A share to reward shareholders handsomely

Traders have lost faith in evergreen fashion retailer Next, but at head office it's business as usual.

I've just spent an afternoon in the company of Next's annual report. The experience wasn't as bad as I feared. Next is the FTSE 100's 61st biggest company. The whole enterprise, debt and equity, is worth over £10 billion.

Big often means complicated, but Next's annual report is readable. The company sells mostly clothes, but also furniture and homewares, mostly in the UK, and mostly its own label, in shops and through Next Directory, a mail order business famous for catalogues that could stop a barn door. Although the shops earn more revenue, the two divisions tie in terms of profit, and Next Directory has grown much faster over the last five years, by 75%.

At 540 stores in the UK and Ireland, Next may have all but filled its home territory. The company operated only one more store at the end of the financial year than it did at the beginning, and most of the 3.7% increase in floor space was because the stores it finished the year with were bigger.

On a like-for-like basis, Next stores earned less revenue than they did in 2015 and Next is relaxing the deadline by which some of the stores it's planning to open this year must pay for themselves. Diminishing returns may be setting in.

For the 53 week year ending January 2016, Next increased revenue 3% and adjusted profit 5%, not a great year by its standards, and likely to be followed by a worse one. Early in May, Next warned revenue could fall by as much as 3.5% in the year to January 2017, which would cause profit to fall by nearly 9%. This is the lower end of a band of possibilities offered by the company, and small increases in revenue and profit are still possible.

An uncertain future

Next is worried about a reduction in consumer spending due to slowing growth in real incomes (after allowing for inflation) and a switch it has detected in our spending habits from clothes to going out. Travel and entertainment suffered most during the Credit Crunch, but we're spending more on them now.

Uncertainties about the immediate future may explain the 30% fall in the previously highly-rated firm's share price since it peaked nearly six months ago. If that's true, investors with longer-term vision ought to take note because Next has been a fantastically profitable business.

Return on capital in 2016 was 29%, which is not atypical, yet a share price of £53.95 values the enterprise at only 12 times adjusted 2016 profit. The earnings yield implies an 8% return if profits are sustained at current levels. If growth resumes, Next should reward shareholders handsomely, as it has in the past.

The problem with this rosy scenario is long-term growth may not come from the high street stores and catalogues that have produced it so far.

Candidates for growth

Likely candidates for growth include the bright spots in 2016's results, the relatively small proportion of Next Directory's sales earned abroad now Next has established distribution hubs in Russia, China and Germany, and sales through Label, part of Next Directory that sells non-competing fashion brands. Both grew full price sales by about 20% in 2016.

Whether plans to grow Next Directory can withstand heightened internet competition is another matter. The division only grew revenue 8% in 2016. In the UK full-price sales grew 5% including Label's contribution but the core business only grew 2%.

Competitors have caught up with Next's delivery and warehousing capabilities and customers have switched from buying on desktop computers to buying on their 'phones, apparently taking Next by surprise. Until very recently it was still serving mobile customers with its site for desktop computers. The company says a new mobile site is converting more browsers to buyers.

Annoyingly, I can't find a breakdown for Next Directory's revenues and profits by source: the internet or the catalogue, but the proportion of customers requiring large catalogues has fallen from 89% to 53% over the last five years, resulting in a reduction in customers paying by credit, a significant source of profit. The remaining credit customers are hard-core though, and spending on credit actually rose marginally.

One interpretation of the annual report is that Next's customers aren't just taking a break from buying clothes, they're taking a break from Next. Until recently its mail-order distribution system gave it an advantage against new internet competition, but the success of the catalogue may have hindered the development of Next's websites and online marketing. This year, ending in January 2017, Next is investing an additional £8 million in online marketing, but perhaps it's the one playing catch-up now.

An attractive idea

I like the idea of investing in Next. The stores hardly seem to have changed over the decades, yet remain fresh and modern. The fashion is reassuringly anonymous, perfect, I suspect, for people who want to be modestly stylish without really standing out: Grown-ups who don't want their children to laugh, their wives to groan, and their dads to borrow their clothes.

But the annual report hasn't given me a clear impression of what else distinguishes Next, and what advantages it has competing for mail order sales on the internet, except perhaps for one thing: good capital allocation, which is jargon for putting profit to work where it will make the highest return.

Companies have a number of options: They can invest their profits in more shops, warehouses, and better websites and systems like Next does, they can buy other companies, they can repay debt, or they can return money to shareholders through dividends and share buybacks so we can allocate the capital into other profitable investments.

Flawless performance

So far, Next has performed pretty flawlessly, investing profitably and returning surplus cash to investors, mostly through special dividends, but also through share buybacks when the shares are cheap.

Although, typically for a FTSE 100 company, the remuneration report is almost as big as a Next Directory catalogue and the pay packets as fat, there's also evidence the board is a little circumspect in allocating itself capital.

Payrises to new board promotions are withheld until they prove themselves, Next is not wedded to benchmarking remuneration to FTSE 100 medians (though it does consider them), and the chief executive has been known to redistribute some of his remuneration to staff.

When the share price fell below its £69 target in January, Next borrowed money to buy back more of its shares than it had intended to in 2016. It will pay the money back in 2017.

This discipline, to return money to shareholders rather than invest it speculatively may have been a significant factor in Next's steady growth, and it may well continue. Led by Lord (Simon) Wolfson, who has been chief executive since 2001, the board is both experienced and youthful.

It feels like a risky time to invest, because the internet has intensified competition and Next has work to do to keep up, but the record of Next's management is cause for confidence.

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.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard