An Apparel Retailer You Won't Find on the Clearance Rack

By Tom Gibbs - April 4, 2012 | Tickers: ARO, AEO, GPS, URBN | 0 Comments

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Urban Outfitters (NASDAQ: URBN) shares trade up nearly 5% this morning on positive news regarding the corporation’s first quarter improvements.  Although nearly all apparel retailers in the sector have been subject to rising commodity costs, increasing gas prices, and inconsistent levels of consumer spending habits, Urban Outfitters did report that same store sales in February and March have increased in the low single digit percentages.  Average analyst price target expectations have, as a result, been upgraded. 

In looking at the retailer’s performance trends over the past several years, however, significantly less upbeat tones tend to resonate.  There are more than a few roadblocks that will continue to hinder the brand’s long-term progress in the highly fragmented apparel retailing space. 

Commodity Uncertainty

Cotton futures closed around 93 cents per pound earlier this week, and although prices have fallen by more than 50% from their early 2011 highs, they are still more than 50% greater than their average prices throughout the mid-2000s to their mid-2010 jump.  Extremely intense competition within the apparel retailing sector, and considering the fact that apparel is a discretionary good that, for the most part, does not have to be purchased, makes it very difficult for most retailers to pass along the elevated input prices to consumers. 

Average Urban Outfitters gross margins of around 39% between 2003 and 2009 have subsequently fallen to the mid-30%s throughout 2011 and to 30.1% in the most recent quarter. 

Despite the general improvement in consumers’ propensity to spend on excess, the uncertainty in the commodity market makes it extremely difficult to trend the corporation’s long-term margin dynamics.  Several different factors including drought conditions in Texas, which is one of the highest volume producers in one of the world’s largest cotton exporting nations, the stockpiling of the good in China and the uncertainty of whether or not it will release the hoard onto the market, and the cotton export ban and subsequent decision reversal by the Indian government, have all been key drivers of the uncertainty. 

In short, the hypothesis is that despite the drop in the price of cotton, there is no certainty as to its exact movements over the mid-term.  Retailers, as a result, are not 100% in the clear just yet. 

Poor Store Dynamics

Due to the number of competitors in the apparel retailing sector and the subsequent inability for any one particular merchant to captivate an above-average level of the market’s consumers, there is always the pressure to capture additional share by rapid store expansion.  It is relatively easy to isolate the retailers that are growing too fast for their own good, as sales per square foot start to dwindle, SGA expenses as a percentage of sales become uncontrollable, and the inevitable store closures take place.  Gap’s (NYSE: GPS) high growth phase throughout the early 1990s was characterized by such subsequent events, as was Starbucks’ similar growth phase following the CEO change in 2000. 

Other brands including Aeropostale (NYSE: ARO), Limited Brand’s Victoria’s Secret, and privately held J.Crew tend to perform better over the long run through a focused and manageable growth strategy that inherently acts to preserve brand exclusivity and pricing power. 

Urban Outfitters, despite it only having slightly more than 400 stores, is more on the Gap-like fast track to growth.  The corporation makes it known that its primary retail goal is to maintain a 20% sales CAGR, and by the end of this year its retail footprint will have expanded by nearly 75% since early 2009.  Although as a percentage of its existing store base the new store construction figures per year have declined minimally, the absolute number of new stores has increased.  As such, despite sales increasing by nearly 35% from 2009, the per square foot sales productivity has dropped 5%. 

Is It Cheap?

Lastly, on a free cash flow basis, Urban Outfitters is one of the most expensive players in the apparel retail space.   Similar to consumers shopping in Urban Outfitters stores, it is important for investors to examine the value they are getting for their purchase of URBN shares – how much are you paying, and how much are you getting?  Examining each of the five apparel retailers -- including Gap, American Eagle (NYSE: AEO), H&M, Abercrombie and Fitch -- on a total sellable square foot basis, the yield (trailing twelve month free cash flow per square foot/enterprise value per square foot) for Urban Outfitters is nearly 70% less than the “industry” average, implying that there is little value to be had in the shares at current valuations. 

With no certain catalysts behind Urban Outfitters shares, there is no reason to think that, with the lack of margin of safety, the investment is worth the recent analyst upgrades.  The corporation’s swift growth is slowly plaguing its per square foot metrics, there is continued uncertainty in the commodity markets (both gas and cotton), and even if consumer spending continues to improve and input prices fall, how easy will it be for the corporation to increase average selling prices after a prolonged period of reliance on clearance prices?

Average selling prices have consistently fallen over the past three years, as the corporation is continuing to push overstocked inventory to prevent a huge buildup.  It is much more difficult to maintain impressive year-over-year sales increases by raising average prices because the retailer’s goods have a significant amount of substitutes.  The store’s offerings already have a historical tendency to be priced relatively higher than other cheap chic brands like H&M, so there would be little chance of Urban Outfitters elevating prices to the full value they commanded when the brand maintained a sense of exclusivity. 

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