A closer look at Next's financial performance

To do some meaningful analysis on retail companies you have to take into account that many of them rent (or lease) rather than own their shops. This means that they are not listed as assets on a company's balance sheet (they are on a property company's who owns them) whilst the agreement to pay rents in the future is a form of hidden debt. To learn more on this topic read my article How to analyse companies with hidden debt.

What this means in practice is that you have to adjust key financial ratios such as return on capital employed (ROCE) for these hidden debts. If you don't include an estimated value of hidden debts, then you might mistakenly think that a company is better or safer than it really is. SharePad can do all these adjustments for you in seconds.

The good news for investors in Next is that even when leases are taken into account this is a company that has scrubbed up really well.

Next has made consistently good returns on investment (ROCE) for years as shown by the green or first bar in the chart above. Both ROCE and profits (the red or second bar) have been on an upwards trend during the last few years and were remarkably resilient during the UK recession of 2008-09.

Lease-adjusted ROCE in the year to January 2015 was an impressive 32%. You won't find many retailers that can do that.

The other classic hallmark of a high quality business is an ability to produce lots of free cash flow. Next passes this test with flying colours with free cash flow per share being consistently close to EPS - a sign of high quality profits.

A company's free cash flow is often less than its reported profits because it is investing (in stocks of goods and new shops for example) to grow the business in the future. However, cash flow is the lifeblood of a business and investors should pay very close attention to it. It's also a lot harder to fudge than profits over the long haul.

These days I spend a lot more time looking at a company's free cash flow return on the money it has invested (CROCI) than ROCE. I want to see a consistent ability to generate high cash returns.

I've used SharePad to estimate a lease-adjusted CROCI (using the combined items feature) for Next.

If you take a look at the chart below you can see that Next has been able to produce some good cash returns ranging from a low of around 12% in 2011 to around 22% in 2013 and 2015 - all very reassuring stuff.

The other ratio that you should never forget to look at when analysing a retailer is its fixed charge cover. This tells you how comfortably a company's trading profits (or EBIT) can cover the interest payments on its debt and the rents on its leased assets.

Some retailers can have fixed charge cover ratios of 1.5 or less which could see them get into financial difficulties if profits fall. Equally important is the trend in the ratio. A fixed charge cover ratio that is falling is often an early warning sign of a company that may be overextending itself.

Next has one of the healthiest fixed charge covers out there. The ratio was over 4 times in 2015 showing that the company's finances are in a very healthy state and could cope with a substantial fall in profits. The trend has also been upwards which is a very good sign.

What's going on at the moment?

UK high street retailers have been under a cloud for some time. Clothing retailers such as Next even more so as people have been worrying that the warm winter weather will have meant that people won't have bought this year's fashions.

Well it seems that Next has hit a bit of a rocky patch but is still doing reasonably well - just not as well as City analysts and investors thought it might do. That said, all these worries have weighed on the company's share price which touched £80 at the end of October and is less than £70 at the time of writing.

Next's recent trading statement said that things had been a bit subdued during the six weeks leading up to Christmas Eve. Underlying sales were slighty lower than last year if new shops are excluded, whilst sales through its Next Directory business only grew by 2%. It blamed the warm weather, increasing competition for Next Directory from rivals and a few problems in getting enough of the right products to sell.

Yet Next has cushioned itself well. It never sells items on sale until after Christmas and has been able to maintain its profit margins. In fact, profits look like holding up reasonably well if you read the trading statement in SharePad:

FULL PRICE SALES, PROFIT AND EPS GUIDANCE FOR THE FULL YEAR

"Full price sales for the year to date are currently +3.7% ahead of last year, just below the bottom end of our previous guidance of +4.0% to +6.0%. However, good control of margins, costs and stock, along with healthy clearance rates means that we expect profits for the full year to remain within our profit guidance of GBP810m to GBP845m, issued in October".

"Our revised central forecast for full year Group Profit is now GBP817m, though this might increase or decrease by GBP7m depending on trade in January. GBP817m would represent an increase of +4.4% on last year. The table below sets out our central guidance for total shareholder returns for the full year to January 2016."

"The guidance in the table above is based on 52 weeks for the years ending January 2015 and 2016. The current financial year will actually be the 53 weeks to 30 January 2016 and we estimate the additional week will add GBP15m to profit before tax."

To sum up

1. Next looks to be a very good business with high ROCE and very good free cash generation.
2. Its financial position is very strong.
3. Its future profits are somewhat uncertain as management has given a wide range of possible sales growth for the coming year.
4. Profit margins are holding up.
5. Stock levels have been controlled well which means bigger discounts to shift unsold items in the January sales are less likely. This is good news for short-term profits.
6. 2016 profits have been boosted by a 53rd week of trading which added £15m.
7. Profits growth for the year to January 2017 could be quite low. Profits could fall if trading gets weaker. This might stop Next's share price from going up too much.
8. Next is likely to have a lot of surplus cash flow in the coming year. More special dividends are possible and could give the shares a high dividend yield.