Bath & Body Works Inc (BBWI) — Q2 2019 Earnings Call Transcript

Thank you, Heidi. Good morning, everyone, and welcome to L Brands' second quarter earnings conference call for the period ending Saturday, August 3, 2019. 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 and in our press releases. Our second quarter earnings release, additional commentary, and our earnings presentation are all available on our website, lb.com. All of the results discussed in today's call are adjusted results and exclude the significant item described in our press release. Stuart Burgdoerfer, EVP and CFO, and I will handle the call today. Thanks, and now I'll turn it over to Stuart.

Thanks, Amie, and good morning, everyone. Our second quarter earnings per share result of $0.24 was above our initial guidance of $0.15 to $0.20 with upside driven by favorability in income taxes. Bath & Body Works continues to deliver strong results with an 8% comp increase and a 7% increase in operating income. The operating income increased at Bath & Body Works, and improvements in the international business and in other segments as a result of the sale of La Senza and the closure of Henri Bendel were offset by a decline at Victoria's Secret. Looking to the second half of the year, our #1 priority continues to be improving performance at Victoria's Secret. As we noted in the commentary that we released last night, John Mehas and Amy Hauk, CEOs at Victoria's Secret Lingerie and PINK, respectively, have made significant changes to our fall assortments. The significant amount of change in our fall merchandise assortments and promotional plans as well as the current trade environment and tariff uncertainty will inherently result in a greater level of uncertainty in forecasting our results for the third and fourth quarters than is typical. That said, we believe the customers will react positively to our new merchandise. And therefore, as we have said consistently, we have assumed in our guidance that Victoria's Secret trends will improve versus recent performance and that Bath & Body Works will continue to deliver strong results. You'll hear more from John and Amy as well as other business leaders at our Investor Day, which is scheduled for September 10. Thanks, and over to you, Amie.

Thanks, Stuart. That concludes our prepared comments. At this time, we'd be happy to take any questions you might have. [Operator Instructions] Thanks, and I'll turn it back over to Heidi.

My question is on the VS Lingerie business. I think you said initial indications in the first part of August have been favorable. I just am curious what you mean by that. And do you think that the lingerie piece, the new fall assortment is enough to replace the lost volume in core bras? I'm just wondering, if we don't see an improvement from the first 2.5 weeks of August, it sounds like Victoria's Secret will not be on track to deliver the expected third quarter numbers. So I'm just trying to understand what the puts and takes are.

Thanks, Kimberly. So as it relates to the new lingerie assortment, modern lingerie, as we refer to it, and initial results as we provided commentary in our pre-released remarks, the consumer reaction, Kimberly, to the new assortment and the new items in it has been favorable and positive; consumers are reacting well. But as you point out in your question, and all I can report to you is what we've observed so far and how things will progress based on our beliefs for fall, the reaction to the new products has been very good. That said, it hasn't been sufficient to overcome the weakness in the balance of the lingerie assortment, including the effect of heavy promotions from a year ago that will continue through the fall season. Importantly, there will be additional new merchandise flowing through the fall season. So the full fall assortment was not in stores in the first few weeks of August, so we are reading a partial result. Additionally, we are very optimistic about our offering and the potential for growth in the sleep and lounge business, which, as you appreciate, will have more SKUs in relation to the total as we move through the fall season, given its giftability and seasonality for sleep and lounge. We have more work to do on marketing, and we believe that our marketing effectiveness will improve as we progress through the fall season. So qualitatively, that would be the additional perspective we have in answer to your question. Again, consumer reaction has been strong and favorable to the new offerings, yet not sufficient to deliver an overall result that changes the trend so far. More new merchandise is flowing through the fall, and we are focused on effectively marketing the changes to drive traffic into the stores. Thanks.

Thanks, Kimberly.

Stuart, can you just maybe talk about how swim performed during the spring season as a whole now that you brought that category back to some extent? Any update on what that category might look like in spring of '20? And then just go back to Victoria's Secret for a second. I just want to understand a little bit about the inventory pickup on Victoria's Secret. Where are you investing? And I just want to tie that back to what I believe you said you've got some hopes to be less promotional in some of the prepared materials that were sent around. Just maybe square that away for us.

Sure. So Paul, as you're asking about, we've reentered the swim business this year. We made that decision relatively late in 2018 into early 2019. So our reentry into that business happened in the latter part of March, as I recall. It generated around $30 million to $40 million of volume versus what it had been in the past. We believe there is substantial additional growth opportunity in swim. Our focus, as we conveyed previously, is to pursue that business online and with a more elevated assortment than we had offered in the past. Consumer reaction to that, while there was some commentary out there about price points, overall, the reaction to what we put in front of customers was positive. It was a good start considering the timing of our decision. There is meaningful growth potential in that category. Again, I'm repeating this to ensure clarity: we intend to pursue that at this time online and not in stores. With respect to the lingerie inventory, the first thing, Paul, I'd want to register, and you know this having followed us for a long time, is that we're working very hard to maintain as much flexibility as possible, particularly for the fourth quarter. We are focused on reducing lead times, ordering frequently, and adjusting regularly. John Mehas and his team are working the assortment literally almost every week in terms of adjusting the on-order. We are making critical investments in the new parts of the assortment. With that said, we've got a lot of flexibility, particularly for the fourth quarter, to read and react to trends and adjust our orders to maximize the pursuit of the items that are performing well and to cancel or adjust items that aren't doing as well. So we're making important investments, and we are certainly optimistic regarding the reaction to the new offering overall, with a lot of flexibility.

Thanks, Paul.

I wanted to pick up on some comments you made in response to a prior question on marketing. You mentioned in the prepared materials that marketing at the Victoria's Secret business was down year-over-year. Could you give us a sense of where marketing is as a percentage of sales in that business? And then you also talked about some changes planned for the back half of the year. Can you talk a little bit more about what you mean by that? Is it an increase in the level of marketing? Is there any change planned to the tone or nature of the marketing message?

In terms of the numerical question, in a rough sense, Victoria's marketing as a percent of its sales is about 5% historically. That includes all forms of marketing. The most important thing I would want to register about marketing, and we've been consistent in this mindset now for a long time, is that everything is on the table. We are taking a fresh, hard look at almost every material aspect of our business. The reason you're asking about marketing for Victoria's is that it's a crucial part of that business. So regarding the messaging, imagery, photography, pricing, promotional aspects, the medium of communication, and the integration of marketing between stores and digital and social channels, John is becoming increasingly involved in it. He spent his initial focus on merchandise because that has the longest lead time, and he's done substantial work in that space, honestly extraordinary amounts of work in a short period of time. He is now shifting his focus slightly – not excluding merchandising, which remains a core responsibility – but he is getting more involved in marketing. We've had changes in senior leadership in marketing recently, and I expect that there will be thoughtful change in our marketing approach as we move through the fall into 2020. John will expand on that when we're together in September.

Thanks, Alex.

I wanted to ask about BBW. Just first, with the 4% store comp, can you give us a sense of how the traffic footfalls are that you're seeing? And what is the back half outlook for BBW and bed from a traffic perspective? Then more broadly, with the remodel program, I think 840 stores in the new concept are planned by year-end. Can you give us a sense for what percent of those you would say are in A malls or off-mall locations? And then, looking forward, given the continued pressure on mall traffic, has the number of BBW stores that would meet an ROI threshold changed much just with respect to the remodel? I'm just wondering how that refresh program evolved as we look to the second half of the fleet.

Sure. There are several questions in there. If I didn't catch them all, Amie will remind me of what I missed. So in terms of traffic at Bath & Body Works in the second quarter, it was about flat, year-on-year. The growth in business came through transaction increases driven by conversion. In terms of the refresh program, we've been very pleased with the results of it. The refresh activity has not been limited to A malls but has also occurred in other mall tiers. We are seeing strong results in almost every situation, regardless of mall tier. We'll continue to pursue the program as we move down the fleet, constantly watching the ROIs. They have been good so far, and we're very optimistic about continuing to pursue this program for the next several years. Regarding the ROI on the program and unit-level economics for Bath & Body Works, frankly, they are outstanding. The fleet is actively managed; we close a few stores every year, and we're also opening stores as well. We're expanding square footage cautiously. The most important aspect of the remodel program is that, along with a strong financial profile, it prepares the business very well for the next 7 to 10 years with a modern store design that consumers respond positively to. This ensures that we won’t face a deferred CapEx situation like some retailers. It's a very positive outcome for the business.

Thanks, Mark, did we get everything there?

I think you did.

All right. Great.

I wanted to follow up on the strategy at PINK to rebalance the good, better, best. Can you just talk a little bit about the go-forward implications on sales and margin that you expect from the strategy?

Sure. We are trying to maintain good balance among price tiers. In any business, you need to balance unit volume growth and transaction volume growth with pricing. As Amy entered the business, she assessed many things, and based on her assessment, she saw an opportunity to drive engagement in transactions and unit volume at lower price points. She has worked hard to avoid extreme shifts, instead ensuring a balanced assortment pyramid between good, better, and best. She felt the business had tilted toward higher price points. So she made adjustments there, including in areas like the bra business, where she is delivering significant volume growth and has achieved a margin profile that's looking very solid.

Thanks. Thanks, Lorraine.

Amie and Stuart, 2 quick ones. On the marketing, I know you can't go into it much now, and hopefully, we'll hear more at the Analyst Day. But I guess the quick question is, will there be a time to change the marketing message in a meaningful way ahead of holiday, meaning should there be some benefits or potential impacts on your Q4 performance at VS from changing the marketing strategy? And then on the international business, it sounds like, based on the commentary, that the operating losses in China are getting a little bit better. Can you kind of give us an update on where we stand from an operating income or loss perspective in China and what the thought process is into next year and beyond in terms of when that business could potentially turn a profit?

Yes. So on the first question regarding the opportunity to change the marketing message meaningfully for the fourth quarter, I believe that there is. John is engaged in it. While marketing is complex and needs to be migrated carefully, the inherent lead times, as I have mentioned earlier, are not nearly as long as those required to design and develop and manufacture new products for the assortment. The simple answer to your question is that, yes, there is an opportunity to make meaningful changes in our marketing message and approach for the fourth quarter. Regarding China, it’s a multi-year situation. We have flagship stores there that play a crucial role in marketing the business, but they are generating losses. Our view right now is that it's a 3- or 4-year journey to reach a profit profile in that business.

Thanks, Ike.

I was wondering if you could maybe give us an update, from what you're doing on a digital perspective, it looks like online continues to outperform stores. So maybe if you could provide some color on what you're doing from a technology perspective to continue to drive that online business and improve the omnichannel aspect for VS and PINK mainly?

Yes. Thanks, Susan. So I think, as you know, but it's important to reiterate, the most important thing we've done in the digital business is a project that we went live with in the last few months, which was a full re-platforming of victoriassecret.com. It had been running on systems and hardware that were over 25 years old. This legacy system served the business very well for a long time, but the time had come to upgrade it. The new platform has been running the domestic business for a couple of months now and is crucial for pursuing numerous customer-facing benefits. This includes buy online, pick up in store. A foundational element we are now working on before rolling out buy online, pick up in store and other similar functionalities is ensuring correct inventory accuracy. Obviously, we have this for financial statement purposes, but I'm referring to item-level accuracy for specific locations on particular days. This is critical, especially considering the vast assortment, particularly at Victoria's. Hence, we are pursuing an RFID initiative in 2019 for Victoria’s Secret. With this new domestic order management system and accurate inventories, we will be able to do numerous things that many retailers can already do. Additionally, the new system allows us to have a broader distribution network for Victoria's in the United States, allowing us to add capacity and flexibility. So those are the largest initiatives we've been working on.

Thanks, Susan.

I was wondering if you could talk a little bit about the List 4 tariffs at 10%. I think most of your products were included on List 4A, but what the impacts of these would be on a dollar basis for 2019 or how we should think about it on an annual basis going forward.

Yes. The List 4 effect is included in our guidance. We considered it in our guidance. We are working to offset some of that impact through various migration of production to different countries and discussions with our supplier partners. We haven't disclosed a specific number, but it is included in our guidance. Importantly, this situation's materiality to our company is not as significant as for many other retailers. The U.S. is our #1 country of production, given the importance of personal care and beauty in our business. In terms of our total sourcing activity, China represents less than 20% and has decreased by almost 10 percentage points over the last 3 or 4 years due to deliberate efforts by our sourcing and production teams to ensure a well-diversified supply base. Therefore, we've covered this in our guidance, and it is not as material to us as it is to many other retailers. Thanks.

Thanks, Bill.

My question is on BBW. It's been a healthy and consistent source of comp and operating income growth for you. I'm just wondering, from a rate perspective, how you think about BBW over the next few years as you consider the various puts and takes to the business, whether it's the impact of supply chain and sourcing costs, a shift to direct, which is growing at a very healthy rate, but then, on the flip side, the benefits from scale and expense leverage that you may be experiencing.

Yes. I understand the importance of your question, but as you would understand, the priority is dollar growth. As we say around here, 'You take dollars to the bank; you don’t take percentages to the bank.' That said, your question is serious. Bath & Body has a long-standing record of effectively balancing dollar growth and long-term health with profit rate. Do I see some downside risk or pressure due to the factors you mentioned? Yes. But we strongly believe that the growth potential in that business remains very high. Its ability to deliver healthy growth in profit dollars, EBIT, or operating income dollars is something we're very confident about, given the categories it's in, strong leadership, and numerous assets, including attractive store design, compelling merchandise offerings, short lead times, and a dedicated sales force. So while there may be some downside on the profit rate, considerable opportunity for dollar growth remains, and that business has consistently demonstrated its abilities over a long time. Thanks.

Thanks, Roxanne.

As you think about Victoria's Secret Beauty, any more color in terms of what you're seeing there, what happened with the July launch, and what you're noticing in the emerging businesses of PINK beauty? And then on the breakdown of CapEx, I believe the store investments are going to 55% of CapEx from 75%. How do you see that moving forward in the business? Is technology investment or direct investment making up what's being removed from store investment?

Thanks, Dana. Victoria's Secret Beauty remains a strong business. As you know, they have significant operations in the fine fragrance and fragrance mist segments. Over the past year or year and a half, they’ve recorded very strong results in the mist segment and decent results in fine fragrances. Our most recent launches have been successful, particularly with their recent fine fragrance launch over the last few weeks. Greg and his team understand the opportunity in fine fragrances. They have 3 or 4 of the top 20 fine fragrances in the industry, which is a fantastic position. While continuing to work on the assortment, Greg is also focused on enhancing in-store selling, and we believe these efforts will drive favorable outcomes in what is already a strong business.

Thanks, Dana.

My question is on sourcing. Just with more volatility in the wake of the trade tensions, and it sounds like you're making some changes on the supplier side. Can you speak to how your ability to chase product on the PINK and VS side is evolving into the back half? Is this furthering your need for airfreight? Or how should we think about the flexibility there? Also, just looking ahead to the fourth quarter, can you just speak to your open-to-buys for holiday?

Sure. To answer the last part first: we're essentially almost fully open for the fourth quarter regarding open-to-buy. With respect to speed and agility in our supply chain, it's something we've historically emphasized positively and renewed our efforts in it over the past 7 or 8 years. Today, we would consider our capabilities in that area, particularly for speed and agility, to be among the best in retailing. Regarding airfreight, essentially everything we produce outside of the U.S. is shipped by air, aside from some gift and accessory items, because the value of speed far outweighs the extra cost of air versus ocean transport. Our agility in the supply chain is vital, and we're in a good position.

Great. Thanks, Kate.

Stuart, I wanted to ask you about the more targeted promos at VS this fall holiday. I feel like you guys may have tried this a couple of years ago with mixed results. Can you talk about the strategy there? Is it important to reach a point where you have fewer promotions in the back half but stronger comps? Is targeted promotions a key part of that? And did you mention the trend through the quarter? I don't know if there was a significant difference between the months in the VS comp.

In terms of targeted versus broad-based promotions, Omar, we continue to seek the right balance between the two. If you have very broad-based promos, you are essentially discounting the entire assortment. Conversely, focused promos allow you to retain full-price selling on particularly strong items. The challenge, which you rightly pointed out, is that broader-based promos tend to drive a stronger consumer response. We’re trying to strike that balance. The key variable that distinguishes this year's approach is that the merchandise assortment is different. So while we may revisit prior promotional strategies, the focus should also be on the strength of the assortment. With Amy and John’s work, we are optimistic that we can achieve favorable results without needing many broad promos. We have flexibility here and will continue to test and adjust our promotional strategy as we navigate the fall season to drive customer responses and margin dollars effectively. For the monthly trends, June was the strongest month, while July was the weakest in the second quarter for Victoria's.

Thanks.

You talked earlier about the rebalancing of the price points that Amy is doing within PINK. Are there any similar plans for Victoria's Secret Lingerie as John looks at the assortment? Additionally, have you identified any cost opportunities that could help improve profitability apart from the assortment and revenue initiatives you're pursuing?

In regard to evaluating good, better, best pricing for Victoria's Secret Lingerie, that is one fundamental aspect of any merchant leader’s evaluation. John has made that assessment, and the offerings at better and best price points for Victoria's Secret Lingerie are significantly up compared to previous levels. If you’ve observed the merchandise online or in stores, you would see more sophisticated merchandise with a higher emotional content. As mentioned at the start of the call, initial consumer responses to new offerings have been promising. Moreover, John and Amy have ensured a clearer demarcation between the Victoria's Secret Lingerie and PINK businesses. PINK targets a college demographic, while lingerie targets a post-college customer at higher price points with greater sophistication. That also plays a role in the good, better, best pricing framework both leaders are implementing. As for cost opportunities, large businesses like ours always have such prospects. However, they come with trade-offs. The company has worked to maintain efficiency over its long history, achieving a record overall company operating income rate of 18% in 2015, which relied on high efficiency. We've experienced sales pressure and margin rate pressure in recent times, taking targeted actions associated with Victoria’s Secret changes. In 2016 and 2017, we made substantial home office cost reductions. More recently, we've minimized variable expenses in selling and marketing. There's always more we can do, but it must be balanced to avoid a detrimental ongoing cost-cutting exercise that could harm the business's near-term and long-term prospects. We are focused on effective retail results in sales and margin but will continuously monitor our expense strategies.

Thanks, Jamie.

Stuart, could you -- I guess 2 questions quickly. Could you -- I know we've discussed the outlook for promotions and how you're working on the mix of targeted versus more broad-based. Can you tell us your expectations for the promotional environment outside of your business as we head into the fourth quarter? I'm trying to reconcile the guidance for inventories to be up in the mid-teens with the comp items you've factored in for the fourth quarter and merch margins planned to be down a bit. Given that a significant portion of annual earnings occurs in the fourth quarter, I'm considering how much room you might have given the somewhat volatile outlook shared so far in the second quarter regarding peer group promotional levels during the holiday season.

Yes. Here are a few thoughts. First, regarding the lingerie segment, the initial markup of goods is significantly higher than in previous years. This allows for better margin rates and increased flexibility regarding promotions. This doesn’t mean we are going into this season with a heavy promotional plan; however, it does provide room for adjustments as necessary. In relation to the promotional landscape, there's always talk about increased promotions as we approach holiday periods. I've seen this cycle for years. We are aware we're amid our 10th year of economic recovery, leading to increased discussions about potential recessions. Ultimately, we offer relatively affordable discretionary items, and I’d point out that Bath & Body's performance remains strong in an environment many consider promotional. Our experience in capturing that market shows high-quality assortments executed well. Thus, we believe Victoria’s Secret is in a position to streamline processes through compelling assortments delivered effectively across channels. Additionally, the higher markup gives us some breathing room to manage promotions better than in recent years. Thanks.

Okay. Can I ask one follow-up on PINK?

Go ahead, Michael.

Sure.

I know you’re running short on time. But regarding PINK, it seems some of the issues with the comps there were, excluding swim, perhaps isolated to single-category product issues. There has been variability across product categories over the past year. With your knowledge of where Vicky's has been over the years, how do you affirm this is contained to single products we can address next season as opposed to identifying metrics on the longer-term health of the brand that may indicate a serious issue requiring attention?

It’s hard for me not to react earnestly; clearly, we feel urgency. If you feel otherwise, we aren't communicating well. There’s ample urgency from management. What our merchants, John and Amy, are focusing on is enhancing merchandise and executing it effectively. We are conscious of the sales pressure Victoria’s segment has experienced over the past years. This has become a multi-year challenge since 2016. Nonetheless, we believe the assets within this business, including brand awareness, store traffic, online presence, sourcing strengths, and strong overall management, create significant assets. When led effectively, we aim for substantial progress this fall and ongoing opportunities for this business over the coming years. We are pursuing all of this with urgency.

Thanks, everyone. That concludes our call today. Thank you for your continued interest in L Brands.