Why Next is the only retailer I’d want to own in my portfolio

The world of business is ruthless, and if there’s one sector that’s more challenging and brutally competitive than any other, it’s retail.

Asos (LSE: ASC) and Boohoo (LSE: BOO) illustrate this point. Six years ago these firms were at the cutting edge of the e-commerce industry. In 2016, shares in Boohoo traded at over 80 times earnings while investors were willing to cough up more than 100 times earnings to buy into Asos’s growth story. In the 10 years between 2008 and 2018, shares in Asos returned more than 3,000%.

Both of these businesses have now run into multiple headwinds and growth has shuddered to a halt. Investors have been quick to jump ship, pushing shares in both Boohoo and Asos down by more than 70% over the past 12 months. In comparison, Next (LSE: NXT) is off just 25% over the past 12 months.

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Next has outperformed because it was prepared. The company’s managers are well versed in navigating through retail storms and outperforming the market.

Over the past 15 years, Next has produced a total return for its investors of just under 9% a year, compared to a return of 5.9% for the FTSE All-Share index. A sum of £10,000 invested in the company in 2007 would be worth around £37,500 today.

Next has plenty of experience of dealing with uncertainty

I think you’d be hard-pressed to find an enterprise that’s as well-managed as Next. Investors reading its annual results are treated to a full-colour review of the organisation, with every division analysed and projections explained in plain English.

The group’s share buyback policy is the perfect example. Next will only repurchase shares if it can achieve a minimum 8% equivalent rate of return (anticipated pre-tax profits divided by the current market capitalisation). If the business cannot earn a 8% return on its investment, it will wait for a better opportunity. And if buybacks look unfavourable, the company’s other preferred method of returning cash is with special dividends.

Management publishes this information so that investors can work the sums out for themselves. At the time of writing, the equivalent rate of return is a little over 10%.

It is not unreasonable to say that without the stewardship of its CEO, Lord Wolfson, Next would not be where it is today. Wolfson worked his way through the ranks of the retailer before he became its CEO (and the FTSE 100’s youngest) at just 33. He has been instrumental in driving the business forward in the constantly changing retail environment. As other retailers have come and gone, Next has kept pushing forward.

As Wolfson notes in Next’s annual report, over the past five years the sector has “changed beyond recognition.” To stand, out retailers have to be a one-stop-shop for consumers. These online aggregators have become “increasingly important” as the barriers to entry for setting up a clothing business have all but disappeared.

In this shifting market, the organisation now has two aims: to extend the reach of the legacy clothing division; and to “build an aggregation business that is the natural first choice for fashion, homeware and beauty customers.”

Next is investing in building a future-proof business

There are two prongs to the company’s plan for becoming a leading aggregation business.

Next’s branded arm, LABEL, sells third-party brands through the Next website, and it is proving to be popular with buyers and sellers alike. Total LABEL sales jumped 69% over the last two years to £865m. Management keeps adding new third-party brands, and plans to focus on homeware brands this year.

Alongside LABEL sits Next’s Total Platform offering. This takes the LABEL concept further, allowing third-party brands to access the firm’s infrastructure. It charges a fee for the service and is targeting a profit margin of 5%-7% on sales through the platform. This is an ingenious way of increasing the return from existing infrastructure investments with minimal incremental spend.

Keeping legacy branches open is an important part of Next’s e-commerce strategy. The group has found that servicing returns in stores is both easier for the customer and more cost-effective for the business. In fact, Next reckons that closing too many stores would become a “potential threat to online sales,” as it would lose collection and return capabilities.

As such, it plans to keep 330 shops open over the next 15 years at a cost of £45m. This is a relatively insignificant outlay compared to projected overall cash flow of £14.6bn for the period.

Unfortunately, falling brick-and-mortar sales will prove to be a drag on earnings for the foreseeable. The firm estimates physical store sales will fall at a compound annual growth rate (CAGR) of 10% over the next 15 years. Online growth will pick up the slack with overall sales growth expanding at a CAGR of 4.1%.

By fully exploiting the benefits of its infrastructure footprint, Next is building a competitive advantage in a market that is becoming increasingly ruthless, and the company plans to spend a further £160m a year over the next 15 years to define, develop and refine its moat.

While I’m impressed with Next’s direction, management and cash generation, the projected sales CAGR of 4.1% for the next 15 years hardly gets the pulse racing. Still, Factset broker estimates put the stock on a forward price/earnings (p/e) ratio of 13.2 with a potential dividend yield of 3.7% - not too demanding considering its evolving competitive advantages and growth prospects. That’s why this retailer is my sector pick.