Shares of L Brands (NYSE:LB) tumbled 16% on Nov. 20 after the parent company of Victoria's Secret and Bath & Body Works posted its third-quarter earnings. L Brands' revenue rose 6% annually to $2.78 billion, which beat estimates by $10 million.

On the bottom line, it reported adjusted earnings of $0.16 per share, clearing expectations by $0.03 but marking a steep drop from its profit of $0.30 a year earlier. L Brands technically "beat" analysts' anemic expectations, but investors should still steer clear of this stock for three simple reasons. 

A Victoria's Secret ad.

Image source: Victoria's Secret.

1. Wobbly comps growth

On the surface, L Brands' comps growth doesn't seem terrible. The declines at its bigger Victoria's Secret brand are seemingly offset by gains at Bath & Body Works.

Segment Q4 2017 Q1 2018 Q2 2018 Q3 2018
Victoria's Secret (1%) 1% (1%) (2%)
Bath & Body Works 6% 8% 10% 13%
Total 2% 3% (3%) 4%

Comps growth, stores plus direct sales. Data source: L Brands quarterly reports.

However, those comps combine L Brands' direct-to-consumer and brick-and-mortar growth figures. If we only look the brick-and-mortar stores, its comps growth looks much worse.

Segment Q4 2017 Q1 2018 Q2 2018 Q3 2018

Victoria's Secret

(6%)

(5%)

(5%)

(6%)

Bath & Body Works

4%

5%

7%

10%

Total

(2%)

(2%)

(1%)

0%

Comps growth, stores only. Data source: L Brands quarterly reports.

These figures indicate that L Brands' store traffic ground to a halt as shoppers avoided its Victoria Secret and PINK stores. That was possibly caused by competition from smaller lingerie and activewear brands like American Eagle Outfitters' (NYSE:AEO) Aerie. Aerie, which established a reputation as an "anti-Victoria's Secret" with body-positive ad campaigns, grew its comps by 27% during its second quarter.

An Aerie ad campaign.

Image source: Aerie.

Victoria's Secret CEO Jan Singer abruptly resigned prior to L Brands' earnings report. It's unclear if Singer's successor, Tory Burch president John Mehas, will fare any better in turning around the ailing brand.

For the fourth quarter, L Brands expects its total (store plus direct) comps to rise 1% to 4%. That represents a possible deceleration from the third quarter, and its store-only comps would likely turn negative.

2. Collapsing margins and deteriorating earnings

L Brands' anemic comps growth might be acceptable if it was expanding its margins and growing its earnings. Unfortunately, the retailer has fallen into the dreaded trap of using markdowns to boost its sales.

That's why its gross margin contracted from 37.8% to 33.5% between the third quarters of 2017 and 2018, as its operating margin plunged from 8.8% to 2%.

L Brands also booked two big pre-tax charges during the quarter -- a $20.3 million on the closure of its Henri Bendel accessories business and an $80.9 million noncash impairment charge related to Victoria Secret's store assets. Those charges, which were excluded from its adjusted earnings, actually caused it to report a GAAP loss of $0.16 for the quarter.

Looking ahead, the company expects its adjusted EPS to fall 0%-10% annually for the fourth quarter, and 18%-24% for the full year. That's why the stock can't be considered cheap at 11 times this year's earnings -- especially when other retailers are generating positive earnings growth with lower valuations.

3. A disappointing dividend cut

One of the only remaining reasons to own L Brands was its dividend yield, which rose above 8% earlier this year as the stock declined. That's why it wasn't surprising when the company cut its annual dividend from $2.40 to $1.20 -- which reduces its forward yield to 4.2%.

That yield is still high, and it looks much more sustainable with a payout ratio of less than 50% of its estimated earnings this year. But once again, plenty of other retailers -- like Macy's -- offer higher yields with positive earnings growth.

Stay away from this sinking retailer

L Brands is clearly struggling to stay relevant as the holiday shopping season starts. There's simply no compelling reason to own L Brands until Victoria's Secret shows some signs of life and it reduces its dependence on promotions to drive its sales.

 

Leo Sun has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.