We Know Victoria’s Secret (NYSE:VSCO)

There is a popular song going around right now by artist Jax called “I know Victoria’s Secret.” In this song, it depicts some of the body shaming issues that have arisen from the view of what “a perfect” woman is supposed to look like. It also talks about the company’s founding, by a male, who then profited off the company and such issues.

The song is not incorrect. Victoria’s Secret & Co. (NYSE:VSCO) was founded by Roy Raymond after a trip looking for lingerie for his significant other, and the uncomfortable experience of doing so. Fast forward, and Victoria’s Secret has been bought and sold, and become part of other companies, to today where it is publicly traded on its own. After nearly a year and a half as an independent, publicly-traded company, they continue to make significant progress in their transformation.

Most know the brand. It is a specialty retailer, primarily of undergarments and intimate wear. Victoria’s Secret stock is a specialty retailer that we have liked and traded in the past, but it has been a horrible market and a horrible time for many retail stocks. However, VSCO stock bottomed out recently, actually a double bottom in the summer, and then late September, and has since been on a rally since, returning some solid gains to traders like us.

The thing is that in the specialty retail space, regardless of the products and target markets, it is those who are best managing their inventory, using smart promotion tactics, and watching costs that are doing best in this environment. Make no mistake, inflation has been a bit of a retail killer. Rising input costs coupled with a consumer whose dollar does not go as far is a bad mix for retailers.

But the Street has bid this stock up, and we think the most recent earnings were strong, but we need shares to pull back following a strong market rally. Look, despite Chairman Powell’s somewhat dovish speech today, rate hikes are still happening and there will be a lag impact. While specialty retail is a very competitive sector, Victoria’s Secret has continued its strong recovery. The stock has had a run, but we think you leverage the next pullback and do some buying if you missed out on getting long in the summer or at the end of September. Here is how we would play it.

The play

First, we would SELL here in the high $40’s (46-47). Let the stock come down then do some buying:

Target entry 1: $42.00-42.50 (40% of position)

Target entry 2: $37.00-37.50 (60% of position)

Stop loss: $32

Target exit: $47.

Performance discussion

So look, Victoria’s Secret clearly has been a winner the last few months and we think momentum can continue despite a tough macro environment. The just reported earnings were mixed to be honest, so we think you let the stock come down some. The company missed consensus estimates on the top line, slightly, while surpassing expectations on the bottom line with a huge beat. Earnings were significantly higher than expected overall.

The top line revenue figure in the Q3 report was only a slight miss, but, it was down from last year. It has been a struggle for many in the retail space this year as inflation has run rampant, and passing the costs on to consumers to preserve margins is working, but consumers are definitely feeling the pinch.

It is our belief that, based on the trends we are seeing for the company, the stock will pull back as we head into the holiday shopping season, unless the broader market remains on a tear. But considering that we are targeting S&P 500 Index (SP500) earnings to be about $220 next year (or about flat from this year), a standard 17X multiple suggests we are way overbought as a Santa Claus rally is underway. Let the market and the stock pull back. There is no rush, plenty of other trades. Let this one come down as we prescribe. Sales came in at $1.32 billion and fell 8.3%. A decline was expected.

The one key metric that we focus on with retailers is comparable sales. Well, they are in free fall here right now. Let the stock fall! Comparable store net sales decreased 11% from comparable store net sales for the prior year’s Q3. While declining sales are an issue, at the end of the day profit is what matters. Gross profit power is falling as input costs continue to rise. The gross profit hit $457.3 million, falling from $565.1 million a year ago. Overall margins were smashed, as gross margin declined to 34.7% from 39.2%. General expenses were down marginally, which we liked, falling 9.4% to $414 million. Operating income thus fell by more than 60% to $42 million, and unfortunately interest expense was up 22%. This is not great, but the lower general expenses and lower taxes led to better-than-expected numbers on the bottom line, despite the huge decline. Net income was $22.2 million, or $0.29 per share. This was a dramatic decline from a year ago at $0.81, but it surpassed estimates by $0.06.

While the stock has run from lows in the summer, we think a breather is needed. This comes despite the valuation of the stock still being quite attractive even after the run, but it comes with declining growth of the company right now.

Looking ahead

As we look ahead for the rest of 2022, the company sees Q4 sales falling in the high single digits. Given the expected expenses, EPS in this all-important quarter should come in between $2.00 and $2.45. That means for the year, sales will fall 6-7%. Ouch. And, net income would be $4.50 to $4.95. Folks, while the stock may seem cheap, earnings will be down from $7.18 last year. This comes despite a nice share repurchase program which has seen a significant reduction in the float. Back in March, the company launched a $250 million repurchase program, and so far, has invested $214 million, reducing the float by 5.1 million shares.

So the repurchases will boost EPS, which is great, but these declines in EPS are a lot to swallow after the stock has rallied 77% off the recent lows. The guidance is fine, but why pay this much for declining EPS of this magnitude, into a possible recession? And while the company is making an acquisition of Adore Me for $400 million – and more – based on performance over the next two years. The cash on hand will cover it, so that hits the balance sheet. But there are 1.2 million customers active. We do think that this is nicely accretive, but, we think the stock is too expensive based on the declines in performance.

We suspect there will be a return to growth possibly next year with the added revenues here, but we will see. For us, you should consider selling here, and coming back into the stock lower.

Take home

Regardless of the valuation, Victoria’s Secret & Co.’s performance is falling hard. After the big run off the lows, selling makes more sense here. Let Victoria’s Secret stock fall over the coming weeks, then come in and buy.