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Urban Outfitters Riding A Positive Wave

|Includes: Urban Outfitters, Inc. (URBN)

Urban Outfitters has clearly shown the quality of its business by reporting an extremely good third quarter compared to the majority of its peers.

The quality of the company's management is clear.

It's necessary to understand whether it still makes sense to hold the stock at the current level.

Seeing value in Urban Outfitters was not difficult considering the multiples the stock was trading through the many attractive characteristics of the company: good free cash flow, no net debt and a good level of diversification among brands, to name a few.

The recent results only confirmed a positive trend that had begun when the market started to discount a softer promotional environment. With a double beat on EPS and revenue, we had a further confirmation that the market got this stock wrong, even after the several upward estimates in the past months. The stock rose 3.7% the day after the earnings release and 1.6% the following day. Although URBN had managed to maintain a healthy performance during a challenging period for the apparel industry, the recent strength has not been very company specific.

Many other peers such as Gap and Abercrombie and Fitch managed to perform really well too. The apparel industry is in a much better condition after trends got rid of excess inventories and engaged in many store closures to optimize their exposure to traditional stores. Less overcapacity and less excess inventories led to fewer promotions, while the expansion of the eCommerce channel and cross-channel purchase options seems to be helping create new opportunities to sell for several brands.

Helped by these tailwinds and a good dose of brand momentum at Free People, the company's sales in Q3 rose 3.5% with comps back in positive territory after a 5% YoY decline in the previous quarter. The big positive here was that all the three brands reported growth, with Urban Outfitters up 1%, Anthropology up 2% and Free People growing 5%.

The performance was not equally positive on margins, which continued to show some weakness due to a combination of factors. On one side, due to the after math of 2 years of intense promotions in the industry, which continues to pressure gross margin. On the other side, the dilutive effect of the increasing penetration of the eCommerce channel, which tends to carry higher variable costs.

Despite their apparently below-average level of optimism, the company managed to outperform most of its peers, showing that a clear and honest approach to the real underlying problems in an industry often allows the companies to face these problems successfully. The challenges brought by the transition to an omnichannel environment remain, but the company has managed them well so far and will probably continue to do so. The only concerns I have are related to the possibility that the company may fail to generate further margin expansion during this transition to a business mode with higher variable costs and while certain competitors continue to accept thin margins if that helps them grow the top line. The financial prospects of apparel brands carry a certain level of uncertainty due to the impact of several headwinds and deep transformations in the industry that are not necessarily bad.

Urban Outfitters' management has shown to have excellent skills and a good dose of honesty. Flat operating margins and growth at every brand are not common for apparel retailers in these days. Anyway, while it surely remains an excellent company with a rock-solid balance sheet and many attractive financial characteristics such as excellent free cash flows and a buyback policy, further upside may only be a result of market's passion for exaggerations.