- URBN's Q4 earnings report wasn't great.
- Total comps were up yes, but it was due to the digital channel at the expense of the stores.
- Margins are still suffering big time with no respite in sight.
About a month ago, I said Urban Outfitters (NASDAQ:URBN) was fully priced. The stock has gone through some enormously tumultuous price moves in the past few years, and after the selloff that took it back to $16 last summer, the stock has more than doubled. The company’s Q4 earnings report shows that it has problems that the market isn't valuing in at these prices.
Same old, same old
I’m referring to weak retail comps and even weaker margins. Last year marked digital channel growth, but not much in the way of the stores. On top of that, margins are getting squeezed. This set of fundamentals is not one you’d expect to see for a stock that is trading very near to its highs, but that is where we find URBN and that is why I’m so cautious here.
The digital channel is winning at the expense of stores
Total sales were up 5.7% in Q4 as comps were higher by 4%. That sounds lovely except that URBN is seeing double-digit comp growth from its digital channel while physical store comps are negative. This is not a new problem by any means but, up to this point, investors seem to have ignored it. We’ve seen countless retailers build out a digital presence only to gain sales in that channel at the expense of their stores. In other words, it isn't creating incremental demand, it is just shifting from one channel to another. URBN is doing that in a big way and has been for a few quarters now, causing not only a false sense of creating excess demand from comps moving higher, but dinging margins in the process.
The problem with this strategy is that selling online in addition to keeping all of your stores is very expensive. Consider this; URBN has opened up what is obviously a very successful online channel, but all of that capacity is in addition to the capacity it has retained via its store network. In other words, it is paying much more to ship and store product than it was with only incrementally higher demand. Running an online channel requires additional inventory, space to store it, shipping costs, labor costs, etc. Making up these costs with higher volume is an uphill battle to say the least. URBN’s Q4 margin profile showed us once again just how this works and it isn't good.
Margins are still suffering
Gross margins declined 176 bps in Q4 (and 259 bps for the full year) due to additional delivery costs from the digital channel as well as lower initial markups. Both of those are large structural problems that are going to be difficult to recover from. Lower initial markups are the result of trying to compete on price, and while that’s fine, it only works if additional volume is enough to offset lost margin; that doesn’t appear to be the case right now. Further, as the digital channel becomes more successful – which is ostensibly what URBN wants – its negative impact to margins will only grow. Eventually, URBN will either have to generate enormous amounts of new demand or begin closing stores as its capacity exceeds the demand from customers. We aren’t there yet, but this margin issue isn’t going to get better anytime soon. You can see the conundrum URBN is in; if the digital channel succeeds, we are likely to see lower and lower margins.
The stock looks pricey for iffy fundamentals
The stock is going for 18 times this year’s earnings as of now, but I suspect that the coming weeks will bring some downward revisions to estimates. It is very apparent that, while total sales continue to grow, the digital channel is succeeding largely at the expense of the stores. That is fine for a time but at some point, URBN’s capacity to sell will almost certainly exceed its need. Margins are already suffering materially and thus, I think forward EPS estimates are at risk for the reasons I've cited.
Even so, URBN’s PEG is about 1.8 right now and that’s not cheap; my line in the sand is 2. But given that URBN is struggling so mightily with its margins and the fact that its margin struggles are driven by strategic decisions, there is no reason to expect improvement. That would require management to pivot away from the digital channel it has worked so hard – and spent so much money – to build and that’s just not going to happen. I think chasing URBN here is extremely imprudent, and if you want to own it, you should be able to do so at a much lower price. Perhaps the Q4 report will be the catalyst to make investors finally see URBN’s margin problem for what it is.
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