Urban Outfitters: Reaching Bargain Territory

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About: Urban Outfitters, Inc. (URBN)
by: The Value Investor
Summary

Urban Outfitters has seen an excellent 2019, but ended the year on a softer note.

Negative store comparables are set to continue for the near term.

Store sales deleveraging and low margins for the online business will weigh on earnings in 2019, despite anticipated sales growth.

Despite these headwinds and elevated capital spending, I see value emerging amidst low multiples, strong margins, and a very compelling net cash position.

Urban Outfitters (NASDAQ:URBN) hit a new 52-week low as shares have been falling quite a bit, just like some other names in the retail/apparel business.

Following the 2017 carnage in the share price of these businesses, the retail category has seen an impressive comeback in 2018. Urban was no exception to this trend as shares fell from $40 to $18 in the summer of 2017. This was followed by a big recovery of shares of Urban and many of its peers. Shares rose back to $45 last summer, but ever since have fallen back to $29 again.

So, with shares of this very profitable retail business trading near 52-week lows, while the business is very well-capitalised, it is time to revisit the thesis.

The Business

Having just reported the results for its fiscal year of 2019, which ended in January of this year, we see a very profitable operation. The company grew sales by more than 9% last year to $3.95 billion, although total sales growth was limited to just a little over 3% in the final quarter of the year.

The business is best known for its fashion apparel, split up among three core brands. Both the namesake Urban Outfitters brand and Anthropologie Group are leading, generating $1.5 and $1.6 billion in sales, respectively. This is complemented by the smaller Free People business with $800 million in sales and a smaller $25 million food & beverage business. Urban acquired this business, but it never really made much sense, nor makes a real contribution to the results.

In terms of segments, the company is 90% focused on retail, with the wholesale business making up for the remainder in revenues. The company has benefited from an improvement in gross margins which rose by 172 basis points on a reported basis and 99 basis point on an adjusted basis, reflective of a better operating environment. Operating margins totalled 9.7% last year and, with a normalised tax rate, resulted in earnings of $298 million, equal to $2.72 per share.

Trading at $29 and change, multiples are very low, given the growth and solid margins, with shares trading at 10-11 times earnings. An important consideration in this is the very strong balance sheet of the business, which operates with nearly $700 million in net cash, with net cash holdings amounting to $6.50 per share with 108 million shares outstanding.

This implies that operating assets are valued at just $22 per share, for an 8 times multiple as the company has a reputation of being a serial repurchaser of its own shares.

The company still has 14.4 million shares to be bought back under the current buyback authorisation, as it bought back 3.5 million shares over the past year.

Why So Negative?

The negative reaction in the share price can in part be explained by the fact that capital sending is set to rise significantly in the fiscal year of 2020, the current year. Capital spending is set to rise from a little over $100 million to a quarter of a billion, entirely driven by investments in fulfillment and European infrastructure, given its ambitions in that area. With depreciation trending at $120 million, net capital spending could easily total $130 million this year, resulting in poor cash flows conversion in the current year.

The softer momentum in comparable sales is a concern, yet +3% growth rates in the final quarter is still a number which would make its competitors jealous. The worry is the composition of growth, with online growth being very good, yet negative comparables are reported for the actual physical store business.

As everyone knows in retail, it is all about comparable sales numbers, certainly, if you have a desire to maintain margins. This is worrying for investors as the company started this year on a softer note than management had anticipated, resulting in anticipated 150 basis points gross margins deleveraging in the first quarter, with potential more deleveraging in other areas to come.

This is disappointing as total comparable sales (stores + digital) are seen positive for the year, yet deleveraging in stores and higher fulfillment costs online might have an overall dampening effect on full year margins and thus earnings.

In fact, I would not rule out real earnings deleveraging to $2.00-2.50 per share based on the comments made, and while that is outright disappointing, given the reasonable economic environment, one still has to recognise the strong net cash balances of the business and investment mode which it still is in. Despite a potential double-digit decline in earnings this year, shares trade at 10 times forward earnings (ex-cash).

Buying Small

Not having major exposure to the retail sector at large, I have long regarded Urban not as a premium brand necessarily but certainly as premium operator, and thus, the current valuation is appealing to me, with some safety being provided by the balance sheet, as well as solid margins.

Being mindful that the 2017 retail carnage is less than 2 years ago, which took shares to levels in the high-teens, I am in no rush to buy the shares just yet, although I would be happy to slowly buy into the current weakness if shares were to fall further to levels in the mid-twenties.

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.