Buy into the Next step

Making the best of a bad situation

In the UK, physical stores have been losing the battle against their digital counterparts for a number of years. Next has actively been trying to reshape its shop estate in response. It has cut its UK store numbers from 540 in January 2016, to 498 at the end of July. At the same time it has been relocating away from high streets to larger out-of-town stores. This means that while store numbers are down, selling space has continued to grow. Importantly, this strategy has substantially cut the retail operation's costs per square foot (sq ft), although the decline in sales per sq ft has unfortunately been more aggressive (see chart).

As well as moving into larger spaces, negotiating lower rents has been an important factor in getting costs down. There should be more savings to come from embattled landlords. This year, Next anticipates renewing 60 leases and halving rent on these stores, saving £9.9m annually. Of these renewals, 18 of these will be turnover-linked, which would protect Next in the event of further decline. Half of its store leases are due for renewal in less than five years, offering the opportunity for further savings. But despite all its efforts, prior to the pandemic, net UK retail profits had fallen by almost 60 per cent over five years, coming in at £168m in the 12 months to the end of January this year.

However, at the same time as its stores have been suffering, Next has had huge success growing its Directory catalogue business online. This has included setting up its online Label website to sell third-party brands. Online growth has also led to growth in its finance business, which allows customers to buy on credit and charges high levels of interest on outstanding balances. The progress in these two operations has prevented severe profit falls over the past five years. Meanwhile, a policy of returning a significant proportion of excess cash by buying back shares means at a per-share level investors have continued to see profits improve.

Next has been able to draw on the resources of its physical retail business to aid its digital ambitions. As well as shared warehouses, Next’s stores have become an integral part of the online distribution network. Online customers collect about half of their purchases in stores. They also bring more than 80 per cent of their product returns back to shops, which helps cut down processing costs and also the time between return and resale. Indeed, these features helped the online business achieve an enviable operating profit margin of 18.6 per cent last year. The high level of in-store returns has also facilitated the better availability of stock, helping to add an additional £30m in stock during Christmas last year. And the finance business also benefits from the development of the online operation, with broader stock ranges helping to increase average customer balances.

All in all, since 2016, Next has changed from having physical retail as its biggest profit generator to having profits dominated by online and finance (see chart), which together have grown 36 per cent over the past five financial years.

* Next Finance first split out in 2018

Covid catalyst

The coronavirus pandemic has hastened a shift towards online shopping and Next, which is already ahead of the curve compared with bricks-and-mortar peers, is grasping the nettle. Its online sales overtook retail for the first time last year, although it started beating stores on profit in 2017. While the pandemic hit sales in the spring, from the end of May Next’s online sales overtook where they were before the pandemic struck, even with stores open. Next’s product mix has favoured a prolonged period of home-working, with its home and children's clothing accounting for more than half of spring and summer clothes sales in 2019. Next has also found its stores well placed, with anxious shoppers preferring to visit larger shops in retail parks, where Next now has 62 per cent of its estate.

The clearest sign of where Next sees its post-pandemic future comes from its capital expenditure plans. It will be massively shifting spending towards its online capabilities and away from store growth. Indeed, in the coming five years it plans to bring store investment down to maintenance levels, with associated capital expenditure of just £16m a year from 2023 compared with an average spend of about £80m in each of the five financial years to January 2020. The chart below shows the full breakdown of the shift in spending plans.

A key focus of spending will be £370m to boost warehouse space by 80 per cent. This will support a £1.7bn increase in online sales capacity. It will also reduce costs, with a new online boxed warehouse, due for opening in 2023, expected to nearly halve the labour costs of online box picking. Essentially Next, which is a company well known for its operational savvy, is attempting to build the kind of infrastructure that would make rivals green with envy. It's therefore perhaps not surprising that it has also started to sell third parties these services – everything from website plumbing, to call centres, to logistics, to click-and-collect, to customer credit.

Next has already signed up designer kidswear retailer Childsplay to what it calls its "Total Platform". Next will get pay-as-you-go income based on sales commission. A similar scheme is also under way with the Victoria's Secret UK lingerie brand, which has been bought out of administration and put into a joint venture, that is 51 per cent Next owned. It is very early days, but nevertheless the Total Platform represents a potentially exciting foray into the kind of growth-focused business model being pushed by the likes of Hut Group, a popular recent IPO currently commanding a £27bn market cap. 

Keep the cash coming

While Next has found inspiration to put its business on the front foot during the pandemic, it has also encountered pain. Accordingly, in April the company put a halt to the cash returns it is famed for. Next’s central forecast is for sales to be down by a fifth this year. Fears about the long-term impact on cash flows are underlined by the importance buying back shares with surplus has had on earnings per share (EPS) growth over recent years. For example, a £300m outlay in Next’s most recent full-year helped to drive earnings per share growth of 5.6 per cent, despite corresponding pre-tax profit growth of 0.8 per cent.

However, the first-half performance also gave reason for optimism. Property sales and staggeringly efficient stock management helped Next reduce net debt in the six months by £462m to around £650m excluding lease liabilities, leaving it with a healthy headroom of £925m. We don’t expect the dividend to return this year given Next’s receipt of furlough support, however, but it may not be too far off. The loan book has thrown off cash and shown few signs of strain to date. Reduced sales and £241m of collections led to customer receivables falling from £1.2bn in January to just under £1bn in July. The end of furlough does present a noteworthy and unpredictable risk, though, and Next has made provisions of £20m for a pick-up in bad debt.