malls. In a 2017 report, Credit Suisse estimated 20% to 25% of malls will be closed by 2022. The pandemic has only served to accelerate these trends.

On the other hand, L Brands (LB) has managed to buck this trend. L Brands is a fashion retailer with brands such as Victoria’s Secret and Bath & Body Works.

Earlier in 2020, L Brands announced the sale of its Victoria Secret division to private equity firm, Sycamore Partners. However, the deal fell through in May, and L Brands retained the brand.

L Brands’ reputation has helped it defy recent retail trends. L Brands is ranked first in consumer satisfaction among specialty retail store brands. Additionally, it has a strong e-commerce presence, limiting the damage from the decline of malls.

Despite these strengths, Moody’s considers L Brands a high credit risk. This is largely due to trends in the retail industry and the pandemic’s impact. Moody’s thus rates the firm as a high-yield B2 credit.

In reality, the firm has recently been able to solidify its liquidity, by raising cash with a debt issuance. Looking at the firm’s Credit Cash Flow Prime (CCFP) highlights the safety of the firm’s credit.

The firm’s cash flows should roughly match operating obligations going forward. In addition, L Brands has a sizable cash build to meet obligations until 2026.

This should give the firm a significant runway to improve operations or refinance.

Moody’s rates the firm as a speculative B2 investment. This implies the firm is at an elevated risk of bankruptcy, despite its strong liquidity position.

Factoring in its strong liquidity, Valens rates L Brands as a much safer crossover XO (Baa3) credit.

Ultimately, L Brands is seen as a credit risk as rating agencies are looking at traditional metrics and overcompensating for the decline in retail. However, when looking at L Brands’ CCFP from a Uniform Accounting perspective, the firm’s minimal credit risk can be seen.

L Brands should have sufficient cash on hand to exceed obligations until 2026. Additionally, the firm has a strong customer base and an e-commerce platform to weather the decline of brick-and-mortar retail.

This is why the company is a safer credit risk than what Moody’s gives it credit for.

LB’s Credit Risk is Still Overstated; Tightening of Credit Spreads and Ratings Improvement are Expected in the Future

Cash bond markets are materially overstating LB’s credit risk with a YTW of 4.058% relative to an Intrinsic YTW of 1.978%. Meanwhile, CDS markets are overstating the firm’s credit risk with a CDS of 304bps relative to an Intrinsic CDS of 167bps.

Meanwhile, Moody’s is also materially overstating credit risk, with its B2 rating five notches below Valens’ XO (Baa3) rating.

Fundamental analysis highlights that LB’s cash flows should meet operating obligations over the rest of fiscal 2021, before falling slightly below operating obligations in each year after.

However, following the firm’s recent debt issuance, LB’s cash flows and cash on hand would be sufficient to cover all obligations including debt maturities through 2025. In addition to this multi-year debt runway to improve operations, the firm has capex flexibility to free up liquidity in the near-term which should allow it to service obligations as necessary.

Moreover, even with a moderate 70% recovery rate on unsecured debt, LB’s sizable market capitalization should facilitate access to credit markets to refinance as needed.

Incentives Dictate Behavior™ analysis highlights mixed signals for creditors. While LB’s compensation framework should drive management to focus on margin expansion and top-line growth, the lack of asset efficiency and leverage metrics indicate Uniform ROA expansion may be pursued by taking on excess debt and overspending on assets.

That said, management members receive low change-in-control compensation, indicating they are not likely to accept a buyout or pursue a sale of the firm, limiting event risk for creditors.

Moreover, although most management members are not material owners of LB equity relative to their average annual compensation, CEO Wexner’s substantial holdings multiple implies he could influence other NEOs to align with shareholders’ interests for long-term value creation.

Earnings Call Forensics™ of the firm’s Q2 2020 earnings call (8/20) highlights that management is confident that deleveraging has caused gross profit to remain flat and that social distancing and limited store capacities are hurting sales.

Moreover, management may lack confidence in the sustainability of increased demand for soaps and sanitizers, and may be exaggerating the pent-up demand from when stores were fully closed.

Furthermore, they may be concerned about their ability to keep running operating centers at such high capacity, continue buying inventory conservatively, and successfully build out Victoria’s Secret and Bath & Body Works as independent organizations.

Given LB’s multi-year debt runway and sizable market capitalization, credit markets and ratings agencies are overstating credit risk. Therefore, both a tightening of credit spreads and a ratings improvement are likely going forward.

SUMMARY and L Brands, Inc. Tearsheet

As the Uniform Accounting tearsheet for L Brands, Inc. (LB:USA) highlights, the company trades at a 23.8x Uniform P/E, which is around global corporate average valuations, but above its own historical average valuations.

Average P/Es require average EPS growth to sustain them. That said, in the case of L Brands, the company has recently shown a 17% Uniform EPS decline.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, L Brands’ Wall Street analyst-driven forecast projects an 80% EPS decline in 2021, followed by a 335% EPS growth in 2022.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify L Brands’ $33.32 stock price. These are often referred to as market embedded expectations.

The company can have its Uniform earnings shrink by 4% each year over the next three years and still justify current prices. What Wall Street analysts expect for L Brands’ earnings growth is far below what the current stock market valuation requires in 2021, but well above its requirement in 2022.

Furthermore, the company’s earning power is 2x the corporate average, but cash flows and cash on hand are below its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals moderate credit risk.

To conclude, L Brands’ Uniform earnings growth is around peer averages, and the company is also in line with its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research