Business Context and Reporting Period
This Form 10-Q covers Limited Brands, Inc. (parent company of Bath & Body Works, Victoria's Secret, and Express) for the quarterly period ended July 29, 2006. 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
| Metric | 13 Weeks Ended July 29, 2006 |
26 Weeks Ended July 29, 2006 |
13 Weeks Ended July 30, 2005 |
26 Weeks Ended July 30, 2005 |
|---|---|---|---|---|
| Net Sales ($ millions) | $2,454 | $4,531 | $2,290 | $4,266 |
| Gross Profit ($ millions) | $853 | $1,642 | $745 | $1,429 |
| Gross Margin (%) | 34.8% | 36.2% | 32.5% | 33.5% |
| Operating Income ($ millions) | $197 | $383 | $153 | $272 |
| Net Income ($ millions) | $113 | $213 | $82 | $165 |
| Diluted EPS ($) | $0.28 | $0.53 | $0.20 | $0.40 |
| Cash & Equivalents ($ millions) | $651 | $651 | $719 | $719 |
| Long-Term Debt ($ millions) | $1,665 | $1,665 | $1,646 | $1,646 |
| Operating Cash Flow ($ millions) | N/A | ($159) | N/A | $97 |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 7% in the quarter and 6% year-to-date (YTD) compared to 2005. Victoria's Secret sales grew 14% (quarter) and 12% (YTD), while Bath & Body Works grew 13% (quarter) and 10% (YTD). Conversely, the Apparel segment (Express and Limited) declined 11% (quarter) and 7% (YTD).
- Profitability: Operating income surged 29% in the quarter and 41% YTD. This was driven by significant improvements in the Apparel segment's operating loss (reduced from $59M to $31M in the quarter) and strong performance at Bath & Body Works.
- Gross Margin: The gross profit rate improved to 34.8% in the quarter (from 32.5% in 2005) and 36.2% YTD (from 33.5%). The improvement was primarily due to fewer markdowns at Express compared to the prior year, partially offset by increased markdowns at Victoria's Secret.
- Cash Flow: Operating cash flow turned negative, using $159 million YTD compared to providing $97 million in the prior year. This was primarily due to a $333 million increase in inventory to support sales growth and a supply chain system conversion at Bath & Body Works.
- Accounting Change: The adoption of SFAS 123(R) resulted in an incremental share-based compensation expense of $9 million for the quarter and $16 million YTD, reducing net income by $5 million and $9 million respectively.
Outlook, Risks, and Management Commentary
- Segment Performance: Victoria's Secret growth was driven by successful bra launches (Angels Secret Embrace) and the PINK sub-brand. Bath & Body Works benefited from the Signature Collection and new hair care lines. Express saw sales declines due to the anniversary of heavy clearance activity in 2005 but significantly reduced operating losses through better inventory management.
- Capital Allocation: The company repurchased $130 million of common stock YTD and paid $119 million in dividends. Capital expenditures were $249 million YTD, focused on new stores and technology infrastructure.
- Liquidity: The company maintains a $1 billion unsecured revolving credit facility with no borrowings outstanding as of July 29, 2006. Working capital stands at $1,231 million.
- Risks: Key risks include reliance on information technology systems, fluctuations in oil prices affecting transportation and utility costs, and the seasonal nature of the retail business. The company also holds approximately $234 million in lease guarantees related to divested subsidiaries, though the likelihood of material liability is considered remote.
- Guidance: The filing does not provide specific numerical guidance for the full fiscal year, noting that interim results are not necessarily indicative of full-year performance due to seasonality.
Investor Verification Checklist
- Inventory Build: Verify the necessity and timing of the $333 million inventory increase, specifically regarding the Bath & Body Works supply chain conversion and potential future markdown risks.
- Apparel Turnaround: Monitor Express and Limited Stores for sustained improvement in comparable store sales, as the current sales decline is attributed to prior-year clearance anomalies.
- Share-Based Compensation: Review the impact of SFAS 123(R) on future earnings, noting $42.6 million of unrecognized compensation cost related to nonvested options.
- Cash Flow Reversal: Assess the company's ability to generate positive operating cash flow in the second half of the year to offset the significant cash burn in the first half.
- Debt Covenants: Confirm continued compliance with fixed charge and debt-to-earnings ratios, though the company reported compliance as of the filing date.