Margin Pressure To Remain For Urban Outfitters In 2017

by Trefis Team
-35.99%
Downside
33.09
Market
21.18
Trefis
URBN
Urban Outfitters
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Urban Outfitters’ (NASDAQ:URBN) fortunes have been up and down for the past few years, and the same can be said for 2017, as well. After posting disappointing fourth quarter 2017 and first quarter 2018 earnings (three months ended January 2017 and April 2017, respectively), the stock price of the company was spiraling downwards. However, better than expected second quarter earnings have turned the tide in its favor, with the stock rebounding since then, gaining almost 30% in value. Does the stock price recovery mean that the company itself is on a road to recovery? Can we expect positive comparable sales growth anytime soon, and will the margin pressure ease up a bit? Below we’ll try to answer these questions.

Beat On Expectations Results In Stock Price Recovery

Urban’s shares shot up 20% on the release of its second quarter earnings on August 15th. While the stock of a retail company going up by 20% is a surprise in itself, what is even more astonishing is that the company’s results were actually quite weak. While URBN managed to beat consensus estimates on both revenues and earnings, its sales were down by 2%, and its earnings by over 33% per share. The comparable sales for the company declined by 4.9%, which is better than the 6.9% that was expected, but it is a bad fall, and the most in seven years. Comps in the Urban Outfitters brand were down a massive 7.9%, while that for Anthropologie were a negative 4%. Free People’s results were the only bright spot for the company, whose comps were up by 2.9%. However, this brand contributes a much smaller share of the revenues as compared to the other aforementioned brands.

On the other hand, a recovery in the stock price was warranted, as the shares in the company had fallen considerably since the announcement of its two prior quarters’ results. The stock was trading at $22.46 on September 12, while our price estimate is lower by about 6% at $21.18.

Comps Recovery Expected

Outside factors aren’t alone in causing the declining sales of the Urban brands. One-dimensional focus on separates, and on tomboy within separates, at the expense of a well-balanced, wider assortment has resulted in a downfall for the Urban Outfitters brand. Furthermore, a higher lead time inhibited the company’s ability to quickly rectify its mistakes. For this reason, the North American business spent the second quarter trying to re-architect its business. Instead of buying a bulk of its assortment earlier, it started buying a smaller quantity upfront, and then bought the remainder, with a faster turnaround, based on the sales. Whereas some of the weakness in sales was a result of a shift in business style, it may bode well for the future. Although the full implementation of this strategy may take some time to even out the flaws, it may already be showing results, with women’s regular price sales for the Q3 to-date showing encouraging results.

Even for the Anthropologie brand, the merchandise lacked its core aesthetic, with pattern and color lacking. URBN has been working to fix these mistakes as well. In the second quarter, the sales of the regular-priced items improved sequentially as the quarter wore on, and if this trajectory continues, the comps should improve. However, the potential reduction in markdowns may hamper the sales growth but may help out the margins. The 3% growth seen in Free People is impressive given the current retail situation. Moreover, considering the prior year’s quarter included higher sales as a result of increased markdowns, the potential of the brand can be considered to be strong.

While the apparel market in the US continues to be challenging, if the steps undertaken by the company do result in an improvement in the assortment, the back half of the year may not be as bad as the first half. Furthermore, URBN has an enormous potential in the international market, where the company has been witnessing positive comps. Keeping that in mind, the Anthropologie brand signed a wholesale distribution agreement to sell its home products in John Lewis stores in the UK. The Urban brand also opened three new stores in Europe during the second quarter. Additionally, the company intends to sign several international franchise and joint venture agreements over the next one or two years. These actions may help the company tide over the weaknesses in the domestic market.

Weakness In Margins To Stay

Urban’s gross profit margins declined by 440 basis points in Q2, to 34.1%, as compared to the corresponding quarter in FY 2017. The main reason for this has been cited to be the underperforming women’s apparel and accessories merchandise at Anthropologie and Urban Outfitters, which forced the company to undertake higher markdowns. Another factor responsible for it is the higher delivery and logistics expense related to the focus on the direct-to-consumer (DTC) channel. These factors together with the higher digital marketing spend resulted in the fall of the operating margin by 470 basis points, to under 9%.

In its prepared statement, the company did state that the gross margin is expected to decline at a lesser rate than that seen in the first half and that August was faring better than the second quarter, with a slight improvement in traffic, and better reaction to the women’s line. This would imply better comps, and consequently a reduced need for markdowns. Whether this trend continues through the quarter remains to be seen. Moreover, the highly competitive nature of the apparel retail business makes the achievement of higher margins pretty unlikely. Since the merchandise is very similar across most retailers, they resort to reducing prices in order to gain market share, which has been wreaking havoc on the bottom-line for many such companies. Hence, while reduced markdowns may give some respite, the margins of retail companies can be expected to remain pressured for the foreseeable future. Moreover, a focus on the better performing segments of the company – DTC and Free People Wholesale – will no doubt have a positive impact on the top-line, but it won’t do the bottom-line any favors.

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Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such communication sparks thinking, and encourages readers to comment and ask questions on the comment section, or email content@trefis.com
2) Figures mentioned are approximate values to help our readers remember the key concepts more intuitively. For precise figures, please refer to our complete analysis for Urban Outfitters
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