Urban Outfitters – Necessary Thoughts On A Winning Investment

Seeing value in Urban Outfitters (URBN) was not difficult considering the multiples the stock was trading at vis vis the many attractive characteristics of the company – good free cash flows, no net debt, a good level of diversification among brands and a rich and relatively safe dividend, to name a few.

The recent results only confirmed a positive trend that had begun when the market started to discount a softer promotional environment. With a double beat on EPS and revenue, we had a further confirmation that the market got this stock wrong, even after the several upward estimates in the past months. The stock rose 3.7% the day after the earnings release and 1.6% the following day. Although URBN had managed to maintain a healthy performance during a challenging period for the apparel industry, the recent strength has not been very company-specific. Many other peers such as Gap (GPS) and Abercrombie & Fitch (ANF) managed to perform really well too. The apparel industry is in a much better condition after brands got rid of excess inventories and engaged in many store closures to optimize their exposure to traditional stores. Less overcapacity and less excess inventories led to fewer promotions, while the expansion of the eCommerce channel and cross-channel purchase options seems to be helping create new opportunities to sell for several brands.

Helped by these tailwinds and a good dose of brand momentum at Free People, the company’s sales in Q3 rose 3.5%, with comps back in positive territory after a 5% YoY decline in the previous quarter. The big positive here was that all the three brands reported growth, with Urban Outfitters up 1%, Anthropologie up 2% and Free People growing 5%.

The performance was not equally positive on margins, which continued to show some weakness due to a combination of factors. On one side, due to the aftermath of 2 years of intense promotions in the industry, which continues to pressure gross margin (down 140 bps). On the other side, the dilutive effect of the increasing penetration of the eCommerce channel, which tends to carry higher variable costs (such as shipping and fulfillment costs). Nonetheless, I have to say that managing to keep operating margin flat in this environment is a great result. The expansion of the DTC channel should bring higher costs and probably did, but the company was able to generate cost savings that offset those higher costs. I have to say it – I think URBN is a company managed pretty well and I have to give the management credit for what they have been able to accomplish in this challenging retail environment.

Unlike many other executives from competitor companies, Urban’s management tends to speak clearly when it comes to assessing the situation of the apparel industry. It is worth noticing that Urban Outfitters’ management expressed a less “optimistic” and probably more honest view about the condition of apparel retailing in comparison to many peers and hasn’t tried to hide the long-term challenges of a transition to an omnichannel retail model. Already in Q4, for example, Urban’s management clearly stated:

I predict within the next three years, total URBN retail segment sales by channel will be almost equal. This would be fine if the increase in DTC sales was wholly additive, but it’s not. Digital shopping is partially replacing store shopping and thus is negatively impacting store traffic and store generated sales. Flat to negative store ‘comps’ are causing occupancy deleverage and eroding four-wall margins.

Despite their apparently below-average level of optimism, the company managed to outperform most of its peers, showing that a clear and honest approach to the real underlying problems in an industry often allows the companies to face these problems successfully. The challenges brought by the transition to an omnichannel environment remain, but the company has managed them well so far and will probably continue to do so. The only concerns I have are related to the possibility that the company may fail to generate further margin expansion during this transition to a business model with higher variable costs and while certain competitors continue to accept thin margins if that helps them grow the top line. The financial prospects of apparel brands carry a certain level of uncertainty due to the impact of several headwinds and/or deep transformations in the industry that are not necessarily bad. For a company like Urban Outfitters, it will be necessary to manage the following headwinds:

Uncertainty regarding levels of foot traffic at physical stores. The increasing penetration of eCommerce has an obvious negative impact on store traffic. The expansion of cross-channel purchasing patterns (buy online and pick up in store, buy in store and get delivered) can mitigate these effects and help create new purchasing opportunities, but the long-term impact of this transition is probably still negative. The result is that stores will report lower levels of foot traffic, leading to weak “four-walls comparable store sales” that will generate negative operating leverage. The company will have to be able to close underperforming stores in weak traffic areas, renegotiate leases and try to generate efficiencies through cross-channel sales. Anyway, this task is not easy, considering that leasing costs may not decline as fast as foot traffic. The second headwind is the lower marginality of the eCommerce business, due to the higher variable costs related to free shipping and fulfillment, and the notorious higher price-sensitiveness of customers who shop online, which is further exacerbated by the strategic choice of many online retailers to compete on pricing and sacrifice profitability for the sake of revenue growth.

Urban Outfitters’ management has shown to have excellent skills and a good dose of honesty. Flat operating margins and growth at every brand are not common for apparel retailers in these days. Anyway, while it surely remains an excellent company with a rock-solid balance sheet (no net debt) and many attractive financial characteristics such as excellent free cash flows and a buyback policy, I wonder if the current valuation at roughly 20x TTM EPS and almost 18x next year expected EPS currently reflects the risk that revenue growth driven by international expansion may not be enough to offset the pressures on margins, which are more related to secular headwinds. If on one side it’s clear that the environment in retail is improving, especially for brands, I wonder if it’s reasonable to expect further strength even after the market has discounted the prospects of a much stronger Q4 compared to the challenging 2015 and 2016. After a solid rebound that followed excessive pessimism from Mr. market and with the current valuation already discounting the prospects of perpetual EPS growth in the low-to-mid single digit range, I am starting to believe that most of what can be taken from this stock has already been taken, and that further upside may only be a result of Mr. market’s passion for exaggerations, this time in the opposite direction.

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Disclosure: I am/we are long GPS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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