Friday, 12 April 2013

Next - The king of share buybacks

Next PLC (LSE: NXT.L) are a company most people in the UK will be familiar with as they are a large clothes retailer with over 500 stores and a FTSE 100 constituent. Perhaps what most people won't be aware of though is the phenomenal success of the shares over the past two decades. Since 1999 (as far back as I can see on Google Finance) the shares have compounded at a rate of 15.3% p.a., and that figure doesn't include dividends. Given other figures I've heard anecdotally from other investors, that figure is even higher if you go back further, rising above 20% p.a.!

Their latest financial report is a brilliant read and it's refreshing to have a company explain what they've done and what they intend to do so clearly without the usual waffle and management speak that's so common. In places they are brutally honest, even to the point where it's slightly comical! Check out this passage:
Planning remains a problem, though often more of a delay than a brick wall. We are actively working with planning officers, councillors and local communities to deliver new shops, investment and jobs. We continue to make a greater investment in the external architecture of our new stores, particularly on Retail Parks. Our aim is to transform the quality of construction associated with out-of-town retail and create the sort of buildings that communities will see as an asset, not an eyesore.
In our dealing with local councils it is noticeable that some are much more pro-growth and pro-jobs than others. Many local councils are enthusiastic and efficient; but a few remain an unhealthy mix of Luddite intransigence and incompetence. Going forward, in areas where councils traditionally have got away with just saying “no”, we will be more active in harnessing the law and the full weight of public opinion to campaign for growth
The part of the report that really surprised me though was the section where they explain their philosophy around share buybacks. Most companies don't really think very hard about share buybacks and when to do them but Next are explicitly clear that they see it as just another re-investment opportunity to be analysed alongside others. It's the kind of thing one expects to read in the Berkshire Hathaway annual letter and reminds me a lot of Outsiders (one of my favourite business books).

It's well worth reading the whole thing yourself, but here's some choice paragraphs:

Despite their increasing popularity, share buybacks are still widely misunderstood. There are still those who wrongly believe that they are some sort of share support scheme. This, of course, would be futile as any attempt to support a share price would evaporate as soon as the money ran out.
The only reason share buybacks can deliver long term value is because they permanently reduce the number of shares in issue and so increase the amount of profit attributable to each share (EPS). An important part of the logic of share buybacks is the implied link between growth in EPS and growth in share price. Whilst, in the short term there might appear to be no link, in the long run share prices tend to reflect the fundamental value of the earnings and dividend stream. If the share price did not rise with EPS, the buyback programme would eventually leave a single share owning all the profits and dividends!
Over the long term, we have been following these rules when considering buybacks:
1. Share buybacks must be earnings enhancing and make a healthy Equivalent Rate of Return (see below).
2. Only use the cash the business does not need. NEXT has always prioritised investment in the business over share buybacks.
3. Use surplus cash flow, not ever-increasing amounts of debt. We have never allowed our share buyback programme to threaten our investment grade credit status and will not do so going forward.
4. Maintain the dividend at a reasonable level through growing dividends in line with EPS. NEXT will continue to increase dividends in line with EPS.
5. Be consistent. NEXT has been buying shares every year for more than 10 years, reducing the shares in issue by more than 50%.
6. For share buybacks to be an effective use of shareholder cash, the core business must have the prospect of long term growth.

I'm not a shareholder myself as I focus exclusively on smaller companies (there's greater share mispricings to exploit) but for the LTBH large cap crowd I'd take a serious look at any company that has such a great record of capital allocation.

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