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Fitch Affirms L Brands, Inc.'s IDR at 'BB+'; Outlook Stable
October 19, 2017 / 4:13 PM / in 2 months

Fitch Affirms L Brands, Inc.'s IDR at 'BB+'; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, October 19 (Fitch) Fitch Ratings has affirmed L Brands, Inc.'s Long-Term Issuer Default Rating (IDR) at 'BB+'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release. The rating reflects L Brands' position as a strong operator of two leading brands, proven track record of driving growth despite challenges in the broader retail space and a shareholder-friendly posture. L Brands has displayed strong customer loyalty and ability to introduce compelling, unique merchandise despite challenges across the mid-tier mall retail space. While near-term performance has been impacted by recent category eliminations and general mall-based retail traffic challenges, Fitch believes that the company's top-line should begin to stabilize as it laps declines from exited categories and recent strategic changes take hold. Continuation of negative comparable store sales (comps) through the 2017 holiday season would be a rating concern. KEY RATING DRIVERS Recent Top-Line Weakness: In early 2016, Victoria's Secret announced proactive plans to eliminate certain apparel categories (including swimwear), eliminated its catalog, and made significant changes to its promotional strategy. These actions, which are aimed at positioning the company for the longer-term, have weakened near-term results. This weakness has been further exacerbated by traffic challenges faced by many mall-based specialty retailers. Comps decreased to positive 1% in 2016 and negative 7% for the first nine months of 2017, compared with an average of about 5% over the five years through 2015. The YTD comps decline has been driven entirely by Victoria's Secret (comps down 12%) as Bath & Body Works produced positive 4% comps during the same period. Victoria's Secret comps have improved notably in recent months, with declines of 7% and 5% in August and September, respectively and September comps in the underlying business (excluding the impact of swim and apparel exits) improved to flat. Given the improving trajectory and continued good results at Bath & Body Works, Fitch expects overall comps to stabilize to around flat by the 2017 holiday selling season. Fitch expects comps to be negative mid-single digits in 2017 as the company continues to work through the impact of the above actions before stabilizing in 2018 and resuming low single digit growth thereafter. The growth of PINK in the U.S., which could be a $3 billion business over the next few years from our estimate of $2.5 billion currently, and the inclusion of the full lingerie lines in expanded Victoria's Secret stores have led to increased productivity per square foot over the past few years. PINK, a collegiate-focused brand which offers intimate apparel, loungewear and related products in vibrant colors and patterns, has expanded Victoria Secret's demographic base by appealing to younger consumers. International expansion also provides a strong top-line and profit opportunity by allowing the company to diversify outside of mall-based locations and reduce operational and execution risks through its substantially franchised model (outside of the UK and Canadian markets). L Brands' strong omnichannel is also expected to be a continued driver of growth. The company had consolidated online penetration of 16% of 2016 sales, with a higher penetration of 20% at Victoria's Secret and 12% at Bath and Body Works. While Bath and Body Works' lower online sales penetration is somewhat protected by the "touch and feel" nature of personal care products, Victoria's Secret should benefit from expected growth in online apparel sales. Sub-$2.5 billion EBITDA Expected: Fitch expects L Brands' EBITDA to decline to about $2.3 billion in 2017 from $2.6 billion in 2016, or about 10%. The decline is driven by a weak top line (forecasted down 3%) and its deleveraging impact on EBITDA margin. Fitch expects gross margin to decline around 100 bps in 2017, primarily on fixed-cost deleverage, and remain flattish thereafter. EBITDA is expected to grow to around $2.6 billion by 2019 as comps flatten out in 2018 and then turn positive low single digits. Reasonable Leverage: Lease-adjusted leverage increased to 3.9x as of July 29, 2017 from 3.5x at the end of 2016 due to the decline in EBITDA. While leverage is expected to remain elevated over the next 12-24 months, L Brands continues to operate within the appropriate leverage sensitivities. Longer term, Fitch expects the company's leverage profile to trend toward the mid-3x given expectations for sales to stabilize and EBITDA to rebound. Shareholder-Friendly Posture: L Brands is committed to returning cash to shareholders through share repurchases and dividends. The company returned about $6.6 billion in cash to shareholders in the five years ending 2016, utilizing approximately $4.4 billion of FCF before dividends and funding the remainder with debt. In light of the recent operational weakness, management has reduced 2017 capex and directed only $476 million towards dividends and share buybacks in the first half of 2017 versus $1.3 billion in the same period in 2016. While the commitment to high levels of shareholder return is a rating constraint for the company, the recent pullback is a modest credit positive. DERIVATION SUMMARY L Brand's 'BB+' rating reflects the company's dominant position in intimate apparel through its Victoria's Secret brand and a strong position in personal care and home products through the Bath & Body Works Brand. The company does not have any large, direct peers but instead competes with a range of department store and mid-tier apparel/specialty retailers. L Brands' good track record of growth and industry leading margins is offset by an aggressive shareholder return policy that dictates leverage. While until recently L Brands' top-line and EBITDA margin trends have been more positive than The Gap (BB+/Stable), leverage is largely comparable for the two mid-tier, mall-based retailers. Gap continues to struggle with longer term operational challenges but has a less shareholder friendly stance than L Brands. Looking at other specialty retailers, the 'BBB-'/Stable ratings of both Coach, Inc. and Michael Kors Holdings Limited consider their lower leverage profiles offset by higher fashion risk of the handbag and accessories category. Signet Jewelers Limited (BB/Stable) benefits from expected longer term stability of the jewelry category, but its rating is dictated by management's stated leverage target. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Fitch expects L Brands to produce negative mid-single digit comps in 2017, improving to flattish in 2018, before increasing to positive low single digits thereafter; --Square footage expansion, if executed successfully, could drive overall top-line growth of around 2%-3% range annually beginning 2018; --EBITDA is expected to be around $2.3 billion in 2017 before rebounding to about $2.6 billion by 2019 as top-line returns to growth; --Free cash flow (FCF) after regular dividends of negative $100 million to breakeven after regular dividends over the next two to three years; --Capex is expected to be around $800 million annually following an elevated $1 billion in 2016, reflecting a more normalized level of spending, inclusive of strategic investments, new store constructions and square footage expansion; --Leverage is expected to be in the high-3x range in 2017/2018 and decline modestly thereafter, assuming flattish debt and the above EBITDA assumptions. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action would require both the continuation of positive operating trends and a public commitment to maintaining financial leverage around low 3.0x. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action A negative rating action could be driven by a prolonged trend of negative comps and/or margin compression from fashion misses, execution missteps or loss of competitive traction. A larger than expected debt-financed share repurchase or special dividend, or weakness in operations that lead to leverage rising to 4.0x would be negative for the rating. LIQUIDITY Liquidity is strong, supported by a cash balance of $1.4 billion as of July 29, 2017 and the company's $1 billion revolving credit facility. The company has a comfortable maturity profile and Fitch considers refinancing risk low given L Brands' strong business profile, favorable operating trends, and reasonable leverage. FULL LIST OF RATING ACTIONS Fitch has affirmed L Brands' ratings as follows: --Long-term IDR at 'BB+'; --Secured bank credit facility at 'BBB-/RR1'; --Senior guaranteed unsecured notes at 'BB+/RR4'; --Senior unsecured notes at 'BB/RR5'. The Rating Outlook is Stable. Contact: Primary Analyst JJ Boparai Associate Director +1-212-908-0543 Fitch Ratings, Inc. 33 Whitehall St. New York, NY 10004 Secondary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Committee Chairperson Monica Aggarwal, CFA Managing Director +1-212-908-0282 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and exclude restructuring charges. For example, in fiscal 2016, Fitch added back $65 million in non-cash stock-based compensation and $66 million in restructuring charges to its EBITDA calculation. --Fitch has adjusted the historical and projected debt by adding 8x yearly operating lease expense. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. 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