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Next shares are a 'tough hold'
By Richard Beddard | Thu, 11th May 2017 - 17:14
If Next's retail business recovers its shares are currently good value, argues companies analyst Richard Beddard. But there's a problem.
I need to talk to you about Next (NXT). I'm thinking of making a tough hold.
A tough hold? WTF's that?
I'm about to show you…
OK. But first, remind me what attracted you to Next?
The chart looked a bit better last year, before I added the results for 2017. Next is a hugely profitable company. I thought it could continue that way, albeit with occasional setbacks, due to the firm's experienced management, and reputation for quality, service and style.
It wouldn't top the rankings in any of these categories, but combined they make Next a pleasurable, mainstream shopping experience. In many ways it's a really balanced company, and that has earned shareholders terrific returns.
So performance has dipped at a quality firm. Why the big frown? Perhaps it's a buying opportunity?
It may well be. But as so often happens with me, I'm learning after a year of ownership, that things are more complicated than I thought.
Take a look at this:
The chart shows a sharp decline in retail profit in the year to January 2017 only partly offset by increasing profit from Next Directory, Next's online and catalogue business.
It gets worse. A trading update earlier this month revealed Next expects total revenue to fall marginally and profit substantially, by between 6.4% and 13.9% in the year to January 2018.
Next had been able to grow revenue and profit, even while like-for-like retail sales have fallen at an average annual rate of 2% over the last five years, by opening new stores, increasing profit margins and growing Next Directory.
For a while, at least, it looks as though Next can no longer make good lost sales.
Problems, problems. Are they temporary? Or is the retail half of Next's profit under threat?
Pass?! You can't pass. This is the big question isn't it?
It is… But… It's… A... Difficult… Question...
Some of the damage is temporary, or at least limited.
Next reports a shift in consumer trends. Currently we're spending more on experiences, like travel and eating out, than on things like clothes and furniture. Someday, we'll probably look at our tattered wardrobes full of Hawaiian shirts and splurge on clothes again.
The business is adjusting to higher import costs due to the weaker pound, but it might just as likely benefit from a strengthening pound in future.
It's also blundered. In haste, to introduce the latest fashions, Next has neglected staple items. The range has holes, which Next is plugging.
I don't think these issues need to worry long-term shareholders, but people are looking at the high growth rates of online retailers and thinking there is a good chance the game is over for bricks and mortar. Next admits it's a legitimate concern.
So the retail half of profit could vanish?
Well, not completely, or overnight.
Let's pretend the retail stores made no profit in the year to January 2017 but it still paid the rent and the salaries. Next would be a viable business! It earned a 22% return on capital in the year to January 2017, so other things being equal, half of Next would earn an 11% return on capital. It wouldn't be a particularly attractive investment, but this is worse than a worst case scenario.
Retail isn't as profitable as Directory, but it's still a good business. Here's a chart showing adjusted post-tax profit margins.
If there is to be a significant permanent decline in retail profit it will happen over many years. Depending on the lease agreements, Next would be able to cut costs by closing unprofitable stores. It may be able to negotiate lower rents and reduce declining revenue by opening new stores in profitable locations.
Helpfully, Next has done some calculations...
What's Next's worst case scenario, then?
The worst case assumes like-for-like sales fall at 6% a year for the next 10 years, 4% a year more than the average over the last five. It also assumes Next closes unprofitable stores when their leases expire, opens no new stores, and does not achieve rent reductions. Even then, Next says net branch profit will be 10% of sales before central overheads, although it doesn't say how many branches it might be left with.
While other fashion retailers, French Connection (FCCN)for example, have been unable to close stores quickly enough to remain profitable, Next's a much stronger business.
Hang on. Brain freeze. How do you reconcile contraction in retail with growth online?
You mean, when you don't know how fast retail will contract, or online will grow?
You speculate, of course.
Faster-growing online retailers like ASOS (ASC) are selling clothes cheaply to gain market share. While ASOS's revenue is comparable to Next Directory's, profit margins are not. ASOS's operating profit margin is just 2.6% according to SharePad, so it makes a fraction of the profit Next Directory does.
Intriguingly a younger, and much smaller pretender, boohoo (BOO), sits between the two. Its profit margins are half Next's, but a multiple of ASOS's.
Maybe ASOS and other pretenders will keep sacrificing profit for growth until they dominate segments of the market. Then they can ratchet up prices (the theory goes) unencumbered by stiff competition.
The template is Amazon (AMZN), which has driven booksellers and music retailers to the wall. But Amazon's job was easier. Partly due to digitisation and partly due to the simplicity of the physical products, music and books are very straightforward to buy and sell online. High Street booksellers didn't already have large, profitable, catalogue businesses supported by warehouses and logistics they could migrate to the Web. And they were taken by surprise, they were the first retailers to taste online competition.
In every respect Next is in a different position, and can probably coexist with the likes of ASOS and boohoo. I believe it's no dinosaur. Next will still be selling clothes in shops profitably in 10 years' time, but Directory will be the most important part of the business.
And Directory's prospects are...
Another difficult question.
The good news is it's grown revenue at a compound annual growth rate of 8.5% over the last nine years. Profit has grown 12% a year compound. But there are signs Next could become less competitive as business continues shifting to the internet.
Directory had a natural advantage earlier in the decade. It already had an efficient distribution network for mail order customers. Rivals building internet businesses had to create them from scratch, but they've caught up now.
Fewer customers are using credit supplied by Next. In mitigation, though, there are signs the rate of customer decline has stabilised to a steady trickle, and though the interest rate is lucrative, credit customers aren't much more profitable than ordinary sales because of the cost of providing related services.
Next Directory sells more third-party brands than it used to, which earn lower profit margins.
As some of the things that made Next Directory special, its catalogue, credit, its own label, become less significant online, Next may have to reduce prices and profit margins to compete.
It might, of course, find new advantages, but if it has already done so, I haven't identified them...
So it's a tough hold?
Having fed in the results of this appraisal, my Decision Engine ranks Next 6/10, a hold, but it's a tough one because my analysis is so speculative.
A share price of £44 values the enterprise at £9 billion, or about 13 times adjusted profit, so if Next recovers, the shares are good value. The problem is, I lack the vision or skill to know.
Such are the dilemmas and contradictions of investing. When there is no obvious course of action, I favour inaction, which means if I didn't already hold the shares, I'd be cautious too.
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.