Urban Outfitters: A Hold For Now But Watch The Comps

| About: Urban Outfitters, (URBN)

Summary

URBN can improve its gross margins in 2016.

URBN’s earnings quality has improved.

URBN’s shares have a fair value of around $36, representing an upside of 6.8%.

2015, in many ways, wasn't a great year for shareholders of Urban Outfitters (NASDAQ:URBN). In retrospect, March 2015 might be seen as a missed selling opportunity by many as URBN's shares reached an unprecedented $47 at one point during that month. It's been almost a year since then and shares have declined by no less than 29% despite an incredible run following Q4 2016 results. This sounds a bit depressing but the good news is that URBN's rather weak stock price performance doesn't accurately capture the strengths and opportunities associated with the company's underlying business. Yet I am neutral on URBN.

After reasonably strong Q4 2016 results, the hike in URBN's stock price has raised new expectations and the bulls look pretty excited. Quite a few of them genuinely believe that in 2016 URBN can significantly improve its gross margins and deliver meaningful comp sales growth. In fact, bullish projections of gross margins are warranted as, over the next 18 months, URBN hopes to completely recover margin lost in previous year's fulfillment center transition. Plus, URBN is wisely planning to actively lower markdown rate at the Urban Outfitters brands which will further drive margins. Nevertheless, as far as comp sales go, URBN faces a bigger challenge.

Overall comp sales for 2015 were down by 2% as the reduction in comp sales at Anthropologie and Urban Outfitters brands overshadowed the comps gained at Free People. The relative contribution of each brand to URBN's consolidated sales, furthermore, reveals an unfavorable picture. For 2015, sales of Anthropologie Group and Urban Outfitters constituted roughly 42% and 40% of URBN's total annual sales respectively, while sales of the company's best performing brand i.e. Free People accounted for merely 18% of total sales. On the positive side, it is worth mentioning that new categories are improving comps and the weak comp sales of 2015 will be easier to beat in 2016.

Companies report financial results according to accrual-based accounting. This makes it easier to manipulate earnings as managements have the option of deciding when to record revenues and other items. As intelligent investors, we should therefore not blindly fall for companies with a proven record of expanding earnings because it is the quality of earnings that matters a great deal. In short, when I am looking at a company as a potential investment, I am interested in knowing the degree to which its earnings are derived from discretionary accounts.

In URBN's case, this is exactly what I am interested in. I also want to see how the company's earnings quality has changed over time. Hence, I compute URBN's accruals ratio using the balance sheet method for 2012-2015. For clarity, you can take a look at the following straightforward formulas before assessing the calculations that follow:

Accruals Ratio = (NOAt - NOA t-1)/ ((NOAt + NOA t-1)/2)

Aggregate Accruals = NOAt - NOA t-1

Where Net Operating Assets (NOA) = (Total Assets - Cash) - (Total Liabilities - Total Debt)

Year

Accruals Ratio

2012

-13.66%

2013

5.6%

2014

28.3%

2015

-9.02%

Click to enlarge

URBN's accruals ratio improved from 2012 to 2014 as a result of rising aggregate accruals. This indicates that the growth in the company's overall earnings during these years was not led by actual cash earnings. Since 2014, however, URBN's earnings quality has improved, and at present potential investors should be pleased with a negative (and falling) accruals ratio that is indicative of persistent earnings.

URBN is sporting a current PE multiple of 18.8x versus a forward multiple of 17.3x. While this clearly does not suggest that the company's shares are priced for perfection, it is still suggestive of the market's optimistic expectations regarding URBN's earnings. The only way URBN's PE can go down from about 19x to 17x is if the share price falls or there is an expansion in earnings. So say if the price stays unchanged, earnings will have to increase by ~9% to yield a PE of 17x. URBN's chances of meeting these expectations depend heavily on the success of its growth strategy.

To determine the intrinsic worth of URBN's shares, I have used a 5-year DCF model based on important revenue and EBITDA margin assumptions. WACC calculated using the CAPM, has been used as the discount rate.

When modeling for revenue growth, note that URBN's top-line growth has been slowing down in recent years.

(Source: Morningstar)

URBN certainly has the potential to reverse this trend but I remain skeptical as the company's comp sales growth has been unacceptably weak. What about non-comp sales growth? Last year 31 new stores were opened, comprising of 14 Anthropologie Group stores, 13 Free People stores and 4 Urban Outfitters stores. A total of 5 stores were closed during the year too. In 2016, URBN is planning to open more or less the same number of net stores including 4 net new Urban Outfitter stores, so I am not expecting radical growth in non-comp sales. Having said this, I do expect the larger formats at both Anthropologie and Free People stores to have a noticeable positive impact on revenues in 2016 and beyond.

In 2020, URBN could achieve ~$5.8 billion EBITDA driven by 5% and 4% revenue growth in 2016 and 2017, respectively, and 2.0% per year thereafter and a 15% EBITDA margin. These are conservative assumptions in my opinion. In addition to this, from 2016 to 2020, I see D&A, tax rate and net working capital running close to their 5-year averages.

Cases

Terminal FCF Growth Rate

WACC/ Discount Rate

Fair Value

Low

2.0%

7.4%

$30.02

Mid

2.0%

6.5%

$35.91

High

2.0%

5.4%

$47.36

Assumptions

Fiscal Years Ending

Jan-15

Jan-16

Jan-17

Jan-18

Jan-19

Jan-20

($ in Millions)

Revenue

3,323

3,489

3,629

3,701

3,775

3,851

% Growth

7.7%

5.0%

4.0%

2.0%

2.0%

2.0%

EBITDA

503

524

544

555

566

578

% of Revenue

15.2%

15.0%

15.0%

15.0%

15.0%

15.0%

Calculation of FCF

Projected Unlevered Cash Flow

Jan-16

Jan-17

Jan-18

Jan-19

Jan-20

Terminal

EBITDA

524

544

555

566

578

578

D&A

(147)

(153)

(156)

(159)

(162)

(237)

EBIT

377

391

399

407

415

341

Pro forma Taxes

(132)

(137)

(140)

(143)

(145)

(119)

NOPAT

245

254

260

265

270

221

Capital Expenditures

(226)

(235)

(240)

(244)

(249)

(249)

NWC Investment

(10)

(8)

(4)

(4)

(4)

0

(+) D&A

147

153

156

159

162

237

Free Cash Flow

156

164

171

175

178

209

% Growth

5%

5%

2%

2%

Calculation of Equity Value

Model

Low

Mid

High

Market

Enterprise Value

3,556

4,284

5,701

4,000

(+) Cash & Equivalents

150

150

150

150

(+) Investments & Other

124

124

124

124

(-) Debt

(115)

(115)

(115)

(115)

(-) Minority Interest & Other

0

0

0

0

(-) Preferred Stock

0

0

0

0

(-) Other

0

0

0

0

Value of Common Equity

3,715

4,443

5,859

4,158

Diluted Shares Outstanding

124

124

124

124

Implied Stock Price

30.02

35.91

47.36

33.61

Upside / (Downside)

-10.7%

6.8%

40.9%

Click to enlarge

URBN's shares have a 6.8% upside potential for the mid case with the high case being extremely optimistic. Many factors would have to coalesce to reach close to 41% appreciation, so the mid case and less so the low case are more reasonable in this instance.

Conclusion

URBN clearly isn't the best stock in the apparel stores industry right now, but this isn't a company whose growth strategy is misplaced. URBN, with its emphasis on investing in category growth, channel growth and geographic expansion, has the capacity to grow profitably. This can be bolstered by the fact that the company ended the fourth quarter with $363 million in cash, which is more than enough to support its ongoing investments. URBN will have to adapt to change as new fashions emerge, but as it stands, its stock is more or less fairly valued and the upside is limited.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.