Urban Outfitters Earnings: Underlying Concerns Overshadow Top Line Gains

Urban Outfitters (NASDAQ:URBN) recently reported solid growth in its revenues for the second quarter of fiscal 2016, backed by continued strength in Free People and consistent recovery of its namesake brand. However, the retailer’s shares fell marginally, as its gross margins and net income declined slightly and it warned investors of slower-than-expected comparable sales growth in the third quarter. Due to traffic-driving promotional activities, a strategy that U.S. apparel retailers are employing invariably, Urban Outfitters’ gross margins shrunk 71 basis points. The retailer’s selling general & administrative expenses (SG&A) increased 8.1% (faster than revenue growth) mainly due to an increase in the penetration of online sales. ^[1] In order to bolster its overall revenue growth, Urban Outfitters has been trying hard to increase its reliance on the online channel, but being a low margin business it has come with some margin pressure.

With its earnings release, Urban Outfitters said that its comparable sales trends in the third quarter so far haven’t been promising, which signals a potential slowdown in the crucial back-to-school season. It appears that the industry-wide decline in foot traffic is taking a toll on the company’s store sales. It may even be possible that Urban Outfitters is having trouble attracting buyers with its season collection, though the company has said that there isn’t enough data available to draw a conclusion. ^[2] This news has raised some concerns among investors, who were already skeptical despite three consecutive quarters of good top line performance.

During the second quarter, Urban Outfitters’ revenues increased 7% to $868 million, driven by 4% rise in comparable sales (including online) and incremental revenues from new stores. The retailer’s net income declined slightly due to weak gross margins and an increase in SG&A, but share buybacks helped it report a year-over-year increase of three cents in net EPS. During the first six months of the current fiscal year, Urban Outfitters repurchased and retired 2.3 million shares for about $83 million. ^[1]

Our $40 price estimate for Urban Outfitters is about 25% ahead of the current market price.

See our complete analysis for Urban Outfitters Inc.

Why Bottom Line Is A Concern

The rapid growth of fast fashion players and a consistent customer shift to the online channel have pushed casual apparel players into a price war. Even Urban Outfitters, which has seen better customer response than other casual apparel retailers, has used some significant markdowns to attract customers. This strategy has weighed heavily on the company’s gross margins, which is likely to persist in the future. Considering the highly fragmented landscape of the U.S. apparel industry and Urban Outfitters’ target market (consumers seeking affordable merchandise), a significant reduction in the level of promotional activities is unlikely. In fact, competition in the online and omni-channel space is significant as well, which indicates that increasing prices will be an arduous task. Accordingly, margins will remain a concern going forward, unless the company decides to accelerate its expansion in un-penetrated international markets, where competition isn’t as intense.

Urban Outfitters is also encountering an increase in fulfillment expenses coming from a rise in direct-to-consumer penetration. While the retailer is aiming to increase its direct-to-consumer penetration to survive the ongoing online customer shift, it is coming at a price in the form of margin pressure. On the surface, it seems that the direct-to-consumer channel should have higher margins since there are fewer expenses related to the retail stores. However, after factoring in the expenses related to storage, packaging and delivery of online orders, as well as sales mix, the channel actually accounts for weaker margins as compared to the brick-and-mortar business. Urban Outfitters wants to earn a higher share of revenues from the online channel, since that is where most of the customers are moving; this would do wonders for the company’s top line, but it would also result in more pressure on margins.

In order to dilute this impact, Urban Outfitters may have to search for other avenues to cut its expenses. At the moment however, the company doesn’t have much to work with, since it has to deal with incremental expenses related to omni-channel initiatives and store expansion.

Why Initial Q3 Comparable Sales Trends Are A Concern

Urban Outfitters’ CFO Frank Conforti mentioned on the earnings call that the company’s Q3 comparable sales were growing slower than the projections. There are indications that this trend has more to it than just the industry-wide decline in foot traffic. Mr. Conforti mentioned that the decline in foot traffic has been similar to previous months, which means that some other factors are also having an impact. The back-to-school season is crucial for U.S. apparel retailers, and Urban Outfitters is no exception. In fact, the retailer earns a major share of its revenues during the last five month of its fiscal year.

Initial weakness in comparable sales indicates that the company may not be well prepared for the season. Urban Outfitters has faced merchandise issues due to product imbalance and off-pitch fashion in the past, which could happen again if demand was misjudged. This appears to be the reason why investors have reacted negatively to the company’s Q2 earnings despite the strong top line growth and EPS beat. ^[3] Though Mr. Conforti said that there isn’t much information available to figure out the problem, he did mention that there are many potential factors that could be impacting comparable sales.

View Interactive Institutional Research (Powered by Trefis):Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap |More Trefis Research

1. Urban Outfitters Reports Record Q2 Sales, Urban Outfitters, Aug 17 2015 [↩] [↩]
2. Urban Outfitters’ Q2 fiscal 2016 earnings transcript, Aug 17 2015 [↩]
3. Sales at Urban Outfitters Off to Slow Start for Quarter, The Wall Street Journal, Aug 17 2015 [↩]