“When the facts change, I change my opinion. What do you do, sir?”
On January 4th, Next (£NXT) released a largely negative trading update that catapulted them into the public consciousness. Not a day went by that I wasn’t offered an article discussing the fallout from this update, which led me to think about the likely apocryphal quote from John Maynard Keynes, written above. Like any sensible investor I am led to ruminate on one of my worst performers of 2016, and whether it may now be time to throw in the towel. So, have the facts changed?
End of season sales for Next were down -7% YOY. Full price sales for the year were down -1.1%. Retail sales were down -4.3% for the year to December 24th. However, Next Directory sales were up 3.6% for the year, helping to largely offset the loss in retail sales.
Sales & Profit Guidance Ranges 2017/18:
Full Year Estimate Year to January 2018 Lower Upper ======================================= ======== ======== Total full price sales versus 2016/17 (at constant currency) - 4.5% +1.5% Total full price sales versus 2016/17 (including currency gain) - 3.5% +2.5% Group profit before tax GBP680m GBP780m Change in profit before tax versus 2016/17 - 14% - 2% ======================================= ======== ========
All told a fairly disappointing update from Next, and certainly one that highlights a growing trend towards negative growth. In spite of this, the Next Directory area of the business is still growing at a fair rate and, provided this continues, will eclipse revenues generated from their Retail operations in 2017/18. If you take a look at the September half-year update, revenues from Retail were £1.083b against £821m for Directory. Furthermore, profits from Directory eclipsed Retail by some margin, coming in at £204.2m for Directory and £133.9m for Retail.
The management at Next forecast a cyclical slowdown in clothing and footwear spend, and have revised down forward profit guidance accordingly (see table above). Next also carry approximately £1.4bn in debt, most of which is long-term. So far, so bad, right?
If you view Next as a growth company you’d be disappointed. Online rivals such as ASOS and BooHoo.com are the current darlings of both the clothing and stock market world. The momentum is definitely with them. But I believe there is merit in viewing Next as an income play.
Firstly the debt, whilst high, is accounted for by management with a Directory debtor book of £1bn. Ordinarily I would be deterred from taking a position in a company with such high levels of debt, but when it has already been accounted for I feel I can rest a little easier.
Secondly Next have an excellent operational business.
Whilst gross margins at Next are lower than the other three companies listed, operating margins are consistently higher. Furthermore in looking at net profit ratios, neither of these three come close to the profitability of Next. Looking at the most recent full year results I found net profit margins (net profit/revenue) of:
Next – 15.9%
Ted Baker – 9.6%
Boohoo.com – 6.1%
ASOS – 1.6%
Next convert a higher proportion of their revenues into profit, by some margin. This results in excellent levels of free cash flow, which in recent years have been returned to investors via share buybacks and special dividends. Management have bought back approximately a third of outstanding shares in the past ten years, and have stuck to a dividend payout ratio of approximately 33%. They dividend yield is currently 3.8%.
Discounted Cash Flow
- Free cash flow has remained consistently high, peaking in 2015 at £630m. I have used a ten year average FCF of £417m which levels out fat and lean years.
- Net income has grown in all but one of the last ten years, at an average rate of 8.04%. This is likely to slow in coming years, therefore I have used a free cash flow growth figure of 4%.
At a current valuation of £40.95 this calculation yields a potential intrinsic value of £47.24. A discount of approximately 13.3%.
Viewed through the correct lens, I believe Next are a solid income stock. Steady dividend growth, funded through excellent free cash flow, generated by a solid operating business. The conservative viewpoint also assumes slowing growth in their operating business, which as management suggest may indeed be cyclical. Management have also recently identified investment in their online and mobile platforms to be crucial to future success, which I would agree with. If you’ve ever tried to buy a suit in their online sale you’ll understand what I’m talking about.
To discuss further, follow me on Twitter @britishinvestor. Until next time, happy investing!
Disclosure: Next is a constituent of the portfolio.