FREE TO READ: Is Next a quality share? 

Next is a very good business. But does it have the necessary characteristics to be labelled a quality investment?

Photo courtesy of Next plc

Few investors would argue that Next has created a great online retail business. This was again demonstrated on Wednesday with a better than expected set of half year results and another upgrade to full year profit guidance.

Full year pre-tax profits are now expected to be around £800m/516.9p EPS which equates to a £36m or 4.5 per cent uplift compared with the previous guidance. Unsurprisingly, the shares reacted well on the back of this.

Next: Full year profit guidance for year to January 2022

£m Profit H120A H121A H122A H221F FY22F
Online 182.5 133.8 318.0 272.0 590.0
Finance 75.8 61.6 65.6 69.4 135.0
Retail 90.8 -144.0 -17.8 117.8 100.0
Other 13.9 -35.0 11.0 13.8 24.8
Recharge of interest to Finance 17.8 17.7 15.7 19.3 35.0
Op Profit 380.8 34.1 392.5 492.3 884.8
Net Interest -53.4 -50.6 -45.8 -39.0 -84.8
Profit before tax 327.4 -16.5 346.7 453.3 800.0

Source: Next/Invest-ability

This is welcome news, but it’s worth remembering that Next made £836m of pre-tax profits back in 2016. Since then it has battled against falling high street footfall by shifting its revenues and profits online before having to cope with the ravages of Covid-19 lockdowns. Its profit recovery is a testament to how well the business is run and its levels of customer engagement.

The obvious question is how easy will it be for the company to kick on from where it is now and grow profits into new territory?

As always, Next is very candid with its views on this and offers plenty of balance on the challenges and opportunities its business faces. My view is that there are reasons to be optimistic.

Next is going to have to work hard and spend money to take online growth up a notch. Its warehouses are close to capacity and will not get much relief until a new one comes on stream in late 2023. It will also have to spend more to upgrade its software systems.

It can just about cope with the capacity it has now by increasing working shifts. This will cost more in wages but I do wonder whether high capacity utilisation could bring further profit hikes due to the benefits of operating leverage. 

This potential benefit has to be considered with the possible slippage of service levels – in terms of longer delivery times – that could be caused by a shortage of warehousing and logistics staff for the peak Christmas selling season. 

However, this is a relative issue as far as Next’s competitive positioning and customer perception is concerned as most of its rivals will face a similar issue. Next is best in class in terms of customer delivery and this is unlikely to change.

What is really encouraging is that there are clear signs of improvement in the quality of the customer offer online. 

Its Next own label sales are going from strength to strength with range improvement and a big improvement in margins. Its third party LABEL business continues to build up scale and is sharing the benefits of growth with its branded partners by cutting commissions in order to drive more volume.

The increase in ranges has put the company in a good place to cope with lower stock availability as it believes that the availability of a higher number of substitutes can still keep its customers happy.

Next is also following the recent trend amongst online retailers by investing in brands directly in order to keep more of the profits for itself and has taken equity stakes in Victoria’s Secret, Aubin, Reiss and Gap UK & Eire.

There’s no doubt that the company has enjoyed a windfall from the pent up demand for clothing and homewares caused by lockdowns and the extra cash that many people have had to spend. This has continued into the second half but will moderate going forward which is not a surprise.

Interestingly, Next does not expect the 3.3m extra customers it has gained over the last couple of years to grow much in the short-term but reckons that the quality of its customer base has improved. It is managing to get more repeat business from customers acquired between January 2020 and January 2021 than from those who were new to the business between 2018 and 2019.

What is quite revealing is that a large chunk of the new customers are buying with cash rather than signing up for credit with Next. These customers spend a lot less but this has been offset by credit customers spending 25 per cent more on average than two years’ ago.

Next’s Online business has been heavily reliant on credit to drive sales as well as providing a very lucrative finance income. This has always been a concern of mine as bad debts tend to spike when the economy is weak. At the moment customer default rates remain very low compared to 2008/09 and there was no increase in bad debt provisioning in the first half of the year.

Is Next a quality share?

I share a lot of people’s admiration for Next in the way it runs its business and how it communicates with investors. It ticks a lot of boxes in terms of profitability and based on an estimated operating profit of £884m it will make a return on capital of around 26 per cent this year based on my calculations. That’s pretty good in anyone’s book.

However, the definition of a quality business is not just about numbers. It’s about other key factors such as robustness and resilience and the ability to deliver consistent growth. Next’s history is not great here.

But it is the future that matters. The company’s customer focus and online sales success is a big plus. Its short-lease profile on a large chunk of its store estate gives it more opportunity to optimise the mix between its bricks and mortar presence and the ability to serve its online business (particularly in the area of cheap and quick returns).

Its Online business is very well invested and will remain that way, whilst its margins of 20 per cent are extremely impressive relative to online peers. However, I’ve never been able to fully get my head around why these margins are so high and why they have not been competed away. I don’t know whether they are a source of strength or a potential source of weakness. 

My doubts on resilience, the sustainability of margins and the long-term growth potential of the business stops me from putting Next in the quality share camp. I still think it is a very good business.

At its current share price of 8325p, the shares trade on a forecast PE of just over 16 times. If I am wrong in my view, then I’d say Next could be very cheap. My thinking is that if the shares fitted the quality growth criteria, the valuation would be a lot higher than it is now.

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