Coronavirus, impact assessment, outlook, stress testing, viability, retail

NEXT plc – Annual report – 25 January 2020

Industry: retail

As might be expected, we begin with a summary of the risks that coronavirus poses to the business and the actions we are taking to weather the storm. When the pandemic first appeared in China, we assumed that the threat was to our supply chain. It is now very clear that the risk to demand is by far the greatest challenge we face and we need to prepare for a significant downturn in sales for the duration of the pandemic.

Levels of uncertainty
We have no experience of a similar crisis so there is no way of predicting the extent that the effect coronavirus will have on our Retail and Online sales. It is not yet clear how widespread the virus will be at any one time, how long the pandemic will last and what the medium to long term effect of this pandemic will be on consumer behaviour.

What we can say
The evidence we have from sales to date in the UK and from our (small) international websites in the worst affected countries is that:

• Demand will be the biggest issue and although the virus is likely to impact our operations, we do not believe this will be as damaging as the very significant drop in sales sustained both in Retail and Online.
• Online sales are likely to fare better than Retail but will also suffer significant losses. People do not buy a new outfit to stay at home. There is some evidence from our overseas sites that as restrictions on movement increase, the difference between Online and Retail sales performance widens, with Online picking up a small amount of the business that cannot be carried out in store.
• Some product areas are likely to fare better than others. To date, our homeware and childrenswear sales appear to be less affected than our adult clothing lines.

Our priority is to do all we can to keep our workplaces and shops as safe as possible for customers and staff. At the same time we must prepare the business for varying levels of sales declines. To that end we have modelled the effects of differing levels of sales declines along with all the measures we can take to ensure that the Company remains within its bond and bank facilities.

Coronavirus stress test
In our Outlook section (page 38) we have included a detailed stress test that gives the likely cash and profit impact for different levels of sales decline. The scenarios model full price sales losses of £445m, £820m and £1bn respectively. These declines represent -10%, -20% and -25% of our annual turnover.

Measures we can take to conserve cash
The stress test details various measures we could take to control costs and conserve cash within the business, given differing levels of sales decline. These potential measures include the suspension of our buyback programme, the delay of discretionary capital expenditure, the sale and leaseback of a warehouse, the part securitisation of customer receivables, the redemption of a loan to our Employee Share Ownership Trust (ESOT) and if necessary, the deferral of our August dividend. Beyond that we, of course, have the option to suspend rather than delay dividends.

More detail is given as to how and when we would trigger these actions on page 45. We should stress that we currently believe it is unlikely that we will need to pull all these levers, but we will ensure that we have the flexibility to take all measures if the need arises.

Combined, actions to conserve cash could retain within the business an additional +£835m of cash. These actions would mean that should the Company lose -20% of annual full price sales we would still have £835m headroom within our current bank and bond facilities at the end of the year. (See page 46).

Conclusion of stress test
The conclusion of our stress test is that the business could comfortably sustain the loss of more than £1bn (25%) of annual full price sales, without exceeding our current bond and bank facilities. This accounts for the business rates holiday announced by Government but excludes any use of Government lending or any measures that may be introduced to help with wages during closure.

Working through the crisis
There will be many challenges to our working practices as the pandemic develops and we are putting plans in place to protect our most vulnerable employees, comply with differing levels of Government restrictions and cope with illness throughout the business. In particular, we are adapting our technology for greater home working and seeking to segregate critical operational teams so as to keep all our vital operations and projects on track.

Sourcing and developing new and exciting product ranges for the back end of the year remains vitally important. This will be a particular challenge because it normally involves a great deal of international travel. Our product teams travel to factories to develop new items and to overseas retail markets for inspiration. Such travel is likely to be impossible as the pandemic progresses. We are putting in place measures to compensate for a lack of face to face contact – video conferencing, online inspiration
“trips” and more.

The continuing imperative – the mission to evolve
This report begins by discussing the real and immediate threat of coronavirus. It would be easy for us to talk or think of nothing else, but that would be a mistake. Our sector continues to experience profound and lasting structural changes and these changes are not on hold. Indeed it is possible that the pandemic may accelerate the transition to online shopping. So we cannot afford to neglect our continuing efforts to transform every part of our business.

This process of learning new ways to serve our customers, collaborate with partners and create value for our shareholders is a task that involves every function in our business. Our buying, sourcing, systems, marketing, warehouse, distribution and store teams are all having to re-invent what we do to adapt to a rapidly changing world.

It is the delivery of new product ranges, web systems, fulfilment methods, marketing techniques, warehouse capacity, business ideas, partnerships and more that will determine our longer term destiny. That requires a culture that embraces change and is not afraid to take risks – no mean feat in a crisis.

The pandemic will end!
One thing we can be sure of, at some point the pandemic will pass and when the dust settles it will be the work we have put into (1) securing the cash resources of the business and (2) moving the business forward that will make the difference to the long term future of the Company.

The following paragraphs summarise our view of how and why people have been changing their shopping habits over the last five years and how we are responding to the long term challenges and opportunities those changes present.

The power of choice and the prospect of the high street stabilising
The internet continues to give consumers unprecedented levels of choice without requiring them to travel to physical stores. The ability of retailers to hold stock in single central locations for nationwide (and worldwide) distribution means that customers can now access products everywhere that they could previously only find in a handful of major shopping locations.

We believe that it is this proliferation of choice that is the most important advantage that the internet brings to the consumer. Of course, the ability to deliver goods to a customer’s home plays an important part in the service Online provides. But nearly fifty percent of our orders (by volume) are delivered to our stores. So for many people the overriding factor is choice, not the convenience of home delivery.

If online trading were only about home delivery, we might reasonably expect high street sales to stabilise and the split between Online and stores to reach a point of equilibrium relatively soon. But if the driver of change is choice then, in our view, that equilibrium is likely to be a long way off and we are preparing ourselves for many years of transition.

The challenge posed by lower barriers to entry
In the same way that the internet has allowed customers to access far more brands, it has also allowed brands to access far more customers. The internet has dramatically lowered the barriers to entering the retail market, allowing small, niche and new businesses to reach millions of consumers without the need to invest in a network of expensive retail shops and all their supporting infrastructure. This is particularly true if they take advantage of trading on aggregation sites like NEXT.

This is all good news for the consumer and so, in the long run, should be good for our industry; but for an established retailer, with a relatively large UK market share, heavily invested in physical retail assets, this change poses a significant and ongoing challenge.

Competing with ourselves
The risk for NEXT is that our customers find new ways to buy competing brands whilst we remain burdened with expensive retail liabilities (rents, rates, wages etc.). Our response has been to lean into this challenge and actively enable our competitors to reach more customers by selling their product on our Online Platform through LABEL.

We have little doubt that the presence of competing brands increases the competition for our own (higher margin) NEXT branded products, but we believe that longer term it is the only way to survive in the online world. There is nowhere to hide on the internet, one way or another our customers will find the brands they want. If they can find what they want on our website they are more likely to come back to us, furthering our ambition to be our customers’ first choice for clothing and homeware online.

Overseas opportunities
Overseas, the internet also presents us with an unprecedented opportunity to leverage our Online assets and profitably develop our brand in territories where we are the new contender. For the first time we have found a way to profitably reach customers who, in any one town or city, are insufficient in number to justify the investment in a retail store. The internet allows access to a large number of dispersed populations in a way that stores never could.

Direction of travel
The speed of change is difficult to predict, but the direction of travel remains the same. Nothing has happened in the last year to change our view that the combination of choice, convenience and speed remains the driving force behind the evolution of the UK clothing and homeware market.

At the heart of our business is our NEXT Brand product and our Online Platform — the combination of our products, third-party brands, warehouses, distribution networks, website, customer base, credit facility, marketing systems and stores. In the year ahead we will continue to improve and develop our Platform and our Brand.

Over and above managing the business through the pandemic we must ensure that we continue to develop the business: its product ranges, operations and online systems.

Much of this work will revolve around the development of NEXT’s Online Platform and its ability to cope with increasing volumes and breadth of offer. The table below sets out some of our priorities by business area.


Uncertainty and Stress Testing
Uncertainty around the scale, timing and impact of the coronavirus pandemic means it is impossible to give meaningful guidance for profits in the year ahead. Instead, we have given a range of outcomes for the current year for different sales scenarios. The resulting stress test is very useful; it gives a clear picture of the possible effects on our balance sheet and finances and points to the practical steps we can take to ensure that the Company is best placed to cope with all imaginable outcomes.

The method we have used to stress test the business is as follows:

1. Start with our Base Case sales, profits and cash flow guidance before taking account of any impact of coronavirus (i.e. based on the forecast given in January)
2. Model varying levels of sales of decline
3. Assess the expected impact on cash flow for each scenario
4. Outline the measures we can take to increase cash retained within the business

Conclusion of Stress Test
The conclusion of our stress test is that the business could sustain the loss of more than £1bn (25%) of annual full price sales, without exceeding our current bond and bank facilities. This accounts for the rates holiday announced by Government but excludes any use of Government lending or any measures that may be introduced to help with wages during closure.

Base Case — Sales
The table below sets out our January central guidance for full price sales growth by trading divisions in the year ahead, before the impact from the coronavirus. For comparison, we have also shown the actual sales performance in the year ending January 2020.


Base Case Profits and Earnings Per Share (52 Week Basis)
In the Base Case we estimated that Group profit before tax would be around £734m, up +0.8% on the prior year. Our January central guidance for sales, profits and EPS is set out in the table below.


The guidance above is based on a 52 week trading period. However, the financial year ahead will be a 53 week period to 30 January 2021. We had expected the additional week of sales to generate profit of around £13m.

Supply Chain Effects
When the coronavirus outbreak started, we assumed that the main impact would be on our supply chain. There has been some effect on supply, though as yet the only meaningful delays have come from suppliers based in mainland China. Mainland China accounts for 27% of our supply base (excluding third-party brands). This number increases to 47% once you account for goods manufactured outside China but made with Chinese fabric and trims (buttons, zips etc.).

So far, half the goods we were expecting from China in the month of February are running late. Most of our factories in China have now returned to work and we expect the supply of stock from China to improve as the year progresses. As yet we do not know what impact the virus will have on our other key territories, though at present it appears that the virus is not having a significant impact on warmer territories. The table below sets out the percentage of stock delivered from our most important territories:


In reality, the threat posed to the supply of goods pales into insignificance when compared with the potential impact on demand. Indeed, the inability of some suppliers to make and deliver the stock we have ordered may help manage stock levels at a time when we are certain to have higher than normal levels of surplus stock.

Sales Impact to Date
The graph and table below show our sales growth in Retail stores and Online versus last year for the year to date. The last column on the right shows sales up to the evening of Tuesday 17 March. The year-on-year performance for mid-February is distorted by the fact that this year the third and fourth weeks were adversely affected by flooding.


Sales Scenarios
We have modelled three scenarios for full price sales as set out below. The first scenario assumes a shorter pandemic duration. The second and third are spread out over 24 weeks. It is important to stress that no one knows, and the phasing shown below is pure guesswork. Our gut feeling is that the -10% scenario is too optimistic, and we believe the -25% scenario is overly pessimistic. The week by week progression does not make much difference to our cash resources and the number to focus on is the total quantum of lost sales rather than the timing.


Cost Assumptions
The paragraphs below set out the way in which we have modelled the major heads of cost.


Base Case Finances
NEXT has long term bond and debt facilities of £1.6bn; all of these facilities are secured for more than a year. Peak debt was forecast to be £1.4bn in August.

The bar chart below sets out our bond and bank facilities in the leftmost bar consisting of £1,125m of bonds and a £450m bank facility maturing in 2024. The central bar shows our Base Case year end and peak borrowing requirements. The right-hand bar demonstrates that year end net debt would normally be more than matched by our wholly owned consumer receivables book.


Base Case Cash Flow Model
The graph below shows our Base Case cash flow for the year ahead, relating to our January guidance. This model assumes, amongst other things, that we buy back £280m of shares over the course of the year. The black line shows our expected net debt position throughout the year, the green line shows the level of our cash resources. As can be seen, in a normal year we would expect to keep headroom of around £210m at peak financing in late August.


Cash Flow Without Mitigating Action
The table below sets out the cash flow impact of lost sales after cost saving measures but without the Company taking any further corporate action to conserve cash (such as cancelling buybacks). For completeness, the EBITDA and Profit before tax the Company would generate is shown in the last two lines of the table.


17 Profit before tax includes the benefit of the business rates holiday.

The following actions can be taken to increase cash resources in the current financial year.

Level 1 Measures: Share Buybacks, ESOT and Capex
Suspending buybacks, employee share option trust (ESOT) purchases and deferring non-essential capital expenditure. These actions will have no or little impact on the short term operations of the business.

Level 2 Measures: Leasebacks, Securitisation and ESOT Loan Recall
We believe we can leaseback high quality assets and recall part of a loan from the Company which has been advanced to the ESOT and securitise some of our customer receivables. These actions have little impact on the operations of the business but are mildly earnings dilutive in future years as, for example, the cost of rent on a leased-back building is likely to be higher than prevailing interest rates on the proceeds of sale.

Level 3 Measures: Delay August Dividend
We could choose to delay the payment of our usual August dividend which comes just before our peak cash requirement. This would only be necessary in the event we saw more than a -20% reduction in sales.

At this time of year (March) we would normally propose a final dividend and we had planned to announce a return of 116.5p per share for payment in August. Instead of proposing a final dividend now (which would commit us to the payment), our current intention is to announce a second interim dividend (of up to 116.5p) at the end of June, for payment at some point between August and October, in the event that (1) the worst of the virus has passed by that time and (2) that our finances permit the payment.

Level 4 Measure: Suspend Dividends
This would be a last resort but, in the event the business needed to conserve cash, we could suspend both the August 2020 and January 2021 dividends which would retain £220m in the Group.

Impact of Levels 1-4 Mitigation
The chart below shows our cash requirements and resources in the event that we lose -20% (£820m) of sales and take all levels of mitigation outlined above. The dotted line shows the scenario where sales are down -25%. As can be seen in the -20% scenario, our minimum headroom is £150m and cash resources at the year-end would rise to £835m. Even in the -25% scenario, our minimum headroom would still be £110m.


Further Measures Not Included in the Model
We have two further significant measures that would help us to increase our cash headroom in May. We could (1) bring forward our Summer End of Season Sale and (2) push back deliveries of stock into June. We estimate that the combination of these two options would increase our headroom by at least a further £100m at that time.

The following table sets out the measures we believe we can take and an estimate of the resulting cash retained at the end of August and Year End. The final line of the table shows the headroom the measures would generate at year end in the -20% scenario.

It is worth noting that, normally, our peak cash requirement would be in August, however, if all measures are undertaken the peak cash requirement moves to the end of May as shown in the previous graph.


Further Increasing our Financing Resources
We are in advanced discussions with our banks to increase our facilities by £200m to provide further flexibility and headroom during these uncertain times. These discussions are progressing well, and we expect the new facility to be in place within the next month.

Revolving Credit Facility Covenants
Under the scenario where full price sales fall by -20%, there is a risk that we may breach the Group’s bank covenants during the current financial year. This would be caused by a temporary reduction in profits, however peak borrowings would remain comfortably within our total facilities.

We have had positive discussions with all our lending banks about this potential scenario. Our discussions have been encouraging and early indications suggest they would agree to a covenant waiver during the financial period to the end of January 2021.

Government Support for Businesses
We believe that Government, acting as lender and employer of last resort, can make an enormous difference to the preservation of retail jobs and businesses during the crisis. The scale and speed of the actions announced on Tuesday are very much welcomed. We believe that the availability of a Government loan facility will do much to stabilise businesses through the crisis.

At present (as can be seen from our modelling) we do not believe that we would need to draw on Government loan facilities, but they are hugely comforting, not least because they will help prevent business collapses and unemployment elsewhere in the economy.

The Government has announced and is considering further measures to assist industry at this exceptional time. For information, If NEXT were able to defer payment of National Insurance, Corporation Tax, and VAT for the rest of this financial year, it would generate an additional cash headroom of £240m at the year end.

Employment and Salaries
We would recommend that the Government urgently put in place measures to support the incomes of those who work in shops that are forced to close. We understand the immense pressure the Treasury are under at this time but would emphasise that clarity and speed on this issue would be useful for retailers and employees alike.

Our industry is facing a crisis that is unprecedented in living memory, but we believe that our balance sheet and margins mean that we can weather the storm.

The crisis will pass at some point. At that time, it will be the work we do to move the business forward that will determine our future success. So our priorities are clear: (1) to do all we can to keep our workplaces and shops as safe as possible for customers and staff, (2) securing the cash resources of the business and (3) continue to develop our Online platform and product ranges throughout the next six months.

Our first quarter Trading Statement will cover the thirteen weeks to 25 April 2020 and is scheduled for Wednesday 29 April 2020.

Lord Wolfson of Aspley Guise
Chief Executive
19 March 2020