Time to Limit the Damage

Limited Brands' rationale for holding its apparel business gets shakier.
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Limited

(LTD)

shares took a beating Thursday as investors wrinkled their noses at foul second-quarter results from the company's apparel division -- Limited Stores and particularly its Express chain.

The retailer posted a loss, despite stellar performances by its crown jewels -- Victoria's Secret and Bath & Body Works -- and it trimmed full-year earnings estimates below Wall Street's expectations.

Contrarians could well view the selloff as a buying opportunity on the premise that the latest disappointment will force the retailer's hand on the issue of divesting the apparel brands. Without its lagging businesses, shares of Limited Brands could be undervalued.

So, will Limited's chairman and chief executive, Leslie Wexner, ever part with his company's namesake brand?

"That has been speculation for a long time now," said Morningstar analyst Brady Lemos. "So far, they haven't given any indication that they're going to do that, partially because Limited is the first brand that Wexner started with, so it's kind of his baby."

Despite any sentimental attachment Wexner may have for the Limited brand, he has shown a propensity for spinning off apparel brands in the past, and he's made no bones about relegating his baby to second-class status in the company's portfolio.

Limited has quietly transitioned itself away from the fashion-driven apparel space and exploited its sweet spot in lingerie and health and beauty products. A decade ago, apparel made up more than 70% of its business; now it makes up roughly 25%. Meanwhile, personal care products used to make up only 4% of its sales; that figure has grown to more than 30%.

The company's Limited stores used to number over 1,000, and now they've been pared back to roughly 400.

During this transition, Wexner unloaded a number of popular apparel brands -- many of which went on to be successful companies on their own. For example, Limited spun off

Abercrombie & Fitch

(ANF) - Get Report

, whose shares have soared 142% since the beginning of 2004. It sold Lerner New York to Bear Stearns, which has since taken it public as

New York & Co.

(NWY)

. The shares are essentially flat since it went public last October. It also spun off Limited Too, which is now a public company named

Too

(TOO) - Get Report

. Its shares are up 65% since the beginning of last year.

Throughout, Wexner held on to Limited Stores and Express, explaining to Wall Street that the apparel business runs in a counter-trend with its other businesses and act as a hedge when one or the other falls on bad times. Last year, the apparel business fell on bad times, as merchandising mistakes caused its core customers to leave its brands in droves. The company has promised a turnaround, but the latest quarterly results don't show much light at the end of the tunnel.

Limited said earnings for the second quarter ended July 30 fell to $113.1 million, or 27 cents a share, from $148.0 million, or 31 cents a share, in the year-ago period. Those results beat Wall Street's consensus estimates, thanks in part to share repurchases, but investors reacted negatively to the apparel results and the company's disappointing full-year guidance.

The retailer now expects to earn $1.36 to $1.38 a share for 2005, below Wall Street expectations for $1.40 a share, according to consensus estimates reported by Thomson First Call. It also expects a slight decline in August same-store sales, having previously estimated that sales would increase in the mid-single digits.

During the second quarter, its net sales rose 4% to $2.3 billion over last year. Its gross margin declined 150 basis points to 34.6%, while selling costs increased 3%. Operating income declined by $23 million.

Its apparel division posted a same-store sales decline of 10%.

"We clearly have a long way to win our core customers back that we spent all of our time last year alienating," said Paul Raffin, president of the Express division, on a conference call with analysts.

The most encouraging thing about Limited's apparel debacle is its willingness to acknowledge it. Executives have called the Express stores' performance "an embarrassment," but they still have not mapped a compelling strategy to turn it around.

The company hired a new apparel manager earlier this year, and said it will get more aggressive in canceling orders of merchandise that doesn't sell well. It also increased the amount of direct-mail advertising, and said it was changing its window displays in hopes of attracting more walk-by traffic.

These steps have not convinced Howard Davidowitz, chairman of Davidowitz & Associates, a retail consulting and investment banking firm.

"Express must go," Davidowitz said. "They stuck with Express and Limited, and what they've got now is an apparel division that is dragging down the multiple, the valuation and everything else in the entire company -- which is otherwise a pretty great company."

With Thursday's selloff, shares of Limited have shed 2.6% so far this year to trade at $22.11 -- roughly 14 times its earnings estimates through 2006.

"At this point, you're not really paying for the apparel business at all," Lemos said. "They're essentially just thrown in for free now. At this point, you're just paying for Victoria Secret and Bath & Body Works, which are two of the strongest retail chains out there. That's not a bad price."

Davidowitz agreed that shares would be undervalued now, as long as Wexner knows that his apparel business is not a hedge for the others.

"I don't see it as a hedge," he said. "I see it as a cadaver."