This week has been a cruel one for Next plc (LON:NXT). It has seen its share price fall by around 17% following the release of a profit warning. In my view, the downgrade in profit expectations for the 2017 financial year was hardly surprising. After all, the company had warned that 2016 ‘may be the toughest we have faced since 2008’.
Looking ahead to 2017, it could prove to be more of the same. Higher inflation caused by weaker sterling could squeeze consumer incomes in real terms, meaning consumer spending takes a hit. Retailers failing to offer budget prices or lacking high levels of customer loyalty could suffer and see their share prices fall in my view.
However, I think that Next will perform well compared to its peers. It has exceptionally strong cash flow, a low valuation and income appeal. Alongside a high degree of customer loyalty, I believe that this makes Next a top turnaround opportunity for the long run.
A difficult outlook
In the short term, things could worsen before they improve for Next and the wider UK retail sector. The UK faces unprecedented risks from Brexit in my view, and this could lead to increased uncertainty as the year progresses.
In particular, negotiations between the UK and EU could progress at a relatively slow pace, or it could seem likely that access to the single market will not be achieved. In such a scenario, it is probable that sterling will remain weak, or even depreciate further and lead to a continued slide in the value of the pound.
The expected result of a weaker pound this year is higher inflation. The impact of this on consumer spending could be negative, since it may mean that UK workers return to the situation from the Great Recession where wage growth lagged price rises.
This could mean that consumers essentially have less to spend than they did in 2016, which was already a tough year for the retail sector. Since Next sells discretionary items, it could fare worse than sellers of staple goods as consumers may delay spending on non-essentials until their financial position improves.
The effect on the retail sector
As was seen in the Great Recession, there will inevitably be winners and losers within the retail sector during a more challenging period.
Sellers of cheaper, budget products may benefit as consumers seek to cut their spending. However, I believe that mid-price point operators could struggle as they lose custom to cheaper rivals and face a quandary as to how to react.
I would be unsurprised if Next’s profit warning is the first of many as the year progresses.
On the one hand they could discount their goods in order to improve sales figures. On the other hand, they may wish to maintain prices so as to keep margins at similar levels to last year.
Unfortunately, the impact on the bottom line is the same. In my view, 2017 could be a difficult year for mid-price point retailers and I would be unsurprised if Next’s profit warning is the first of many as the year progresses.
Next’s customer appeal
However, I also believe that Next will cope better than most of its sector peers this year. It enjoys a relatively high degree of customer loyalty which was in evidence during the last recession.
For example, its sales and net profit only fell in one year from financial year 2008 onwards. This occurred in FY 2009 when sales declined by 1.7% and net profit was 7.5% lower. In all other years since 2008 it has seen positive growth and even in FY 2009, the company was able to reduce net debt by £111 million and thereby put itself on a stronger financial footing for the future.
Regarding its current financial standing, I believe the company’s strong cash flow could help it to survive better than most retailers in 2017.
In this week’s trading update, Next stated that ‘it expects the company to be strongly cash generative, with surplus cash from operations of between £255 million and £345 million’. This could be a differentiator between it and other retail stocks in my view, since it will allow Next to return surplus cash to investors while also offering lower risk than elsewhere within the industry.
Valuation and income appeal
Next’s cash flow will allow it to pay special dividends of 180p per share in FY 2018. This amounts to a yield of 4.4% and when added to the ordinary dividend, means that it could yield as much as 8.3% in FY 2018. In my view, this is a yield which is too good to miss for income investors and it highlights just how cheap the company’s shares have become.
This is backed up by its P/E ratio of 9.3. Although EPS is expected to grow by 1% in FY 2018, I feel that there is scope for additional downgrades to its profitability.
…this is a yield which is too good to miss for income investors and it highlights just how cheap the company’s shares have become.
Although further downgrades could hurt its share price in the near term, it is nevertheless relatively undervalued on a long term basis. Buying now could mean a failure to find the bottom in the company’s share price, but over a 3-5 year timeframe Next could be trading on a significantly higher multiple of EPS in my opinion.
The prospects for the UK retail sector remain disappointing in my view. Brexit is likely to cause further uncertainty in the UK’s economic outlook, which could lead to weaker sterling and higher inflation.
In turn, this may hurt consumer spending as salary gains fail to match a rising price level. In such a scenario, retailers which lack significant customer loyalty or who fail to match customer expectations on price through discounting may see their sales fall.
In my opinion, Next will be able to survive 2017 in good shape relative to its peers. As the Great Recession showed, it has a high degree of customer loyalty and when matched with its strong cash flow this should position it well for survival.
Its high yield and low valuation also make it an appealing long term buy in my view, although high volatility means its shares are unlikely to be suitable for widows and orphans during the course of 2017.