Victoria's Secret Has Potential And Is Directionally Correct, But Wait For Lower Prices

seekingalpha04-30

Victoria's Secret is the leading women's intimate wear brand in the US and one of the best-known brands globally in this category.A decade of positioning failures led to several scandals and the loss ...

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Robert Way Victoria's Secret (NYSE:VSCO) is the leading women's intimate wear brand in the US and one of the best-known brands globally in this category. The company was spun off from L Brands in 2021 after close to one decade of positioning and management failures, which led to several scandals and the loss of customer connection with new generations. Since 2021, with a new management team, the company has been reorienting to what I believe is the right direction. VSCO has substantial brand equity and global operations with much potential under the correct strategy. I believe the new team is delivering, although I disagree in some areas (particularly promotions, SG&A management, and capital allocation). Considering the brand potential, the macro challenges, and the aspects of management's new strategy and execution that I like and don't like, I believe the company is correctly priced at current levels. However, it would become an opportunity at lower prices, closer to $15. Note: Unless otherwise stated, operational and plan data has been obtained from the company's FY23 10-K, the company's October 2023 Investor Day, and the company's earnings calls. Company intro Great brand equity: Victoria's Secret is VSCO's leading brand. It is probably the best-known brand in the category globally, and it still holds a substantial market share in intimates in the US (above 20%, according to Investor Day data). There are many indications of this dominance. According to VSCO's Investor Day, the company holds a substantial share of the US women's intimates market (20%). Victoria's Secret Instagram page has 75 million followers, an absurdly high value, comparable to titans like Chanel (60 million) or Zara (62 million). Another indication of the brand's equity is the successful business segment in other lines, like fragrances (making 1/3 of the company's current revenues) and international (providing 25% of the company's retail sales, 11% of revenues). Large US footprint: The company has close to 900 DOS, 830 of which are in the US. VSCO has been closing stores for the past few years, and its management has commented that the US market is saturated in terms of stores. Global potential: As mentioned, ex-US sales represent 25% of sales, but given VS' brand equity, this level has considerable potential in the future. Leveraged: My rule of thumb is that apparel manufacturers and retailers should carry no debt unless the conditions are very good (very low fixed rates at large maturities). VSCO is a mix of both. The company carries about $600 million in very convenient 4.9% fixed-rate debt maturing in 2029, which should not be repaid until maturity. On the other hand, it also has $400 million in expensive SOFR + 3.5% loans, which should be repaid. In the aggregate, I am not comfortable with a level of about $1 billion in debts (including working capital facilities) and $100 million in interest payments (more than 1/3 of current operating income). Data by YChartsLow ownership: According to the company's latest proxy, management's stake in the company is very small, less than 1% in aggregate. The company has no important active shareholders, with the largest stakes in the hands of passive investors (Blackrock, Vanguard, FMR). Tarnished heritage The good days: VS' brand equity comes from nearly 20 years of absolute dominance in the US market, projected abroad via top-of-the-line brand building. Between the 1990s and the 2010s, VS took the US market by storm, amassing as much as 30% market share. The company successfully expanded into adjacent lines like sleepwear and fragrances and opened franchised stores abroad. Terrible reaction to customer change: However, VS lost contact with customer trends in the middle of the 2010s. The world was redefining feminine sexiness and beauty. This cultural shift was so intense that VS' concepts started to be considered outdated. You can quickly look for a Victoria's Secret Fashion Show from the 2000s or 2010s to find all tall, skinny, caucasian models. The problem is VS' lack of change when customer views changed. In fact, VS compounded the problem by becoming reactionary to change. The company's creative team stepped on all the potential pitfalls of the time. They openly commented that trans women and plus-size women were not beautiful. They were slow to incorporate other ethnicities. Finally, they were openly accused of harassing the models. These behaviors paid a steep price in the very susceptible ambient of the late 2010s, with the #MeToo movement in full fledge. Product errors: The company was also slow to adapt to customer taste changes in form factors. VSCO lost the opportunity to lead in sports bras and cupless brass. Again, customers were demanding something different, in this case, comfortability above form or looks, but VSCO did not give them that, so they moved on to other brands. Redirectioning In 2021, VSCO was spun off from its parent company, L-Brands, which had overseen brand growth since the early 1980s. A new management team, some of which came from L Brands' other divisions, was put in place. Redirecting to current trends: The management team quickly reoriented the company's media, models, and products to fit a massive reorientation in customer tastes. VS incorporated more diverse models and started offering more comfortable products like sports bras and cupless bras. The new VS angels include Megan Rapinoe, Priyanka Chopra, Mariah Carey, and Naomi Osaka. The more classical angels were not removed, only complemented. The potential is still there: Some people argue that transitioning to a new aesthetic is impossible. This argument goes against the company's success history. If you look for Victoria's Secret materials during the 1980s and 1990s, when the company expanded at a breakneck speed, their style was more conservative, luxurious, and diverse. VS already did transitions of style before, this is common in fashion. At the core, the company must represent what women want regarding intimate wear and beauty. Return to brand investment: Apparel brands are all about building an emotional connection to the customer via intangible investments. If a brand is not investing in intangibles and top-of-the-funnel marketing, it will eventually lose relevance. I like management's recent initiatives, including relaunching the VS Fashion Tour (which originated in 1985 and continued until 2019, when it was canceled). The company also invested in a campaign under the 'My Wings, My Way' lema, again connecting the VS angel wings with diverse beauty. Inconsistencies in marketing and promotions: Despite the above, the company has also shown inconsistencies. In the latest earnings call, management mentioned that their priority would be performance (bottom-of-the-funnel) marketing, which is more expensive and transaction-based and does not build the brand as much. The company also prioritized commercial (instead of brand) marketing expenses in 2024. This is inconsistent with building the brand, which is VSCO's main asset. On top of that, the company continues to be promotional, again showing inconsistency with brand building. Management mentioned that 4Q23 was more promotional than 4Q22 and that 1Q24 is expected to be more promotional than 1Q23. In part, this is blamed on the macro and the competitive environment, but in general, I believe promotions are a dangerous strategy which can damage the brand and financial results long-term. Focus on capital-light growth abroad: Management's plan includes not opening new net stores or gross square footage in the US, where the plan is to remodel, consolidate, and increase productivity. Store growth is expected to come from partnerships abroad. The goal is to eventually reach 900 stores outside of the US (the same number as inside the US). The partners will pay for most of the CAPEX, with VSCO concentrating on brand building and distribution centers. The company has relaunched a global partner yearly meeting in the US, localized some of its products (for example, for the much more conservative Middle Eastern countries), is expecting to open a new distribution center in the Netherlands to serve EMEA, and opened flagship stores. Again, I agree with this direction, with the company focusing on brand and product and partners focusing on retail store operations and expansion abroad. Retail experimentation: The company is opening Stores of the Future with novel concepts like integrating adjacent brands (like PINK and Adore Me), or new technologies like digital wardrobes. After the acquisition of Adore Me in 2022 (an intimate wear DTC e-tailer), VSCO is also experimenting with the box subscription model (where the customer receives a regular box with products from which it selects the ones that she wants to keep), and with fit services (copying plus-size specialized competitors like Torrid). Again, these initiatives are important if they are done on a small scale and kept as a cost center because they allow for experimentation and innovation. Not the best capital allocation: I disagree with the company's recent decisions regarding capital allocation. First, it decided to purchase the online brand Adore Me for close to $700 million ($400 million in cash and $300 million in earnouts) instead of paying down debt. Adore Me was bought at 2 to 3x sales (the company sold $250 million in FY23), compared to VSCO's P/S multiple of 0.2x. Management argued that Adore Me has important technology and complementary capabilities, but I am generally skeptical of M&A, especially during a challenging time like VSCO at the moment. Second, the company repurchased close to $250 million in shares in 2022 and $125 million in 2023. Against paying expensive debt, this is not a great use either. Recently, VSCO announced an authorization for another $250 million in share buybacks, consolidating what I consider an incorrect decision. SG&A mismanagement: VSCO suffers from a challenging macro context that led it to guide lower sales for FY23 on the 4Q23 earnings call. However, the company is planning to grow SG&A investments, which already grew more than 10% in FY23 compared to FY22. They argue that when the company returns to growth, those costs will leverage down. I believe this is a dangerous strategy and that management should be very concerned with operational efficiency. If management wants to invest more in some areas, it has to deprioritize others to keep expenses in check. Spending more on the promise of future revenues is a risky behavior. Valuation Let us summarize the pros and cons of the company so far. Pros  Significant brand equity in the US and abroad. Large market share in the US. The new management team has redirected the brand and products to fit current customer tastes, leaving behind the terrible mistakes of the late 2010s. I generally agree with the company's focus on brand building and store expansion abroad through partnerships.  Cons  Financially leveraged in an already operationally leveraged business in a challenging macro context. Some aspects of the marketing strategy like high bottom-of-funnel investments and high promotions are inconsistent with brand elevation initiatives. Capital allocation decisions have been risky, prioritizing M&A and buybacks over debt repayment. The same can be said of SG&A management. The management team's ownership is very low, and there is no strong shareholder. Apparel manufacturing and retailing are cyclical, competitive businesses with large fluctuations in demand, revenues, and operating margins.  VSCO trades at an EV of $2.2 billion and a market cap of $1.4 billion. Considering management's guidance of $6 billion in revenue and adjusted operating profits of $270 million for FY24 (4.5% adjusted operating margin), interest expenses of $100 million, and income tax rates of 25%, we are talking of an EV/NOPAT multiple of 11x (NOPAT of $200 million), and a P/E ratio of 11x (net income of $127 million). These are not extremely high multiples, which I believe balance out the company's positive aspects (mainly the brand equity) with the negatives (mainly in strategy inconsistencies or excessive risk-taking) and the general risk of the business operations.  Therefore, I believe VSCO is fairly valued but not an opportunity now. I would become more interested in the name at share prices below $15, which (ceteris paribus) would imply a P/E and EV/NOPAT ratio below 10x, providing more protection to downside scenarios and potential in upside scenarios.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2431228223"}