Debunking NEXT PLC Operational and Financial Data

Sometimes, when a company’s share price fell more than 50%, you may be wondering if this is a value trap or buying opportunities or a reversion to the mean.

Fundamentally, the fall in share price is down to analysts forecasting declining earnings of between -2% to -14% for next year, even with these declines, NEXT will have: –

  1. An operating margin better than most clothing retailers;
  2. A high return on invested capital, but it wouldn’t be 50%, but between 30% and 40%.

 

But what if NEXT PLC financial numbers look dodgy and the insiders knew about it and sold out first. Then, you need to figure out traps (or, multiple) traps set by the firm’s management.

The best way is to run a few tests on the company’s manipulation of its data and the historical valuation of its business.

 

P.S. Some of the analysis below is covered by my main article “Is NEXT’s Share Price Offering at “50% OFF” Presents Value Buying Opportunity?

These are the tests I set for NEXT PLC.

 

  1. Dividends test

When you see, a business pays out dividends or been increasing its payout every year, and it makes you feel, you made a solid investment in a profitable company.

However, there are ways a mediocre business can pay these dividends to shareholders. Ways like:

  1. Using the firm’s cash reserves;
  2. Borrowing money from the financial institutions;
  3. Delay paying your suppliers;
  4. Borrowing money via the ownership of subsidiaries;
  5. Reduce capital expenditure by choosing to lease, instead of owning the assets outright.

One yardstick to recommend is comparing shareholders’ return (includes both dividends and share buybacks) with their net earnings over the long-term.

You are looking for coverage of cash returned to shareholders’ cash against what it generates in operational earnings. With data going back to 1999, it made an aggregate of £6,282.7m in net profit and returned £6,854.1m for shareholders, an average coverage of 0.91.

This coverage is low, where normal businesses look for two times dividend coverage. Therefore, despite, rising profits it needs to find external funding to plug that gap. The rise in debt borrowings was that extra financing (more on the sustainability of NEXT’s debt borrowings below).

When a company engages in share buyback, it sometimes confused investment websites like London Stock Exchange or Interactive Investors on reporting the REAL YIELD that shareholders are receiving.

For instance, on the LSE.co.uk (a popular stock trading platform and forum) and see it say NEXT’s dividend yield of 3.86%, but the inclusion of share buyback would take the yield to 10%, although this means shareholders are giving up on some of their holdings (in return for a higher share price).

 

The second measure for quality dividend coverage is free cash flow.

This coverage averages 0.82. So, NEXT PLC (since 1999) and has paid out an extra £1,230m it didn’t have in their pocket.

How was the shortfall met?

We know the retailer uses debt to make up its shortfall as it saw an increase close to £1bn from zero but is this sustainable?

 

  1. Quality of Business

Sometimes, a business uses accruals liabilities (trade payables) to mask its internal problems such as low borrowings and this present a problem for investors because “out of the blue”, a big cash outflow will catch them by surprise! In this scenario, it is best to leave surprises to the lazy investors.

To avoid unpleasant surprises, you need to compare NEXT’s Payables with its assets and sales.

 

NEXT's payables vs. sales vs. assets

Source: NEXT PLC’s annual reports.

Using Payables as a carrot stick, you can detect various manipulations. The idea behind the above chart is to spot a rising trend one way or the other and be able to interpret your findings.

If trade payables saw faster growth than sales growth, it means NEXT is delaying payment to suppliers leading to some adjustable cash outflow in the future. The NEXT’s chart for this ratio (the red line) remains proportionally stable.

 

When it comes to interpreting the payables % against total assets it could go two ways: –

One, payables, as % of total assets increase steady, or

Two, payables decline vs. total assets.

An increasing trade payable as % of total assets could mean the firm is increasing its efficiencies as assets turnover faster. On the other hand, the firm could be delaying payments to suppliers.

Solution: Assess the company’s “Average Payment Period,” if this is increasing, then the business is likely to address its creditors by paying them off.

 

A declining payables level could signal to investors that the business is overvaluing its assets meaning operational activities do not correspond to the value management placed on its assets. Therefore, a probability of assets write-downs leads to a reduction in future profits or incurrence of losses.

 

To combat “Payables against Sales”, or “Payables against Assets”, try Payables against Costs of Goods Sold because both metrics are tied to each other destiny.

NEXT PLC's Trade Payables vs. Costs of Goods Sold

Source: NEXT PLC’s annual reports.

With an increasing trendline, it is signalling NEXT PLC is delaying payments to suppliers. In fact, NEXT’s average payments to suppliers reached 117 days (the highest recorded), the average is 97 days.

Working out any future cash outflows to suppliers

Any analysts doing this due diligence would calculate how much NEXT would pay back to suppliers by working out the daily payables expenses, this is:

£896.5m by 365 days = £2.45m per day.

If you take NEXT’s average payable days of 97 days, for instance, it means NEXT needs to pay £49.1m extra to store its equilibrium with their suppliers.

£2.45m multiply by 20 days = £49.1m.

Given that NEXT earns £667m it represents less than 8% of profits, so not a big concern.

 

Your second line of defence for Quality Checking is tracking the change in net cash earnings over trade receivables.

 

NEXT's cash earnings quality

Source: NEXT’s PLC annual reports.

The lower this ratio goes, the greater the fall in quality of earnings. Reason being is you want to keep receivables from growing too fast because they help to boost sales and this, in turn, increases the company’s earnings.

The chart showed a range between 0.6 to 0.9, but the latest ratio is the lowest since 2000 and could contribute to the fall in its share price, however, earnings are volatile and wouldn’t be a good measure.

3. Liquidity

As mentioned in section one, is debt take-up sustainable for NEXT PLC? Given earnings in 2016 came in at £667m and free cash flow circa. £450m it would take NEXT two years to clear their loans.

Some investors view current assets as liquid enough to cover the firm’s current liabilities. But in extremely rare conditions, it may not be the case when short-term liabilities are increasing as inventories can’t be sold off and credit customers defaulting at record levels.

You need some protection.

One way to go about this is to assess the company’s operating cash flow to cover current liabilities. As current assets do not generate sales, operating cash flow is the business saviour for meeting current liabilities.

NEXT's cash flow coverage of short-term liabilities

Source: NEXT’s PLC annual reports.

Right now, the ratio is at 50%, if NEXT forgoes dividends and capital expenditure it could reduce short-term liabilities by 50%. But, realistically they can stop returning cash to shareholders, so the free cash flow generation of £469m, or 40% of current liabilities.

That means NEXT can cover 40% of current liabilities with free cash flow or 50% using operating cash flow and the rest it must rely on current assets.

 

 

4. Efficiency

Next, we look at the company’s productivity measure relating to the number of employees, regarding revenue generation and cash earnings.

NEXT's PLC Employee Productivity

Source: NEXT’s annual reports.

NEXT PLC manages to increase revenue per staff in the last six years when this metric was stagnating for a long period. One such measure management was able to streamline labour is by reducing full-time staff and utilise more part-time employees.

NEXT may have stated it employs 50,000 workers, but a better measure is the “full-time” equivalent number, and that peaked at 40,000 in 2009. Now, there are 30,000 “full-time” equivalent employees.

Meanwhile, cash earnings per employee doubled.

Main factor is down to its online division helping to optimise the retailer operations.

 

5. Market Metrics

The historical undervaluation of NEXT PLC is apparent. See below:

NEXT PLC Share Price vs. EPS

Source: NEXT’s PLC annual reports.

On that basis, analysts are pricing in a drop in future EPS of 10%, and that justify the 50% fall in the share price. Although this is harsh compared with other retailers, it is the individual companies themselves that are under the microscope because different businesses have different type of shareholders and financial institutions holding its stock!

Back in 2008/09, earnings fell 18% and subsequently recovered, but it didn’t the company’s share price diving by 70%!

 

Using other market metrics:

NEXT PLC's Market Metrics

Source: NEXT’s PLC annual reports.

On past results, NEXT PLC indicates undervaluation, but future results will determine if valuation levels are marked higher or lower. But if you compare 2008’s market valuation (the same year earnings declined by 18%), then don’t be surprised that NEXT’s market valuation can go a lot lower.

 

 

CALL TO ACTION

Before you put your hard-earned cash into a business, ask yourself the following:

  1. Are dividends paid out of earnings or external finances?
  2. Is the company boosting earnings from big increases in receivables?
  3. Are assets overvalued?
  4. Are the company’s payables days increasing too fast?
  5. Is the business overvalued on a historical basis?