BBWI

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended July 30, 2005, for Limited Brands, Inc. (parent company of Bath & Body Works, Victoria's Secret, Express, and Limited Stores). The company operates specialty retail brands selling intimate apparel, personal care products, and apparel through mall-based stores and direct response channels. The results for the quarter and year-to-date were below expectations, primarily driven by significant declines in the Express segment.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Net sales increased 4% in the quarter and 2% year-to-date compared to 2004. Growth was driven by Victoria's Secret (+6% Q, +5% YTD) and Bath & Body Works (+10% Q, +8% YTD), which offset declines in the Apparel segment (-9% Q, -13% YTD).
• Profitability: Operating income declined 10% in the quarter and 27% year-to-date. The decline was primarily due to a significant drop in operating results at Express, which turned from a profit of $15.8 million in the prior year quarter to a loss of $42.5 million.
• Margins: Gross profit rates decreased to 34.6% (Q) and 32.9% (YTD) from 36.1% and 35.2% in 2004, respectively. This was driven by higher markdowns at Express to clear slow-moving inventory and increased costs/markdowns at Bath & Body Works.
• Debt: Long-term debt increased significantly to $1.65 billion from $648.3 million in the prior year, following the issuance of $500 million in notes and a $500 million term loan in late 2004 to fund a tender offer and special dividend.
• Cash Flow: Net cash provided by operating activities decreased to $97.5 million (YTD 2005) from $154.4 million (YTD 2004), largely due to lower net income and changes in working capital.

Guidance, Outlook, and Risks

• Management Commentary: Management attributes the poor performance at Express to a fashion assortment that did not meet consumer preferences regarding style and price. Corrective actions include increased investment in denim, canceling underperforming orders, and new direct mail programs. Victoria's Secret and Bath & Body Works continue to grow via new product launches (e.g., IPEX bra, Tutti Dulci, Breathe).
• Capital Allocation: The company completed a $100 million share repurchase program in May 2005 and another in August 2005. A new $100 million repurchase authorization was approved in August 2005. Capital expenditures for 2005 are projected at $550–$575 million, up from $431 million in 2004, driven by system upgrades.
• Risks and Contingencies:
  • Hurricane Katrina: As of September 6, 2005, approximately 40 stores remain closed due to storm damage. Management does not believe the ultimate resolution will be material to financial position, though operations may be impacted.
  • Tax Matters: The company is pursuing a potential tax refund of up to $85 million plus interest related to foreign earnings for the years 1995–2000. A potential tax benefit of up to $74 million could be realized under the American Jobs Creation Act if a qualifying reinvestment plan is implemented.
  • Guarantees: The company holds approximately $321 million in remaining lease guarantees for divested subsidiaries (e.g., Abercrombie & Fitch, Dick's Sporting Goods), though the likelihood of material liability is considered remote.

Investor Verification Checklist

• Express Turnaround: Verify if the new denim investment and store traffic initiatives are stabilizing comparable store sales and margins in the Apparel segment.
• Inventory Levels: Monitor inventory turnover and markdown rates, particularly at Express, to ensure gross margin recovery.
• Debt Servicing: Confirm compliance with debt covenants given the increased leverage ($1.65B debt) and interest expense ($45M YTD).
• Tax Resolution: Track the status of the IRS appeal regarding 1995–2000 foreign earnings and the implementation of the reinvestment plan required for the American Jobs Creation Act benefit.
• Hurricane Impact: Assess the final cost of store closures and insurance recoveries related to Hurricane Katrina.