BBWI

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended August 4, 2007, for Limited Brands, Inc. (parent company of Bath & Body Works, Victoria's Secret, and formerly Express and Limited Stores). The reporting period is defined by the company's fiscal calendar, with the second quarter ending August 4, 2007. The company operates specialty retail stores in the U.S. and Canada, focusing on intimate apparel, personal care, and beauty products.

Key Financial Metrics

Material Changes vs. Prior Period

• Divestitures: The company completed the divestiture of a 75% interest in Express (July 6, 2007) and Limited Stores (August 3, 2007). These transactions resulted in a $302 million pre-tax gain on Express and a $72 million pre-tax loss on Limited Stores, significantly boosting operating income.
• Revenue Growth: Net sales increased 7% in the quarter and 9% year-to-date compared to the prior year, driven by Victoria's Secret growth (16% quarterly) and the inclusion of La Senza sales, partially offset by the exit from the Apparel segment.
• Margin Compression: Gross profit rates declined to 31.3% (quarterly) from 34.8% in the prior year. This was primarily due to lower merchandise margins at Victoria's Secret (promotional activity) and Bath & Body Works (inventory charges and assortment misses).
• Debt Increase: Long-term debt increased from $1.665 billion to $2.908 billion due to the issuance of $1 billion in notes ($700M 10-year, $300M 30-year) and an increase in term loan borrowings to $750 million.
• Restructuring: The company incurred $38 million in pre-tax restructuring charges related to a 10% reduction in corporate headcount and $13 million in impairment charges for a personal care business.

Guidance, Outlook, and Risks

• Capital Allocation: The company completed a $1 billion share repurchase program in August 2007 and authorized a new $250 million repurchase program. Dividends remain at $0.15 per share.
• Segment Performance: Victoria's Secret comparable store sales grew 4% in the quarter, while Bath & Body Works declined 4% due to soft sales during key themes and promotional activity. The Apparel segment is no longer a reportable segment following divestitures.
• Liquidity: Cash and cash equivalents rose to $1.193 billion, supported by proceeds from divestitures ($548 million from Express) and debt issuances. The company maintains $1.5 billion in available revolving credit.
• Risks and Contingencies:
  • Lease Guarantees: The company retains approximately $301 million in lease guarantees for divested businesses (Express, Limited Stores, and others), though management deems the likelihood of material liability remote.
  • Tax Uncertainty: Adoption of FIN 48 resulted in $128 million of unrecognized tax benefits. $14 million of this could change in the next 12 months.
  • Operational Risks: Risks include supply chain disruptions, foreign currency fluctuations (La Senza), and the impact of inflation on costs.

Investor Verification Checklist

• Divestiture Adjustments: Verify the final closing adjustments for the Express and Limited Stores transactions, as the reported gains/losses are subject to change.
• Inventory Valuation: Review the $19 million inventory charge at Bath & Body Works and assess the risk of future markdowns given the reported assortment misses.
• Debt Covenants: Confirm continued compliance with debt covenants (fixed charge and debt-to-earnings ratios) given the significant increase in leverage.
• Share Repurchase Execution: Monitor the execution of the new $250 million share repurchase program authorized in August 2007.
• Tax Position: Track the resolution of unrecognized tax benefits, particularly the $14 million potentially at risk in the next 12 months.