Is NEXT’s Share Price Offering at “50% OFF” Presents Value Buying Opportunity?

So, not only is NEXT PLC offering a 50% discount to its customers, but its share price fell by more than 50% to £38/share from £80/share during 16 months. The REAL question is:

Does NEXT PLC shares represent a bargain like their clothing line or are we bracing for further reductions ahead?

A Quick Glance of Next PLC

Looking at NEXT PLC’s fundamentals, it has operating margins at 20%* portrays a healthy retailer with decent margins that is higher than hot retailers like BOOHOO and ASOS of which its margins are between 4% and 7%, respectively.

These online retailers are growing faster than NEXT meaning future profits and margins will likely increase faster.  

However, the PEG Ratio (keeps track of changing market value and earnings growth) put NEXT on 0.61, compared with BOOHOO’s 0.93 and ASOS’s 5.04 meaning the market places higher value to these online retailers’ profits than NEXT, despite having lower operating margins!

*NEXT’s operating margins have never been below 10% (going back to 1999)!

On the other side of the spectrum, luxury retailers like Burberry, LVMH and Hermes have more say on “Pricing”, therefore it can command higher operating margins. This is down to the power of their brand names projecting fashion status and social status (or, it could be the quality garments it produces). At the high-end of the fashion segment, NEXT beats Burberry’s operating margin of 17%, and are not far behind LVMH and Hermes.

These luxury retail stocks command higher P/S and P/E numbers than NEXT!

Does the straightforward and quick research proves NEXT PLC is a bargain for value investors?

Am no expert in the day-to-day running a clothing business, that’s for people like Philip Green and Mike Ashley. But, I do know how to analyse a retailer’s financials. And like any retailers, it needs to grow profits and generate cash.

Below, are the following factors you need to know about NEXT PLC:

1. NEXT PLC earnings power, which includes the subsequent cash flow analysis;
2.  A breakdown of NEXT’s revenue breakdown, and why there is a surprise in its directory division.  
3. A simplify, but useful analysis of NEXT PLC’s market and enterprise value in proportion to various financial metrics, including KPIs measures.
4. For those short to medium-term traders, a useful breakdown of NEXT’s technical analysis share price chart.
5. Finally, an evaluation and likely direction of NEXT PLC’s share price in the medium-term, including a brief summary.  

The Earning Power of NEXT PLC

The earning power of NEXT is almost “Unmatched”, compared to its rivals. Here is what I mean:

In 2016, the retailer produced £469m in free cash flow. If they decide to cancel dividends and buybacks for one year, it would save £811m. NEXT’s cash balance would swell to £740m and nearly covers its total debt (NEXT’s total debt and cash balance in 2015 is £841m and £275.5m, respectively).

In a different angle, NEXT’s free cash generation can pay off 55% of total debt and it also covers interest costs at 15X over.

Moreover, since 1999, NEXT’s free cash flow generation totals over £5.6bn, but it also paid out £6.8bn to shareholders. Furthermore, the number of share issue declined by 65% to 150m from 370m, which adds to the company as a legitimate retailer not manipulating its accounting profits.

Analysing NEXT’s cash flow statement

As mentioned earlier, NEXT produced a total of £5.6bn in free cash flow since 1999, while not recorded a single “negative” FCFs figure in the period. In the last five years, NEXT average free cash flow amounts to £530m per year.

NEXT’s net cash flow from financing (bottom of the “cash-flow statement”) is a sign of strength, despite its “negative” subtotals for the last 16 years. It means management were busy returning cash to shareholders and was willing to take on some debt (to the tune of £1bn) because its earnings power allow it this privilege.  

NEXT’s Secret Weapon

Before we reveal the company’s secret weapon, let us break down the firm’s two distinct divisions, its online directory and “Stores” division.

Source: NEXT’s annual reports.

Its online division grew faster and that translates to a compound rate of 11.4%, compared to 6.5% in their store division. Moreover, its online earnings have surpassed its retail earnings for the first time!

With a lower sales figure, that means NEXT’s online division achieved net margins of 24%-25%, higher than its reported net margin of 15%. Curiously, the net margin made by established online retailer, ASOS is 3% with BOOHOO tagging along at 6%!

The secret sauce revealed

If you think NEXT had managed to source from cheaper suppliers like retailer Primark and selling it at “Marks & Spencer” prices, then you are deeply mistaken. The secret to NEXT’s earnings success is the firm’s credit services (store credit card).

In 2015, NEXT manages to bank £170m interest fees, making up ONE-THIRD of total profits and 50% of total online earnings. This is not surprising because, although a typical credit card fee is 18%-20% APR from the bank, NEXT charged close to 25% APR! 

Source: NEXT’s annual reports.

The growth in NEXT’s interest income from its credit services look big, but it has been declining as more shoppers were shopping online. It explains why earnings growth in its retail division has stalled.

As long as NEXT remains fashionable and customers remain online, their credit card business would prove lucrative. However, if a normal recession occurs, when consumers feel the need to save and not spend, or choose cash, instead of credit, then NEXT (along with the whole service sector) will feel the pinch.  

You would think NEXT is charging exorbitantly higher rates than other general retailers, but see below:

P.S. Only Topshop and M&S charge less than NEXT PLC.

Key Performance Indicators and Market Valuation

Did you know NEXT PLC consistently achieved negative like-for-like sales in eight out of ten years? Me neither.

Source: NEXT’s annual reports.

Nobody raised any alarm bells to this phenomenon, but how is it possible that the firm were increasing its profits margins year-after-year without improvement in the efficiency of its stores. It perfectly accompanies the fact it is gobbling up retail space at an alarming pace (RED LINE) with revenue per Sq. Ft declining.

Source: NEXT’s annual reports.

So, if there are any readers, please explain why this is possible?  

Spotting the historical trend

Some investment websites analysed stocks by looking back at the company’s results for the last three years. It is typically unhelpful to their readers because short period analysis excludes the business cycle trend where shareholders want to know if the business is sustainable.

The solution is to review a company’s performance over 10, 15 or 20 years helping to paint a clear picture of the business cycle from peak to trough. Also, we can assess how a company, fundamentally reacts to a recession. This “all-round” research is useful for a retail investor looking for that historical trends and spotting that opportunity to invest at the right time.

NEXT’s Historical Valuation Trend

Earnings yield

A reciprocal of the PE Ratio, the earnings yield paints a picture of NEXT tussle with market sentiment versus operational performance.  The current earnings yield averages 8.37%, based on the average share price of £55.84/share in 2016.

Next year, earnings expect to fall by 3.4% to £644m. With the current share price of £39/share making the earnings yield rise to 11.3%.

Source: NEXT’s annual reports.

Given that NEXT average earnings yield is 7.61%, then you would think 11.3% is a bargain? In a historical context, NEXT’s earnings yield reached 16% during financial crisis of 2008/09, though at one point it touched 20%!

EV/EBIT

On an enterprise value to earnings basis, NEXT is 7.75 times, the lowest since 2008/09 and below its 18-year historical trend of 10.9 times, that same metric, two years ago, was at 15 times!

Explaining Earnings Yield and EV/EBIT Trend

So, why both these metrics are trading below historical averages when the business fundamentals have slightly deteriorated?

One important factor to remember is the future of “E” in these ratios! NEXT’s management warned that earnings would come in below guidance. Here are the following quotes from management:

“We may see a further squeeze in general spending as inflation begins to erode real earnings growth.”

“As previously indicated, following the devaluation of the Pound, we expect prices on like-for-like garments to rise, but by no more than 5%.  We expect that this will depress sales revenue by around 0.5%.”

Furthermore, management expects a £29m rise in costs for the following reasons:

1. National Living Wage;
2. Energy taxes;
3. Wage Inflation;
4. Website improvements.

All this means profits before tax range from £680m to £780m, which translate to a decline of -14% to -2% from previous year result. By putting this in a historical perspective NEXT’s shares fell from £19/share to as low as £6.17/share, a drop of 67%, when net income declined by 18% from £354m to £302m in 2008/09.

Sales are not vanity when in pursuit of a trend

Using EV/Sales and P/S, we get this chart:

Source: NEXT’s annual reports.

Not surprisingly, NEXT is close to its historical average, regarding their sales valuation. The current EV/SALES and P/S range between 1.5 and 1.6 times, the worse reading since 2011.

Explaining NEXT’s historical share price adjustments

The change in NEXT’s share price is affected by the retailer ability to reduce their share count (number of shares in issue), this effect the whole share price dynamic.

For instance, NEXT average share price in 2000 was £6.22/share, but when adjusted for the fewer shares in issue it is equivalent to £15.46/share. Below a table shows the change in NEXT’s share price adjusted and unadjusted:

Source: Finance.Yahoo.com.

Notice that at an adjusted basis, NEXT’s share price in 2008 is lower than it was back in 2000 meaning if today share price was to drop to £20/share it could be cheap in a historical context.

Therefore, THINK MARKET VALUATION, not SHARE PRICE!!

P.S. The above example should be taken into context that NEXT’s operations experience a temporary setback, which is EASILY fixable!

Share Price Forecast for NEXT PLC

The short-term share price projection

With limited technical analysis skills at hand, the technical chart is alerting you to a possible “divergence pattern” in NEXT’s share price and “convergence patterns” in two famous momentum indicators in the MACD and RSI.

For the above to occur, NEXT’s share price need to close below £35.5/share (its “BREXIT” low point) and, provided the momentum indicators do not make new lows!

Therefore, I recommend a BUY on NEXT’s share price between £33 and £35/share”.

Why?

Because, the momentum indicators would likely see its convergence pattern intact, if not, DO NOT get into this trade!  

The target sell price is £45-£47/share, a 30% upside.

P.S. Follow the 50 days simple moving average trend line, as NEXT’ fails to break above it twice meaning the continuation of its downtrend.

NEXT’s medium and long-term share price prediction – Using Macro Factors

This is harder to predict because of uncertainties surrounding its future earnings. However, I come to the conclusion that any short-term spike in its share price will be short-lived because fundamentals remain weak. Factors affecting NEXT future earnings are:

1. Inflation spike due to the weak GBP; – Necessities like food and energy costs spike, therefore non-essentials like clothing will come under pressure. So, it shouldn’t surprise you if NEXT lower forecast earnings again.

2. Bank of England raising interest rate; – this probability is low if inflation rate spike is temporary, but if inflation is persistently high, then rates could go up.

This action would tighten household budgets further due to RISING mortgage costs.

3. Will higher inflation leads to higher wages; – Inflation can be offset if employees get a wage increase equal to or greater than the inflation increase, therefore stabilising various sectors of the economy.  

Therefore, despite NEXT’s competitive advantages my forecast of NEXT’s shares would trade at £30 per share in a years’ time. However, at that level it represents a bargain for investors, but only if NEXT manages to sustain net income of £550m or more.  

I could be wrong in this forecast, but I could be very right.

Summary

1. NEXT PLC share price fell by more than 50% in the past 15-16 months.

2. NEXT PLC current operating margin is 20%, but likely to fall this year. However, since 1999 it never went below 10%!

3. NEXT’s PEG ratio stands at 0.61, which lower than BOOHOO’s 0.93 and ASOS’s 5.04.

4. The retailer’s online division has operating margins at 25% helped by interest income fees, which accounts for 50% of online earnings and 33% of total group earnings.

5. In the company’s retail division its revenue per SQ. Ft. declined from £1,000 to £650, while tripling in sizes.

6. 2017’s profit before tax guidance is between £680m to £780m, which is -14% to -2% lower than 2016.