We believe that Urban Outfitters Inc. offers a compelling short opportunity at current levels as the market is overestimating the Company’s competitive advantage and recent growth trends are simply unsustainable. .  We see fair value around $25 (~30% downside), given comparable multiples for maturing specialty retailers, potential negative earnings revisions, and an overall repricing of the stock.  The stock is priced for perfection, and while comps and current trends have been exceptional, investors have failed to account for (i) challenging growth estimates, (ii) high price points for their target market and (iii) the potential for shifts in consumer taste.  Also, we believe that the size and volume of recent insider sales are an issue for consideration.  An Urban Outfitters short is somewhat analogous to a play on the ‘Wal-Mart effect’ seen in equities throughout 2008 (Big Lots, Dollar Tree, Overstock, TJ Max).  We’ll caveat that we generally prefer special situations investments, instances where there are structural issues or situations where we have a true informational edge, however; URBN is simply a valuation short.  We see this story playing out over the next six months as slowing growth trends warrant a revaluation of this equity.

Urban Outfitters Inc. (“Urban”, “URBN”, or the “Company”) is a lifestyle apparel retailer operating two core retail concepts (Urban Outfitters and Anthropologie) and a wholesale business (Free People).  Urban was formed by President and Chairman Richard Hayne in 1970, along with financier Scott Belair (a director on URBN’s board).  Hayne has built a remarkable business (Hayne has somewhat relinquished day-to-day control to CEO Glen Senk within the last year) and has grown URBN into one of the country’s premiere specialty retailers, defining a niche and challenging conventional wisdom.  URBN has grown rapidly over the past four years from $423mm in FY revenue 2003 to $1,508mm in FY 2008 (29% CAGR), outpacing peers of any scale in the face of a recession.  Please see below for detail on each individual division (note the Company has other smaller divisions such as Terrain and other concepts they are looking to roll out, however they are rather inconsequential to the story).

·         Urban Outfitters (42% of FY 2008 sales) – the Company’s flagship brand has 132 stores throughout the US, Canada and Europe, a catalog, and two websites.  Urban Outfitters targets style conscious, sophisticated young adults ages 18 to 30 through a unique merchandise mix (think retro t-shirts, apartment decor, hand-sewn blouses, trendy hats – essentially a department store for wannabe hipsters).  Stores average 9,700 square feet (note this is huge for retail) and carry ~35,000 SKUs, with an average ticket of ~$50.  Sales are roughly broken down as follows; Women’s apparel & accessories (60%), Men’s apparel and accessories (20%), and home / gift (20%).  Stores are located in large metropolitan areas, select university communities and enclosed malls.

·         Anthropologie (37% of FY 2008 sales) – Anthropologie operates 115 stores throughout the US, a website and catalog.  Anthropologie targets 30 to 45 year old women with unique stylish designs.  Stores are located on street fronts and in malls, with ~7,500 square feet and an average ticket of ~$80.  Apparel and accessories are ~75% of sales, with home furnishing / gifts at ~25%. 

·         Direct-to-consumer (14% of FY 2008 sales) – sells to consumers via the Company’s web sites and catalogs for all three brands.  The direct-to-consumer segment has grown with the Company’s brand and currently ships ~40mm catalogs per year.

·         Free People Wholesale (6% of FY 2008 sales) – the Company’s wholesale operation buys from vendors (to Urban Outfitters) and distributes to ~1,700 stores throughout the US.  Free People Wholesale sells to smaller ‘better’ retailers, and also to larger upscale retailers (Nordstrom & Saks).  Free People Retail (1% of FY 2008 sales) is a relatively young division, with the first store opened in 2002.  Targeting ‘adventurous and free-spirited’ 25 to 30 year old women through a unique assortment of apparel, accessories and gifts.  There are 21 stores, with average square footage of 1,600 and average ticket of ~$95.

 

URBN’s historical financials are laid out below.

 

 

 

The Company believes the overall market opportunity is quite large and recent growth suggests they are correct.  The Company’s stated goal is to increase net sales by at least 20% per year through a combination of opening new stores (stated 15% goal), growing comp store sales, continuing the growth in direct-to-consumer and wholesale operations and introducing new concepts.  URBN should be able to grow its store base ~15% per annum over the short to medium term (we think their longer-term target of growing from the current 268 stores to 750 stores is simply unrealistic), however an expansion strategy such as this carries a few primary risks; (i) brand dilution / stretching thin, (ii) expanding into less favorable markets and (iii) changing consumer tastes and preferences.  These points are described in more detail below:

·         Brand dilution / stretched strategies – URBN is branching out into five retail concepts (Urban Outfitters, Anthropologie, Free People Retail, Terrain and Leifsdottir), which begs the question as to when this Company stretches itself too thin.  You cannot be all things to all people and specialty retail is one area where this old maxim holds true.  URBN aims to create ‘emotional bonds’ with customers, however; the emotional bond of a boutique store is lost when you have ~750 related stores nationwide (their target).  URBN’s transition from a trendy, ‘new’ boutique to a maturing specialty retailer is inevitable and the market will react accordingly.  Maturing specialty retailers (Abercrombie, American Eagle, Aeropostale) trade at ~0.9x EV /2009 sales and ~10.2x 2009 PE – URBN trades at 2.7x CY 2009 sales and 22.9x CY 09 EPS.  URBN is growing faster than these comps and dominates their niche for now, but such a disparity in valuation is unwarranted.

o        While small, an example of a stretched strategy is Terrain, the Company’s gardening concept which was rolled out in 2007.  Terrain is an upscale gardening store, where URBN aims to sell high-end gardens and accessories to customers in a unique, comfortable environment (think music / food / upscale gardening specialists).  This is completely out of URBN’s core competency, and while management asserts that this will not be a distraction, we think this is a fair example of their mindset with respect to brand extensions.  Terrain is not necessarily detrimental to financial performance, rather indicative of stretched strategies and management focus.

·         Expansion into second tier markets / Saturation – there are currently 268 core URBN stores (Urban Outfitters, Anthropologie, Free People), and URBN aims to grow the consolidated store base by 15% annually.  This is remarkable as it comes at a time when we expect other specialty retailers to rationalize their store base given demand.  As URBN looks to penetrate new markets, expansion into second tier cities is inevitable.  Stores in Boise or Omaha hardly carry the cache or move inventory comparable to those in NYC, or Miami.  URBN’s initial core stores are truly special, located in large DMAs and select university communities.  URBN’s latest vintage (late 06 / 07) stores are increasingly mall-focused and stretching to second-tier cities.  As an anecdotal example, there are two stores in NYC within 10 blocks of each other and six stores in NYC in total – the core markets are becoming saturated.

·         Changing consumer tastes – the upscale 18 – 30 year old market is highly coveted and notoriously fickle.  URBN’s merchandising / buying groups are top notch, but consumer tastes do not stand still.  The retail industry is simply too competitive and generally unpredictable with respect to consumer tastes.  Note: URBN’s stumble with consumer tastes in 2006 (discussed briefly towards the end of this write-up) is a good example of how one bad season can change the perception and momentum of a brand (and cripple a stock).

At $35.64 per share, URBN’s market cap is $6.2bn and TEV is $5.8bn.  The Company has no substantial long-term debt and book equity is $968mm.  The capital structure is quite typical for specialty retailers, financed entirely with equity.

 

 

 

 

On consensus estimates, URBN is trading at 2.6x sales, 11.8x EBITDA, 23.4x P/E, 24.0x free cash flow to equity for the fiscal year ending January 31 2010.    At $35.64 URBN is trading near a 52 week high of $37.09, up 31% YTD vs. the S&P retail index roughly flat.  URBN is up 55% vs. the S&P retail index off 15%.  While we believe there is potential for negative earnings revisions towards the end of 2008 as the economy catches up and average ticket prices come down, the consensus numbers leave no room for error.  See the output table below with summary trading statistics.

 

 

 

Given the current valuation and recent operating performance, we believe upside is muted.  We’d note that URBN recently released July comp store sales which were very impressive (URBN consolidated up 13%, Urban Outfitters up 19%, Anthropologie up 7%, Free People up 10% - versus relatively easy comparisons from 2007).  Comps get more difficult later into 2007, as June / July were the first months when URBN began to really recover from the 2006 stumble.  For now, growth trends remain strong, and we cannot predict when they will begin to slow but they inevitably will.

·         July comp store sales up 13% - It is quite notable that URBN barely budged on this news, which leads us to question what was priced in, and what was the market expecting (>15% comp store sales growth in today’s retail environment)?  We’d also note that sell-side research is quite bullish on this name – of the 23 analysts that cover URBN there are 12 buys, 10 holds and one sell. 

·         URBN recently reported Q2 FY 09 earnings– results were stronger across the board and the Company did not release guidance.  The Company beat consensus revenue and EPS estimates, and continued the relatively upbeat tone on the call.  Revenues were up 30%, operating profit was up 75%, net income and basic EPS up 79%.  There isn’t really much more to elaborate on, Q208 went perfectly for URBN – we suggest readers listen in on the Q209 conference call to get a sense of the unbridled optimism from URBN / research analysts.  If management is so optimistic, why hasn’t anyone bought a share of stock (note no cash insider purchases since 2006).

 The Company is simply priced for perfection, and the valuation is even more shocking when you analyze certain relevant retail competitors (see comp table below, the numbers are calendarized vs. URBN’s FY mentioned throughout this write-up).

 

 

 

As noted above, (founder, President and Chairman) Richard Hayne has built this company from the ground up.  He owns ~35mm shares, worth ~$1.2bn at current prices.  One of the our initial attractions to URBN as a short candidate was the share price performance, coupled with the significant stakes that Hayne has sold this year (~$50mm to date).  Hayne has been quite prescient at selling on strength, with notable sales in mid-2004 and fall 2005 (both preceding large drops in the stock).   Note that Hayne did not sell any shares at all in 2006 when the stock was in freefall.  We’d caveat that Hayne still holds a considerable stake in the Company and this is likely part of a normal asset diversification strategy.  This in itself is not reason to get short, but certainly an interesting reference point.  Other insiders have been selling and exercising options at a somewhat alarming pace when you compare their exercises / sales to their aggregate interests in the company (director Scott Belair, CFO John Keyes, President Tedford Marlow).  We cannot verify an insider purchase since September 2006.

 

·         While it’s likely that we are early, the key (and only fundamental) risk to our short thesis is that URBN could continue to execute on plan in an increasingly difficult macro environment. URBN could continue to grow its store base at 15% per year while outpacing the industry in comp store sales, maintaining industry-leading margins and sales metrics, and not diluting the brand.  We think this is improbable, as (i) legitimate markets for expansion are limited, (ii) consumers will feel the pinch of inflation / a slowing economy and shun ~$80 jeans, (iii) a nationwide expansion of a boutique brand will eventually dilute the customer experience, and (iv) consumer tastes could change.  2008 comp store trends set a high bar and expectations are detached from reality.  We’d note that the Company recently reported July comp store sales up 13% - yet the stock barely budged.  Although 2007 provides easy comps, when the market begins to discount mid double digit comp store sales (in a recession!) as a given, we get excited about a short.

·         Potential Short squeeze – reported short interest of 34mm shares, or 25% of the float / 8.5 days to cover is high compared with the broader market but not necessarily retail as the good shorts that have worked out are quite crowded.  URBN has had a relatively high short interest (averaging 15 – 28% of float over the past two years) given the high valuation and retail risk, so this is nothing new.  Borrow is generally freely available.

·         Slowing growth – URBN’s YTD growth has been undeniably impressive given the current economic malaise; however, there is no question that this is unsustainable.  With price points of ~$40 for t-shirts and ~$80 for jeans, URBN’s growth will slow as college students and young professionals begin to trade down (Wal-Mart Effect).  We estimate  the stock is pricing in ~20% core store expansion through FY 2011, implying 420 stores with identical store metrics as seen today (sq footage / sales / square footage / margins).  These are challenging growth assumptions and are detached from reality.

·         General repricing of the stock – let’s assume that the consensus EPS for 2009 / 2010 are spot on, then we have a company trading at 29x FY 2009 EPS / and 23x FY 2010 EPS, not cheap in any market let alone when the S&P is at ~15.0x EPS, and retail comps are at 11.7x CY 2009 EPS.  These are reference points, as the S&P (in aggregate) is not growing at 20 / 25% per year but the fact is that there is no room for error.  The stock is priced for perfection, and bulls are convinced that URBN can buck trends that affect the entire economy and retail industry indefinitely.  If URBN were to trade at the median CY 09 multiple for retail comps it would imply an $18 stock price; we think a more reasonable scenario is for URBN to trade at ~17x 09 EPS (a fair multiple for a maturing specialty retailer) the stock would be worth $26.  Picking a price target for a name like this is an exercise in futility; once momentum stories like this break they break hard and we believe the stock would fall to the mid-teens.

o        We are firm believers that the fashion industry is much akin to the film industry – unpredictable over time and not investor friendly.  URBN does not take much direct fashion risk as they are a retailer (vs. a producer), however, merchandisers run the risk of not being up on the latest trends.  Consumer tastes change constantly, sometimes with no valid or logical explanation.  Note that in 2006,URBN badly whiffed and misjudged consumer tastes with merchandise that simply did not fit and was way too edgy (URBN is hip, but not ‘that hip’ – this write-up does not do justice to the blunder, but URBN rolled out Euro-styles to the US which consisted of big tops and skinny bottoms, or an ‘inverse triangle’, needless to say they did not stick in the US).  URBN arguably did not recover from these missteps until later in 2007 (negative year-over-year comp store sales for core URBN in Q107, Q207, modest increases in Q307) and has been on a roll ever since.  URBN has to do too many things right while expanding their store base 20% per year and branching out into new concepts.

We believe that URBN is priced for perfection, and thus offers a compelling short opportunity. Long-term growth expectations are unreasonable and specialty retail businesses simply cannot generate abnormal returns for shareholders over time.