Valuation: NEXT plc (LON:NXT) 24H1 (2024)

I first posted this in November 2023 on the Trading 212 app in the Value Investing community under the username “Anathema”

Another valuation piece on a recent position I have opened.

Who are NEXT?

I expect pretty much everyone in the UK recognises NEXT, but for those who are not UK based, NEXT are predominantly a clothing and home decor retailer, but who have recently been on a bit of an acquisition and expansion spree in recent years, either buying or agreeing licensing arrangements with Joules, Cath Kidston, MADE.com, Lipsy and Jasper Conran.

Segments are broken into Retail, Finance, Online and (effectively) 'Other' (including sourcing, international and property management). Joules (bought last year) has its own segment and recently, the Company has introduced 'Total Platform' as a segment, which I will talk about a bit later. Lipsy has been removed as a segment.

Online has grown from roughly 33% of revenues to 55% over the last 5 years, now contributing around 50% of underlying profits, while retail has dropped to around 25% of profits. However, it seems to have plateau'd recently at around one third of revenues. Finance makes up around 6% of revenues but 17% of profit, while Joules and Total Platform make up a few percent of revenues and profits each (Total Platform profit being a few percent positive and Joules' profit being a few percent negative at Group level).

The Bear Case

Pretty simple - the recession is coming! Retail tends to have low margins, is highly sensitive to weather, etc etc. Maybe there is the usual argument about di-worse-ification, and for sure Joules is currently making a loss. Simon Wolfson openly admits the integration of Joules has been more challenging than anticipated, and this could act as a drag on earnings in the future.

Also, debt is not insignificant, at around 80% of equity, or 170% of equity including leases.

The Bull Case

I genuinely believe NEXT has a strong arsenal other retail groups don't have. I personally feel it operates with few direct competitors, maybe M&S in physical stores, John Lewis, or Online retailers like ASOS (who I think are a different proposition entirely).

But I think the strongest opportunity is for NEXT to grow its Total Platform offering. NEXT has a very strong online, warehousing and stock management product. It already offers this as a service to other companies and, with the acquisition of Joules, is now expanding its offering to include more backend services like payroll management. They expect this to be attractive to a number of smaller retailers and it offers very strong profit margins (40% - 50% of segment revenues). Especially if a recession squeezes margins for other retailers, the opportunity to outsource these services might become more attractive.

Even during COVID, NEXT still turned a profit of around half the EPS of prior and more recent years, which I think is no small feat.

Although debt is high, interest cover is around 30x and effective rate is around 3%, and my adjusted Operating Cash Flow is around 6x - all very affordable currently.

By the numbers

5y CAGR revenue growth is around 4% and has been increasing. My adjusted gross margin (excluding fixed costs like employee wages, depreciation & amortisation, etc.) has increased from 53% in 2017 to around 65% in 2023, EBIT margin generally hovers around 18%, exc. covid, and has been growing at 4% CAGR for last 5y, increasing from 2% CAGR after covid. Net profit margins are around 14% (exc. covid) and EPS has been growing at over 5% per year, helped by around 2% reduction in shares outstanding via buybacks. Net profit margins are under a bit of pressure from SG&A increases currently, presumably a consequence of wage inflation, which hopefully will moderate going forwards.

Quick ratio, current ratio and total assets-to-liabilities are all healthily greater than 1. Working capital is fairly steady at around 22% of revenues, and dividend payout ratio is comfortable at around 33% by either earnings or free cash flow.

Return on assets is around 18%, strengthening since covid but down on pre-covid returns of > 20%. ROIC and ROCE are healthy at 25% - 30%. WACC has been increasing as Beta has been increasing over the last few years, but is still a reasonable 7% by my calculations. This means returns are comfortably outpacing the cost of capital.

Inventory turns have been decreasing, leading to an increase of days' inventory held and an increase in cash conversion cycle to over 210 days. CapEx is slightly ahead of depreciation costs, and FCF is strong at over £7/share, around 9% yield. P/E is now in the middle of recent ranges, at around 12.

Fair Value

Assuming:
- EPS in range £4.20 (2017) to £5.40 (24H1)
- EPS growth flat to +5%
- Tangible book value of £2.50 to £4 (vs nominal value of £9)
- WACC in range 5% to 8%
- RFR in range 2% - 4%
- Exit P/E in range 10 to 15
- FCF in range £4.20 (2018) to £5.50 (2023) this ignores several years of £6 - £7 FCF/share inc. 24H1
- FCF growth in range -15% (recent drawdown) to +5% (5y CAGR growth)

I get the following fair values:
P20: £62 (FCF or EPS similar)
P50: £66 (FCF) to £70 (EPS)
P80: £73 (FCF) to £77 (EPS)

I have probably bought in at a relatively high position, nearer the P80, but I am comfortable to hold based on the above analysis and average down if the opportunity permits.

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