Image credit: Next plc

I don’t normally have a problem with volatile stocks or deep drawdowns on value investments. But during the time I held Next (LON:NXT) shares, I was unable to find my usual level of conviction. I’ve documented some reasons for this here and here.

I suppose I wasn’t entirely convinced that Next really was a value stock. By this I mean that I wasn’t sure if there was any unrealised value in the group, or whether it was simply fairly priced for a business whose profits are currently declining or at best stagnating.

After the firm’s strong Christmas trading statement and the stock’s subsequent journey back to the £50 levels, I decided to sell, locking in overall profit of 26%, equivalent to an annualised total return of 32%.

This sales may prove to have been short-sighted. We will see. I wouldn’t rule out buying back in again if the stock appeared cheaper. But I’m trying to tighten the strategic focus of my portfolio on genuine value and special situations.

I’m not sure if Next is either at the moment. Here are a few metrics to illustrate why I came to this conclusion:

• PE10 = 15.6 – Next’s earnings grew powerfully in the years up to FY16. They’ve fallen since then. For this PE10 to be cheap you’d have to take a view on Next as a growth business, not a mature business. I don’t see this.
• Forecast P/E of c.12.5 & prospective yield of 3.3%. The board’s decision to switch back from special dividends to buybacks probably makes sense. But this valuation seems entirely fair to me. With earnings expected to fall this year, it’s hard to see why the stock should be worth much more.
• Uncertainty and a new lack of disclosure over the future profitability of the Directory Credit business. Although the Directory Credit loan book is an attractive asset per se, recent comments have suggested the profitability and growth rate of this lucrative element of Next’s business could be changing.

I freely admit I may have been too cautious and too pessimistic with Next. I wouldn’t be entirely surprised to see the shares trading much higher by the middle of this year. But I’ve made my decisions as part of a wider clear out of retailers in my portfolio.

One problem may be that non-food retail is not a sector I feel I understand very well — while the accounting is simple enough, the dynamics and growth drivers of this business aren’t entirely clear to me at the moment.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Image credit: Next plc

Disclosure: Roland owns shares of Next.

When a company changes the information included in its results, I tend to get worried. In my experience, there’s always a reason for this. And it’s rarely good news for shareholders, especially when the missing data relates to a key profit driver.

The problem

One of the things that worries me about Next plc (LON:NXT) and some of the other big retailers is their dependence on consumer credit. Last year, I estimate that roughly one-quarter of Next’s operating profit came from interest payments (currently 22.9% APR) made by the group’s store card customers.

But until now, Next has at least been transparent about the money it makes from credit.

Indeed, I tweeted about the shocking scale of its customers’ indebtedness last year, after the group’s 2016 interim results were published:

Is it me, or do credit customer stats from Next’s interims $NXT.L suggest problems w/ UK consumer spending habits? pic.twitter.com/j28Z6H7vTr

— Roland Head (@rolandhead) September 16, 2016

It’s gone!

The screenshot above provides a breakdown of key stats about Next’s customer credit operation. It was taken from last year’s interim results. Next’s financial reporting is generally a model of detail and consistency and this table has been a regular feature over the years.

So naturally I looked for the equivalent table in last week’s interim results. But it was missing.

I then looked back to last year’s annual report. It was missing from there, too.

So why has Next stopped breaking out these figures? After all, if last year’s H1 interest income figure was repeated in H2, then interest from credit customers accounted for nearly a quarter of Next’s £827m operating profit last year.

What do the reporting changes hide?

For some reason, someone very senior at Next has decided not to include a breakdown of the group’s consumer credit business in its results anymore.

This isn’t a fluke — this will have been a carefully considered, deliberate decision. Changes like this  worry me. They’re usually done for a reason, and it’s not always good news.

So why has this change been made? I can see three possible reasons:

1. Next wants to distract attention from the declining profitability of its retail business.
2. The profitability of the credit business about to decline and the company wants to delay recognition of this.
3. Both 1. and 2. are true.

1. Deteriorating retail profits: I think credit profits are being used to disguise the deteriorating performance of the retail business. Looking back, this may have been a systematic process that’s taken place over several years:

• In February 2015, the company reduced the minimum payment on its credit accounts from 9.4% of the balance to 5%. It was surprised at how rapidly balances rose, saying that monthly payments reduced across the board, not just from those who were previously paying the minimum. During the six months following the reduction, the group’s Directory debt balance rose by £120m, or 18%.
• In its 2015/16 results, the company said “credit sales grew by only 2%. However, reduced minimum payments led to higher balances”. Interest income added 0.6% to Directory margins.
• In its 2016/17 results, the company said that “higher interest income, as a result of reduced minimum payments” added 1% to Directory operating margin.

Interest income would have risen even faster, except that Next has cut its credit APR from 25.9% to 22.9% since 2014/15.

Overall, I estimate that Next’s credit business accounts for about 50% of Directory profits and adds about 5% to the group’s operating margin. My concern is that this dependency could be rising as underlying retail margins fall.

2. Are credit profits under pressure too? At the same time, the company is being slightly cryptic about the outlook for its credit business (my bold):

It remains to be seen whether we will be able to improve or even maintain the stability we have achieved.  We believe it will be harder to sustain this improvement as we approach the anniversary of our marketing drive and come up against tougher comparisons.  We will have a better understanding of the long-term outlook for our Credit business in six months’ time.  Towards the end of this year we plan to launch at least one new credit offer.

Should I hold or sell?

In last week’s interim results, Lord Wolfson discussed at length how in a worse-case scenario, with LFL store sales falling by 6%, the group’s bricks-and-mortar business would still be profitable and cash generative.

I thought the narrative was convincing except for two points:

• Retail LFL sales fell by 8.3% during the first half. That’s considerably more than 6%.
• Directory profits aren’t growing fast enough to offset the decline in retail profits.

While I agree that Next is likely to remain profitable and cash generative, that doesn’t mean those profits are going to rise. With the stock now trading on nearly 13 times 2018/19 forecast earnings, I’m starting to think the shares may be fully priced.

I’m still holding, but I’m losing conviction. I’ll update this piece if I decide to sell before the next set of results.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.