Bath & Body Works, Inc. quarterly report, Q1 FY2010

Business context and reporting period

The filing is Limited Brands, Inc.’s unaudited Form 10-Q for the thirteen weeks ended May 1, 2010, compared with the thirteen weeks ended May 2, 2009. Bath & Body Works is one of the company’s brands and reportable segments; these results are for the consolidated parent, not Bath & Body Works alone. The filing’s fiscal 2010 first quarter is the period covered, notwithstanding the request metadata identifying 2009 Q1.

Key financial results

• Comparable-store sales rose 10%, versus a 7% decline in Q1 2009. Sales grew 12% overall; Victoria’s Secret sales rose 12%, Bath & Body Works 7%, and Other 20%.
• Consolidated cash was $1.188 billion at May 1, 2010, down $616 million since fiscal year-end. Current assets were $2.687 billion and current liabilities $1.135 billion.
• Debt was $2.525 billion, down from $2.897 billion a year earlier. The company prepaid the remaining $200 million term loan in March and reported no borrowings under its revolving facility; $847 million remained available after letters of credit.
• Financing cash outflow was $570 million, including $373 million of dividends (the regular and special dividends together equaled $1.15 per share) and the $200 million term-loan repayment. Investing cash inflow was $11 million, including returns of capital from Express and Limited Stores.

Material changes and management commentary

Management attributed improved sales and margins to stronger merchandise assortments and lower promotional activity, as well as sales growth and expense leverage. Gross margin increased 4.1 percentage points, while operating expenses rose $26 million but fell as a share of sales to 26.4% from 28.0%. Segment operating income was $167 million at Victoria’s Secret, $38 million at Bath & Body Works, and a $20 million loss in Other.

Other income was $62 million versus a $1 million expense in the prior-year quarter. It included a $49 million pretax gain from an Express cash distribution that reduced the carrying value of the investment to zero at the distribution date. The company also reported a 39.8% effective tax rate, compared with 19.5%; the prior-year rate benefited from favorable resolution of tax matters. Q1 interest expense included $10 million from terminating interest-rate swaps.

After quarter-end, the company issued $400 million of 7.00% notes due 2020 and used the proceeds to repurchase $134 million of 2012 notes and $266 million of 2014 notes. It expects to record an approximately $25 million loss on that debt extinguishment in Q2. Express completed an IPO on May 13; the company sold 1.3 million Express shares, retained approximately 18% ownership, and expected to recognize an approximately $50 million pretax gain in Q2. It was evaluating whether to continue equity-method accounting for the remaining investment.

Outlook, risks and contingencies

No specific earnings or sales guidance is provided in the supplied filing text. Management said the retail environment remained uncertain and described a conservative approach to inventory, expenses and capital spending, while focusing on retail execution, merchandise, marketing and store experience. Management stated that available capital resources were sufficient for foreseeable requirements and that it was in compliance with credit-facility covenants at May 1, 2010.

• Disclosed risks include weak consumer confidence or spending, mall traffic and retail competition, seasonality, fashion and merchandise execution, foreign sourcing and shipping disruption, currency and interest-rate movements, credit ratings and debt service, and legal, regulatory and tax matters.
• The company had approximately $130 million of guarantees relating to leases of previously disposed businesses. Certain guaranteed payments totaled $80 million net of an Express letter of credit; the recorded fair value obligation was $8 million. No liability was recorded for other guarantees because payments were not considered probable.
• A securities class action filed in November 2009 against the company and certain officers remained pending. The company intended to defend it, but said it could not reasonably estimate a possible loss or range of loss. Management did not expect ordinary-course legal proceedings to materially adversely affect financial position or results.
• The independent accountant’s interim review was substantially less in scope than an audit and expressed no audit opinion; it reported no material modifications believed necessary for GAAP conformity.

Important facts for investors to verify

1. Confirm the period and entity: this is Limited Brands’ consolidated Q1 2010 report, not standalone Bath & Body Works or Q1 2009.
2. Assess how much reported pretax and net income reflects the $49 million Express distribution gain, and distinguish this from recurring operating performance.
3. Review cash conversion and working-capital seasonality: operating cash flow remained negative despite higher net income, and cash declined substantially following dividends and debt repayment.
4. Track post-quarter debt refinancing costs, the expected Q2 extinguishment loss, and the Express IPO gain and revised ownership/accounting treatment.
5. Monitor lease guarantees, the unquantified securities litigation exposure, credit ratings, and the company’s ability to sustain dividends while funding operations and debt service.