BBWI

Business Context and Reporting Period

This Form 10-Q covers the thirteen-week period ended April 29, 2006, for Limited Brands, Inc. (parent company of Bath & Body Works, Victoria's Secret, and Express). The company operates specialty retail stores and direct response channels selling intimate apparel, personal care, and beauty products. The financial statements are unaudited and reflect the adoption of SFAS 123(R) regarding share-based compensation effective January 29, 2006.

Key Financial Metrics

Cash Flow: Net cash used in operating activities was $288.0 million, compared to $213.0 million in the prior year, primarily due to working capital changes. Capital expenditures totaled $123.4 million.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 5% year-over-year, driven by a 10% increase at Victoria's Secret and a 6% increase at Bath & Body Works. The Apparel segment (Express and Limited) saw a 2% decline in sales.
• Profitability: Operating income surged 57% to $185.9 million. This was largely due to a significant turnaround in the Apparel segment (from a $29.7 million loss to a $16.4 million profit) and strong performance at Victoria's Secret.
• Comparable Store Sales: Total comparable store sales increased 5% (up from a 5% decline in 2005). Victoria's Secret posted an 8% increase, while Express improved to a 4% increase after a 21% decline the prior year.
• Accounting Change: The adoption of SFAS 123(R) resulted in $7.6 million of share-based compensation expense, reducing operating income by approximately $5.3 million compared to the prior year's accounting method.

Outlook, Risks, and Management Commentary

Management Commentary:

• Victoria's Secret: Growth was driven by successful bra launches (Angels Secret Embrace, Body by Victoria) and the PINK sub-brand. The company is testing expansion of PINK and Intimissimi.
• Bath & Body Works: Sales growth was offset by a decline in gross profit rate due to increased promotional activity and merchandise mix. The company launched its first catalogue and is testing reduced assortments to improve store navigation.
• Express: Results improved significantly due to better sell-through at regular prices and lower unit costs following assortment changes.

Risks and Contingencies:

• Oil Prices: Rising oil prices may increase transportation and utility costs and adversely affect consumer spending.
• IT Systems: The company relies heavily on information technology; system failures could materially disrupt operations.
• Guarantees: The company holds approximately $254 million in lease guarantees related to divested subsidiaries (e.g., Abercrombie & Fitch, Dick's Sporting Goods), though management believes the likelihood of material liability is remote.

Capital Allocation: The company repurchased approximately 3.5 million shares of common stock for $81.8 million during the quarter. A $100 million repurchase program authorized in February 2006 remains active, with approximately $58.3 million remaining as of April 29, 2006.

Investor Verification Checklist

• Verify the sustainability of the gross margin expansion at Express, which drove the segment's return to profitability.
• Monitor the impact of increased promotional activity on Bath & Body Works' gross profit rates in subsequent quarters.
• Review the effectiveness of the new Bath & Body Works catalogue and reduced store assortments on sales trends.
• Assess the impact of rising oil prices on transportation costs and consumer demand as noted in risk factors.
• Confirm the company's ability to maintain liquidity given the significant cash outflow from operations ($288 million) and continued capital expenditures.