Victoria’s Secret: The Business Is Slowly Turning Around (NYSE:VSCO)

Description

I believe consumers’ feelings toward the Victoria’s Secret (NYSE:VSCO) brand are beginning to improve, indicating a potential turnaround for VSCO. Although the management turnaround strategies seem to be bearing fruit, it is unfortunate that supply chain headwinds are likely still going to persist in the near term, which I expect will overshadow its turnaround efforts (i.e., hard to see on the P&L). That said, I still think VSCO has a great long-term opportunity and is capable of capturing its lost market share and recovering margins back to a normalized level. So long as VSCO can continue to execute, I think this will be a very strong “show me” story combined with a “beat and raise” eventually. However, I would warn that the recovery will not be linear. The best time to invest is, therefore, when the turnaround begins to show early signs of success, which I anticipate will occur in 2H23. Until then, this is a hold.

4Q22 results review

With an adjusted EPS of $2.47 for 4Q22, VSCO beat both its own guidance and the market consensus. Reduced SG&A and tax rates are primarily responsible for the better-than-expected results. That said, revenue declined, and gross margins were largely in line. Management guided for mid-single-digit revenue growth for FY23 and EPS in the $4.90-$4.95 range. For 1Q23, revenue is expected to drop by the mid-single digits year over year, and an EPS of $0.30 to $0.60 is expected.

Thoughts on guidance

In my opinion, VSCO’s revenue guidance for 1Q23 points to a difficult environment in North America. As evidence, consider the fact that management is expecting 1Q23 sales to fall by the middle single digits. And if I were to break it down even further, I would say that the Core VS business is expected to decline at a high-single-digit % rate, which is consistent with the average 8% Y/Y decline in revenues seen throughout 2H22. Investors will not be pleased to hear this, especially since management has stated that they anticipate the VS North American business to continue to face difficulties, with no sign of turning around in the extreme near term. The silver lining is that we can expect growth in VS International.

However, if we go one step further, I think overall growth will pick up, which could pique the interest of investors. Taking my expectations that the decline in core business revenue from the 1Q23 (negative high single digits) to the entire year (relatively flat), this implies an acceleration in 2H23 organic topline growth. Several active growth strategies lend credence to my belief that this is possible. Launching the new VS & PINK customer loyalty program, the first rewards program for the company that allows customers to earn rewards regardless of payment method, is a key strategy that I believe would help. Opening more “Stores of the Future,” which I believe will make up a sizable proportion of the retail sector overall, is another strategy that will support a reacceleration in growth as well. Lastly, an easy comp in 1H23 would also make it easier for an acceleration in 2H23.

Margin

EBIT margin is expected to remain flat in FY23 as management anticipates a slight increase in gross margins and a similar increase in SG&A. At the gross margin level, I expect the slight increase to be supported by the addition of AdoreMe, which has a higher gross margin, and the recoupment of freight and raw material cost. However, I anticipate the latter to be nearly fully offset by continuing promotional activities. During times of uncertain macroeconomic conditions, I cannot fault management for gearing up on promotions as I view it inevitable in order to sustainably increase both customer volume and market share. Specifically, management expects a gross profit margin of 37.5% to 38.5% for 1Q23.

Managers pointed to four categories of SG&A spending that have grown since last year. First, money put toward technology for strategic growth initiatives like the loyalty program. The second is that by 2023, the technology separation from Bath & Body Works (BBWI) should be finished. In terms of both money and streamlined processes, this should have a significant impact on savings. Third, there ought to be some SG&A volatility due to the incorporation of AdoreMe business. Finally, management hinted at increased bonus incentives all year long. Taking everything into account, management is providing guidance for SG&A to be in the $460 million to $470 million range. This includes a significant amount of AdoreMe marketing spending in 1H23 and also the peak cost of separating Bath & Body Works tech in 2Q23.

Summary

While there are still supply chain challenges that may affect Victoria’s Secret’s turnaround efforts in the near term, I believe the brand has a great long-term opportunity to recover its lost market share and margins. The 4Q22 results were better than expected, with management providing guidance for mid-single-digit revenue growth in FY23. However, the revenue guidance for 1Q23 suggests a difficult environment in North America, particularly for the Core VS business. Despite this, there are active growth strategies in place that could drive an acceleration in 2H23 organic topline growth, including the launch of the new VS & PINK customer loyalty program and the opening of more “Stores of the Future.” At the gross margin level, I anticipate slight increases supported by the addition of AdoreMe and cost recovery but offset by continuing promotional activities. Overall, I recommend holding off on investing until there are early signs of success in the turnaround efforts, which I anticipate in 2H23.