Victoria’s Secret: Tough Times (NYSE:VSCO)

On the final day of 2021, I believed that shares of Victoria’s Secret (NYSE:VSCO) were seeing a solid set-up for 2022 after its shares have been lagging since the spin-off from its former parent company L Brands. A low high-single-digit earnings multiple and strong balance sheet made me upbeat, a bit too early as it seems.

Some Background

Victoria’s Secret once was the driver behind the success story L Brands, and after its business has seen its fortunes revert, Bath & Body Works has taken over the leadership role within that company. That being said, the worsening performance of Victoria’s Secret did have an impact on all of L Brands at the time, being a key driver for the split up of the business.

During the early innings of the pandemic, L Brands aimed to sell Victoria’s Secret at a very low price of around a billion. Fortunately, the deal did not go through, with a spin-off having been the outcome later in the summer of 2021.

Despite some missteps, Victoria’s Secret generated some $6 billion in sales and over $900 million in EBITDA in the trailing twelve months ending in the first quarter of 2021. Pegging D&A charges around $300 million, I saw EBIT around $600 million a very substantial amount.

With 88 million shares outstanding following the spin-off, and shares trading in the fifties, I was quite upbeat as net debt of $400 million looked quite manageable as well. With earnings power seen around $6 per share, the valuation argument was quite clear.

I saw a run rate for the business to generate over $6.7 billion in sales, $1.2 billion in EBITDA and earnings around $7 per share, as the company was actually seeing some growth at the time of the spin-off. With shares trading at the high-forties late in December, a 0.5 times sales multiple and 7 times earnings multiple looked very compelling. My investment thesis was not really based on compelling growth, which had come to a standstill late in 2021, but more so the expectation of the business to maintain the earnings power and allow valuation multiples to expand over time.

2022 – Tumultuous

After shares started the year around the $50 mark, they initially rose to the sixties in March, fell to the mid-twenties this past summer, and now trade at $40 per share.

Following tough comparables, the company posted a 5% fall in first quarter sales. While adjusted earnings were stronger than guided for at $1.11 per share, they were down a lot from the $1.97 per share posted in the first quarter of 2021. Second quarter results, as released in August, showed a similar picture with sales down just over 5% as adjusted earnings fell from $1.71 per share to $1.09 per share.

Net debt rose to $780 million following poor cash flow conversion amidst an inventory built-up as well as share buybacks, reducing the share count to 84 million shares in the process, as debt remains very manageable. For the year the company now saw sales down in the mid- to high single-digit declines from the $6.8 billion revenue number this time last year, suggesting some more sales declines to come.

Full year operating earnings are seen at a midpoint of $550 million. With $780 million in net debt and tax rates, this should still translate into earnings power of around $4-5 per share. With a current enterprise valuation just north of $4 billion, the business trades around 0.7 times sales, at just around 5 times EBITDA and a high single-digit earnings multiple.

A Deal

Given the challenges in a tougher economy and harsh comparable, the company surprised me a bit with a substantial deal in November. Victoria’s Secret has reached a $400 million (upfront) cash deal to acquire intimates brand Adore Me. While the deal tag will likely increase a bit along the way, the purchase is significant, equal to 10% of the valuation here.

Fortunately, the accompanied deal presentation revealed that the number 1 digital native growth brand in intimates generates some $240 million in sales. With earn-outs likely resulting in a 2 times sales multiple, that comes at a premium as Victoria’s itself trades at just 0.7 times sales. No margin details have been announced, other than that the business is profitable. While the company sees this acquisition as a platform for further growth in this direct-to-consumer channel, some buybacks might be a better use of funds here.

While I am not too pleased with this deal, pushing up net debt to $1.2 billion again, for a 1.5 times leverage ratio, I want the company to be discipline with capital as it is not performing too well on an operational point. Hence, leverage should not come in too high and money should likely be spent on buybacks here. That being said, the overall valuation is compelling enough to maintain the long position, although I am the first to admit that my 2021 thesis has not played out at all.