There is a faintly aggressive undertone in Next’s annual report for the year to December 2017, with talk of ‘attacking’ costs.
Each month Richard Beddard trawls through annual corporate results for his Watchlist and the Share Sleuth portfolio of companies that satisfy key valuation metrics such as earnings yield and return on capital – and profiles the most interesting candidates.
Judges Scientific (JDG): set to profit despite stop-go
In comparison to 2016, the year to December 2017 was a good year for Judges Scientific. The scientific instrument manufacturer increased revenue 25 per cent and profit by more than 50 per cent.
Judges buys and operates small privately owned businesses that make specialist scientific equipment, predominantly used by universities worldwide to measure things. They’re mature, profitable businesses often with growth potential, but to varying degrees they also produce surplus cash, which the company uses to buy more subsidiaries. This is a profitable strategy, because Judges can buy companies in private markets very cheaply. Once they’re incorporated, their profits and cash flows are valued much more highly by stock market investors.
Investors must be careful not to be blinded by growth rates of acquisitive companies. The addition of profitable new subsidiaries will always mean more revenue and profit. During 2017, Judges acquired one business, and the year before it acquired four. But ignoring the profits from these new businesses, it still grew revenue healthily by 17 per cent.
Profitability also improved, although it’s still at historically low levels. By comparing profit to all the capital the company has invested at cost, we can see whether Judges really did acquire companies cheaply enough to profit from them. Even in 2016, Judges’ worst year, return on total invested capital was 9 per cent, an acceptable return. That year was probably unusual. The company had recently made its largest and most expensive acquisitions, and two of them barely made a profit, probably because of constraints on government funding for universities.
University funding remains under pressure in many places. Judges’ progress is more likely to be stop-go than go-go, as it was in the previous decade; but increasing precision in scientific research and industry will require more machines. Under very experienced management, ultimately Judges should prosper. A share price of £26.60 values the enterprise at £164 million, 21 times adjusted profit in the year to December 2017. The earnings yield is 5 per cent.
Next (NXT): Stores fears overdone?
There is a faintly aggressive undertone in Next’s annual report for the year to December 2017, as it explains what it’s doing about a 1 per cent decline in revenue, a 7 per cent decline in profit and more profound challenges in retailing. The retailer is ‘attacking’ costs, and is deploying its new data management platform for the first time ‘in anger’ to better target advertising spending. It’s renegotiating expiring store leases so they cost less and expire more quickly, and introducing restaurants, cafes, barbers and concessions into stores to share the rent and contribute to profit.
Next has been investing heavily in IT staff and systems to beef up its websites, and networking the physical stores so they work like a distributed warehouse: supplying products to each other and to online customers if needed.
The good news is that some of Next’s problems were temporary. The weak post-Brexit pound increased the cost of imports at the same time as demand reduced due to a squeeze on wages. The company had also focused its ranges on fashion at the expense of products people routinely buy, resulting in a sharp dip in revenue at the beginning of the financial year. The pound has since rectified itself, and Next has rectified its ranges, which means revenue might improve slightly in 2019.
More profound is the transfer of sales online. Sales at Next’s retail stores fell 8 per cent, while online sales increased 9 per cent. The company already earns more profit online, but lost retail sales are expensive because store costs such as rent, rates, and electricity cannot be reduced quickly. Retail profit fell 24 per cent.
In contrast, much of the cost of selling online – delivery, handling returns and dealing with customer enquiries – is variable and increases with sales. Combined with investment in IT, that meant online profit increased only 7 per cent.
In the year to December 2017, Next was barely more profitable than it was during the financial crisis. That said, many retailers would envy a return on capital of 20 per cent. In the year to January 2019, profit is still likely to decrease as Next grapples with store costs, but it should fall by much less than last year.
Customer preference for online brings opportunities as well as challenges, meanwhile, and fears about the future of the retail stores could be leading traders to underestimate Next’s online potential. Label – the bit of Next Online that sells other brands – and overseas online sales are growing rapidly. Next has also stopped the decline in customers using next pay, its lucrative credit business, and plans to extend it to retail stores.
A share price of £51.80 values the enterprise at £10.1 billion, about 15 times adjusted profit. The earnings yield is 7 per cent.
Portmeirion (PMP): Flattered by weak pound
Judging by the headline results, Portmeirion did very well in the year to December 2017, but strip out the beneficial effect of the weak pound and the first full-year contribution from Wax Lyrical, the scented candlemaker it acquired in 2016, and revenue grew more modestly at about 4 per cent. Portmeirion remains highly profitable. In 2017, return on capital was 17 per cent.
Portmeirion may have sown the seeds of more rapid growth during the year. The company, which still mostly makes decorative tableware, launched a new range: the Sara Miller London collection. The plates, bowls, cups and saucers are striking and have received good reviews. In addition Portmeirion launched 200 new home fragrance products, candles and reed diffusers, under its existing tableware brands, which include Spode and Royal Worcester. In total the company launched well over 1,000 new products – double the normal rate.
Portmeirion Botanic Garden remains the biggest brand by far, earning more than £30 million of the company’s total revenue of £85 million in 2017. It is arguably the most famous tableware pattern in the world, and the big hope is that some of Portmeirion’s newer patterns might enjoy similar success.
The launch of so many new products will be a test of the company’s strategy, which requires it to keep established brands fresh and launch new brands. Sales of Portmeirion-branded candles and reed diff users will also reveal whether the acquisition of Wax Lyrical has taken the company a step closer to becoming a broader supplier of British homewares around the world.
While we wait to see how these initiatives develop, one area of the business is flailing. In South Korea, which in 2013 seemed destined to overtake the UK and become Portmeirion’s second biggest market after the US, the company is in something of a meltdown. The company hasn’t adequately explained what’s going on in South Korea, nor a synchronous surge in revenue in the rest of the world segment.
A share price of £11.40 values the enterprise at £134 million, or about 16 times adjusted profit in the year to December 2017. The earnings yield is 6 per cent.
Strix (KETL): High profit standards
Strix floated on the stock market last August and has just published its first annual report as a listed company, but it’s a much more established business than you might think. Its ticker code, KETL, is also a coded message about what the company actually does: manufacture kettle controls. Strix’s core product is the safety control that disconnects the power from the heating element when a kettle boils.
Strix had a busy year to December 2017. It launched a new range of controls, increased the level of automation at its factory in China, and signed contracts with Boots and Tesco to supply another product: Aqua Optima. Aqua Optima is a water filter brand which the company launched in 2005.
It has been making kettle controls much longer, though, and traces its history back to 1982. Strix has other products and technologies up its sleeve too, such as a turbo toaster that toasts bread three times faster than normal.
A share price of 140p values the enterprise at £265 million, about 13 times adjusted profit in the year to December 2017. The earnings yield is 7 per cent. Based on the limited information in the company’s admission documents, Strix appears to have been consistently profitable and cash-generative in the past, probably because it supplies a vital component in a relatively inexpensive appliance.
There are risks, of course. Strix floated with substantial debt, which it is paying down with equally substantial cash flows. And it has competitors producing lower-quality components at lower cost. Strix’s strategy is to increase the standard of its own controls, while protecting its intellectual property and investigating and reporting appliances using substandard controls to the authorities.
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