I’ve had my eye on Next PLC for a long time and now, thanks to some recent and dramatic share price declines, the shares may at last be as attractive as the underlying company.
Next PLC is one of the UK’s most successful retailers, having shrugged off the Global Financial Crisis and Great Recession with relative ease. Even including those more than slightly negative environments, the company has managed to grow its earnings and dividends at double digit rates year after year.
However, all good things come to an end. In this case the CEO’s recent admission that “The year ahead may well be the toughest we have faced since 2008” did not go down very well with the market. In fact the only thing that did go down well was the share price; down 35% from a high of around 8000p to 5200p today.
So now that the shares are much cheaper than before, would I buy them? I think I might, and here’s why:
Impressive earnings, dividend and share price growth
As I’ve already mentioned, Next has grown at double digit rates, as the chart below shows:
Per share earnings growth has been spectacular, but total revenue growth has noticeably lagged both per share earnings and dividend growth. I’ll explain why in a moment, but first, here are my key financial stats for Next, as compared to the FTSE 100:
- 10-Yr growth rate = 12% (FTSE 100 = 2%)
- 10-Yr growth quality (consistency) = 83% (FTSE 100 = 50%)
- 10-Year profitability (ROCE) = 43% (FTSE 100 approx. 10%)
Note: You can find a description of those metrics on the stock screen page, and you can calculate them for any suitable company using these investment spreadsheets.
Next’s profitability figure of 43% (based on return on capital employed) is a little misleading as the company rents rather than buys its stores, so the stores aren’t noted on the balance sheet as assets.
That makes the capital employed side of return on capital employed look smaller than it actually is, which in turn makes the percentage profitability figure higher than it actually is.
If I estimate the value of the company’s stores at eight-times their rental cost (read Richard Beddard’s brief explanation of “capitalising leases“ to understand why) then that adds about £1.6 billion of capital assets to the balance sheet.
That adjustment reduces ROCE down to about 20% on average, which is still extremely good, but not as borderline ridiculously good as 43%.
I’m sure that lease capitalisation aficionados will tell me that I haven’t made enough adjustments here, but this is only an illustration and in practice I don’t capitalise lease obligations at all (for much the same reason as I don’t capitalise the cost of human capital – i.e. wages – either).
Next also has the following features, which I like:
Small debts: Next’s borrowings are relatively minor, and only amount to 1.7-times its five year average post tax profits, whereas I’ll allow a ratio of up to four-times for cyclical companies such as retailers.
Small pension obligations: Next’s defined benefit pension scheme is very small and so any pension deficit is unlikely to cause problems.
No large acquisitions: I’m not keen on companies that make lots of large acquisitions and Next has made none in the last ten years.
Low capex requirements: Companies that have to make large capital investments can often struggle in difficult times, and difficult times are when a value investor is typically looking to buy. In Next’s case capex is low at just 25% of profits on average, which is what I’d expect from a retailer as they don’t typically have to invest heavily in factories or heavy equipment.
There is a bit more to analysing a company than that, but those are at least the main financial metrics (and if you want more details have a look at the defensive value investing articles page).
At this stage I would say that Next appears to be a very successful and relatively low risk retailer.
Share buybacks and special dividends
One interesting point about Next underlies the reason why its per share earnings and dividend figures have increased much faster than its total (i.e. not per share) revenue.
Although this is to some extent down to improvements in profit margins, it has also largely been driven by the company buying back around 40% of its shares over the last ten years.
Buying back shares can be a sensible use of shareholder cash as it increases the value of each remaining share and avoids the income tax associated with dividends. But buybacks should only be used if the expected rate of return on the shares purchased is higher than a shareholder could expect if they had received a dividend instead and reinvested it.
Most companies that I have looked at don’t have a clear returns target for their buybacks, but Next is different.
In the 2016 annual report it states that its current buyback limit price 6962p, above which it does not expect the investment to return more than its hurdle rate of 8%.
It is very interesting then that the shares reached a peak of 8000p before their recent decline, suggesting that these investors were happy with returns of less than 8% or that they were more optimistic about the future than the company’s own management (and almost nobody is more optimistic about a company’s future than its management).
Because of that high share price the company has switched in recent years to paying out a special dividend rather than buying back a significant amount of shares.
For the last three years the special dividend has been similar in size to the normal dividend, effectively doubling the income from this high growth company.
A collapsing share price makes Next interesting again
Even though the company wouldn’t buy its own shares above 6962p, its share price still climbed to 8000p last year. Today, after those worrying words about a tough year from the CEO, the share price is down to around 5200p.
That means the company must think its shares are a good investment once again, and I would be inclined to agree.
At 5200p Next is the 21st most attractive stock on my stock screen of more than 240 consistent dividend payers, based on its combination of growth, quality, profitability and both earnings and dividend yields.
Although Next’s dividend yield is just 3%, which may not seem like much, it is one of the best on offer for a company with such a compelling track record of double-digit growth.
Other ratios such as PE10 (price to ten-year average earnings) are just as attractive relative to other high growth companies.
As for the tough year ahead, of course I don’t have a crystal ball, but I see no obvious reason why 2016 should be any worse than 2008 which was, after all, almost a repeat of the Great Depression.
And even if 2016 does turn out to be as bad as 2008, would that be so bad?
In 2008-2009 Next’s profits fell slightly but then quickly recovered, and in the years after 2008 its share price climbed more than 800% from 900p to 8000p.
I’m not saying Next’s shares are going to climb 800% from where they are today, but 2008 wasn’t so bad, as long as you bought the shares after the share price had already declined.
I just bought some more NXT to average down my position. It’s a very shareholder friendly management (love this aspect in a company), and so far it has been run in a sensible way.
As you point out they have little debt and a lot of cash at hand, the decline in share value is probably because the stock has been oversold over the comments of the CEO and the weakness of retail sector in the UK.
John Kingham says
Hi Stal, unfortunately I’m not able to initiate a position in Next just yet, but with a bit of luck I’ll be joining you soon enough (unless this blog post becomes wildly popular enough to move the price, which I seriously doubt).
diy investor (uk) says
Great analysis as ever John.
The fall in recent weeks has been overdone imho. The company will be returning £200m to its shareholders over the coming year or 388p. That will come via dividends and share buybacks and is equivalent to a return of over 7%.
I am not suggesting the shares are a snip but given the sound fundamentals, loyal customer base and growth potential of its online offering, good value at current levels.
If I were not winding down my shares portfolio, I would probably be topping up now.
John Kingham says
Hi John, thanks. I had noticed from your blog that you’re leaving the land of stock pickers and heading off to the passive hills. Good luck with that, I hope it works out well for you.
Probably a sensible thing for DIY to do.
I am not so positive on Next as you guys are. First when the CEO says that things will go worse before going better, I listen to this.
Usually CEOs are telling you lies that things will get better next day, when even as an outsider you understand this is not the case.
In my opinion probably people have realised that their garderobes are full of clothes and given the uncertainty in the economy, they can do a bit without buying more stuff. This is what a consumer discretionary business is all about, myself I do not invest in them, unless we are after a recession and I can see people who stopped buying their stuff for 2-3 years coming back to their shops in droves. I am not sure this is the moment now.
In my opinion there are better stocks there which were trown away by investors last year and at the start of this year. One example is Alcoa. I bought at $8.30, $9.50 and added a bit at $10. I have a target of $15 for this once the split in two companies is done. Aluminium is going to be used more and more and you do not get two many occasions to buy stocks cheap.
John Kingham says
Hi Eugen, I must admit that it is slightly unusual for an existing (rather than new) CEO to say that things will be so tough. Such comments are rarely helpful for the share price and therefore the CEO’s bonus package. But then again the CEO of Next keeps giving away his bonus package to long-term employees, so perhaps he’s not desperate to maximise his income (I shan’t go into the details of why that might be the case!).
Martin Williams says
Interesting analysis. Do you know how the growth/rankings look if you take actual earnings, rather than EPS ? And, perhaps, total dividends + buybacks in place of DPS.
The decision may not be different.
John Kingham says
Hi Martin, dividends plus buybacks is an interesting idea, a bit like “shareholder yield” which Meb Faber has written about.
I could probably put those figures together (total earnings and total dividend+buybacks), but I don’t have them to hand and it would be a lot of work to re-rank the whole screen using them.
My guess would be that Next would be less attractive on a growth front as its growth rate would be lower, but more attractive on a valuation ratio front as its price to dividend (now dividend+buybacks using your example) would be more attractive, because dividend+buybacks is higher than dividends alone.
The first would weaken Next’s rank while the second would improve it, so it’s not entirely obvious how it would affect it, but it sounds like an interesting experiment.
Or, I could go the other way and rank everything using only per share figures, i.e. use revenue per share instead of total revenue.
I think from a technical point of view I should do that anyway, but revenue per share is an odd metric and I wanted to base the rankings on information that investors could get from annual reports with ease, and information that investors were reasonably familiar with, neither of which is the case for revenue per share.
Martin Williams says
I was thinking the same re your paras 3 & 4. If I have a moment I’ll re-work growth along the lines suggested. If I come up with anything I’ll comment again.
I’m not familiar with Meg Faber’s writings, the term “shareholder yield” is exactly what I was seeking.
Andy Curtis says
my first analysis agrees with you. Please don’t think I am anywhere near as experienced as you though. Then i looked at the Cashflow statement and saw the large change in working capital. Used Stockopedia to drilldown to find this is due to a large change in Accounts Receivable. Now I am trying to think what the change means. Is it positive or negative and I think it means the Accounts Receiveable has increased (alot), could this be credit sales? So although the profit for the sale is recognised the money is yet to come in.
I next went to the Balance Sheet. Inventories increase alot as well. Could this be unsold stock from last year? Or a need for a lot more inventory because they have more stores?
Then from your piece you mention the CEO saying, ‘tough year ahead’. Could this be having to sell on credit and not having sold last years stock?
I don’t know the answers, don’t even know if my thoughts are anywhere near true either. Just thought I would mention it and see what you thought.
Regards … Andy
John Kingham says
Hi Andy, thanks for highlighting those points but I don’t really have much to say about movements in receivables, stock or other working capital items. Working capital is something I just don’t look at in detail because I haven’t yet found it to be a significant indicator of future fortunes for the sort of high quality company I focus on.
My general assumption is that in these high quality companies, the people who run the business have many years of experience within the sector, and are far better positioned to know how the company’s working capital should be managed than I am.
Of course working capital could still be managed badly, in which case it could become a problem. But as I said, for high quality companies I haven’t seen working capital (primarily relating to cash flows and liquidity) become a major issue. Borrowings on the other hand, which I do look at, are frequently a major component of serious problems.
Borrowings relates to the need of working capital and resulting free cash flow to reinvest, pay dividends etc.
I do not think that credit sales have increased so dramatic as the figures show, I believe this is the way to account for loan inventories given in advance for their supply factories in Asia. Next provides all the inventory and those people in Asia put the shirt together.
So I believe this is the result of an increase of inventory in the supply chain, financed by Next.
In my opinion, now that I looked it up, things look a lot worse than I thought when reading in FT about Next, so probably the CEO was smart in explaining these issues before having to cut dividends next year.
Not on my investable list, so I wish you luck.
“Buying back shares can be a sensible use of shareholder cash as it increases the value of each remaining share”
John, I don’t see how buying back shares increases the value of the shares you already own, since the intrinsic value of the company has not changed, and the cost of buying back the shares compensates for the “perceived” increase in your share value you think you have because you are looking at a smaller pool of shares.
In my mind it’s financial engineering at it’s worst and particularly the worst kind when a company buys back shares at an “above intrinsic value” level.
There are some other things to consider before buying Next shares:-
1. The pre-tax profits have stalled and look like they are going to be reduced.
2. The earnings per share growth has all but stopped, from historic double digit growth rates to as low as 5% last year and negative this year. Given that shares have been bought back, you would expect these numbers to be flattered. That tells me that had the number of shares stayed the same, the EPS would be even lower.
3. All the kids are buying their clothes from ASOS that offer “cooler offerings” at lower prices and free return rights. H&M are also taking share from Next.
4. Amazon are the biggest online clothes retailer in the US and are spending a fortune on UK investment in the same.
The lease costs won’t go away if Next sales turn negative, just like they didn’t at Tesco and it caught them out badly.
Personally I’d look for something else — Next might be a rebound if it holds together, but it’s catalogue sales are coming under pressure and I don’t imagine Next margins are going to stay as high as they have been anymore.
John Kingham says
Hi LR, you’re right, I worded that paragraph a bit badly. The key point is the second sentence:
“buybacks should only be used if the expected rate of return on the shares purchased is higher than a shareholder could expect if they had received a dividend instead and reinvested it.”
Or, you could say that the expected rate of return should be higher than the weighted average cost of capital. But regardless, the basic point is that, as you say, shares should only bought for less than their perceived “intrinsic value”, however that is measured.
I don’t want to get into some sort of tit-for-tat debate about the merits of Next as I hate defending individual stocks, even those I currently hold, but regarding each of your points:
1. Yes probably, but my guess would be that it’s a short-term setback
2. Yes EPS growth is flattered by buybacks, but in recent years buybacks have to some extent been replaced by special dividends because of the lofty share price, and that partly explains the lower EPS growth, but not entirely.
3. I have no idea what kids wear or buy (!) so no comment.
4. Indeed, but catalogue shopping has existing since the dawn of time (almost) and some percentage of people like to try stuff on in a shop first.
Your points are all valid any may well turn out to be correct, but I don’t think the negative case is obvious or more likely than the positive case, so on its current valuation I still like Next. Whether or not I actually end up owning a slice of it is in the hands of the gods as I’m not looking to buy anything new until the start of June.
John – Just maybe June would be a better time, but I haven’t a clue really.
One things for sure, Next is a higher quality offering than BHS right now.
I imagine a dividend cut would be a good time to consider buying Next, or when the Directors open their wallets.
I mention a dividend cut, because it seems ridiculous to have a negative cash flow of £220M at the end of January and pay out £568M in dividends.
Also when you look back at the dividend payout in 2011 it was £135M against a net income of £602M, or approximately 22%.
In 2016 (for last year) it was £568M against a net income of £867M, or approx 66%.
I thing this change in payout ratio was responsible for Next share price to be over inflated to £80 and at £51 it’s still not cheap enough yet, but I could be wildly wrong of course.
I’d prefer to see Next get it’s payout ratio well below 40%.
Woodford funds comments in March. Unfortunate that the fund bought at the peak price, but is confident to add to the holding again, before a second leg down in the share price :-
“Among the largest detractors from performance was Next, which was very weak in the last week of the month after announcing its full year results. The results themselves were in line with expectations, but the company’s outlook statement pointed to a difficult year ahead, with management citing both changes in consumer behaviour (reduced clothing purchases) and more caution on the consumer economy. Next has a habit of managing expectations well, but this guidance has clearly worried the market. We are less concerned, however.
We see the comments from Next’s management team as negative for the wider retail sector and indeed for consumer cyclical stocks more broadly. But, as far as Next itself is concerned, we think that the market has reacted inappropriately to the update. We invest in Next because it is an exceptional retailer with strong free cash flow generation. All of this free cash flow is returned to shareholders via the dividend and, depending on the share price level, either share buybacks or special dividends. We continue to believe that Next will deliver a very attractive long-term total return through a combination of its current dividend yield and continued growth in its free cash flow generation. As such, we took the opportunity to add to the holding.”
John Kingham says
Hi LR, I guess I shouldn’t care but it’s nice to know that Woodford and his team are on board. As long as he doesn’t buy enough to push the share price out of my reach…
Indeed, often the nicest time to buy is when no one is talking about a stock. I’m digging into Next a bit deeper and trying to take my “sceptical about retail” hat off and be a bit more objective. The annual reports are very candid in their provision of information about the business, it’s make up, divisional breakdown and what their objectives are for each part.
That is refreshing — I’ll keep reading. No rush here I suspect.
As someone once said to me, can’t recall who mind, “the stock market will still be there tomorrow”
John — This topic has indeed grabbed my attention, and there are a couple of very simplistic observations that came up from trawling through the history and wondered what you make of them :-
In it’s 10 year records, the revenue has grown from £3.3Bn to today £4.2Bn – a rise of approx 27% or 2.7% a year linearly or less compound.
The Profit during this period has grown from £478M to £836M – a rise of 95%.
The share price rose in that period to a peak from a low of 1000 to 8000 — 800% growth and if you take it’s current price 5085 —- over 500%
Also the Market cap to Net Assets is incredibly high at £7708M / £311M — some 25 times it’s net asset. That’s of course if you put much stay in such a statistic for a relatively asset light business — but still it’s a massive number.
Looking at these stats it’s really hard to say where Next share price should sit. Of course you could say back in 2007-8-9 it was incredibly undervalued, and today it’s coming back to fair value.
How much is perception I wonder?
Perhaps a share price growth inline with raw profit growth is a fairer way to value the business? Am I playing devils advocate in suggesting £20-£30?
John Kingham says
“it’s really hard to say where Next share price should sit”
That about sums up the whole game of equity investing doesn’t it!
The balance sheet is a bit odd as capital employed and book value are very low given the scale of the business, largely because total assets is very small. The impending accounting change that will capitalise lease obligations will add say another couple of billion in assets (i.e. the value of the stores), so those ratios will look less outlandish. However, I don’t use balance sheet ratios like that so it won’t affect how I view Next.
As for fair value, my stock screen implies a price north of 10,000p (£100), although whether I would hold the shares at that level is another matter.
John, Indeed the puzzle of investing. I guess Woodford’s fund thinks similarly, as they started buying it at it’s peak at the 800p level and again after the recent sell off, although nowhere near today’s lows.
I wish I could be reassured – but looking at some of the other selections and high entry levels at Allied Minds, Prothena, Alkermes, The AA, Centrica, Drax, Rolls Royce, Astra Zeneca bla bla — I often wonder if a dart board with the names around the edge could achieve as handsome a result.
Good job investment is a long game, what??
Interestingly I’m reading — before your good book, “common stocks and uncommon profits” by Philip Fisher – I guess you’ve read this one — what did you think?
John Kingham says
No I haven’t read that book. I read at speaking pace, i.e. very slowly, so it takes forever to read a book and I have a long waiting list of books I’d like to read, of which Fisher’s is one.
I am eternally jealous of my wife who can flip through books like she’s skim-reading them; but no, she’s read every word and can consume a book in a day or two with ease whereas it usually takes me several weeks.
Take a look at the article on NEXT in the Telegraph Questor column. They make a number of interesting observations. One I was drawn to was that the debt to equity is over 3!!. Apparently this means a small difference in profits can have a large effect on the share price. That sort of makes sense to me intuitively although I can’t write it down as an equation just yet. The other comment they make is that the credit customers are falling away and its this segment that accounts for much of the companies profits. On the basis of these arguments I would tend to avoid it myself or at least take a half position.
John Kingham says
Hi Andrew, yes Next’s debt to equity will be high because of its slightly odd balance sheet, but I prefer to look at debt to earnings instead, and by that measure debt is relatively low.
As for credit customers, I think they’re likely to continue to decline which will be a drag on performance. But again I don’t think it’s obvious how that will pan out or how badly (or not) it will affect growth, so at this stage I’m not overly concerned by it.
you are a traditional investor and I am trying to adopt Peter Lynch’s method. I must say that currently there is more a currency panic impact on the FTSE due to the conservative weird words of the last few days. NEXT is one of the share that is suffering most and I must say that the current price is not so exciting because the currency might have an impact on the final spreadsheet. I would prefer to wait until the quote below 4000 or the PE around 7. I hope that I am wrong.
Unfortunately the entire FTSE seems a bit silly: companies with best fundamentals are oversold and those with negative profit margin are overbought. I am wondering when this irrational trend will end.
Hi John — just referring back to this article and looking on again at Next — I haven’t decided yet, probably just as well as the stock is still falling :– this struck me as a point to consider below :-
Here are the last 5 years cash flow figures :-
The cash from operations has increased from £526M in 2012 to £608M in 2016 — ok pedestrian but respectable.
— Capital expenditure averaged about £100M over the years 2012 to 2015 but jumped to £151M in 2016 — I guess this was due to expanding into larger shop premises and the cost of shutting smaller outfits.
Now look at the dividend payments :-
in 2012 they paid £135M which was exactly 22.4% of net income for that year
in 2015 they paid £434M which was 53.44% of net income for that year
Last year they paid £568M which is now 65.5% of net income.
How far will they go with this trend?
Net Change in Cash – was positive, only slightly from 2012 to 2015 and then swung to negative (£220M) last year.
This has resulted in £53M in the bank — OK this may all be planned, but it may be difficult for Next to grow the % of dividend payments above the 65.5% and maintain any cash at all.
If sales fall by only 5% it could be that net income in 2017 will struggle to match the last few years and the pay out could suffer.
This is the vulnerability I’m thinking about.
John Kingham says
Hi LR, I think those dividend amounts include their special dividends, which of course are far from guaranteed and I wouldn’t be surprised at all to see them dropped for a while.
Fortunately (from my perspective) I don’t account for special dividends, so my valuation of Next doesn’t depend on them.
However, I would be surprised if there was a cut to the base dividend, but of course it isn’t impossible.
John, Yes the discretionary element of the special dividend is interesting. I wonder if this will reflect further into the stock price if this “expectation” is dashed and the special is reduced or in the event of another profit warning, removed altogether?