Description

Urban Outfitters Inc. (Nasdaq: URBN) is a liquid mid-cap retailer trading at an attractive EBIT/EV yield of 11.0%. Although Urban Outfitters operates mainly in the retail and wholesale apparel industries, they also offer a broader selection of consumer products, including furnishings, footwear, gifts, electronics, beauty products, and more. A key differentiator for the company’s brand versus competitors is its quirky sense of style, which ranges from hipster to retro.

The Obvious Bear Case

Apparel retail is a difficult business characterized by fierce competition, a fragmented industry, and rapidly changing consumer preferences. There are few barriers to entry, as today anyone can open a small boutique or a web page at low cost. Consumer retailers are also highly exposed to macroeconomic trends. If the economy slows, consumers reduce discretionary spending, which has an immediate impact on retailing revenues. Additionally, as consumers are increasingly shopping online, traditional bricks and mortar operators are being displaced. 

Against this backdrop, URBN has been losing market share in a weak consumer environment, and a challenging market for apparel, with retail store performance faltering, as the industry continues trending towards ecommerce. Recent growth in URBN’s ecommerce sales has been offset by declining store sales.

Yet the company appears committed to bricks and mortar. URBN’s store count increased from 443 in Q1F2013 to 574 in Q1F2017, with plans to open 24 new stores in F2017. Competitors including American Eagle, Aeropostale, and Gap seem all to be going the opposite way and closing stores.

URBN had pushed into international markets (foreign sales accounted for 13.2% of total sales for F2016) in hopes that it could expand in less mature markets, but its international business has also stalled out, with F2016 foreign sales falling slightly. Brexit, currency and growth issues surrounding Europe may continue to thwart international plans.

If you aren’t discouraged yet, read on.

Segment Overview

URBN operates in retail, with a portfolio of recognizable brands, including Urban Outfitters, Anthropologie, Free People, Terrain, Bhldn, Vetri Family, and retail/wholesale with Free People.

We’ll discuss retail first, representing the lion’s share (91.6%) of sales, and then move on to wholesale, representing the balance.

Retail

Retailer includes in-store retail sales and direct-to-consumer online sales. URBN’s retail Y/Y revenue growth in Q1 was 2.2%.

The direct to consumer channel (ecommerce) posted double-digit growth, and outperformed the stores, helping to balance negative YoY in-store sales growth during Q1F2017. Ecommerce is a part of URBN’s omni-channel strategy which aims to provide consistency between URBN’s in store and online experience. For example, URBN sources products by accounting for both online and in-store sales by allowing online orders to be filled by both fulfillment centers and retail stores. This allows the company to limit incomplete orders due to out of stock items.

Although URBN offers limited disclosure of performance by brand, we will provide a brief discussion of URBN’s brands below.

--Urban Outfitters

The flagship brand, Urban Outfitters, targets a younger audience, between the ages of 18-28, and operates 179 stores in the US, 18 in Canada, and 43 in Europe. The North American, and European retail segments account for 32.5% and 8.0%, respectively, of consolidated net sales for F2016. The YoY segment comp rate increased by 2.0% in Q1, and gross margins improved.

--Anthropologie Group

This subsidiary includes three separate lines, Anthropologie, wedding brand Bhldn, and home and garden center Terrain, which accounted for 40.1% of North American retail for URBN in 2016. Anthropologie Group operates 197 stores in the US, 12 in Canada, and 9 in Europe. Anthropologie tailors to contemporary and sophisticated women between the ages 28-45. Bhldn specializes in a wide range of wedding apparel and Terrain distributes outdoor wear. Anthropologie retail comps were flat in Q1, and gross margins were flat.

--Free People

Free People sells private branded merchandise aimed at women 25-30, and operates largely in the US, with 109 US stores and 5 in Canada. Free people retail accounts for 10.1% of consolidates net sales for 2016. Free People’s retail segment comp slipped by 2% in Q1F2017, due to a poor buy and resulting markdowns.

--Vetri Family Acquisition

In sum, the retail bricks and mortar business is sleepy and mostly flat, with Urban Outfitters being the lone bright spot. Perhaps in response to these dynamics, URBN recently purchased Vetri Family restaurant group, a chain of casual dining restaurants. The idea is to create an integrated experiential “lifestyle center” which brings shoppers in by offering food along with lifestyle goods, and help URBN develop a broader merchandise concept. Desperate times call for desperate measures, I guess. Then again, pressure turns coal into diamonds.

Wholesale

Free People makes up URBN’s entire wholesale component at 7.6% consolidated net sales for F2016. URBN operates its wholesale business through Free People, which designs clothes for young women, and markets them through specialty and department stores. The good news is that as of Q1F2017, wholesale had 15% Y/Y growth, and with better margins than retail. We think the wholesale segment provides some opportunities for revenue and profit growth.

Brand

Fundamentally, URBN is a branding specialist, focused on creating an emotional bond with the customer, and leverages a highly creative and entrepreneurial culture. URBN started in 1970s, with a store near the University of Pennsylvania’s campus, and they have stayed true to the vision of offering a social/cultural shopping aesthetic in an upscale urban environment.

If you visit an Urban Outfitters store, you’ll appreciate this immediately. The feel is one of vintage or hipster style, offering a hint of rebellion, with an almost thrift store ambience. For New Yorkers, think Brooklyn. This appeals to the college crowd and the youth consumer, and sets the brand apart from others.

URBN owns and embraces this culture, and this sensibility informs the family of brands. Moreover, they are survivors. The company has continued to evolve and adapt, and has successfully transplanted the model in other urban or quasi-urban areas, from Los Angeles, to Charlottesville, VA. There’s something special in the company’s DNA.

What’s that you say? None of this abstract brand talk particularly excites you, since you’re a numbers person? Let’s take a step back and look at a few of the financial drivers that demonstrate the power of the brand and shape the financial picture for URBN.

Historical Returns on Assets/Capital, and Free Cash Flow

Below are URBN’s returns on assets for the past 8 years (most recent first):

12.1%, 11.9%, 14.0%, 13.4%, 11.6%, 15.3%, 14.1%, 13.5%

The return on capital show a similar pattern over the past 8 years (most recent first):

17.2%, 16.4%, 19.7%, 17.6%, 16.2%, 19.7%, 17.8%, 17.2%

This stable and consistent return series is admirable and places the company in the top tier of all mid/large cap companies the past few years.

Furthermore, URBN is a cash flow machine, having generated >$1.5bn in free cash flow over the past 8 years. 

We think these metrics demonstrate that URBN’s brand represents a sustainable competitive advantage that will allow the company to continue to earn strong returns and free cash flow.

Current Financial Strength

In the past 12 months alone, URBN generated $341 mm of free cash flow, in addition to earning the strong returns highlighted above. Cash flow increased, returns on assets increased, and gross margins increased. In the past year, asset turnover (sales/total assets) increased, indicating enhanced operating efficiency. Despite comparatively slow recent sales growth, URBN has compounded annual sales growth at approximately 9% over the past five years.

Stock Repurchases

URBN has been steadily repurchasing shares for the past few years, reducing share count from ~160mm shares 5 years ago to ~117mm shares today. During Fiscal 2016, they retired 12.7 mm shares for $382 mm. In February, the Board authorized the repurchase of 20 million common shares, and the company repurchased 0.3 million common shares for $11 mm during Q1.

Summary

In analyzing retail, it’s easy to get bogged down with Amazon fears and/or the minutia of operating results, the performance of individual brands, or in this case, the contribution from growth segments such as ecommerce, wholesale and the new restaurant group. The reality is that URBN faces challenges--which they recognize--and they are adapting and overcoming (possibly).

Clearly, over the years URBN’s unique brand and corporate DNA has enabled it to do a lot with its capital and asset base, and generate a lot of cash for the enterprise. The brand continues to drive sales growth. The company continues to repurchase shares. There are strong recent signs of operating momentum. We believe these trends have a chance at remaining in place. And as we all learned from value investing 101, investing is about what you get, but also about what you pay...

The stock is cheap today at a 11.0% EBIT/EV yield, making it one of the cheapest stocks in the market. We think this is a reasonable price to pay for a solid franchise.

Catalyst

-Continued growth in wholesale

-Continued growth in Ecommerce

-Vetri acquisition drives sales

-Share repurchases