BBWI

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended August 3, 2002, for Limited Brands, Inc. (formerly The Limited, Inc.). The company operates specialty retail stores and direct response businesses under brands including Victoria's Secret, Bath & Body Works, Express, and Lerner. A significant corporate event during this period was the March 21, 2002, acquisition of the remaining minority interest in Intimate Brands, Inc. (IBI), making it a wholly-owned subsidiary and resulting in a recombination of the two entities.

Key Financial Metrics

Material Changes vs. Prior Period

• Sales Performance: Reported net sales decreased 4% year-over-year for both the quarter and year-to-date periods. However, excluding the sale of Lane Bryant in 2001, net sales increased 8% due to a 4% rise in comparable store sales and the addition of 117 stores in the Victoria's Secret and Bath & Body Works segments.
• Profitability: Operating income increased 82% for the quarter and 74% year-to-date compared to 2001. This improvement was driven by a 2.7% increase in gross income rates and a 0.5% decrease in operating expense rates.
• Segment Results:
  • Victoria's Secret: Sales up 9% and operating income up 38% for the quarter, driven by strong bra/panty performance and fewer markdowns.
  • Bath & Body Works: Sales up 4% but operating income down 33% due to higher markdowns and an inability to leverage store costs against a 2% decline in comparable store sales.
  • Apparel: Sales up 4% and operating income improved significantly (from a loss of $50M to a profit of $5M) due to better inventory management and higher initial markups.
• Balance Sheet: Total assets increased to $6.14 billion from $4.00 billion in the prior year, primarily due to the $1.6 billion stock issuance for the IBI acquisition. Goodwill increased to $1.32 billion following the acquisition.

Guidance, Outlook, and Risks

• Capital Expenditures: Management anticipates 2002 capital spending to be $400 million or less, funded principally by operating cash flows. This is a decrease from the $209.8 million spent in the first half of 2001.
• Special Items: The year-to-date results included a pre-tax, non-cash special charge of $33.8 million related to the modification of stock-based compensation awards during the IBI recombination. Excluding this charge, adjusted operating income for the year-to-date would be $278.0 million.
• Legal Proceedings: The company is involved in various lawsuits, including labor practice claims regarding manufacturers in Saipan and shareholder derivative actions regarding the 1999 tender offer. Management does not expect these to have a material adverse effect. Settlement discussions are ongoing regarding shareholder litigation related to the IBI exchange offer.
• Risks: Key risks include changes in consumer spending, competition, weather patterns, reliance on foreign production, and the ability to secure suitable store locations.

Investor Verification Checklist

• Adjusted vs. Reported Earnings: Verify the impact of the $33.8 million non-cash charge and the exclusion of Lane Bryant sales when comparing 2002 performance to 2001.
• Comparable Store Sales: Confirm the 4% comparable store sales increase, noting the divergence between Victoria's Secret (+5%) and Bath & Body Works (-2%).
• Inventory Valuation: Review the company's estimates for inventory markdowns, particularly for Bath & Body Works where higher markdowns impacted margins.
• Debt Structure: Note the repayment of $150 million in notes in May 2002, leaving $248 million in long-term debt and a $1.25 billion available credit facility.
• Goodwill Impairment: Monitor the $1.32 billion goodwill balance, which is subject to annual impairment testing under SFAS No. 142.