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%)
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 is 6,962p, 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 6,962p, 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.