The contrarian investor’s nightmare

Next, the clothing retailer, has tormented me for years. A model of success even in adversity, it’s so repulsive I’ve never even opened its annual report. But that’s about to change…

Here’s the chart. Next is at the top of its form. At nearly ''30 the shares have risen 1,200% since Sharescope time began:

Investors must love this company, which has made so many of them so much money. Shareholders must be so complacent after all they fat years, they hold out of habit.

With a market capitalisation of nearly ''5bn you’d only need 13 Nexts to rival facebook for heaven’s sake. Since teams of analysts follow it, how can it possibly be neglected, unloved? How can it be cheap?

In the topsy-turvy world of a contrarian investor where bad means potential for improvement and good means potential to stumble, Next is a nightmare. It never seems to have a bad day.

But, my insecurities, and predilections for beaten-up companies aside, there’s another reason I fear Next. I’m afraid I won’t be able to make any sense of the accounts. How can a company’s debt to equity ratio be 372% while operating profits are 22 times the size of its interest payments? The former suggests we should be panicking about Next’s debt, as well as Greece’s. The latter suggests Next is so extraordinarily profitable it could easily afford to take on more debt, unlike Greece.

Profitable? Yes profitable. Return on Equity is 176%.

Are these figures real? With returns like that Google ought to switch to flogging cardigans.

The answer is yes, the numbers are real, thanks to the denominator of the gearing and profitability ratios: equity. Next has minuscule equity, which makes both profit and debt look enormous when you compare them to it.

So here’s another question. How can a company that makes so much profit have so little equity? After all profits are retained by the company…

…Or they’re returned to shareholders in dividends and share buy-backs. The figures are real because Next buys back shares on top of its dividend instead of paying off bank debt and saving some cash for a bad day. As I said, apparently it never has one.

Not having much equity could be a bad sign as its the accounting value of what shareholders own, but Next gives it back to shareholders, which is a good thing so long as it doesn’t need to dip into that non-existent equity to stay afloat.

The problem is how to value the company, or assess its finances, when the buy-backs have set the traditional tools of analysis, like gearing and return on equity, spinning like a compass in the Bermuda Triangle?

Then there’s the small matter of the leases, a ''1.8b financial obligation not recorded on the balance sheet, which means Next is a lot more indebted than it looks.

There’s precious little value in the assets so we must look to earnings and whether Next can easily afford to pay the rent and leases out of it. The unlevered, long-term earnings yield measure I’ve been working on can help with earning power and a modified interest cover ratio will help with affordability, work that is worth doing for two reasons:

1. Next could be a mildly contrarian choice, if performance dips, or if investors desert the sector as one retailer after another goes bust.
2. It appears to be an incredibly efficient business, and I’d like to know why.