Cube Midcap Report (19 Sep 2019) – Should Next fear changing mix? #NXT #IGG

Cube Midcap Report (19 Sep 2019) – Should Next fear changing mix? #NXT #IGG

Good morning,

It’s Roland here with today’s Midcap Report. On my radar for today are:

Next (NXT)

  • Share price: 5,918p (-4%)
  • Market cap: £7.9bn

Half-year results

Today’s half-year results from the FTSE 100 retailer contain few surprises. Boss Lord Wolfson has left guidance unchanged for the full year, which is perhaps why the Next share price has fallen slightly. The firm’s previous update, which I covered here in July, benefited from an upgrade.

In this report, I plan to take a brief look at the headline figures from the half-year results. I then want to look in more detail at the changing mix of the group’s profits and the impact this is having on profitability.

I remain a big fan of Next and share Graham’s view that it’s a high-quality business. But I do think there are risks investors should be aware of as the firm’s operations undergo a strategic shift.

Results summary

Next’s group sales rose by 3.7% to £2,058.8m during the six months to July. Pre-tax profit was 2.7% higher, at £319.6m.

Growth came from a 12.6% rise in online sales and a 9.9% increase in finance revenue. Retail (store) sales were down by 5.5%.

NXT 1h20 sales split

The group’s focus on shareholder returns continues. The interim dividend has been increased by 4.5% to 57.5p per share.

Guidance for the year assumes £300m of share buybacks, which are expected to provide a 5.1% uplift to earnings per share. As ever, the quality and transparency of the firm’s reporting is outstanding — here’s a snapshot of how management expect the current year to turn out:

NXT FY20 guidance

Source: Next interim results, 2019/20

Checking back to last year’s results, Next reported earnings per share of 435.3p. Using the figures above suggests that we can expect earnings of about 458p per share this year.

That puts the stock on a forecast price/earnings ratio of 13, with a prospective yield of 2.8% (based on broker forecasts).

As I’ve commented before, this seems a reasonable valuation to me, although not necessarily especially cheap for a business that’s delivering almost no underlying profit growth.

Changing the mix

The shift in Next’s revenue mix over the last five years is staggering. Fortunately, to save me having to wade through old reports and piece together the data, Next has (of course!) provided a snapshot to show this change:

NXT five-year sales mix (1H20)

The group’s mission is to become the market-leading online aggregator for fashion and homewares. In today’s report, chief executive Simon Wolfson has included a long essay explaining the challenges and changes this shift has brought.

(If you’re a shareholder or would simply like to learn more about how modern retail works, I would strongly recommend reading the full version of today’s half-year report – here.)

“Economically uncomfortable”: Lord Wolfson admits that the shift online has been “economically uncomfortable”. To his credit, he highlights growing pains with the group’s warehousing infrastructure. These mean that the cost per item picked, excluding wage inflation, is 10% higher than in 2016.

One complication is that offering a wider choice of products can introduce diseconomies of scale. For example, the group’s online sales have risen by 47% over the last four years, but the number of unique items sold (SKUs) has risen by 141%. This means larger warehouses and potentially longer picking times. As a result, warehousing capex is expected to “maintain rather than improve” the efficiency of these operations.

Profit vs eps: Lord Wolfson also points out that although this year’s sales are expected to be 8% higher than in 2015, costs associated with the shift online mean that profits are expected to be 7% lower than five years ago.

However, capital discipline and continued strong cash generation mean that the group has been able to return £1.7bn to shareholders over the period, through dividends and buybacks. This means that earnings per share for the current year should be 9% higher than five years ago — a new record.

Shareholders have never had it so good! But can a big online business continue to provide returns on this scale?


Next’s business has three profit streams — retail, online and finance. Here’s how they contributed to the business during the first half:

NXT 1H20 profit split

Retail: Retail profit fell by 23.5% in H1, even though retail sales were only 5.5% lower.

Next’s H1 retail margin has fallen from 7.9% last year to just 6.4%. That’s a big drop in one year.

I believe we’re seeing operational gearing in reverse here, thanks to stores’ relatively high fixed costs. Although rents are coming down, this can only happen at lease renewal. The group says about 50% of leases are due for renewal within five years.

Online: Lord Wolfson’s comments about diseconomies of scale in the online business appear to be illustrated by today’s results. Online sales rose by 12.6%, but online profit was only 8.4% higher.

This implies the group’s online profit margin fell from 18.3% in H1 last year to 17.6% this year. However, this is still an impressive figure, in my view. For context, Boohoo generated an adjusted operating margin of 9.9% last year.

Finance: Customer credit remains a crucial part of the Next business model and contributes more than 20% of operating profit. As I see it, profits from this operation can be used to offset the lower margins on sales of third-party product online.

This lending business is very profitable. Next’s profit margin on finance rose from 50% in H1 last year to 56% during the first half of this year. That’s not entirely surprising when you consider the group’s cost of funding is 3.6%. I believe customers are charged 23.9% APR.

Bad debts are under 5%, while 76% of customers have used the service for more than five years. I suppose we must assume that they’re happy with this service and the price they pay for it.

My view

There are a lot of moving parts in the Next business. Two concerns stand out to me from today’s results.

Retail: Will rents fall quickly enough to prevent the retail division becoming loss making?

Widespread store closures aren’t necessarily desirable, as 50% of orders are collected from store and 82% of returns are made via this channel. So while the store estate evolves and moves to a lower rental base, margin pressures from this division could grow.

I wonder whether the clever utilisation of the store network to support the online business is one reason why Next’s online margins are so much higher than at rival retailers?

Profit growth: Earnings per share are continuing to rise thanks to the financial engineering of share buybacks. I have no problem with this, but in my view, the business will need to return to absolute profit growth at some point if it’s to remain an attractive investment.

It’s not clear to me how soon this is likely to happen, if at all. However, given the quality of Next’s management and the group’s strong execution to date, I would be happy to continue holding these shares.

IG Group Holdings (IGG)

  • Share price: 627p (+8%)
  • Market cap: £2.3bn

First-quarter update

(At the time of publication, Roland has a long position in IG Group Holdings)

The IG Group share price is up by nearly 9% at the time of writing, after a solid first-quarter update from the CFD and spread-betting group.

Strong results: You may remember that IG and its peers were hit by new restrictions on the amount of leverage they could offer to retail clients in August last year. So comparisons with the first fiscal quarter of last year (June-August) give us a chance to see how the business is performing under the new regime.

The signs are positive, in my view. Performance versus the same period last year was broadly unchanged:


In fairness, this year’s results appear to have been improved by more favourable (volatile) market conditions in August than in 2018. But I think these figures are still pretty credible, given the scale of the regulatory changes.

Continued growth: First-quarter revenue of £124m in the group’s core OTC leveraged business (CFD and spread betting) was significantly ahead of the £110.1m average for Q2-Q4 last year. This suggests the group’s focus on high value, professional clients is offsetting much of the impact of the regulatory changes, which only affect retail [amateur!] traders.

Strategic uncertainty? IG’s core business is still performing well, but efforts to diversify into exchange-traded derivatives and stock trading appear to have delivered limited results so far.

In May 2019, the company identified a number of growth opportunities, including new products and expansion into Asia. According to today’s update, revenue from these opportunities rose to £19.9m during Q1, compared to £7.4m in Q1 FY19.

Annualising this figure suggests a total of £80m or more for FY20, versus £60m last year. Chief executive June Felix is targeting £160m of revenue from these areas in FY22.

I’m not yet completely convinced that this will be enough to return IG to sustainable long-term growth. But given the group’s high margins, cash generation and market-leading reputation, I’m happy to continue collecting the stock’s 7% dividend yield for now.

I’m afraid I’ve run out of time to cover Saga today. Suffice it to say that the over-50s insurance and travel company is still looking for a new boss. In my view, the situation remains challenging and uncertain, as the group is struggling to differentiate its services from all-age alternatives.

Thanks for reading,



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