L Brands officially spun off Victoria Secret and now Bath & Body Works (BBWI) is an independent company. This is great news to me as I think BBWI is a “Secret SaaS” business, a topic which I discussed before and will get into here.
Why do I like BBWI?
- High margin category with growth tailwinds (beauty, fragrance)
- Fragrance has difficulty translating to online without trust – Brands matter
- BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance
- Like many other brick-and-mortar retail (B&M) businesses, discovered the power of omni-channel during COVID – I believe it will structurally benefit the business
- Many focus on LTV / CAC as well as gross profit return on sales and marketing for SaaS and DTC businesses – the thinking being because it is a more variable cost business and you can tie the two
- But strong B&M brands have high initial upfront investment (e.g. the stores), and then serves the customer and drives loyalty with more limited incremental spend. We shouldn’t forget this.
- Business has been “trapped” inside L Brands
- Not sure analysts gave BBWI its full consideration when it attached to VS – a brand that is facing significant competitive pressure and heavily dependent on malls.
- Not as impacted by supply chain issues, but the “baby could get thrown out with the bathwater”
- BBWI sources most products from their facility in Ohio, not China. 80% sourced from US. Broader sell-off in retail could create an opportunity
As an aside, the Victoria Secret spin may end up being like Joel Greenblatt spin-off: the market hates VS so much that it gets to an extremely attractive price as people sell the spin. Time will tell. Don’t get me wrong, I would probably be one of those dumping VS if I received it.
Business has been “trapped” inside L Brands
I’m going to start with the last point first because it is quick. If you listen to the latest BBWI call, it is clear to hear analysts are still a bit confused how to model BBWI – it hasn’t been standalone before. Things like normalized capex, SG&A, and others were frequently brought up. I had to do some digging to find long-term gross margins for BBWI. All this is to say – you have to do some work to learn the most you can about BBWI standalone.
Second, BBWI and VS fortunes have been the complete opposite. As such, if you just looked at L Brands as a whole, you might miss the success story within occurring at BBWI shown below:
High margin category with growth tailwinds (beauty, fragrance); Fragrance has difficulty translating to online without trust – Brands matter
BBWI has 28% operating income margins, which both shocked and didn’t shock me.
Granted, this is LTM, where they benefitted from more of a “DTC” model during COVID and less promotions, though their physical stores were closed for 90 days in 2020.
On one hand, the margins are top quartile. On the other, fragrance and beauty are notoriously high margin categories.
Why is fragrance a high margin category? The packaging and everything involved with fragrance related products are usually a small cost. What drives the sale is the actual smell – and that takes technical know-how that is hard to replicate.
It’s analogous to beauty – beauty products are high margin because it tends to be a tough category to replicate, it is tough to get good distribution, and there is a degree of customer trust and loyalty (“hey this worked for me, you should try it”) which is hard to break into. Oh – and obviously consumers will pay up for these products if they “work”.
BBWI is at the center of some of these trends. Clearly, you can see their growth in the numbers I posted previously as well.
BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance
I like the simple “razor, razor-blade” model from BBWI. They have “wallflowers” which consumers plug into the wall and dispenses the fragrance. These plugins can be simple or decorative, like seasonal ones shown below.
They aren’t too cheap, as a razor is for the blade, but the scents offered are consistently refreshed and tend to be “optically” cheap. For example, 5 refills for $24 tends to be a consistent sale.
Compare that to one Yankee candle which is more than that for just one candle (which will burn longer, but the optics to a customer aren’t the same. I could dwell on this point, but to me, I don’t think consumers do that math).
I hate anec-data, but my wife and mother are consistent buyers here (thank you Peter Lynch for recognizing this investment thesis!).
Management has several slides that show they are thinking about this the right way. Find ways to increase retention rates and drive value.
If this is Secret SaaS, can we look at BBWI metrics with the lens of SaaS?
This isn’t perfectly accurate, but I think it is instructive. If you assume 15% of SG&A is for attracting incremental customers, then the company has a ~3 year payback. Again, that is just a fixed assumption and hard to get a direct feedback response for a legacy B&M player.
However, this is extremely difficult to determine for B&M retail. Especially one where we have limited stand-alone detail… But as noted before, the investment in SG&A comes upfront and to some degree, it is a “build it so they come” model.
But Warby Parker put it well in their S-1:
“While we have the ability to track where our customers transact, we’re channel agnostic to where the transaction takes place and find that many of our customers engage with us across both digital and physical channels; for example, many customers who check out online visit a store throughout their customer journey, while others choose to browse online before visiting one of our stores.”
To me, it is clearly the other way around for fragrance. Once you get comfortable that BBWI isn’t going to sell you something awful in their fragrance line up, you are likely to buy online from them (and perhaps, not from a brand you don’t trust). Or, you find several fragrances you really like and consistently re-order them.
I think they are just too interlinked to derive anything useful from this analysis. Instead, we can just focus on margins and FCF to get a sense of health.
On that B&M note, the company is 35% mall (says 99% are cash flow positive), 31% are off-mall (i.e. stand-alone stores, all cash flow positive) and 31% digital – super-enabled by COVID. They also have a small, international franchise business making up the balance.
I see a similar set-up longer term as Big Lots, which I wrote about how they can pivot their footprint. You can see in the table below that off-mall stores and Class A and B malls are clearly worth keeping. Class C and D? Less… And the Class D malls have the shortest lease terms remaining.
BBWI specifically called out closing stores in non-viable declining malls and remodeling others for an sales uplift.
BBWI Driving More Loyalty
While I’ve already stated why I think BBWI has a loyal customer base, BBWI is doing more. It makes sense – to create value from their existing customers, they need either more trips or for them to spend more in stores per trip.
Loyalty programs typically achieve this. For example, offering a 25% off coupon to loyal members typically gets them to either start an order they might not have done previously, or add one more thing… this incremental sale drives a lot of value for the retailer.
BBWI is testing that now: customers in the loyalty program spend 30% more than non-loyalty members.
A Quick Word on Value
BBWI is expected to generate $5.2BN in FCF between 2022-2025, or 30% of market cap. I even think that could be conservative. The company is returning significant amounts of cash to shareholders (continued the L Brands dividend, doing a $1.5BN share buyback) and I think the valuation is very reasonable at around 10x EBITDA.
However, they are earning high margins lapping a COVID bump. Essentially, the company saw a significant increase in sales, especially online, despite their stores being closed for 90 days during the pandemic. In the 2H of 2020, they were able to pull back on promotions which boosted margins.
I am not too concerned. This is a wide gap, but management targets $10BN in revenue (from $6.4BN in 2020) over the next 3-5 years. They assume some of this margin will be given back and EBIT margins will be in the low to mid-twenties. The stock is currently trading at 10x EV/EBIT on this forward number. Not too cheap, but not overly expensive given the business model either.
If I take the $6.4BN of revenue they did in 2020, apply a 22.5% margin to it I get $1.4BN of EBIT instead of $1.8BN. Based on their PF balance sheet for the spin, I calculate ~$910MM of tangible invested capital. This is true for most successful retailers thanks to leases (which can be a double edged sword), but that ROIC is fantastic.
Bottom line, I think BBWI deserves a premium multiple.