The situation is once again looking grim for L Brands (NYSE:LB). After reaching a deal in February to sell 55% of Victoria's Secret to private equity firm Sycamore Partners, news came out last week that Sycamore wants to end the agreement. Investors had been counting on the $525 million deal to help drive recovery of the multi-brand retailer.
On April 22, Sycamore Partners filed a lawsuit in Delaware seeking a declaratory judgment that its move to end the Victoria's Secret agreement with L Brands is valid. According to press reports, Sycamore says store closures and a halt to rent payments in April related to the coronavirus pandemic breach terms of the deal. L Brands said it would fight the lawsuit, enforce its contractual rights, and work to close the planned transaction.
If Sycamore succeeds in ending the agreement, the questions surrounding L Brands may be more about survival than recovery. Let's take a closer look at why this is such big trouble for L Brands.
A struggling brand hit hard by the coronavirus fallout
Victoria's Secret, once a star in the world of lingerie, has grappled with declining sales in recent years as a new generation of shoppers turned away from the glamorous image and opted for alternative brands that focused more on comfort and emphasized inclusivity in their marketing. For 2019, L Brands reported impairment charges of more than $725 million linked to Victoria's Secret goodwill and assets. The brand's North America sales dropped 8% to $6.8 billion, and it recorded an operating loss of $616 million.
The bright spot for L Brands has been its bath and skincare products chain. Bath & Body Works reported record results in 2019, with sales climbing 12% to $5.2 billion and operating income increasing 11%. Still, Victoria's Secret's troubles have hurt overall earnings at L Brands. The company posted a net loss last year, compared with a profit a year earlier, and operating income sank to $258 million from more than $1.2 billion.
According to the sales agreement, L Brands would retain 45% percent of Victoria's Secret and use proceeds from the deal to pay down debt. The idea was for Sycamore to turn things around at Victoria's Secret, so that L Brands could focus on recovery and maintaining momentum at Bath & Body Works.
Before the transaction could move forward, the coronavirus outbreak hit. In recent weeks, L Brands has temporarily closed stores in the U.S. and Canada, drawn down $950 million from its revolving credit facility, suspended its quarterly dividend, cut pay for senior vice presidents, and furloughed workers. The company said it has sufficient current liquidity, with more than $2 billion in cash.
According to court filings, the deal did have provisions that allow for the possibility of an event like the pandemic to trigger a “material adverse effect” clause. Wording like this is typically included in deals to allow a buyer the chance to renegotiate if extraordinary events have a financial impact on the business up for sale. So the deal is likely to be different even if Sycamore is required to go through with it.
What does all of this mean for L Brands' recovery?
Even if the deal with Sycamore was completed, I wasn't bullish on L Brands or the potential for buying its stock. Without Victoria's Secret, L Brands is really just Bath & Body Works. Though growth has been strong at the soap and skincare products retailer, I'm not convinced it is enough to drive solid, long-term growth. That said, the brand sale scenario was better than the previous situation.
If and when this coronavirus pandemic finally runs its course, L Brands will exit the crisis with a weakened financial situation. There are going to be significant lost sales, rising inventory levels, and costs related to store shutdowns. Add to that the cost and complexity of a legal battle with Sycamore and the financial picture is dim.
If Sycamore prevails, the presence of Victoria's Secret would make a possible recovery much more difficult and expensive. And the chances of finding another buyer for a struggling retail chain seem unlikely in the current environment. Shares in this consumer discretionary retailer have lost about 50% of their value since their peak shortly after the Sycamore deal was announced. Considering the current news, I wouldn't buy them right now at any price.