Bath & Body Works, Inc. (BBWI) Q3 2018 Earnings Report, Transcript and Summary

Good morning. My name is Heidi, and I will be your conference operator today. At this time, I would like to welcome everyone to the L Brands Third Quarter 2018 Earnings Conference Call. I will now turn the call over to Ms. Amie Preston, Chief Investor Relations Officer for L Brands. Please go ahead.

Thank you. Good morning, everyone, and welcome to L Brands' Third Quarter Earnings Conference Call for the period ending Saturday, November 3, 2018. As a matter of formality, I need to remind you that any forward-looking statements we may make today are subject to our safe harbor statements found in our SEC filings. Our third quarter earnings release, additional commentary and earnings presentation are all available on our website, lb.com. As you know, 2017 was a 53-week year. All of the sales dollars, margin and operating income results discussed on this call are on a reported basis for the quarter ending November 3, 2018 versus October 28, 2017. Comparable sales are on a comparable calendar period, quarter ending November 3, 2018, versus 13-week period ended November 4, 2017. Additionally, all the results discussed on the call today our adjusted results and exclude the charges related to the closure of the Henri Bendel business and store impairments described in our press release. I'd also like to clarify that the fourth quarter and full-year sales-to-comp spread in our commentary yesterday excludes the extra week last year. Including the extra week, the sales-to-comp spread in the fourth quarter is negative 2 points and, for the full year, is 2 to 3 points. Stuart Burgdoerfer, EVP and CFO, and I will handle the call today. As you know, we have leadership transitions in the Victoria's Secret Lingerie and PINK businesses, and our other leaders are focused on executing the important holiday time period. Thanks, and now I turn the call over to Stuart.

Thanks, Amie, and good morning, everyone. As outlined in the third quarter commentary that we released yesterday afternoon, the L Brands management team is very clear-minded about where we are. Parts of the business, Bath & Body Works, Victoria's Secret Beauty and our international franchise business are performing very well. However, our overall results are unacceptable, driven by declines in Victoria's Secret Lingerie and PINK. We made some important decisions in the quarter, including the decision to close the Henri Bendel business, pursuing alternatives for La Senza and reducing our dividend and committing to deleverage to enable us to increase our focus on our core businesses and strengthen our company in the long term. Our #1 priority is improving performance at Victoria's Secret Lingerie and PINK. We have new leadership in place or to come. Amy Hauk has joined the PINK business, and John Mehas will be joining us from Tory Burch in early 2019 to lead the Victoria's Secret Lingerie business. We're committed to a full review of the business. Everything is on the table, including our brand positioning, marketing, talent, real estate, cost structure and, most importantly, our merchandise assortments. By executing against our strategy, focusing on the fundamentals, staying close to our customers and leveraging the strength of our brands, we will deliver on our commitments for our stakeholders, customers, associates and shareholders. Thanks, and over to you, Amie.

Thanks, Stuart. That concludes our prepared comments. And at this time, we'd be happy to take any questions you might have. In the interest of time and in consideration to others, please limit yourselves to one question. Thanks, and I'll turn it back over to Heidi.

[Operator Instructions] And your first question comes from the line of Alexandra Walvis with Goldman Sachs.

You mentioned in the -- you mentioned that you were looking at some, potentially, bringing back some of the categories that you have been in before, including swimwear, footwear, eyewear. Could you talk us through a little bit what that might look like? Why the choice of pursuing those via licensing arrangements, for example?

Sure. Thanks for the question. Well, it's an important decision and, fundamentally, a decision that reflects listening to our customers. We'll be back in the swim business in the spring of 2019. And as we shared in our circulated commentary, we're going to be entering some other exited categories. We've already begun marketing and selling of boots, for example, but also eyewear and other license businesses. And importantly, we'll be back in the swim business in 2019. Naturally, you would have follow-on questions about specifically when and how much and a quantification of those things. We are developing our plans in detail. Nothing more to share today. But again, a very important decision to re-enter some important businesses and pursue other growth initiatives through a licensing approach.

From the line of Paul Lejuez with Citi Research.

You mentioned everything's on the table. I'm curious where you're putting your emphasis currently, spending your time. How is Les spending his time? And I'm also curious if all of this work is happening now on the Victoria's Secret side or if we have to wait until John gets there before we start to see maybe some changes. And also curious just about the decision for Les to not be on the call today.

Sure. So Paul, in terms of just taking a fresh, hard look at everything, I mean, it starts with decisions that we've announced. So eliminating losses related to noncore businesses, Bendel and La Senza previously announced. But important and aggregating to about $85 million of annual operating income, a big decision in part of "everything." The re-setting of the dividend to better match the operating results of the business in consultation and approved by the Board with outside advice, also a very important decision. But most importantly, as shared in the remarks and circulated remarks and even already this morning, the most important thing that we can do and that we're focused on is addressing the opportunities in the Victoria's Secret Lingerie and PINK businesses. And first and foremost, again, consistent with our mindset over a long period of time, it does start with the merchandise. Leadership is critical. We've got new -- Amie rejoining or joining the PINK business recently and John coming. You're asking if we're looking at everything now or whether some of that will wait. Certainly, everything is on the table, but understandably, some of these things will take more time than others, and some of them, importantly, will be led by -- the evaluations will be led by Amie and John, respectively. So broad in scope. Timing will depend on the nature of the opportunity. Not all these things will happen overnight, as you can appreciate. But importantly, nothing is off the table, meaning we are fundamentally looking at and will look at everything.

Les on the call.

Les on the call, we've got a good management team here, and I spend a lot of time with the Wall Street community and I'm comfortable representing the company in this forum. Les spends time with investors, and we'll have an investor update sometime in the first part of 2019, and certainly, Les will be critical and lead that update.

Your next question is from Ike Boruchow with Wells Fargo Securities.

Maybe, Stuart, for you. I guess, I wanted to ask about merch margins at Victoria's Secret and your promotional cadence in general. I guess, maybe could you talk about where -- I don't know how you want to maybe go into this, but maybe where your markdown rates are today versus history? And kind of maybe, is there or should there be a larger focus on inventory management within Victoria's and an AUR improvement, as you're kind of attempting to re-base this business and you bringing back swim and maybe get some traffic back in the stores? But just to kind of create a healthier VS business in which you can ultimately begin to grow against.

Thanks, Ike. So in terms of merchandise margin rate and merchandise margin rate improvement opportunities, first and foremost, Ike, it starts with the quality of the merchandise. And what I mean by quality is the strength of the customer response to what we're offering her. And if it's fresh and new and compelling, obviously, your opportunity for full-price selling and healthy margins is very strong. And when we're running our businesses well, that's what we -- we're able to deliver. Bath & Body, for example, is delivering that now consistently. And Victoria's, in its periods where it's had its strongest performance, has also delivered that. So it really does start with the quality of the merchandise. With respect to what's going on now with respect to margin rates and an important connection that you make and, certainly, we make to inventory, margin rates, particularly in the PINK business, were pressured in the third quarter and deliberately so on our part. We launched the fall season with a distortion into bling, apparel with a lot of embellishment and a lot of investment in the product. The customer didn't respond to that in the way that we hoped for. We didn't get paid for that investment. And we very aggressively took markdowns to clear through much of that inventory in the third quarter, which put a lot of pressure on the PINK margin rate, which had a big impact on the overall segment margin rate. In addition, that investment in the product drove our average unit costs up, and again, as I mentioned, we didn't get paid for it. So a lot of pressure in the PINK margin rate in the third quarter because we took a risk going into the fall season about -- a merchandise idea about embellished bling in apparel, I'm summarizing, and didn't get paid for that. But once we saw that, our view was, let's clear it. Let's get through it. Let's adjust this quickly as we can. Amie has been very focused on that since joining the business, adjusting the assortment as quickly as possible. As you know, things got short lead times and a mindset to adjust quickly, and they have, but it put a lot of pressure on the margin rate. And importantly, PINK ending the third quarter, moving through substantially all that inventory, the AUC pressure will go on a bit more into the fourth quarter because we haven't sold through all those bits, but substantially all of them. Our commitment to inventory management, Ike, has been strong over a long period of time. We certainly made some investments in the lingerie business through the last couple of years, some of which paid off, some of which have not. But as we've indicated previously and reiterating today in this update, we're very committed to ending the year with inventory in a good position quantitatively and qualitatively. And it does put -- to get to that place, put some pressure on the margin rate. All that said, I'd just come back to the beginning, is leveraging our speed capabilities, which we have substantially developed over the last 10 years and based on the quality of the merchandise, those are the key drivers of driving rate and dollar growth in the business. And the business is very focused on the assortment. So that'd be our mindset. Thanks, Ike.

Your next question comes from the line of Mark Altschwager with Baird.

This is Drew North on for Mark Altschwager. Folding up all the changes that you've announced thus far, meaning the closure of Henri Bendel, the potential actions on La Senza, the asset impairments, along with the fact that you're lapping the Angel Card reallocation and incremental wage investments, do you see a path to stable EBIT margin next year? And then as a follow-up on that, how should we think about the margin architecture for the Henri Bendel and La Senza businesses as those operating losses go away? Is that a bigger benefit to gross margin or the SG&A build?

Okay. Thanks, Drew. Generally, with respect to 2019 views, as you know, we'll provide detail about that in February. So not going to get ahead of ourselves with respect to a '19 view of the P&L and operating income rates and so on. With that said, there's substantial opportunity to improve the profit rate in the business. The question will be the time frame that it takes to achieve that. There have been significant operating income rate pressure in the Victoria's Secret segment, driven in meaningful part by both margin rate -- merchandise margin rate decline and deleverage of occupancy and SG&A expenses. In terms of the Bendel impact, the most important impact is the elimination of that loss that I commented on earlier of an aggregate about $85 million. As to how that breaks by line, we'll detail that if it's material as we do our guidance for 2019 in February. Other aspects for the question?

No.

Hopefully, Drew, that's helpful to you. But the biggest operating income rate improvement is, obviously, related to the Victoria's Secret North America business. Again, in terms of a decline versus peak, not quite equal parts but pretty close between merchandise margin rate decline and expense deleverage. Volume will solve that, along with some work on rationalizing real estate where we can and a fresh, hard look at the cost structure that we alluded to in our circulated remarks. Thanks.

And your next question comes from the line of Susan Anderson with B. Riley FBR.

I was curious about the international business, I guess, for VS. Have you seen the same underperformance, particularly in the Intimates business, that you've seen in the U.S.? And then also, I guess, if you have -- if you have not, I guess, what's the difference there that you think is driving international to perform better?

Susan, the short answer to your question is, generally speaking, we have seen the same challenges with respect to the Intimates business in the international markets as we've seen in the United States. So the challenges we've seen in the States have also played through in the U.K. and other parts of the world.

And your next question comes from the line of Brian Tunick with RBC.

I guess, Stuart, curious maybe if you can share with us a little maybe the Board's thinking about what John brings to the table. Obviously, Jan from Spanx and Nike, just maybe give us a sense of what John brings to the table, why he's the right guy now, given all these changes. And then secondly, maybe, Stuart, talk about the balance sheet and maybe whether a leverage ratio. But sort of like what are the contexts that you're looking at here, before maybe equity shareholders might get any of the free cash flow after the debt paydown?

Sure. So as it relates to John, Brian, you've been following the industry for a long time, been following us for a long time. You know how important the merchant leadership is in these businesses. It's just so critical. And the management team here was very -- tried to be very thoughtful and considered the decision very closely as we evaluated leadership for both PINK and Lingerie. As to John specifically, he is a very accomplished retail leader. He's got a very strong reputation with those that he's worked with most closely. He's worked in some of the most successful and with the most successful retail leaders in the industry and in periods of time, whether it was at the Gap or at Ralph Lauren, periods of time where those businesses had very strong results in their heydays, if you will. He has served female customers for meaningful and substantial parts of his career. John has got very strong business acumen. He's got a lot of substance. He's been involved in and led turnaround and high-growth situations. And in summary, Brian, we're very pleased that John will be joining the business. Thanks.

Balance sheet.

And with respect to balance sheet, we're not formulaic about it, Brian. But obviously, the ratios, whether it's the dividend payout ratio, the yield, the adjusted leverage ratios, have gone out of the historic ranges for us. And so the Board, again, with outside advice and very deliberately considered by the Board and approved by the Board, we made an important decision to reduce the dividend from $2.40 annually to $1.20. In terms of the cash freed up -- and some of this will be dynamic, obviously, as operating results play out over the next few years, but deliberate discussion about what we'll do with that cash. And as indicated in our commentary, in the release and in our circulated commentary, that freed-up cash will be used principally to reduce debt in the near term. We're more comfortable with a leverage ratio in the mid-3s. Again, not formulaic about it, but it's risen meaningfully as the operating result in the business has declined and made an important decision to re-set those things over the next few years with the decision, beginning in March, to reduce the dividend. As to how and when some of that freed-up cash gets back to shareholders, obviously, our long history has been to return excess cash to shareholders, as you know, through a combination of regular dividends, special dividends and share repurchase activity but, at this time, felt it appropriate to make the adjustments we've made. Thanks.

And your next question comes from the line of Jamie Merriman with Bernstein.

Two things you said in the release, one was about international and the real estate strategy there. So I was wondering if you can just talk about how much flexibility you have with your real estate strategy internationally and what that might look like? And then the second one, which you talked about, Victoria's Secret reassessing internal talent. And so I was wondering if there's other things you expect we should look for in terms of key roles to be filled or changed.

On international real estate, first and foremost, we've had some important learning from our recent results. So as it relates to opening new stores, the number of stores, the size of stores, et cetera, we made, I think, significant adjustments in terms of what we're doing for company-owned markets for Victoria's Secret, meaning smaller stores and a substantial reduction in activity at this time. So that's the first point I'd want to register. The second point I'd want to register, and I think it's the thrust of your question, is what can we do? What are our real, practical options with respect to existing real estate? And as you appreciate in the question, some of the lease terms internationally tend to be longer lease terms. Most of the lease terms, for example, in the U.K. are 15-year leases versus the more typical 10-year leases in the United States or Canada. So we don't have as much flexibility. But with that said, we're going to take a hard look at it. We're taking a hard look at it. We'll continue that review over the next several months, and it's an important part of the management of the business. But again, I would also reemphasize the first part, which is as it relates to further real estate activity, opening new stores and the size and nature of stores that we continue to open, we've made some important adjustments in China; smaller format stores and a meaningful reduction in CapEx for Victoria's Secret in the United States, in Canada and the U.K. with a very substantial reduction. On the flip side of it, we continue to invest in Bath & Body Works remodels because the performance of those projects, the return of those projects has been very, very good. And we continue to see about 20% sales growth with respect to those projects and, as we've mentioned consistently, a much stronger experience for the consumer and setting the business up well for the next 10 years, if you will, in terms of a fresh, relevant, compelling environment for customers. So important adjustments in Victoria's. Some lack of flexibility based on lease term, but we will take a hard look at it. Adjustments there in terms of learning for Victoria's and a continuation of investment at Bath & Body, again, given the strong, positive response from customers translating through to sales and a good economic result for that business.

And Jamie, the reference to talent in the Victoria's Secret portion was really just referring to the changes in leadership with Amie and John.

And your next question comes from the line of Kimberly Greenberger with Morgan Stanley.

Stuart, I wanted to ask about the traffic-driving promotions that are going on at Victoria's Secret. Obviously, there will be promotions and markdowns to clear through product mistakes, and we would expect that those would remain over time. And hopefully, the mistakes will just -- will lessen with time. But that's just one piece of it. On the traffic-driving promos, that also seems to be eating away at the merchandise margin, and I'm wondering what are the criteria that you're looking for that would give Victoria's Secret confidence to step away from those traffic-driving promos? Is it a certain level of store comp? Is it a certain level of store traffic? And then as you evaluate your real estate portfolio, particularly here in the U.S. where you've got a great deal of flexibility, what are the criteria that you're considering whether or not to close those stores?

Okay. So Kimberly, on promotions at Victoria's Secret, the first and, I guess, the most fundamental answer to your question is on the most significant promotions, what we do is we test them. And we test them in a set of stores and compare the results from those tests to balance the chain and match stores. And what we're looking for is incremental sales and incremental margin dollars. So that's a critical input to a decision about the need to drive promotions into the store or traffic into the store. We also try to more qualitatively access impact on brand and also, separately, look at the need to drive trial and acquire new customers. But in terms of hard evaluation, we test the most significant promotions, and we look at, are we getting a better result or not in terms of sales and margin dollars? Obviously, you appreciate, you mentioned in your comments, there can be periods of time where we're driving particularly intensive amounts of promotion of declared goods and clear mistakes. But as it relates to just driving footfall into the stores, it's -- does it drive sales, margin dollars, trial, customer acquisition? Most important criteria are financial ones versus balance a chain or match stores. So that's how we think about them. With respect to real estate, fundamentally in the United States, fundamentally, it's a financial decision but it's one that considers sales transfer of nearby stores and to a lesser extent, we're getting more learning on this, any sales transfer that may go to the online or direct business. So it is simply what are the costs to exit a store and how does that relate to the ongoing cash flow effect of the store in question and the sales transfer to nearby stores. So principally, a financial evaluation with some qualitative assessment based on quality of venue and looking at things over the prediction over the next 2 or 3 years felt in a particular trade area or venue. We have been doing -- as you know, Kimberly, we close a lot of stores every year. We're doing some more purpose testing for Victoria's around closing some stores that may not be as obvious financially but really observing the sales transfer effects. We have rules of thumb. We've closed a lot of stores over time, but we're pursuing a little bit more of a learning agenda there in a couple of situations that we might not naturally close to see if the expected sales transfer results hold up in these few tests. But it's a financial decision fundamentally. Thanks.

Your next question comes from the line of Paul Trussell with Deutsche Bank.

You have emphasized in the release and comments this morning that merchandise sounds like the root of the VS and PINK issues. If maybe you can just elaborate a bit more on what the customer feedback and response has been regarding what hasn't worked or, perhaps, what steps need to be taken, where -- what your areas of focus are in terms of taking steps to improve the merchandise. And then separately, if you can give just a little bit more, Stuart, on puts and takes on the margins kind of by segment, right? So in BBW, just kind of what's working there? And how should we think about the ability to continue to see further progress in overall operating income? And then on the VS side, you mentioned the PINK impact. Can you quantify that at all? And how should we think about overall markdowns versus occupancy shrink and other factors that may have impacted margins?

So on the merchandise, fundamentally, it comes back to -- and I apologize if this seems basic or obvious, and I'll try to provide some examples to bring it to life in our business. If it's fresh, new, distinct, compelling, she responds well to it, and we get paid for that work through volume and pricing. Examples within Victoria's Secret would be the T-shirt bra, which has been a very, very strong success. Selling in the mid-$20 range, been priced up multiple times, has Victoria's Secret prominently as part of its look on many of the straps that are sewn on that bra in terms of her interest in the brand and been a terrific success. Another example of success would be the Illusion bra within Victoria's Secret, which sells in the mid-$30s, so a higher-priced bra. And it's got a fabric and a fit and a feel that is well-received by the customer and has driven a lot of volume at a very healthy margin rate. So those would be 2 examples within the bra business at Victoria's that have worked very well. Conversely, where we've got bra franchises where we haven't had enough innovation recently, the Body by Victoria franchise or the Angels collection within the bra business, we've had softer results and more challenged results, and we've had to take pricing down and be more promotional to drive reasonable volume, et cetera, in those businesses. The sleep business at Victoria's, an area of distortion for us this fall and very relevant to this time of year. Very strong consumer response to that assortment. It's been heavily tested. We're making a big investment in that business this fall. And based on testing, we're optimistic that we will deliver meaningful growth at a healthy margin in that business. In the beauty business, Greg has had 6 quarters of positive comps in that business and margin dollar results getting stronger and stronger with a potential for a very good fall season. Driven a very good mist business there, leveraging speed and fashion in that business and the customer responding well; having some good, strong fragrance launches, fine fragrance launches in that business. So we've got examples of things within Victoria's that are working well that I've provided, and then we've got some other examples that are not. The bling business in PINK took a point of view from a fashion standpoint, and the customer didn't respond the way that we hoped. And the fleece business has been soft there as well. And then, again, on the other side, you always have things that are working and that aren't. The sport business within PINK is working well; sleep in that business also working well; and sherpa, and this is a broad-based trend in the industry, but our offerings in sherpa selling through very well with a very strong response to it. So that's kind of how it goes on the merchandise, and that's why it's so important is how do we make sure that we're very close to the customer? How do we leverage our speed capabilities to have more of the good stuff and less of the bad stuff? And that all starts with merchant leadership and strong execution of fundamentals in these businesses. With respect to puts and takes on margin, there are a lot of puts and takes. I think, sensing from your question, Bath & Body broadly, has just had a very strong run and the team there are working hard to continue that into the important fourth quarter and beyond into 2019. Importantly, they're having strong business in each of their major merchandise categories, so hitting on all cylinders, if you will. Not complacent about that in any respect. They're working very hard to continue that trend. And when you're hitting on all cylinders, as they have been, you're able to reduce your degree of promotion accordingly and still get a very strong overall result. In terms of what's reflected in our fourth quarter guidance, we have a little bit more of a conservative assumption just going into the fourth quarter, and on their margin rate, we'll hope to do better than that. Obviously, the business is incented, and we'll work hard to strike the right balance in promotion. And there might be a little bit of upside there, depending upon how things go, a lot of business yet to do in the fourth quarter. But there are a lot of puts and takes on margin rates. Obviously, ongoing pressure in the Victoria's segment. And again, I tried to provide a little background just now on our assumptions for what -- the results of what happened in the third quarter for BBW and our mindset as we go into the fourth quarter. Thanks.

Your next question comes from the line of Omar Saad with Evercore ISI.

Most of my questions on VS side of the business have been asked and answered. I wanted to ask about BBW, though, as you go through the re-set on the Victoria's Secret side of the business. It's great that the strength in BBW, the margins, the growth rates. As you think about some of the pitfalls that hit VS that you're now reevaluating with everything on the table, how do you ensure the Bath & Body Works business stays -- strength continues, gives you the flexibility to do what you need to do on the Victoria's Secret side? Some of the pitfalls on the Victoria's Secret side, how do you keep that from happening in the BBW side? And any sort of insights into, I mean, how that business continues to grow the way it does, new customers versus deeper spend from existing customers, the reliance on promotions, et cetera?

Yes. So Omar, it's a good question, and it's one that we think about a lot. As -- in backdrop or a reminder on Victoria's, for meaningful periods, years through 2015 for Victoria's, PINK was driving the majority of growth in that business. And I mentioned that as it relates to your question on BBW about how do we make sure, how does that team make sure, and Nick and team are very focused on this, how do we make sure that we're delivering balanced growth and appropriate growth in all of the major books of business? And so, as you know, that home fragrance business within Bath & Body has been so strong and driven just outstanding growth. And the management team there, led by Nick, are very focused on how do they make sure that they continue to have strong results in their books of business beyond home fragrance, the original core of the business in terms of body care. And as I commented on a minute ago, one of the really encouraging things is through that focus. And they don't always get it exactly right, but they drove a lot of change in 2017 and then more change from learning in '17 into '18, now are having very good results, in addition to home fragrance, in the body care business, in the hand soap business, in the giftable parts of their businesses. So first and foremost, it's about making sure that you have balanced growth, meaningful growth in your major categories of business. But really, even before that, it is about the stability and capability of the management team. And Les, Nick, very focused on that, the Board focused on that in terms of how do we ensure that we have the right leadership and, where appropriate, that we have the right stability in that leadership. So those would be thoughts. I think the other mindset within Bath & Body, and I'd like to think this is true for the whole company, but I think Bath & Body does it particularly well, is just very regular testing in the business, whether it's about a new product acceptance or key promotions or key time periods or, for that matter, selling models or selling concepts or things that they do in the online business. This mindset of taking risk, testing, learning, adjusting quickly to drive the business, I think Bath & Body particularly executes those tests very, very well and it's an important ingredient to their success. So hopefully, Omar, that gives you some backdrop on how we think about it. Thanks. Yes.

Your next question comes from the line of William Reuter with Bank of America.

My question is, you talked about an absolute reduction in debt, but you don't have a lot of debt that's callable. You do have a couple of bonds that come due over the next couple of years. I guess, would you consider taking those out ahead of their maturity date? Or I guess, how would you go about reducing your debt?

Yes. Most of it will come through the normal financing activities. So we've got $2.6 billion worth of debt coming due over the next few years. And as we roll that debt over, we'll be reducing amounts outstanding as those maturities come. There will be select opportunities to reduce debt in advance of maturities. And where it makes economic sense to do so, and that's a complicated evaluation that I think you probably appreciate, we will pursue those opportunities where it makes economic sense. But most of it will likely happen as debt comes due. Thanks. Yes.

Your next question comes from the line of Oliver Chen with Cowen and Company.

This is Ross Collins on for Oliver. Just on the VS side, we'd just love to hear any thoughts around your digital strategy in terms of what's working versus where the biggest opportunity might lie in terms of connecting with both current and prospective customers. And then, just more broadly, how do you think about your digital platform versus your store base in terms of engaging or re-engaging new or lapsed customers? And then secondly, just a clarification on leverage -- the financial leverage target. Was that a gross or a net debt-to-EBITDA figure?

Sure. So on our digital business at Victoria's and digital strategy, I think as you appreciate, we view it first in terms of where we are today as a very strong and successful business. The penetration rate is high. Again, for L Brands, in total, over $2 billion of online business, I think, underappreciated by the marketplace because we also have a meaningful store business. But we have a $2 billion online business at a very high profit rate. We think one of the disclosures are not consistent externally, but we believe and we've commented on the profitability of our online business at north of 20% EBIT rate. So substantial in size, highly profitable and growing at a very healthy rate. So just important to register all that, and I realize I'm doing a bit of a commercial there, but it's important to understand that about our business. The next thing I would say about the business is that we are investing meaningfully in that business. And in fact, as we reviewed our capital spending plans with the Board recently, we expect to double the investment in the digital business in 2019 versus 2018. So substantial investment in that business. You may be aware that the largest technology, most significant technology project that we've got going in our company right now is the re-platforming of the Victoria's Secret digital business that will enable us to do a lot of things for the customer that, at present, we're not able to do. Things like buy online, pick up in store, fulfilling from multiple DCs, other benefits for the consumer, including globally, those things will be rolling out over the next couple of years. But we're re-platforming that site today. So very healthy business. There are functions that are available to the consumer that others provide that we'll be pursuing over the next couple of years. But again, we are making very substantial investment in that part of our business. Second part of your question was about -- Amie, I'm trying to remember.

Leverage.

Oh, leverage ratio. So that is -- we look at it on a...

Adjusted debt-to-EBITDA.

Yes. He's asking about net versus gross of cash, though.

Yes. Looking for it.

Yes, we look at it -- thank you, Amie. We look at it on a gross basis. Thanks. And again, we're not overly formulaic about it. But again, our ratios are higher than they have been, and we believe it appropriate to reduce the overall debt level and return to ratios closer to where they were in, say, 2015. We'll do that over the next few years. Thank you.

Your next question comes from the line of Adrienne Yih with Wolfe Research.

Stuart, so my question's twofold. One is on merchandise. So the decision to exit swim, to re-enter it in some format next year, the miss on bling, in the past, you've done testing and sort of more reading and reacting to how the customer would respond to such movement. Wondering if -- what's telling you to go back into swim now? And how is that decision made amongst the kind of senior level management? Secondarily, on the inventory, it's been up in the mid- to high-teens and I assume distorted more so at Victoria's Secret. When you bring that "in line," I think you said with sales at the end of the year, should we expect the AUR will be better but that the comp at VS would probably decelerate? We've seen many retailers kind of go for profit maximization, and that's sort of in the result.

Okay. So on swim, we are where we are. I'm not going to spend a lot of time looking back, frankly. I mean, you can look back and learn, but I'm not going to go into that at length. As to why we made the decision that we did it, fundamentally, it's about what the customer is telling us. And again, one could question the original decision. Again, the decision at that time was to focus our energy and our resources on our most critical categories, that being bras and panties at Victoria's Secret Lingerie. But as we evaluate the situation today, a very important decision and we believe a good one, to re-enter the swim business again, driven principally by customer feedback that we've received. So -- and again, there will be more to come on that as we further develop and detail out our plan for 2019. With respect to inventory levels and merchandise margin rates, again, the driving commitment for us as we work through the fall season and ensure that we're in a good position to have a strong 2019 is we're going to end inventory clean quantitatively and qualitatively. And yes, you're right to observe that, at times, that can put pressure on the margin rate. And we saw that some in the third quarter with PINK as they moved through goods that they needed to move through. But again we want to, from a customer point of view, we want to start with a fresh, compelling assortment as you begin important time periods as -- and working to do that as we start this fourth quarter for PINK. And we'll ensure that, for the business in total, that, that's how we end 2019 -- or excuse me, 2018, as we get started into 2019. The amount of pressure on margin rates will be something to see as we move through the quarter. Thanks.

Your final question then comes from the line of Janet Kloppenburg with JJK Research.

Stuart, I was just wondering if you could talk a little bit more about the PINK business. You talked about clearing out the loungewear that you didn't -- you know, was a bad bet you didn't get paid on. Do you feel like now the assortments are more in line with where they should be or, like the Victoria's Secret Lingerie business, there's a lot of work to be done there? I just hope to get your perspective on the degree of turnaround effort that will be required to bring growth back to PINK.

So Janet, just in candor, that's one of the hardest things for anybody to evaluate, which is probably why you're asking about it. And I respect the question. What I do know is that Amie is a very talented leader that has spent 10 years with us and a lot of time prior to that in this industry. And her curiosity, her energy, her action orientation, her understanding of the business end-to-end is very, very strong. With that said, Rome wasn't built in a day, as you appreciate. And so do I believe that Amie is making a difference? Absolutely. Do -- can we predict when that translates through to sales growing 5% to 10% and margin rates up meaningfully year-on-year? I think the time will tell as to the time frame involved in that. But what I do know is that Amie, along with some others that are very talented within the PINK team, are very focused and working it very hard. But it's a really hard question to answer. The good news is we give the -- our investors regular updates on our business, and we'll be sure to be commenting on progress in the PINK business through the fourth quarter. Thanks. Appreciate it.

Thanks, Janet. That concludes our call this morning. Thank you for joining us. We'd like to wish everyone a very happy Thanksgiving.

Thanks.

This concludes today's conference call. You may now disconnect.