After being one of the strongest performers during the last quarter, Urban Outfitters (URBN) appears to be feeling the impact of the difficult retail environment. The company recently stated that its comparable store sales in the third quarter are rising in mid-single digits, compared to 9% growth observed in the previous quarter.  Following this, Urban Outfitters’ shares stumbled by almost 10%, marking the company’s biggest drop since January last year. Despite the third quarter lull, we remain optimistic on Urban Outfitters’ long-term outlook as its growth fundamentals such as brand strength and direct-to-consumer channel remain intact.
What’s Weighing On Urban Outfitters’ Growth In The Third Quarter?
The U.S. apparel industry is highly competitive with retailers offering a broader and deeper set of promotions to gain market share. Also, U.S. consumers have been watchful of their spending on non-discretionary items. A couple of months back, the National Retail Federation forecasted a steep decline in consumer spending during this year’s back-to-school season. According to its survey, average spending by families with school and college students will decrease by almost 8% during the period of mid-July to mid-September as compared to the same period last year. This decline can be attributed to the sluggish economy and change in shopping trends. 
The survey found that eight out of every 10 shoppers were planning to lower their spending. About 76% of the college shoppers said that they will spend less this season and 37% said that they will shop only during discount sales. Interestingly, around 45% shoppers were planning to use their previous year’s products rather than shopping again.  Moreover, there has been a change in the shopping trend where shoppers buy products at the start of the season to take advantage of initial markdowns and do not return until end of the season sales.  As a result, they only buy products at discounted prices which impacts the apparel retailers’ sales. About 24% of the families had shopped for their children before or at the start of the back-to-school season this year, up from 22% in 2012. Additionally, U.S. consumers are diverting some of their spending toward cars and houses due to low interest rates and are holding back on apparel purchases. 
Hence, the present state of the U.S. retail environment is quite weak and weighing on a number of retailers such as Aeropostale (ARO), American Eagle Outfitters (AEO) and Abercrombie & Fitch (ANF). It has also mitigated the sales of some of the strong performers such as Gap (GPS) and Urban Outfitters.
The First Half Of The Year Was Much Better For Urban Outfitters
Although Urban Outfitters' third quarter sales trends might not be encouraging, it has emerged as a winner during the last few quarters. During the last year's holiday quarter, when the apparel industry was reeling under the impact of hurricane Sandy, Urban Outfitters posted record growth. The retailer’s comparable store sales increased by 11% driven by a staggering 44% rise in its direct-to-consumer revenues.
In the first quarter of fiscal 2014, while the entire apparel industry remained weak due to prolonged winters, payroll tax increase and delayed tax refunds, Urban Outfitters once again registered solid growth. Its revenues and comparable store sales increased by 14% and 9%, respectively, driven by strong brand performances and surge in direct-to-consumer revenues. The retailer carried this momentum in the second quarter as well, registering 9% comparable store sales growth when most retailers in the industry were struggling to even match their previous year’s level. Therefore, we expect the company to come out of this temporary weakness in the near term backed by its strong growth fundamentals.
Strong Growth Fundamentals Support Our Optimistic Outlook
Strong Brands: Urban Outfitters is the company’s mainline brand, which has established a strong image for itself in the U.S. market. The brand associates itself with preppy looks, with edgy products such as Christmas catalogs with controversial slogans etc. This has resonated well with the teenagers who are very particular about trendy products. Also, Urban Outfitters is an affordable brand, which makes it a viable option for customers in the current retail environment. Over the last three quarters, the brand’s comparable store sales have grown by 5%, 6% and 11%, respectively.
After a dismal 2012, Urban Outfitters’ Anthropologie brand has improved considerably. The company achieved this turnaround by doing a complete product overhaul for Anthropologie, by shifting the theme from preppy and quirky to more soft, sensual and feminine looks. The brand’s customers responded positively to this change, which helped Urban Outfitters operate more regular priced and fewer discount sales. This resulted in Anthropologie’s comparable store sales jumping by 8% and 9%, respectively, in the first two quarters of fiscal 2014. We believe that the company can maintain this momentum with firm inventory control, launch of new products and strong focus on the brand’s designs.
Although Free People is a small brand for Urban Outfitters, it has been growing at a tremendous pace. During the last three quarters, the brand’s comparable store sales have increased by almost 40% on an average. Free People has managed this growth with appealing products and marketing campaigns, and growing online channel. The brand offers a viable option for Urban Outfitters’ international expansion, as evident from encouraging customer response in Japan.
Direct-To-Consumer Channel: Urban Outfitters’ direct-to-consumer business accounts for about 24% of the retailer’s revenues and has been growing at a rapid pace. Over the past four years, the retailer’s direct revenues have increased at an average annual rate of 25% driven by growing popularity of online shopping and Urban Outfitters’ strong brand recognition. The company’s mobile commerce platform, several mobile apps, technological advancements and web-exclusive products have also aided this growth. Going forward, we expect this channel to remain the key driver for the retailer as the outlook for online apparel retail growth in the U.S. is very optimistic.
Our price estimate for Urban Outfitters stands at $48, implying a premium of about 25% to the market price.
Disclosure: No positions.