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OPINION

The Next embarrassment of riches

The Next embarrassment of riches
September 24, 2015
The Next embarrassment of riches

Problems of success are ones that every company – and investor – might welcome, but even so, they can be a bit embarrassing. “In 2011 the Board awarded me an incentive scheme [whose value] was closely linked to the Company’s shares. In the last three years, thanks to everybody’s hard work, Next has grown its profits per share by 65 per cent and the company’s shares have trebled.” Lord Wolfson told Next employees last year. “As a result… my [share award] has become more valuable than I could possibly have hoped.” He said he’d sacrifice it and the £4m saved would enable Next to pay all its longer serving people an extra bonus.

This did not stop the High Pay Centre from pointing out that even after this, his pay was about 450 times the average salary for a Next employee, a differential second only to that in WPP. Even so, Lord Wolfson deserves some credit, as does Next, for placing limits on high pay. Next imposed a cap on the payout from its long-term share plan, admittedly high at £2.5m; and Lord Wolfson has effectively capped his take home pay at £4.5m. This is about the same as the dividend income he is likely to receive from the 1 per cent of Next that he owns.

But, as Mr Weight has also pointed out, most chief executives’ pay is about 0.025 per cent of their company’s market cap. Active fund managers charge many times this and often do no better than those with passive strategies. On this basis, good chief executives are good value.

So how does Next measure success? It says that because it’s mainly a single business, the growth in earnings per share (EPS) is best for its annual bonus. Since nothing significant is earned from peripheral businesses, this measure indicates how well its growth strategy is being achieved in the short term.

For its long-term share awards, it uses total shareholder return (TSR), preferring ranking rather an index. Fine if its outperformance continues, but if it falters, this risks the eventual payout becoming a bit of a lottery (as discussed in TSR: confused.com? on 13 July 2015).

These two performance measures could be regarded as facets of a similar thing: the performance that EPS measures is in the past; the performance that the TSR share price values, influenced by past and forecast EPS, is the future.

EPS appeals to directors partly because headline EPS is published and everyone can see where it comes from. The complication comes with the one-off issues that every company faces, some within executives’ control, some beyond it: such as supplier problems, the weather, accounting changes, tax credits or the sale or purchase of bolt-on businesses. Selecting which factors are exceptional is often a matter of judgement, so the adjusted “underlying” EPS that some companies use as a performance condition is a less reliable figure. Next merely calculates pre-tax EPS for its annual bonus to avoid distortions from tax.

Critics say that EPS can be manipulated for short-term window dressing, such as by price increases, late payments or over zealous cost cutting. Distortions can arise from increased debt and off-balance sheet vehicles. Income can be recorded too soon; costs can be capitalised. Accounting conventions only go so far; some figures inevitably need estimating and boundaries might be pushed when profits falter.

And then there are buybacks: with fewer shares in issue, EPS goes up, and so does the dividend yield and the share price, at least in the short term. Many companies buy back their own shares regardless of the price, and Lord Wolfson has published his own rules. Investment for long-term growth comes first; buybacks depend on the expected rate of return; they must be earnings enhancing and funded from surplus cash flow, not debt. He has honed this policy over the last ten years, during which time Next has bought back over half its shares in issue. When the share price is too high, it pays a special dividend instead - as it is now doing.

Can buybacks influence EPS as a performance measure? Yes, because they reduce the number of shares in issue; so Next makes suitable adjustments. But then: what about the special dividend alternative? It adjusts for it as well to avoid any “unintentional reward or penalty for management”.

And there’s another, not so obvious, consequence of Next’s success. At its current share price, it’s paying special dividends. As long as Next keeps to its own rules, renewed buybacks could herald a “buy” signal for investors.