Bath & Body Works Inc (BBWI) — Q1 2017 Earnings Call Transcript

Thank you. Good morning, everyone, and welcome to L Brands' first quarter earnings conference call for the period ending Saturday, April 29, 2017. As you know, we released detailed commentary last night, which is available on our website. As a matter of formality, I need to remind you that any forward-looking statements we may make today are subject to our safe harbor statement found in our SEC filings. Our earnings release, additional commentary, and our earnings presentation are all available on our website, lb.com. Stuart Burgdoerfer, EVP and CFO; Nick Coe, CEO Bath & Body Works; and Martin Waters, President of International, are all joining us today. And now I'll turn the call over to Stuart.

Thanks, Amie, and good morning, everyone. Our first quarter earning results were slightly ahead of our beginning-of-quarter guidance. We reported earnings per share of $0.33 compared to our guidance of between $0.20 and $0.25. $0.06 of upside was driven by the lower-than-forecasted tax rate. After a particularly challenging February, which we believe was related in part to a delay in the timing of income tax refunds, we gained momentum through the remainder of the quarter. Looking forward to the remainder of the year, we have confidence in the growth opportunities for our business. Our brands are strong and lead their categories, and we have an experienced and aligned leadership team. We're continuing to invest in initiatives that will drive significant growth, including White Barn remodels at Bath & Body Works and investment in China. As you know, about a year ago, we made strategic changes at Victoria's Secret to streamline the business, focus on our core categories, and accelerate growth. While these investments and strategic actions will continue to put pressure on results in 2017, we are confident that they are providing the platform for accelerated future growth. Beyond the short-term impacts to this year, we remain committed to our goals of growing annual operating income by 10% and an operating income rate in the high teens. We will continue to focus on the things that we can control and manage inventory, expenses, and capital spending with financial discipline. With that, I'll turn the discussion over to Nick.

Thanks, Stuart. Good morning. I want to note that we ended the quarter with results that improved significantly from the beginning. After overcoming the challenges of February, we regained positive momentum in March and April. This underscores our business's agility in recovering when faced with difficulties. Our earnings decreased by 9% for the quarter, primarily due to increased occupancy costs as we invest in our brand, ensuring that our stores reflect that importance. We've always aimed for an appealing store experience, and we have shown that we can achieve a return on that investment. The retail landscape is dynamic, and traffic was challenging for many in Q1. However, we successfully drove good traffic through our flexibility, resulting in average unit retail growth. The home fragrance sector was a significant contributor, and we also saw body care gaining traction during the quarter, thanks to our investments in that area. We are continually improving our speed and testing methods, gaining insights into customer preferences for products and promotions, which provides us with valuable ideas as we approach the second quarter. Q1 has been our most intensive testing phase, yielding insights on how to manage the business and brand effectively. We are optimistic about the direction of our product offerings, while also remaining committed to meeting customer expectations through our responsive strategies. Additionally, we will maintain our focus on operational and financial discipline. Now, I’ll hand it over to Martin.

Thanks, Nick. Good morning, everybody. In the international business, we experienced a continuation of some of the challenges from 2016 in the first quarter of the year, including softness in beauty, difficult market conditions in the Middle East and Turkey, some FX pressure, and, of course, our investment in China also continues to negatively impact us in the near term. I'd also note that profitability in the U.K. was down in the first quarter, driven primarily by the exit of swim and apparel and some additional pressure from the preopening costs in Dublin and some FX impacts. On a brighter note, the Bath & Body Works business did very well in the quarter, with positive comps and growth in operating income. We opened our first two full assortment stores for Victoria's Secret in Mainland China in the first quarter to good response. We continue to be bullish about growth opportunities in China and around the world, and 2017 will be an exciting year for us as we continue to build on our footprint globally. Amie?

Thank you, Martin. That wraps up our prepared remarks. We are now open to any questions you may have. I'll hand it back to Lisa.

Just curious, have there been any moves that were made on the Victoria's Secret side of the business that you're reconsidering in any way, either for the second half or FY '18? And then I think you guys made a comment that you were looking to focus on the constructed bra business in the second half. Just curious if that meant in any way that you'd be pulling back from bralette and/or sport as a percent of mix.

Paul, it's Stuart. So in terms of the significant changes that we made at Victoria's Secret, are we considering reversing or stepping back from any of those changes? The short answer is no. We feel very good about the decisions that we made and that they are the right changes to drive focus and accelerated growth for the business. The second question was around constructed bras, sport bras, and bralettes. It's not a de-emphasis, Paul, on bralettes or sport bras, but rather, I would just say, an increased flow of newness and compelling bra launches in the constructed bra space that we believe will improve the result in that segment and get it back to the growth trajectory that we would expect. So it's not a de-emphasis, but rather increased flow of compelling new ideas, particularly beginning in the July period that we expect will drive healthy growth in that part of the business. Thanks.

Stuart, my question is on gross margin. It fell 330 basis points here in Q1. I'm wondering if you could break down the buying and occupancy deleverage piece of that from the merchandise margin. And then it sounds like gross margin is expected to be a bit better in the second quarter. How should we think about those two components within your guidance for Q2?

Yes. Thanks, Kimberly. In terms of the gross margin decline, the bigger driver was the buying and occupancy deleverage. There was some decline in the merchandise margin rate as well. As we move forward, we believe that, based on the quality of our inventory, that we'll see an improved result in the merchandise margin rate trend in the second quarter. Inventories are in great shape. We did a lot of liquidation last year in the semiannual sale at Victoria's. We believe that we'll have a better rate outcome at Victoria's, including through contributions in the beauty side of that business. Thanks.

Just big picture. Could you just talk about some of the learnings regarding the changes that you've made in your promotional strategy? What's working and what's not? More specifically, could you speak to the expected go-forward category comps in lingerie? Obviously, down meaningfully here in the first quarter as you have a lower AUR offsetting what you all said was a mid-teens growth rate in total lingerie bra units. Help us understand how we should think about that as the year progresses as we lap and cycle some of the robust bralette growth in the second half last year.

In our promotional strategy, the most significant change we made was the decision to eliminate the catalog at Victoria's Secret, which we believe was the right move for our business in today’s environment. This was our first major adjustment, and we are confident it was a positive step. We recognize that engaging with customers can take many forms, including digital, electronic, email, and social media, all of which we actively utilize. Additionally, we initiated significant changes in our direct mail programs about a year ago. Previously, our mailings focused on standard, highly promotional offers that lacked variation, like discounts on bras and free panties. Now, as we progress through 2016 into 2017, we are reaching out to customers more frequently through direct mail, but in a way that's consistent with our brand, offering a diverse range of more compelling and interesting offers that are less harmful to our brand image. This reflects what we have learned. Concerning growth in the key lingerie categories, we expect any significant category within our business to achieve mid-single digit or better sales growth on a comparable basis, maintaining healthy margins. This is our general outlook as we manage these businesses, and we anticipate starting to realize this growth in the major lingerie categories this fall.

Our question is about your framework and approach regarding the store base. Most of your stores are profitable or at least financially sound. I'm interested in your assumptions about potential store closures at competing companies that are beyond your control, including department stores and specialty retailers. Considering the store bases for both Victoria's Secret and Bath & Body Works, as well as online growth, what overall guidelines do you have? How might these guidelines change based on the factors you monitor while prioritizing investments in higher versus lower-productivity stores?

Sure. So that's a big question, big subject you're asking about. Our first guideline is to ensure that our store environments are interesting and exciting. Through a combination of the store design, the merchandise we sell, and the experience that our sales associates provide, we create an environment that is compelling for consumers. The most important guideline is that. Our belief is that when we do that well, we have very strong bricks-and-mortar results, which we do. Our productivity in both our major businesses is north of $800 a foot, and 99% plus of our stores generate positive cash flow. We open and close stores every year and have for years and years, so we're regularly maintaining the fleet. We have not seen a significant impact when department stores close their stores. That's not a new phenomenon, by the way, and we've studied it over the last 5 to 10 years on a mall-specific basis. We haven't seen any meaningful impact to our businesses in those specific situations. We have a lot of flexibility in our real estate, and that comes in two forms. One is strong protections in the majority of our lease agreements where if mall occupancy levels fall below a certain level or certain named tenants are no longer doing business in a mall, we have the right to leave that situation with no lease liability. The second is that our capital spending, particularly in North America, is pretty short cycle, meaning that we can make adjustments based on macro factors and our own company-specific performance on a pretty short cycle. At this point, we're expecting CapEx around $850 million, a significant adjustment based on performance judgments regarding risk and reward. The first priority is to make it interesting for consumers, and there are many retailers outside of L Brands where they've maintained strong brands and compelling assortments, doing very well despite the challenges. Our health in our real estate fleet is strong, and we have a lot of flexibility. That's how we think about it.

I wanted to ask about monthly sales. It's great that you guys still give us the color on a monthly basis. More recently, you've had some challenges achieving guidance that you set out ahead of the month. So I just wanted to ask about the thought process when you set your target for monthly sales. Is it a function of kind of run rate? Or is it more aspirational of what you hope to achieve? For May, we noticed you didn't take the opportunity to update your expectation for May in this earnings release. Does that suggest you're on track with what your performance objectives are for the month?

Thanks, Lindsay. It's Stuart. With respect to the guidance that we provide at the beginning of a month, I would call it a 50-50 view, meaning an expectation as we start the month. It's not an aspirational number nor is it a sandbag number, so I'd describe it as a 50-50 view. If we go back over the last 5 to 7 years, when our business is performing very well, we meet or exceed those numbers. When we encounter unanticipated challenges, sometimes we miss the number. More often than not, over a longer period of time, we've met or exceeded those numbers. So that's how we think about it. Regarding May, our performance to date is in line with what we expected at the beginning of the month, which reflecting the negative impact of the non-go-forward business, was to be down mid- to high single. On a go-forward basis, there would be a slight increase in comps for the month. That was our beginning-of-month expectation, and today we're running in line with them. Thanks.

This is Kate on for Brian. I guess, just on BBW. It seems like home fragrance has really been leading the comps, but it seems like there are some green shoots going on in the body care categories. Can you just expand on what you're seeing there, and what we should be looking for as the year progresses in categories outside from home? Also, can you remind us what store comp we need at BBW in order to leverage occupancy, just given the real estate projects happening?

Thanks. We'll go to Nick, obviously.

Sure. Well, I think what we're experiencing in our body care business is that customers have a much higher degree of curiosity as it relates to the product from a health, well-being, and efficacious aspect. We feel good about the early reads, the early signs that we've got as we've ventured into that category. Customers continue to want to come to us for a full body care experience, whether that be fragrance or shower gel. As we continue to play in those areas, we're experiencing strong receptiveness. So that's a pretty big clue for us. As it relates to other categories, we're testing products aggressively. As I mentioned earlier, it's one of our most aggressive quarters in terms of testing, giving us insights into what strategies work and what don't. The return on investment we need from our stores is in the high single-digits comp territory, and we're pleased with the results from those remodels. Our single most important asset is our brands, and as we consider the lack of investment that has gone into retail, we don't want to fall into that category. So you're going to see ongoing pressure on our P&L as we continue to invest in stores, but we're looking for the right ROI that provides a great experience for our customers. We like the results so far, and we'll adjust accordingly.

Great. We had a follow-up on the bra category. As you lap all of the deflationary pressure from bralettes this summer, should we expect to see some stabilization in price there? With the trial activity in lingerie and sport, it's been extensive for a few quarters now. How has that performed versus expectations? Do you expect to see some moderation of that in the back half?

Anna, it's Stuart. Do we expect to see stabilization in overall AURs as we move through 2017? The answer is absolutely yes. Given the growth we drove in the back half of '16 and the first part of '17 in the bralette and sport bra businesses, that will stabilize. As previously commented, the team is very focused on newness, innovation, and compelling bra launches in the constructed space in the back half of the year. We absolutely expect prices to stabilize. Regarding driving unit growth and trial in bralettes and sport bras, we were aggressive in promoting those segments in the fall and spring, successfully driving significant unit growth in those categories. We expect that growth to moderate in the back half of the year but still be relevant and healthy. The constructed bra business continues to be the substantial majority of our bra business, and with a regular flow of newness and innovation, we expect that to remain strong.

I just wanted to follow up on the gross margin discussion earlier. Looking beyond Q2 guidance, it incorporates a pretty sharp inflection in the back half of the year. Can you just update us on the drivers of that? Maybe give us a sense of the magnitude of the shift on the buying and occupancy line and what's embedded from a merchandise margin expectation perspective?

Yes. We are expecting improvement in the merchandise margin rate in Q2 as we commented on earlier. We would expect some improvement in merchandise margin rates in the fall season as well. The deleverage related to buying and occupancy should also moderate, given the year-on-year volume difference. The pressure we are feeling now due to the exits, particularly in Bath & Body Works, is greater in the first part of the year than it will be in the back half, considering the seasonality of that business. Therefore, we expect the buying and occupancy rate pressure to moderate as we move through the year.

This is Kevin Heenan on for Bob Drbul. I just wanted to focus on the PINK business. It's been a strong performer in recent years and represents a big piece of the total Victoria's Secret business. I just wanted to hear your thoughts on the opportunities for that segment, as well as some challenges or risk factors unique to that segment versus the Victoria's Secret and Bath & Body Works components.

Sure. With respect to our PINK business, we believe that it has the potential to literally double in North America. That's a pretty bullish statement, but based on how clear-minded the business is about the target customer and the opportunity to grow through additional square footage. Many of our stores today don't have sufficient square footage to offer the full assortment of PINK merchandise to our customers. Many stores do well north of $1,000 a foot. The brand is well-defined and very relevant. The real estate opportunity is significant. The online opportunity is significant and growing very well. The sourcing and supply chain capabilities, lead times, and read-and-react capability are very strong in this business. So we see tremendous growth potential in this segment over the next several years.

I don't know if this is for Stuart, but I think it is. Can you talk about the bralette category penetration last year being about 10% of the bra category? Where do you think that could go? It looks like you're adding in constructed bralettes or structured bralettes at a higher price point. What have you seen since implementing those in terms of the willingness for customers to buy that category at the higher price point?

Sure. In terms of last year, it depends on which part of the year you discuss regarding penetration. In the first quarter last year, the bralette business for Victoria's Secret lingerie was minor. It's now running about 10% of the total. That's where we are in terms of growth and penetration. As we previously discussed, we wouldn't expect that to get significantly larger than it is today. With respect to bralettes that feature more construction or support, exploring whitespace between broad categories is important for any retailer. We're optimistic about growth potential in some of the whitespace in major segments.

As you assess top-line performance at brick-and-mortar across the fleet, are there any noticeable differences between your A versus your B and C stores? How do you feel about the size of the fleet today? Are you seeing any flexibility with rents?

I previously provided a thorough answer on how we approach real estate, so I don't want to repeat that. Regarding variability by mall type, the short answer is, in the first quarter and periods beyond that, we don't see a lot. I am literally looking at this information right now, and we don't see a lot of variability by mall tier; some, but it's not significant. Our real estate is in great shape due to regular monitoring. Regarding lease flexibility, I mentioned our lease terms and situations in more challenged malls where we have month-to-month flexibility. Lastly, the opportunity to get lower rents can exist, but one important aspect of real estate is that it's about location. A retailer's top strategy shouldn't solely be to get lower rents. We aim to avoid overpaying but prioritize investing in our stores and maintaining great locations and productivity. Thanks.

Could you provide an update on the Victoria's Secret beauty business, both on a sales and margin basis? How has it trended in the first quarter? What are your assumptions for the rest of the year?

Yes. On the beauty business, we have a new leader in that area. Greg Unis just celebrated his one-year anniversary, coming from Coach, and he’s doing a terrific job. He's rationalized the SKU count by roughly 40%. Importantly, this helps ensure a focus on true key items, driving volume in key products. The flow of production into what we refer to as the beauty park, is substantially greater than it had been historically. We expect significant margin improvement in that business, which we believe will continue into the second quarter. There is nice growth online, and although we experienced some sales pressure in-store, they improved significantly through the quarter. February was tough for beauty, as it was for most of our businesses, but March was better and April was even better than that, with margin dollar results outperforming sales. We feel momentum in the beauty business and are very optimistic about Greg and his leadership. We believe we have significant growth ahead.

As you think about the China opportunity, any updates there? Any learnings relative to product assortment? How are you thinking about sales and investment requirements?

Dana, thanks for the question. We're feeling good about China. We're really making progress on four fronts. As you heard me say earlier, we opened our first full assortment stores, two stores opened in February, with good results and strong customer reactions. We have four more stores scheduled for the balance of this year and then aiming for 10 to 12 stores next year. Our beauty business, which has been in operation for nearly two years now, is doing very well in those VSBA stores, achieving double-digit comps in the first quarter. Our third business is direct-to-consumer in China, which began in the fall and has been building month-on-month. We’re excited to move to next-day delivery in China during the summer. The team is also making real progress on hiring high-quality personnel and building capability. We're feeling very positive about the business, with demand patterns and customer behavior reflecting that our replication model works similarly everywhere. What we find is that bestsellers here tend to be bestsellers there. The two major differences are size distortions for our smaller customer base and regulatory lead times for getting products to market. Aside from those factors, we're feeling optimistic about our business.

Stuart, could you share your confidence in the constructed bra business rebounding in the second half? What underlying trends or tests are supporting your positive outlook? Additionally, what do you anticipate for pricing in the constructed bra business? Do you believe you can sustain the historical average selling price in that category?

Yes. Janet, as you recognize in your question and as we commented on in the remarks that were circulated last night, we're not going to disclose details about the bra launches for this fall, simply because it’s too important. We’re optimistic about those launches and the nature of what will come. Newness will flow—some in the second quarter, particularly towards the end of the second quarter. Jan and the team do have a good lineup for fall, but I won't comment any further on that. Regarding selling prices or average unit retails in the constructed bra business, it ultimately depends on product quality. As we continually produce fashionable and beneficial merchandise with emotional appeal, that's how we get compensated. We're optimistic about the potential for a strong fall season, particularly with the momentum we foresee building in the second quarter. Our inventories are in great shape, as we have previously remarked, inventory per foot is down 12%. As we start the fall season, more than 90% of our Q4 buy remains open. Our agility as a company is excellent, and we feel our momentum is strong.

I was just wondering—sorry if I missed this as I hopped on late. Could you talk about the competitive environment over the past 10 years? I know there has been some discussion about smaller players emerging, but you appear to be gaining share in terms of units. Do you feel the competition has become stiffer due to more players in your categories or other factors?

Thanks, Susan. We'll start with Nick and end with Stuart.

That's a broad question when considered over the past 10 years. I think many different elements have led to what we could call either stiffer or more aggressive competition. Clearly, the marketplace is influenced—for better or worse—by what's happening in the online channel. We're grateful for the business we've had and the gains we've made in that channel. Impressively, we've been able to gain in that channel while maintaining store momentum. It's critical to have a healthy store base, which is why we continue to invest in stores. An additional factor is that with the apparel business being less than thrilling, that exerts certain pressures in the pricing arena. Customers' expectations around pricing, promotions, and markdowns grow increasingly high. It's essential that we leverage our short cycles and ability to re-enter businesses with full-price selling effectively. The upcoming macro trend is interesting—customers engaging in a healthy and good-for-you lifestyle does impact retail environments and customer beliefs. The strength of the Bath & Body Works brand presents opportunities. We've driven our traffic gains even during tougher retail conditions, and the brand's elasticity allows us to adapt to trends while balancing the foundations of our business.

I would just add three or four points. The retail categories we operate in, such as intimate apparel and personal care, exhibit strong loyalty characteristics and potential for high inherent profitability. We're leaders in those segments, giving us a substantial advantage. The presence of competition is not new; many retailers have tried to enter these spaces, with varied success. Lastly, our disciplined approach to controlling distribution channels ensures our brands are only sold in our stores and online through our websites. This control reinforces and protects the leadership position of these brands.

That concludes our call for today, and thank you for your interest in L Brands.