Margins To Remain Pressured For Urban Outfitters In The Third Quarter

by Trefis Team
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Urban Outfitters
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The apparel retail industry has been plagued with the rise of Amazon and fast-fashion brands such as H&M and Zara. As a result expectations from companies in the sector have remained pretty poor come this earnings season. Hence, it should not come as a surprise if Urban Outfitters (NASDAQ:URBN) is able to surpass consensus estimates this time around as the bar has been set low. The company has also been seeing favorable earnings estimate revisions recently, which is a sign of positive news surrounding Urban right before their earnings disclosure. This time around a significant decline in earnings on flat sales growth is expected. If the company is able to outperform the poor results expected, it should provide a boost to its stock price, similar to what happened post the second quarter earnings announcement. Below we’ll highlight a few factors we feel will be impacted in the third quarter.

Comparable Sales Recovery Expected

Outside factors aren’t alone in causing the declining sales of the Urban brands. One-dimensional focus on certain products at the expense of a well-balanced, wider assortment has resulted in a downfall of 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 itself. 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. Although the full implementation of this strategy may take some time to even out the flaws, it is expected to show some results in the third quarter. For the Anthropologie brand, the potential reduction in markdowns may hamper the sales growth in the quarter but may help out the margins. The 3% growth seen in Free People in Q2 was impressive given the current retail situation and the fact that the prior year’s quarter included higher sales as a result of increased markdowns. This implies that the potential of the brand can be considered to be strong.

While the apparel market in the US continues to be challenging, if the initiatives 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 opened three new stores in Europe during the second quarter. Additionally, the company intends to sign several international franchises 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.

Margin Pressure Will Remain

Urban’s gross profit margins declined by 440 basis points in Q2, to 34.1%, as compared to the corresponding quarter in FY 2016. The main reason for this had 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 held responsible for the decline was 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 a better reaction to the women’s line. This would imply better comps, and consequently a reduced need for markdowns. However, 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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