Small Cap Value Report (4 May 2016) - NXT, BHS, AVG

4th May '16 by Paul Scott

45 comments 22423 reads

Good morning!

Next (LON:NXT)

Share price: 5070p (up 1.8% today)
No. shares: 150.1m
Market cap: £7,610.1m

(at the time of writing, I hold a long position in this share)

Q1 trading update - It's clearly not a small cap, I know. The Q1 update this morning seemed a bit soft, but what's interesting is that the share price quickly rebounded from an initial drop. I'll stick my neck out here, and suggest that we might have reached a low after big recent falls. Mind you, I thought that at 5600p too! Market timing is not really my thing.

I've waited a long time to be able to buy Next shares at a reasonable price.

Today's update says that the retail stores are suffering, with sales down 4.7%. However, Next Directory is doing well, with sales up 4.2%. That seems odd, and lends credence to the claims that some of the fall in High Street sales could be weather-related.

I remain of the view that it's just a very competitive market, with lots of online competition, giving people less of a reason to visit the High Street. I don't believe that there is any issue with overall consumer demand - spending habits are just shifting. More money seems to being spent on leisure - e.g. J D Wetherspoon (LON:JDW) reports LFL sales up 3.8% today.

With clothing so cheap now, you do reach a point where the wardrobe is just full to bursting point. Apparently women today have something like 4 times as many clothes as they did a few decades ago.

As always, the update from Next is a model of clarity, check this out:

I have highlighted the word "guidance". So to all the companies who tell me, "We can't give guidance to the market" - my reply is, "Yes you can, and you should".

The upper & lower range, which is tweaked as the year progresses, is a wonderful way to manage investor expectations. Everyone should do this.

My opinion - this is a great quality business, making excellent margins. It's vastly better than say Marks and Spencer (LON:MKS) in almost every respect. Yet the price is now very reasonable, a fwd PER of c.11-12. That's a real bargain in my view. As always…

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JohnEustace

4th May '16

The difference between us is that I don't think interest rates are going back to what we would regard as normal any time soon. They can't because governments and mortgage holders would all be bust.
I'm old enough to remember paying 13% on our mortgage but I think we are in a new normal now.

Rustbucket

I agree, can't see even 5% interest rates for at least 5 years. I remember 15% mortgage rate, ouch.

apad

Tricorn lost the RR pipes contract to AVG. At the time the CEO of TCN said that RR wanted them to work for nothing. Later TCN sold its aero division to AVG. At the time I remember AVG had some fibreglass Formula 1 business as well.
AVG have now sold their aero history at a time when RR will be applying even more pressure on margins.
If you look at the board of AVG they have a finance background and are probably good dealmakers.
What they do not have is a good engineering background or a theme for the group's activities.
I, also, do not know whether this is a good deal, but I would be very wary of "apparently quite exciting growth potential in <>"
apad

gus 1065

From memory, the BHS business was acquired from The Storehouse Group leaving behind the Mothercare business with the original management team. I believe the purchase was financed by a combination of PG's own equity (I think his first major deal prior to this was buying, turning around and then selling on the Jean Jeanie business leaving him with a decent pot of capital) and a £200m acquisition loan provided by Barclays Capital and one of the German Landesbanks.

cig

The liability is usually index linked, so if bond yields go up at the same time as inflation, the impact on funds may not be that significant.

BTW if you are certain interest rates will "normalise" any time soon, you may want to make a fortune trading long rates derivatives.

Star8

Cig

Taking your BTW point first - timing is everything. Interest rates will rise if the last 500 years of interest are any guide - but when is completely unknown as is the speed of normalisation. Taking a short position with unknown timing which may be years into the future, can be a good way to lose a fortune especially since there is a significant carry cost. A possible straw in the wind is the sharp downturn in (corporate) bonds earlier this year when long duration IG bonds we held in GBP and USD dropped about 10% - stunning moves which quickly reversed to the original prices . The implication to my mind is that future sharp moves in the Bond markets will not necessarily be due or in the proportional measure of Central Government rises in interest rates but may caused by a stampede out of bonds by Fund Managers afraid of losses in absolute terms. Further as you may be aware Hedge Funds also look for any trends and then exploit it.

Your first comment assumes a "usually". There is no data I have seen as to the degree of inflation protection this and also where there is inflation, the index used RPI or CPI chosen may understate actual inflation. Further as I understand it some funds have limited inflation protection in terms of indexed benefits.

Finally the long end of the yield curve is fixed by markets not by governments to a significant extent. If yields go from +1% approx real interest rates now at the long end to a not unknown real interest rate of say 4% then there is quite a significant reduction in liabilities even if your assumption of a linkage inflation - interest rates is correct. The exact figures will depend on the level of inflation and interest rates.

The implication of your words are that if one is overloaded with debt the only solution is to massage the market with artificially low interest rates for ever more. Given that the UK government is running a budget deficit and therefore debt is growing and given the current low economic growth rate , there is a real possibility of the debt burden growing ever larger on the economy. That is eventually an unsustainable situation - interest payments - eventually consume all government revenues. Japan is in the forefront of this situation and has continued far longer than most / all observers thought possible. Perhaps Japanese cultural solidarity is a factor.We wait and see.

My other problem with your words is that recognised star investors have said that the famous words you imply "This time is different" never apply.Sooner or later market forces assert themselves.

If a government could simply keep interest rates low regardless of inflation and market forces and also print money then how come countries through the ages eg Germany, Brazil, Argentina succumbed to economic and market crashes, bond default etc.BTW I too paid mortgage interest at 15% - but as compensation inflation boosted the value of our house..

Well, is it already different "As interest rates mark their seventh anniversary at the historic low of 0.5% this week, the figures will reassure Bank of England policymakers that they can keep borrowing costs low without fearing a rapid pick-up in inflation. Some economists have even raised the idea of interest rates being cut closer to zero". Yes later we will get back to boom and higher rates but it could be 5-10 years time. Japan has been in this situation for over 20 years.

Governments in the past have not acted or acted too late. Problem is now we are already at low interest rates when the next recession comes what options are left?

Velo

RE: BHS Pension deficit.

I don't get it.

How do pension deficits increase year after year?

Thought after Maxwell et al, it had been outlawed - both "borrowing" from a pension fund and companies voting themselves a "pension holiday".

Were the pension reforms after Maxwell window dressing, then?

hayashi22

I would have to say that it looks as though TCN may have sold its aero related business to Avingtrans too cheaply .Reflects poorly on the management there.

mpat89

With AVG, the net equity of the deal exceeds the market cap of the stock.

Therefore even if the residual business is valued at £1 there is a gain to be had in this stock?

Rates were at 2% from 1932 to 1951 except for the two months of Aug and Sep 1939. Prolonged low rates are not unknown in the history. If you look at the interactive on the Guardian website it's our lifetimes since the 1970's that are the crazy times.
http://www.theguardian.com/business/interactive/2008/nov/05/interest-rates-history

xcity

Pension fund deficits or surpluses are a function of assets on one side and interest rates and life expectancy on the other. If interest rates rise, the deficits will fall.

xcity - I remember back in the day, the company I worked for, suspending contributions to the company pension fund because it was in "record surplus". I was outraged, what would they do if it ever fell into a deficit then?

I left that company eons ago. It went to the wall some half a dozen years ago.

Hot Socks

Paul I'd be interested in any words of wisdom on the Next balance sheet and debt. I've not looked in masses of detail but the gearing seems very high. I found the same issue when looking at Imperial Brands recently (although the ratio of profit to debt is much better for Next). These businesses have great track records but I find the leverage off putting - if circumstances turn against them is the debt going to limit their ability to recover? I'd be interested to know how/why you get yourself comfortable in the case of Next.

Radicalgreens

Paul, great article and detailed analysis on BHS. We do love to knock our entrepreneurs. Not sure why people equate large financial gains with the entrepreneurs behind these ventures being likeable - Steve Jobs being a classic (US based) example, albeit imperfect. Carl Icahn maybe a better example. It seems a particularly British thing to go after those who are the brashest rather than basing on actual misbehaviour.

Whilst PG ultimately failed with BHS and it's repositioning over the 15 years of his ownership, I suspect by 2005 he'd reconciled taking a portfolio approach of backing his winner (Top Shop) and, having already made very significant returns from BHS, shifting this to being a cash cow / in run off. In value investing / private equity terms this may well have been the only rational decision. How many retail businesses with the scale of BHS can we point to that have been successfully repositioned in the last 15 years? I doubt anyone would have been able to justify an ROI to justify the very high level of cash investment that'd be required to reposition the business. Isn't this what Warren Buffett did with the original Berkshire Hathaway business to then fund his acquisitions?

Amazingly the press have talked about a hypothetical float that could have solved the BHS problem of repositioning by being able to raise additional capital from the City. Surreal - effectively risking pension fund money via naive fund managers buying a high risk and heavily promoted story from new managers that a very skilled entrepreneur wouldn't back.

As well as the very high intracompany charges and dividends, the property income received + current value are hard to get behind but all of these together will have made the deal a compelling success by 2003 when the business was recapitalised with debt.

It's worth emphasising is that the ultimate metric is cash on cash return (capital invested vs realised). Rather than notional P&L intracompany "losses", assertions that I don't think hold water in terms of PG being presented as losing money on this deal. It's also worth noting that whilst PG bought the business for £200m from Storehouse in 2000, it isn't clear how much cash investment the major shareholders (who appear to be PG / Caring / Hunter) provided. Which is the real metric. Indeed press at the time stated / in 2003 stated Robin Saunders of WestLB lent £200m for the deal, and together with a colleague ended up with 1% of BHS personally.

andrea34

5th May '16

For info for any Next holders, Chronic Investor view is as follows:

Most of that sales decline is down to unexpectedly cold weather in March and over Easter, but other retailers - so far at least - don't seem to be hurting quite so much as Next. For that reason, we remain cautious on the shares and, at 5,180p, stick with our neutral recommendation. Hold

I think Paul's articles are more worthwhile reading though :-)

Sales are down 1%? Share price is down 37%, I think that is all in the share price. As for other retailers I think they are also struggling on the high street, yes weather was colder than normal. I would not take any notice of IC magazine.

All the rage at one time.

It's one of the consequences of defined benefit schemes where the company is responsible for making sure those benefits are paid. Now they tend to use long-term adjustments which is more appropriate, but they didn't then.

Defined contributions are better in this regard and might have had a better press if companies hadn't taken advantage of the switch to reduce contributions. And wouldn't look so bad if governments hadn't artificially reduced interest rates. They are much better insulated from employer bankruptcy.

MichaelFBS

Dear Paul

Just wanted to add my thanks for the detailed breakdown of the BHS figures. Really interesting and as somebody else has said here, it should be compulsory reading by everybody who comments on the demise of BHS.

With regard to Sir Philip Green himself I really can not give an opinion. I have never met him and I certainly would not believe what I have read in the papers. However I am pretty certain he has been a net benefit to the UK economy. So he is rich and successful (never traits that Brits of any hue seem to admire for some reason) and he paid a dividend of £1.2B offshore to save say £600m in tax but it does seem to be forgotten that none of this is or was illegal.

I can understand why he paid the divi offshore as it is simply too large a take. That said if it had been me I would have paid the tax just so that I could be in the UK and with my wife for as long as I chose rather than the time dictated by the tax man!

Like Paul I look forward, hopefully, being cross examined by MP's.

As an aside I am surprised, knowing that his father died at (I assume as PG was only 12) an early age of an heart attack, that Green does not do something about his weight and if he doesn't I hope Arcadia has a succession plan in place.

BR

Michael

Small Cap Value Report (4 May 2016) - NXT, BHS, AVG

Next (LON:NXT)

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Paul Scott

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