Despite the UK high street being a tough place to do business, Next (LSE: NXT) has proven to be a shining star in recent years, as the business has gone from strength to strength.
Indeed, Next has weathered the credit crunch particularly well, by appealing to a demographic that wants a mix of style and value for money. It has avoided a race to the bottom on price and has been able to command above-average margins due to a surprisingly high level of customer loyalty.
If anything, this loyalty has increased during the credit crunch, despite Next not having a particularly strong brand. Its core strength of selling decent quality consumer staples at reasonable prices, however, means that customers know they are unlikely to buy anything particularly horrific from Next.
This ‘fear’ to stand out seems to be something that Next plays on very successfully, with its clothing lines in particular being relatively conservative and yet surprisingly popular.
Furthermore, the business model remains highly attractive, with Next having strong operating cash flow and very low levels of capital expenditure. This means that free cash flow is high and reliable and puts the company on a very generous free cash flow yield of 6.6%.
This is well above average and highlights the appeal of shares at current price levels. In fact, were the free cash flow yield to fall to a still attractive 5.5%, it would mean shares trading at around 6,650p, a premium of just over 20% to the current share price.
Such gains appear to be realistic, since a 5.5% free cash flow yield would still be viewed as relatively high, especially when the Bank of England base rate remains at just 0.5%.
Furthermore, free cash flow has increased in all but one of the last 5 years, showing not only the strength of the business model during tough times, but also the expansion potential. If free cash flow were to increase in the medium to long term, the free cash flow yield may not have to fall to as low as 5.5% in order for investors to register a 20% gain on their investment.
So, Next possesses a relatively high degree of customer loyalty, with the business being able to deliver the right mix of value and style and being the chosen store of a large number of consumers who wish to ‘play it safe’ when it comes to fashion. It also appears to have upside of 20% or more, based on a generous free cash flow yield.
