Are Next shares really oversold?

To say unloved Next has struggled this year is an understatement. Granted, retailers haven't had it easy, but Next's Directory business has been flashing warning signals for some time as crucial credit customers dwindle. Last week's warning that this year could be its worst since the financial crisis has left the shares battered and bruised. They're now trading at a big discount to the sector, but is Next really good value, or a share to avoid?

Broker Numis Securities goes for the former. On the slide since early December, Next shares have slumped by over 30% since, although a period of calm from the beginning of 2016 has been bookended by two significant sell-offs.

After crashing 17% last Thursday through major technical support at 6,500p, Next shares now trade on less than 13 times earnings per share (EPS) estimates for the year to January 2017, a 15% discount to the sector. Numis thinks that's "good value", and analyst Matthew Taylor believes investors could receive a big chunk of Next's 7% free cash flow yield, too.

Despite the dramatic reaction to chief executive Lord Wolfson's shockingly bearish tone, Taylor is hanging tightly to what he thinks is a silver lining and has upgraded the stock to 'add'. The price target of 6,300p stays, too.

"The company's comments will either prove prescient, in which case it may be better prepared for the slowdown than its peers, or overly cautious, suggesting that the shares have been oversold."

Next didn't actually do too badly in the year to 30 January, but it was the surprise warning that 2016 could be its worst year since 2008 that plunged the share price to a two-year low. Driven by its credit business, the group's Directory division is a growing concern for many as the number of valuable credit customers declines.

With these shoppers worth around five times the annual contribution of cash customers, this accelerated decline is bad news, especially as the boss doesn't see levels stabilising for a number of years.

"The year ahead may well be the toughest we have faced since 2008," Lord Wolfson warned last week. "Our instinct, along with the volatility of our own sales, suggest that it would be sensible to prepare for a tougher economic environment. We are therefore revising our full year guidance for sales and profits in the year ahead."

Mixed forecasts

A red pen was taken to forecasts, and they now look quite different from estimates made in January of 1-6% growth in both sales and profit. Next now thinks sales could either fall by 1% or grow by 4%, while profit before tax could be anywhere between £784 million, a 4.5% decline, and £858 million, up 4.5%.

As it's early in the year, this guidance is suitably broad. Expecting an increase in revenue of 2% to £4.2 billion in the 12 months to January 2017, Numis downgrades 2017 adjusted pre-tax profit forecasts by 5% to £817.5 million in expectation of a flat year-on-year performance. Last year, Next made nearly £820 million.

A lot is riding on the seasons doing what they're meant to this year: if the sun shines in the summer and the frost bites in the winter, Next's seasonal ranges should fly off the shelves. That could deliver a positive surprise, but management is taking no chances and is improving its buying processes, expanding retail stores and cutting back on external costs.

By refreshing its recruitment methods, wallet share and newer business channels, management hope to also stabilise its Directory business.

Numis is confident this is enough: "Although the core business is essentially mature, we see enough levers for the group to deliver earnings before interest and tax [operating profit] growth of 3-5% per annum over the medium term, with EPS potentially higher if the mispricing of the shares continues."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.