Bath & Body Works Inc (BBWI) — Q3 2018 Earnings Call Transcript

Thank you. Good morning, everyone, and welcome to L Brands' Third Quarter Earnings Conference Call for the period ending Saturday, November 3, 2018. 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 statements found in our SEC filings. Our third quarter earnings release, additional commentary and earnings presentation are all available on our website, lb.com. As you know, 2017 was a 53-week year. All of the sales dollars, margin and operating income results discussed on this call are on a reported basis for the quarter ending November 3, 2018 versus October 28, 2017. Comparable sales are on a comparable calendar period, quarter ending November 3, 2018, versus the 13-week period ended November 4, 2017. Additionally, all the results discussed on the call today are adjusted results and exclude the charges related to the closure of the Henri Bendel business and store impairments described in our press release. I'd also like to clarify that the fourth quarter and full-year sales-to-comp spread in our commentary yesterday excludes the extra week last year. Including the extra week, the sales-to-comp spread in the fourth quarter is negative 2 points and, for the full year, is 2 to 3 points. Stuart Burgdoerfer, EVP and CFO, and I will handle the call today. As you know, we have leadership transitions in the Victoria's Secret Lingerie and PINK businesses, and our other leaders are focused on executing the important holiday time period. Thanks, and now I turn the call over to Stuart.

Thanks, Amie, and good morning, everyone. As outlined in the third quarter commentary that we released yesterday afternoon, the L Brands management team is very clear-minded about where we are. Parts of the business, Bath & Body Works, Victoria's Secret Beauty and our international franchise business are performing very well. However, our overall results are unacceptable, driven by declines in Victoria's Secret Lingerie and PINK. We made some important decisions in the quarter, including the decision to close the Henri Bendel business, pursuing alternatives for La Senza, reducing our dividend and committing to deleverage to enable us to increase our focus on our core businesses and strengthen our company in the long term. Our #1 priority is improving performance at Victoria's Secret Lingerie and PINK. We have new leadership in place or to come. Amy Hauk has joined the PINK business, and John Mehas will be joining us from Tory Burch in early 2019 to lead the Victoria's Secret Lingerie business. We're committed to a full review of the business. Everything is on the table, including our brand positioning, marketing, talent, real estate, cost structure, and, most importantly, our merchandise assortments. By executing against our strategy, focusing on the fundamentals, staying close to our customers and leveraging the strength of our brands, we will deliver on our commitments for our stakeholders, customers, associates and shareholders. Thanks, and over to you, Amie.

Thanks, Stuart. That concludes our prepared comments. And at this time, we'd be happy to take any questions you might have. In the interest of time and in consideration to others, please limit yourselves to one question. Thanks, and I'll turn it back over to Heidi.

You mentioned that you were considering reintroducing some product categories that you've offered in the past, such as swimwear, footwear, and eyewear. Can you explain what that might entail? Why are you opting to pursue these through licensing arrangements?

Sure. Thanks for the question. Well, it's an important decision and, fundamentally, a decision that reflects listening to our customers. We'll be back in the swim business in the spring of 2019. As we shared in our circulated commentary, we're going to be entering some other exited categories. We've already begun marketing and selling boots, for example, but also eyewear and other licensed businesses. And importantly, we'll be back in the swim business in 2019. Naturally, you would have follow-on questions about specifically when and how much and a quantification of those things. We are developing our plans in detail. Nothing more to share today. But again, a very important decision to re-enter some important businesses and pursue other growth initiatives through a licensing approach.

You mentioned everything's on the table. I'm curious where you're putting your emphasis currently, spending your time. How is Les spending his time? And I'm also curious if all of this work is happening now on the Victoria's Secret side or if we have to wait until John gets there before we start to see maybe some changes. And also curious just about the decision for Les to not be on the call today.

Certainly. Paul, when we take a fresh look at everything, it begins with the decisions we've previously announced. This includes eliminating losses from noncore businesses like Bendel and La Senza, which will contribute to about $85 million in annual operating income. Resetting the dividend to align better with our operating results, in consultation with the Board and external advisors, is also crucial. Most importantly, our focus is on capitalizing on opportunities within the Victoria's Secret Lingerie and PINK businesses. As always, it starts with merchandise, and leadership plays a key role. We have Amie rejoining the PINK business and John coming onboard. While we’re examining everything, some aspects will require more time than others, and evaluations will be led by Amie and John. The scope is broad, and timing will vary based on the opportunities we identify, so not everything will happen immediately. However, we are committed to thoroughly evaluating all possibilities.

Les is on the call.

Les is on the call, we've got a good management team here, and I spend a lot of time with the Wall Street community and I'm comfortable representing the company in this forum. Les spends time with investors, and we'll have an investor update sometime in the first part of 2019, and certainly, Les will be critical and lead that update.

Maybe, Stuart, I wanted to ask about merchandise margins at Victoria's Secret and your promotional strategies overall. Could you discuss where your markdown rates currently stand compared to historical levels? Additionally, should there be an increased emphasis on inventory management within Victoria's Secret and an improvement in average unit retail, as you work to re-establish the business, bring back swim, and draw more customers into the stores? The goal is to create a healthier Victoria's Secret business that can ultimately begin to grow.

Thanks, Ike. In terms of merchandise margin rate and potential improvements, it all starts with the quality of the merchandise. By quality, I mean how well the customer responds to what we offer. If our products are fresh, new, and appealing, then we have a strong opportunity for full-price sales and good margins. When our operations are running smoothly, we're able to achieve this. For instance, Bath & Body is currently performing consistently well in this area, and Victoria's has seen similar success during its strongest periods. It really begins with the quality of what we sell. Regarding the current situation with margin rates and their relation to inventory, particularly in the PINK business, we intentionally experienced margin pressure in the third quarter. We started the fall season focusing on bling and embellished apparel, which required a significant investment. Unfortunately, the customer response didn't meet our expectations, and we had to take aggressive markdowns to move that inventory, resulting in a negative impact on PINK’s margin rate and the overall segment margin rate. This investment also raised our average unit costs, which compounds the margin challenge. We took a risk with our merchandise offering but had to pivot quickly when we realized it wasn’t working. Amie has been actively adjusting the assortment since joining us, and while we've faced some pressure on the margin rate, we are committed to managing our inventory effectively. We have made investments in the lingerie sector over the years, some successful and others less so. However, we are dedicated to ending the year with a strong inventory position both quantitatively and qualitatively, which may put some pressure on the margin rate. Ultimately, leveraging our speed and the quality of our merchandise are the main drivers of growth in rates and dollar sales. The business remains focused on the assortment. Thanks, Ike.

This is Drew North on for Mark Altschwager. Folding up all the changes that you've announced thus far, meaning the closure of Henri Bendel, the potential actions on La Senza, the asset impairments, along with the fact that you're lapping the Angel Card reallocation and incremental wage investments, do you see a path to stable EBIT margin next year? And then as a follow-up on that, how should we think about the margin architecture for the Henri Bendel and La Senza businesses as those operating losses go away? Is that a bigger benefit to gross margin or the SG&A build?

Thank you, Drew. Regarding our outlook for 2019, we will provide detailed information in February, so I won't speculate on the profit and loss or operating income rates at this time. However, there is a significant opportunity to enhance the profit rate in our business, although the timeframe for achieving this remains uncertain. We've faced considerable pressure on operating income rates in the Victoria's Secret segment, largely due to a decline in merchandise margin rates and the impact of adjusted occupancy and SG&A expenses. Concerning the Bendel situation, the key effect will be the removal of the associated loss of approximately $85 million that I mentioned earlier. We will break this down by line item if it is significant during our guidance for 2019 in February. Are there any other questions?

No.

Hopefully, Drew, that's helpful to you. But the biggest operating income rate improvement is, obviously, related to the Victoria's Secret North America business. Again, in terms of a decline versus peak, not quite equal parts but pretty close between merchandise margin rate decline and expense deleverage. Volume will solve that, along with some work on rationalizing real estate where we can and a fresh, hard look at the cost structure that we alluded to in our circulated remarks. Thanks.

I am interested in the international business for Victoria's Secret. Have you noticed the same underperformance in the Intimates segment as you've experienced in the U.S.? If not, what factors do you believe are contributing to the better performance internationally?

Susan, the short answer to your question is, generally speaking, we have seen the same challenges with respect to the Intimates business in the international markets as we've seen in the United States. So the challenges we've seen in the States have also played through in the U.K. and other parts of the world.

I guess, Stuart, curious maybe if you can share with us a little maybe the Board's thinking about what John brings to the table. Obviously, Jan from Spanx and Nike, just maybe give us a sense of what John brings to the table, why he's the right guy now, given all these changes. And then secondly, maybe, Stuart, talk about the balance sheet and maybe whether a leverage ratio. But sort of like what are the contexts that you're looking at here, before maybe equity shareholders might get any of the free cash flow after the debt paydown?

Sure. Regarding John, Brian, you have been observing the industry and our company for a long time, and you understand how vital leadership is for merchants in this sector. The management team here has approached the decision regarding leadership for both PINK and Lingerie with great care. Specifically about John, he is a highly skilled retail leader with an excellent reputation among his colleagues. He has worked with some of the most successful retail leaders in the industry during their peak performance times, including at the Gap and Ralph Lauren. Throughout his career, he has served female customers in significant ways. John possesses strong business acumen and has substantial experience in both turnaround and high-growth scenarios. In summary, Brian, we are very excited to have John join our company. Thank you.

Balance sheet.

Regarding the balance sheet, we approach it with flexibility. However, our ratios, including the dividend payout ratio, yield, and adjusted leverage ratios, have moved outside of our historical ranges. Consequently, the Board, after careful consideration and consultation, decided to reduce the dividend from $2.40 to $1.20 annually. In terms of the cash that will be available—this will vary as our operating results evolve over the next few years—we have had thoughtful discussions on how to utilize that cash. As mentioned in our previous releases, the primary use of this cash will be to pay down debt in the short term. We are aiming for a leverage ratio in the mid-3s. While we are not sticking to a strict formula, the ratio has increased significantly as our operating performance has declined. We deem it necessary to recalibrate our strategies over the coming years, starting with the dividend reduction in March. As for how and when we will return some of this freed-up cash to shareholders, we have historically focused on returning excess cash through regular dividends, special dividends, and share repurchase programs. At this time, we believed it was appropriate to make these adjustments. Thank you.

Two things you said in the release, one was about international and the real estate strategy there. So I was wondering if you can just talk about how much flexibility you have with your real estate strategy internationally and what that might look like? And then the second one, which you talked about, Victoria's Secret reassessing internal talent. And so I was wondering if there's other things you expect we should look for in terms of key roles to be filled or changed.

On international real estate, first and foremost, we've had some important learnings from our recent results. So as it relates to opening new stores, the number of stores, the size of stores, et cetera, we made, I think, significant adjustments in terms of what we're doing for company-owned markets for Victoria's Secret, meaning smaller stores and a substantial reduction in activity at this time. So that's the first point I'd want to register. The second point I'd want to register, and I think it's the thrust of your question, is what can we do? What are our real, practical options with respect to existing real estate? And as you appreciate in the question, some of the lease terms internationally tend to be longer lease terms. Most of the lease terms, for example, in the U.K. are 15-year leases versus the more typical 10-year leases in the United States or Canada. So we don't have as much flexibility. But with that said, we're going to take a hard look at it. We're taking a hard look at it. We'll continue that review over the next several months, and it's an important part of the management of the business. But again, I would also reemphasize the first part, which is as it relates to further real estate activity, opening new stores and the size and nature of stores that we continue to open, we've made some important adjustments in China; smaller format stores and a meaningful reduction in CapEx for Victoria's Secret in the United States, in Canada and the U.K. with a very substantial reduction. On the flip side of it, we continue to invest in Bath & Body Works remodels because the performance of those projects, the return of those projects has been very, very good. And we continue to see about 20% sales growth with respect to those projects and, as we've mentioned consistently, a much stronger experience for the consumer and setting the business up well for the next 10 years, if you will, in terms of a fresh, relevant, compelling environment for customers. So important adjustments in Victoria's. Some lack of flexibility based on lease term, but we will take a hard look at it. Adjustments there in terms of learning for Victoria's and a continuation of investment at Bath & Body, again, given the strong, positive response from customers translating through to sales and a good economic result for that business.

And Jamie, the reference to talent in the Victoria's Secret portion was really just referring to the changes in leadership with Amie and John.

Stuart, I wanted to inquire about the traffic-driving promotions at Victoria's Secret. Clearly, there will be promotions and markdowns to address product errors, and we anticipate that these will continue over time. Ideally, the number of mistakes will decrease moving forward. However, that's just one aspect. Regarding the promotions aimed at driving traffic, they appear to be impacting the merchandise margin, and I'm curious about the factors that would give Victoria's Secret the assurance to move away from these promotions. Are you looking for a specific level of store comparable sales or a particular level of store traffic? Additionally, as you review your real estate portfolio, especially in the U.S. where you have considerable flexibility, what criteria are you using to determine whether to close stores?

Regarding promotions at Victoria's Secret, our approach involves testing significant promotions in select stores and comparing the results to our broader chain and matched stores. We focus on incremental sales and margin dollars as key indicators when deciding on promotions to increase store traffic. Additionally, we assess the qualitative impact on the brand and the necessity to attract new customers. For a thorough evaluation, we analyze whether promotions lead to improved sales and margins. We acknowledge that there are times when we may drive intense promotions that don’t yield the desired outcomes. The primary criteria for promotions center around financial performance rather than store matching. When it comes to real estate decisions in the U.S., these are primarily financial evaluations that consider potential sales transfers from nearby stores, with an increasing focus on any transfer to online sales. We weigh the costs of exiting a store against the ongoing cash flow implications and potential sales impacts on nearby locations. We regularly close stores based on financial assessments, and we are currently conducting more tests regarding store closures to gather insights on expected sales transfer outcomes. Ultimately, while we have established guidelines for closing stores, we are exploring additional learning opportunities in specific cases.

You mentioned in the release and your comments this morning that merchandise seems to be the main issue for VS and PINK. Could you elaborate on customer feedback and responses regarding what hasn't worked, and what steps need to be taken to improve the merchandise? Additionally, can you provide more details on the factors affecting margins by segment? Specifically, what's working in BBW, and how should we view the potential for continued progress in overall operating income? Also, regarding the VS side, you mentioned the impact from PINK. Can you quantify that and clarify how we should consider overall markdowns compared to occupancy shrink and other factors that may have affected margins?

On the merchandise front, it boils down to key factors, and I apologize if this sounds basic. If the products are fresh, new, distinct, and appealing, customers tend to respond positively, which translates into sales and pricing success. For instance, the T-shirt bra has been a major hit at Victoria's Secret, selling in the mid-$20 range and seeing multiple price increases. It's prominently featured in the brand's look, contributing to its success. Another successful item is the Illusion bra, priced in the mid-$30s, which has been well-received due to its fabric, fit, and feel, driving strong sales at healthy margins. Conversely, some bra franchises like Body by Victoria and the Angels collection have suffered due to a lack of recent innovation, resulting in weaker performance and the need for promotional pricing to stimulate volume. In the sleep segment, there was a strong consumer response this fall, leading to significant investment in that area. Based on testing, we're optimistic about delivering meaningful growth with good margins here. The beauty division has experienced six consecutive quarters of positive sales and improving margin dollars, with promising prospects for the fall season driven by a successful mist and fine fragrance business. While some areas are thriving, others, like the bling business in PINK, have not met expectations, and the fleece category has also been weak. However, the sport and sleep categories within PINK are performing well, as well as our sherpa offerings, which have received a great response. This reflects the importance of being closely aligned with customer preferences and leveraging our speed to highlight the successful products while minimizing the less successful ones. Successful merchant leadership and strong execution of fundamentals are critical in our businesses. Regarding margin dynamics, there are various factors at play. Bath & Body has had a strong performance and is focused on maintaining this into the crucial fourth quarter and into 2019, performing well across their merchandise categories. This strong performance allows for a reduction in promotions while still achieving excellent overall results. For our fourth quarter guidance, we've adopted a slightly more conservative stance, hoping for better results on margin rates despite challenges in the Victoria's segment. We've discussed the implications of our third-quarter results for Bath & Body and our approach for the upcoming fourth quarter. Thank you.

Most of my questions about the Victoria's Secret side of the business have been addressed. However, I wanted to inquire about Bath & Body Works as you navigate the reset on the Victoria's Secret side. It's encouraging to see the strength in Bath & Body Works, particularly in terms of margins and growth rates. As you consider the challenges Victoria's Secret has faced and are now reassessing, how do you ensure that Bath & Body Works continues to perform well and gives you the flexibility you need for Victoria's Secret? What measures can you take to prevent similar issues from arising with Bath & Body Works? Additionally, could you share some insights on how that business maintains its growth, particularly regarding attracting new customers versus increased spending from existing ones, and the overall reliance on promotions?

Yes, that's a great question, and it's something we think about frequently. To give you some background on Victoria's, for a significant period leading up to 2015, PINK was the primary driver of growth in that business. This relates to your query about Bath & Body Works and how the team, particularly Nick and his group, is focusing on ensuring balanced and appropriate growth across all key business segments. As you're aware, the home fragrance segment within Bath & Body has performed exceptionally well and has driven impressive growth. The management team, under Nick's leadership, is dedicated to ensuring continued success not just in home fragrance but also in body care, which is the original core of the business. One of the encouraging aspects is that, thanks to their focus, even though they don’t always get it right, they implemented significant changes in 2017 and learned from those to achieve strong results in 2018 as well. This has positively impacted not only home fragrance but also the body care, hand soap, and gift-oriented segments. The key is to achieve balanced and meaningful growth across major business categories. Equally important is the stability and capability of the management team, with Les and Nick deeply committed to this, and the Board concentrating on ensuring they have the right leadership and stability in place. Additionally, Bath & Body has a proactive approach to regular testing, whether it's related to new product acceptance, promotions, or online sales strategies. This culture of taking risks, testing, and quickly adapting is something Bath & Body executes particularly well and is crucial for their success. I hope this provides some insights into our approach. Thank you.

My question is, you talked about an absolute reduction in debt, but you don't have a lot of debt that's callable. You do have a couple of bonds that come due over the next couple of years. I guess, would you consider taking those out ahead of their maturity date? Or I guess, how would you go about reducing your debt?

Yes. Most of it will come through the normal financing activities. So we've got $2.6 billion worth of debt coming due over the next few years. And as we roll that debt over, we'll be reducing amounts outstanding as those maturities come. There will be select opportunities to reduce debt in advance of maturities. And where it makes economic sense to do so, and that's a complicated evaluation that I think you probably appreciate, we will pursue those opportunities where it makes economic sense. But most of it will likely happen as debt comes due. Thanks.

This is Ross Collins filling in for Oliver. Regarding the VS side, we would like to hear your thoughts on your digital strategy, specifically what is effective and where you see the biggest opportunities to connect with both current and potential customers. Additionally, how do you view your digital platform in relation to your physical stores when it comes to engaging or re-engaging new or returning customers? Lastly, could you clarify the financial leverage target? Is that figure for gross or net debt-to-EBITDA?

Sure. So on our digital business at Victoria's and digital strategy, I think as you appreciate, we view it first in terms of where we are today as a very strong and successful business. The penetration rate is high. Again, for L Brands, in total, over $2 billion of online business, I think, underappreciated by the marketplace because we also have a meaningful store business. But we have a $2 billion online business at a very high profit rate. We think one of the disclosures are not consistent externally, but we believe and we've commented on the profitability of our online business at north of 20% EBIT rate. So substantial in size, highly profitable and growing at a very healthy rate. So just important to register all that, and I realize I'm doing a bit of a commercial there, but it's important to understand that about our business. The next thing I would say about the business is that we are investing meaningfully in that business. And in fact, as we reviewed our capital spending plans with the Board recently, we expect to double the investment in the digital business in 2019 versus 2018. So substantial investment in that business. You may be aware that the largest technology, most significant technology project that we've got going in our company right now is the re-platforming of the Victoria's Secret digital business that will enable us to do a lot of things for the customer that, at present, we're not able to do. Things like buy online, pick up in store, fulfilling from multiple DCs, other benefits for the consumer, including globally, those things will be rolling out over the next couple of years. But we're re-platforming that site today. So very healthy business. There are functions that are available to the consumer that others provide that we'll be pursuing over the next couple of years. But again, we are making very substantial investment in that part of our business.

The second part of your question was about Amie, I'm trying to remember. Leverage.

Oh, leverage ratio. We analyze it on a gross basis. Thank you. We are not too rigid about it, but our ratios are currently higher than they have been, and we find it necessary to reduce the overall debt level and bring the ratios back to levels similar to those in 2015. We plan to achieve this over the next few years. Thank you.

Stuart, my question has two parts. First, regarding merchandise, can you explain the decision to exit swim and then consider re-entering it next year? You've previously conducted tests to see how customers respond to these changes. What's prompting the return to swim now, and how is this decision made at the senior management level? Second, about inventory, it seems to be in the mid- to high-teens, particularly at Victoria's Secret. When you bring that in line with sales by the end of the year, should we anticipate an improvement in the average unit retail, but a slowdown in comparable sales at Victoria's Secret? We've noticed that many retailers are focusing on profit maximization, and that seems reflected in the outcomes.

We are currently where we are with swim. I'm not going to dwell on the past, though it can provide insights. The decision we made was fundamentally based on customer feedback. While the original choice was to focus on our most critical categories, bras and panties at Victoria's Secret Lingerie, we've decided to re-enter the swim business, primarily due to customer input. There will be more details on this as we develop our plan for 2019. Regarding inventory levels and merchandise margin rates, our priority is to end inventory cleanly, both quantitatively and qualitatively, as we head into a strong 2019. It's true that this can occasionally pressure margin rates, and we experienced that in the third quarter with PINK as we moved inventory. However, from the customer's perspective, we want to start with an appealing assortment heading into key time periods, specifically as we enter the fourth quarter for PINK. We aim to end 2018 with this strategy in mind as we move into 2019. We will monitor the pressure on margin rates as we progress through the quarter. Thank you.

Stuart, could you elaborate on the PINK business? You mentioned clearing out the loungewear that didn't work out financially. Do you believe the current assortments are more aligned with expectations, or is there still significant work needed, similar to the Victoria's Secret Lingerie business? I'd like to understand the extent of the turnaround efforts required to drive growth for PINK.

Janet, I appreciate your question, as it's a challenging topic to assess. I can tell you that Amie is a highly skilled leader with a decade of experience with us, plus significant time in this industry before that. Her curiosity, energy, proactive approach, and comprehensive understanding of the business are all very impressive. However, as you know, meaningful change takes time. I believe Amie is making an impact, but predicting when that will lead to a 5% to 10% sales increase and significant margin improvement year-over-year is uncertain. Only time will clarify that. What I can confirm is that Amie and other talented members of the PINK team are dedicated and working diligently. It's a difficult question to answer, but we regularly provide updates to our investors and will continue to share progress in the PINK business as we move into the fourth quarter. Thank you.

Thanks, Janet. That concludes our call this morning. Thank you for joining us. We'd like to wish everyone a very happy Thanksgiving.

Thanks.