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How Safe Is Your Money In NEXT plc?

Next (LSE: NXT) shareholders have seen the value of their stock rise by more than 300% over the last five years, and the company has just increased its guidance for 2014/15, and is forecasting sales growth of between 5.5% and 9.5% this year.

nextHowever, Next shares don’t look especially cheap to me, and I’m beginning to wonder if it might be time for shareholders to lock in some profits. To help me decide, I’ve taken a look at three key financial metrics for Next.

1. Interest cover

What we’re looking for here is a ratio of at least 2, to show that Next’s earnings cover its interest payments with room to spare:

Operating profit / net interest costs

£722.8m / £21m = 34 times cover

Next’s interest payments were covered 34 times by its operating profits last year, suggesting that the firm’s dividend is unlikely to be threatened by borrowing costs, which always have priority over dividends.

2. Gearing

Gearing is simply the ratio of debt to shareholder equity, or book value. I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

In its most recent published accounts, Next had net debt of £530.1m and equity of £286.2m, giving net gearing of 185%. This is surprisingly high and concerns me, given Next’s enthusiasm for share buybacks and special dividends (the latest of which, for 50p per share, was announced this week).

In my view, Next should use some of its surplus cash to reduce its gearing levels to a more prudent level — perhaps 60-70% — before continuing with its programme of shareholder returns.

3. Operating margin

One of Next’s historic strengths is its operating margin, which has risen gradually from 15%, to more than 19%, since 2009.

Indeed, Next’s 19.3% 2013/14 operating margin is on a level with that enjoyed by luxury brand Burberry (18.8%), and much higher than the margins of peers such as Ted Baker (12.3%), Moss Bros (3.9%), and Debenhams (5.5%).

Buy, sell or hold Next?

Next’s strong brand, good eye for fashion, and tight control of stock and discounting have helped make it far more profitable than most of its peers.

However, Next shares currently trade on a forecast P/E of 17 and offer a prospective yield of 3.6%. In my view, Next looks fully valued, and rates as no more than a hold. 

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This high-tech small cap was spotted by the Fool's expert small cap analyst, Maynard Paton, who believes that the firm's profit margins could rise sharply, delivering 'double-digit total returns' over the next five years.

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Roland does not own shares in any of the companies mentioned in this article. The Motley Fool has recommended shares in Burberry.