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Victoria’s secret opportunity

Business has been tough for US retailers, resulting in weak performance across the sector. However, excessive selling off in the sector has provided some opportunities for investors to gain exposure to attractively-valued companies with effective strategies for adapting to change. Mitch Reznick, Co-head of Credit, and Ilana Elbim, Credit Analyst, select L Brands, home of Victoria’s Secret, as an attractive opportunity in the US retail space.

Challenging conditions: priced in, or leading to overselling?
Despite a supportive US economy, with improving macroeconomic data and rising consumer confidence, retailers have suffered. This is primarily due to secular changes in the industry, which include: consumers’ growing preference for experiences instead of clothing, declining tourist numbers (and therefore holiday shoppers), unseasonal weather, and increasing competition from e-commerce pure players such as Amazon.

This has led the performance of speciality retailers and department stores to weaken in the past few quarters. Most have reported worsening like-for-like store sales, and increasing competition has forced prices – and hence operating profit margins – down. Some have responded by closing bricks-and-mortar stores to adapt to the growth of online shopping.

These challenges have led many investors to short or divest from US retailers. As a result, valuations across the sector are now extremely low compared with historical levels. As shown in figure 1, the aggregate credit spreads of US retailers are far greater than two standard deviations from the historical three-year average. Taking a closer look, we believe that some issuers have fallen too far and have become compelling investment opportunities.

Figure 1. Mark-up: the spread of the US retail index relative to its historical three-year average

Source: Bloomberg as at 25 April 2017

L Brands: a strong credit profile
One such opportunity is L Brands, whose lines of business include lingerie and apparel through Victoria’s Secret, and beauty products through Bath & Body Works. The company’s credit fundamentals indicate that it is a very strong BB-rated issuer: it has a robust profit margin and generates healthy cash flows, and keeps its lease-adjusted net leverage under control (see figure 2). L Brands also has better environmental, social and governance characteristics than its peers: the company’s QESG Score of 83 is higher than those of competitors PVH and Hanesbrands, which have scores of 75 and 72 respectively[1].

For credit investors, the company’s main weakness is perhaps its high distributions to equity holders, in the form of dividends and share buybacks, which should be the only reason why it is not rated investment-grade. However, reaching this status does not seem to be a main target of the company’s management team.

Figure 2. L Brands: a model high-yield issuer in the retail industry

Source: L Brands as at 28 January 2017

Strategic shift

Like most of its peers, L Brands’ like-for-like store sales have been disappointing in recent months. To compete against online rivals, Victoria’s Secret aims to provide an enhanced in-store experience defined by an exclusive atmosphere, with some stores showing clips from the brand’s signature fashion shows, which are originally broadcast on US prime time television. Although it sells beauty products rather than pampering services, Bath and Body Works’ fragrances, soaps and other personal care goods are aligned with consumers’ growing appetite for experiences.

L Brands has also changed its promotional strategy, which is affecting operating profits in the short term. The company is marketing new products heavily rather than offering coupons, and has closed certain apparel lines, such as swimwear, in order to increase sales in the future. The expected pressure on profits during this change, coupled with disappointing guidance for the coming months, has resulted in the spreads on its cash bonds and credit-default swap (CDS) widening significantly. After trading well below the US BB non-financial high-yield index until the start of 2017, these instruments are now trading at wider spreads (see figure 3).

Chart 3. L Brands’ 2022 cash bond and five-year CDS are now trading at a wider spread than the index

Source: Bloomberg as at 25 April 2017

Quality on sale

L Brands is likely to face further pressure in the short term, but we believe the company is moving in the right direction. Its focus on promoting new products instead of offering coupons should help the company develop its appeal to new customers and deliver positive results in the second half of the year. Also, its beauty division should offset some of the current weakness in its apparel business. Overall, we believe L Brands’ low valuation does not reflect its strong credit profile and future prospects and that it therefore represents an attractive investment opportunity.

The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. The views and opinions contained herein are those of the authors and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.

[1] The QESG Scores is Hermes’ proprietary measure of ESG risk. It combines best-of-breed ESG research from external sources with engagement insights from Hermes EOS, our stewardship team, to capture a company’s current level of ESG risk, and its trend.

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Nexo Capital, Hermes' French Representative
Paul Voute, Head of European Business Development