With the UK high street highly distressed, the majority of analysts are sitting on the fence with ‘hold’ ratings on one of the retail sector’s biggest constituents, clothing-to-homewares colossus Next (NXT).

Long revered for its best-in-class retail disciplines and management team, not to mention an impressive record of surplus capital return, Next is rebuilding investor confidence following a downturn in fortunes.

In fact, 2017 was ‘the most challenging year we have faced for 25 years’ according to CEO Simon Wolfson. A difficult clothing market and self-inflicted product range errors were among the reasons for earnings decline.

Despite this doom and gloom, shares in Next have held up quite well. At the time of writing they are trading close to a 12-month high of approximately £52, although still considerably below the £80 level seen in late 2015.

According to Reuters, 12 analysts currently have ‘hold’ ratings on the stock, versus eight with ‘sells’ and only three with ‘buys’.

Full year results (23 Mar) from the one-time stock market darling drove a relief rally in the unloved shares. Investors welcomed the absence of another profit warning.

Shareholders were actually treated to a crystal clear analysis of the challenges facing the fashion purveyor and a study of its strategic responses in terms of online investment, improved stock availability and how the company plans to manage its store estate.

To help you better understand the company’s situation, we’ve pulled together the bull and bear case on the stock. You should also note that Next’s latest trading update is scheduled to come out at the same time as this article (10 May 2018). Assuming there are no major setbacks in that trading update, we remain fans of the stock and have a long-standing ‘buy’ rating.

THE BULL CASE

Cash generation

Next’s strong cash generation, dividend yield and a £275m share buyback for the current financial year should enable the retailer to invest in competitive advantage and provide a degree of downside share price protection.

Best-in-class management team

Despite the challenges of a tough clothing market and the acceleration of the structural shift from bricks-and-mortar stores to online, Next remains a well-managed company with tight cost and stock control and a focus on full price sales.

Profit declined again last year, yet it was in-line with previously issued guidance, demonstrating how well the clothing retailer is managed. We note that Next now makes more profit online than it does from physical stores.

Self-help levers to pull

In common with other physical store retailers, Next is over-spaced. It trades from 528 bricks-and-mortar stores as well as its large online business, Next Directory.

Yet the company does have self-help levers it can continue to pull. These include continuing to ‘churn’ the store portfolio, bearing down on sourcing costs, shortening leases and filling floor space with an array of concessions.

Interestingly, its net rent fell by 28% in 2017 on 19 stores where the leases were renewed. Landlords have also paid for a large part of store refitting costs.

Improving cost and consumer backdrop

Wolfson and his management team appear confident that rising costs, a squeeze on consumers’ real incomes and the shift in spending from ‘stuff’ to experiences are cyclical trends which may start to come to an end in the year ahead.

Furthermore, any rise in the pound should restrain import costs and help to put a lid on inflation, becoming a tailwind if the currency keeps appreciating throughout 2018.

We urge to you read Next’s financial results because the way the company communicates its strategy and performance is streets ahead of any other listed company in terms of clarity.

THE BEAR CASE

Food for the bears has been served by investment bank Berenberg, which recently reiterated its ‘sell’ rating following the annual results, albeit with an increased price target of £38.

Its bearish thesis is that a restructuring will ultimately be required.

While Next has benefited from the structural shift of sales online, Berenberg argues the aforementioned 528-strong
store estate has become a burden, hindering its capacity to invest in product and online.

And whilst the company has a long history of strong financial discipline and cash returns, this will come under pressure if its market share declines.

Undifferentiated product 

‘We believe Next’s product remains undifferentiated, online is simply cannibalising store growth at an incremental cost and the store estate is a misallocation of capital leading to market share erosion. Given the weak comparatives, we would sell after the first
quarter results on 10 May 2018,’ writes Berenberg.

It argues that Next’s slow supply chain means its products are exposed to greater competition. Next sources 89% of its product from Asia on 32-week lead times, making it difficult for Next to respond to fashion trends and maximise the efficiency of its inventory.

This forces the retailer to concentrate on more basic products for which customers are more focused on price.

‘We believe its basic product is particularly exposed to the shift of sales online and, in particular, to the competitive threat from Amazon,’ continues Berenberg.

‘While some investors question the likelihood of consumers buying clothing from Amazon, we expect it to become the largest clothing retailer in the US over the next 12 months. We believe it is aggressively taking share in Europe, driven by a strong delivery proposition and low prices.’

From Shares’ own experience, we think it is important to note that many of the clothes sold on Amazon are poor quality, sold cheaply in the hope that the customer won’t care because the price point is low. Consumers will only go down this route so far before they yearn for better quality products, even if it means paying slightly more money, in our opinion.

Online growth laggard 

Berenberg insists Next’s online growth is lagging that of its peers. Once its third party business LABEL is stripped out, Next’s private-label online sales only crept up 0.4% in the UK in the last financial year.

The investment bank attributes this weakness to Next’s undifferentiated product and the lack of a free home delivery option.

Capital misallocation

Next’s verdict is that its ‘extremely profitable’ store portfolio is an asset, albeit one declining in value, rather than a liability.

Yet Berenberg argues the estate is a misallocation of capital and ‘with capex levels broadly flat over the last two years, a growing credit book, limited sales growth and profit decline, return on invested capital is in decline’.

Significantly, new retail space remains Next’s biggest investment, yet according to Berenberg the current strategy is ‘formulated to maximise short-term returns based on its current business model, rather than adapting to maximise its longer-term market share potential as the industry faces a major overhaul’.

It believes this commitment to offline stores (from both an opex and capex perspective) is preventing Next from investing in areas that matter most to the consumer (product and delivery), leading to market share erosion.

Sporting too many stores, Berenberg says that even shuttering outlets at this stage in the game would hurt the online business.

‘First, the online business would lose the benefit of the store estate as a marketing tool,’ says Berenberg, and second, ‘given that circa 50% of the online business is click-and-collect, we struggle to see how it would be unaffected. Management would face a choice, in our view, of losing sales or offering free home delivery. This would further erode profitability.’ (JC)

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