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Anytime a CEO of a company resigns, investors must evaluate what effect it will have on the company's future prospects. We believe that the most recent CEO change at Urban Outfitters (NASDAQ:URBN) gives investors the opportunity to establish long-term positions in this company at a depressed price, as we have done.

After the markets closed on Tuesday, January 10, Urban Outfitters announced that Glen Senk has stepped down as CEO and resigned from the board of directors. The company appointed Chairman Richard Hayne as CEO, effective immediately, and said that Glen Senk would stay to manage the transition. The stock promptly plunged almost 15%, as investors fret that the management change will stymie efforts to turn the company around. We, however, think that the turnaround will continue, and that the stock is a compelling investment at these levels.

On the simplest level, there are 2 kinds of CEOs. There are CEOs that are a great asset to their company, such as Warren Buffett, and there are CEOs that are good managers, but are replaceable. We think Glen Senk was a good CEO, but one that can be replaced. At the end of the day, the way to measure a CEO's performance is the stock price of his or her company under their tenure.

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Glen Senk was appointed CEO of Urban Outfitters in May 2007, and since then, the stock has increased by over 12%. While this performance is far above that of the broader market, it lags the performance of the retail sector (NYSEARCA:XRT), which is trading at record highs and has outperformed Urban Outfitters by over 10% since Senk was appointed CEO. This mixed performance shows that Senk was a capable CEO, but that he delivered little to Urban Outfitters in terms of unique or irreplaceable qualities. We think that Richard Hayne, who also founded the company in 1970, and has been its chairman since 1976, will be able to steer the company through this period.

While investors rarely, if ever, like abrupt management changes, the concern over the direction Urban Outfitters' turnaround will go is responsible for most of the plunge in the stock. Yet we think that it will continue, and that management will steadily improve the company's results. While 2012 will be a transition year, this has been largely priced into the stock prior to this development, and we do not think that things will be materially different with Hayne as CEO.

In 2012, Urban Outfitters is expected to post earnings per share of $1.28 on revenues of $2.5 billion. While revenues are going to grow 9.4% from 2011, earnings will drop 20%. Why the divergence? It has to do with inventory. Urban Outfitters had its inventory increase 27% over the previous year last quarter, and it will take some time for the company to work through these issues. Below we give a 3-year overview of Urban Outfitters' financials and estimates for the next fiscal year. As a reminder, Urban Outfitters' fiscal year does not align with the calendar. Its fiscal year ends in January.

Urban Outfitters Financials (Fiscal Year)

2013 (Estimates) 2012 (Estimates) 2011 2010 2009
EPS $1.60 $1.28 $1.60 $1.28 $1.17
Revenue $2.8 billion $2.5 billion $2.3 billion $1.9 billion $1.8 billion
Cash Flow per Share N/A N/A $2.20 $1.82 $1.65

Urban Outfitters is a company in transition, and its holiday sales figures are proof of that. While the company posted record sales of $577 million for November and December on a dollar basis, comparable store net sales decreased 4%. But direct to consumer (e-commerce) sales increased 15% this season, a testament to the company's ability to maintain its relationship with consumers, despite what Glen Senk labels as "fashion missteps." While earnings have been depressed in fiscal 2012, they are expected to "bottom" in the first quarter of fiscal 2013, when the company is expected to post earnings of 26 cents per share. Then earnings are expected to rebound to 41 cents per share in the second quarter of fiscal 2013. Based on fiscal 2013 earnings estimates of $1.60, Urban Outfitters trades at a P/E of about 15.6.

On the last conference call, Glen Senk and other executives talked about what the company is doing to better manage inventory and improve profitability. Calvin Hollinger, chief information officer spoke of how the company is using, "a mobile point-of-sale device in all of the stores now. And with that, if we do not have your size or your color, we can search the inventory and fulfill that automatically from that point-of sale-device from our direct channel. So it gives us tremendous customer service and inventory flexibility on the back end."

We think the inventory issues at the company will soon abate, and while Glen Senk was an adept manager, we see no reason why improvements cannot continue as before with a new CEO. Fashion missteps were at the root of the rise in inventory, and they are why Urban Outfitters has had to cut prices to clear inventory, eating into its margins. We think that new executives hired by the company will be able to work through these fashion missteps.

Urban Outfitters is not a one-person show. The company has a slate of capable executives leading the company, and we think that with Richard Hayne as CEO, they will be given a more prominent role. Recently, Urban Outfitters appointed David McCreight (former president of Under Armour (NYSE:UA)) as head of its Anthropologie division and Charles Kessler (former senior vice president of corporate merchandising at Coach (NYSE:COH)) as Chief Merchandising Officer of the Urban Outfitters division. Glen Senk spoke quite highly of their qualifications and performance on the conference call, and we think that it is these executives, as well as the rest of the Urban Outfitters team that will drive performance going forward.

Stifel Nicolaus analyst Richard Jaffe believes that Hayne is well qualified, but that his age and limited workload in the past few years may lead some to question his long-term commitment to the company. For the record, Jaffe kept his buy rating and $32 price target on the stock, citing the strong management team Urban Outfitters has in place, as well as its strong cash flow. We think that from a corporate governance standpoint, an outside CEO could be good for Urban Outfitters going forward.

Richard Hayne will most likely stay on as CEO for several years, but retire after the company has been put back on the correct path. Furthermore, Hayne will be staying on as chairman, and we rarely like to see a company's corner office and chairmanship be filled by the same person. However, the fact that Hayne will most likely stay only for a few years, to help repair the company he founded, mitigates our corporate governance concerns.

In conclusion, we think that at these levels, Urban Outfitters is a compelling long-term investment. The company trades at a price-to-cash flow ratio of 11.66, a large discount to the retail average of 17.6. And at 19.49 x 2012 earnings and 15.6 x 2013 earnings, the stock is inexpensive. Earnings have been depressed at Urban Outfitters due to missteps the company is working hard to resolve, and we have confidence in its strong management team.

While we think the market and several analysts as a whole have placed too much weight on this surprise development, we are glad it has occurred, for it has allowed us to establish a position in Urban Outfitters at a depressed price. We are confident in the long-term potential of this company, and believe that investors who buy in at these levels will be rewarded for their faith.

Source: Buy Urban Outfitters: CEO Change Creates Long-Term Opportunity