Next continues to ride the wave of structural change

Amongst all the doom and gloom on the UK high street, clothing retailer Next is a bright spot. Over the year to January 2019 total sales at Next increased 2.6% and full price sales grew 3.1%. As the retail revolution marches on, Next’s latest annual report is well worth a read, both for its candid reporting on the challenges facing the sector and its illuminating views on where it will end up.

Next was been a stalwart of the high street for nearly 40 years. To remain relevant, its business model has changed dramatically over the last 15 years. In 2003 non-store related sales, which it calls ‘directory’ sales, accounted for 23% of turnover and most of these were orders placed over the phone. Today directory accounts for 53% of total sales and they are made online. Next sold no third party brands in 2003; by 2018 third party brands accounted for 22% of sales. From a base of zero in 2003, overseas orders represent 17% of sales today.

Next views online retail as an opportunity and a threat. On the latter, barriers of entry for new brands without prime retail space have been removed which adversely impacts incumbent retailers. At the same time the internet offers existing retailers like Next the opportunity to create an aggregation platform for multiple brands across multiple geographies.

The Next Annual Report clearly illustrates the extent of the online retail challenge. Sales in its physical stores fell 7.9% in 2018 but stores operating costs were constant (except stores with lease expiries where Next has negotiated an average 29% rental discount). Whilst online sales growth of 14.7% appears to tell a positive story, every online order added to variable costs – an extra 6p per £1 of business that transferred from offline to online. Therefore, Next is working hard to stand still.

Despite falling sales and static costs in physical stores, Next believes that stores remain vital to its future success. This is primarily because of their role in online fulfilment - it costs less to deliver to stores than to homes - and returns - over 80% of online returns come back via stores.

What does the future hold for Next in this context? Well its views on one possible direction (which they state is NOT a plan or a forecast) are clearly set out in a ‘15 Year Stress Test’ which assumes that:

• Physical retail sales will fall by 10% per annum
• Existing stores with leases of over three years are 25% over-rented
• Market rents will fall 5% per annum from 2023 onwards
• Stores with profitability of less than 4% will be closed at lease renewal, those with 4-15% profitability will be held over at passing rent, stores of 15-20% profitability or 20%+ will be renewed at market rent for 3 and 5 years respectively
• Maintaining only profitable stores will mean the existing portfolio shrinks from 507 in January 2019 to 150 in 2033
• 120 new stores will be opened to support online sales
• Online sales will grow at a compounded annual rate of 6%
• Overseas sales will grow at a compounded annual rate of 12%

Regardless of whether the individual predictions above are correct, the broad direction of travel anticipated by Next certainly aligns with how Advent Capital Investments Ltd views the retail landscape. The expansion of online retail has much further to go and high street retailers ignore it at their peril. Those that remain relevant will need to disrupt themselves by offering a seamless integration of online/ offline and becoming curators of multiple brands, as Next is doing.

Maintaining a high street retail presence will be necessary for successful UK retailers, but its role will evolve from being primarily a place to buy goods towards a showroom and a place to collect and return online orders. Space requirements will change. We expect the quantum of retail space to fall in aggregate with retailers operating from fewer, smaller stores. As most physical stores will be loss leaders, retailers will be fickle with their location choices and rent sensitive. This is exactly the future strategy envisaged by Next and provides cold comfort for landlords hoping that the recent retail value falls in the MSCI indices will be short-lived.

Guided by our thematic investment approach, Advent Capital Investments Ltd has maintained a low weighting towards high street retail for some time and this is reflected in our performance. Once values have corrected there may be future investment opportunities in locations and formats that we believe will endure, such as convenience, value and experience retail in mixed-use growing locations.

James Thornton 

CEO of Advent Capital Investments Ltd