We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our investment in L Brands (LB).

Excerpt (Arif Karim speaking):

L Brands is one of the newer names in our portfolio. It is the parent company of specialty retailers Victoria’s Secret and Bath and Body Works. Last year, Victoria’s Secret did nearly $8 billion in sales, virtually all of it in the US while Bath and Body Works did nearly $4 billion.

The stock has been under pressure over the last year due to changing consumer behavior in the mall-based retail business, and we initially started buying when the stock had already declined about 30% from its high. Shifting consumption patterns and increasing ecommerce purchasing behaviors have led to significant declines in mall traffic and pressured most if not all mall-based retailers, especially since the promotions-heavy holiday season last year. Despite making our initial purchases at levels that we felt were a discount to intrinsic value, the stock has continued to decline and as Sean noted, it was our weakest holding this past quarter.

In addition, Victoria’s Secret has been in the process of discontinuing and clearing out less differentiated apparel and swim wear, which have distorted mostly stable underlying financial results for the continuing business. These two factors combined to create a lot of noise around the stock while fundamentals have been mostly stable in the underlying business. Once we get past these factors, we believe healthy trends will reemerge in the go-forward business in the US while traction in their new China strategy will refocus investors on the very profitable and large growth opportunity offered in the global market place as I’ll explain shortly.

So, the industry pressure in the near-term has given us the opportunity to invest in a very rare type of company in the consumer discretionary space; one that has a strong moat and global opportunity. After all, underlying demand for underwear is not being disrupted and neither are soaps, lotions, and candles. In addition, the branded experience is not being disrupted either as we’ll discuss.

L Brands is just really beginning to tap the global opportunity, beginning with China, a market as large as the US, where the company launched the first two Victoria’s Secret stores last month to great fanfare and long lines of customers. In fact, Victoria’s Secret’s annual fashion show, a spectacle viewed around the world, is watched by 400 million people…. In China alone! The brand is indeed a global one with 800 million people watching the annual fashion show each year, highlighting the power of the brand and the experience.

In China, it is launching with strong brand recognition into a large, highly fragmented market with no strong incumbent leader and a middle and upper class that seeks out branded goods and experiences. After all, the Chinese middle class buy 1/3 of luxury goods globally. We expect strong growth to follow over the next decade as stores are rolled out with strong complementary ecommerce sales. Other parts of the globe are being served by select franchise partners and also have tremendous sales growth opportunity ahead.

As a result, we believe the market is significantly undervaluing the brand, product moat, and global expansion opportunity because of near-term changes in consumer purchasing patterns in the US. An indication of this is its 5% dividend yield, which in today’s rate environment would only be justified by a permanently declining business or unsustainable dividend, neither of which we believe to be the case.

Ultimately, we believe that L Brands will be able to successfully navigate changes in retail shopping trends under the leadership of its founder and retailing genius Les Wexner, as he’s done for 50 years. The company’s robust and faster growing ecommerce business at 17% of sales demonstrates this, and it’s more profitable to boot!

So a little background — L Brands was founded by Les Wexner, literally the inventor of what’s known as specialty retail in the 1960’s, an era when one-stop shop department stores selling everything were the norm. His insight was to optimize return on capital by focusing on specific niche products that catered to customer’s needs but also had a high turnover rate on the racks while carrying healthy margins. His first store was the women’s apparel shop called The Limited, started in 1963.

Since then he created or acquired new concepts and developed them under the Limited Brands umbrella including Express, Structure, Abercrombie & Fitch, Victoria’s Secret, Bath and Body Works, Lerners, and White Barn Candle Co. If store recognition is an element of success, many of you will probably recognize a few of these names from your visits to your local mall, a testament to Wexner’s knack for retailing. He is regarded as one of the greatest retailers ever.

Over time, Wexner has spun out or sold a lot of these store concepts as L Brands has evolved with the market. Today, L Brands is predominantly comprised of the two retail brands with solid competitive moats and business models — Victoria’s Secret and Bath and Body Works. We believe these to be highly resistant to the kind of commoditization that internet retailers like Amazon are driving in the traditional retail world. Both businesses are vertically integrated – meaning they make their own branded products, which they sell through their own branded stores and websites, with strong product and brand loyalty, that deliver emotional experiences beyond the products alone. It’s the differentiated, experiential nature of the products that make them highly resistant to the permanent disruption we see across the retail space.

Diving into the business, Victoria’s Secret (and its younger PINK subsidiary) sells women’s underwear in a store experience that provides a specialized one for the women it targets, generally in the 16-35 age range. It has 35% market share, nearly 10 times its closest competitor, and sells 6 out of every 10 bras in the US. The stores serve as galleries for these high turnover products while the brand’s appeal allows it to earn a high margin, driving strong returns on capital and making the business very valuable.

Its consumers shop there because fit, comfort, and style are very personal and individualized aspects of the product and the well-trained service staff are available to help customers figure out the products that would be best for them in a comfortable environment. In addition, it’s a category in which price is a lower priority for a significant segment of customers, indicating that these customers are willing to pay a premium for the product when it meets their higher priorities. The products are highly designed to meet the paradoxical priorities of durability for everyday use while also being composed of seemingly delicate materials and providing the right fit for various body types.

Bath and Body Works (and its subsidiary White Barn Candle) focuses on fragrance products such as soaps, lotions, and candles. It is the leader in this segment as a focused specialty shop with a strong following among its customers.

Again, this is the kind of product that is highly experiential (as of yet, there’s no way to smell scents online!). This makes the store an important aspect of the shopping experience. It is also a consumable product business that caters to a fundamental building block of every human experience. Whether it’s a scent to use on yourself or to create a certain atmosphere in your home, Bath and Bodywork’s products help customers do just that. For many of their customers, the scents they’ve been buying for years are an important part of their everyday routine. Any time the company discontinues a scent it triggers panicked buying as customers stockpile scents that they’ve used for years and don’t want to lose access to.

From an ecommerce perspective, companies like Amazon are generally distributors of products. They make it difficult for other undifferentiated retail distributors such as Macy’s, JC Penny’s and Target to compete effectively because they all have access to the same branded or unbranded products, and Amazon generally has a much better and more convenient customer experience and a lower cost model to boot. The staff of Ensemble are all Amazon Prime members and we fully believe in the distribution dominance of Amazon over traditional retailers.

However, companies with differentiated products, durable brand appeal, and strong customer service or experiences such as Victoria’s Secret, Bath and Body Works or companies like Apple, Nike, and Tiffany, can largely retain control of the distribution and profitability of their products. Their branded products are sought after by customers who will leave the online mall called Amazon and go to the branded sites in order to purchase these differentiated products. At the same time, these types of retailers can sell through Amazon if it suits their interests.

This is exactly the type of companies that we can have confidence in the future of even as customer buying patterns change. They may buy differently, and sales may be lumpy in the near term as channels shift, but as long as they keep buying the products our portfolio companies make, we believe shareholders will be rewarded over the long term.

You can read a full transcript here.

Clients of Ensemble Capital own shares of Apple (AAPL), L Brands (LB), Nike (NKE), and Tiffany (TIF).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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