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Urban Outfitters: Death by a Thousand Price Cuts

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The retail sector took a big step forward yesterday, posting the best gain in nearly five months. And yet, shares of apparel retailer Urban Outfitters (Nasdaq: URBN  ) missed on the bottom line for its fourth quarter. Profits plummeted 48% for the period largely because the company had to mark down more merchandise in order to sell year-end inventories. Shares are trading down on the news, but let's take a deeper look at what this means for the company going forward.

Plenty of retail players have stumbled only to return stronger. However, I'm not so sure Urban will have the same luck. Analysts lowered their expectations for Urban in the weeks leading up to its earnings announcement. Yet the retailer still managed to disappoint with earnings per diluted share of $0.27, which was below Wall Street estimates of $0.29 a share for the company's fourth quarter.

In need of a makeover
The retailer's weak performance surprises me considering Urban is armed with strong brands including Anthropologie, Free People, and its namesake Urban Outfitters. Unfortunately, the Anthropologie chain struggled to sell much of its women's apparel inventory and was forced to increase price cuts on the clothes. This negatively affected gross margin, causing it to fall 9.5 percentage points from the same quarter a year prior.

Management is committed to improving the amount of full-price sales their stores make -- as they should be. But leveraging pricing power is very different from ignoring customers' demand for more affordable pricing. The '70s hipster styles of the Anthropologie and Free People brands are much pricier than similar styles from competing retailers. By comparison, a basic tank top that costs $28 at Free People goes for just $16.95 at The Gap.

For a retailer that competes in the same product price range, consider Abercrombie & Fitch (NYSE: ANF  ) . A&F is a good contrast here because the retailer recently struggled with its own pricing dilemma. The company resisted discounting its products through the recession, but as inventory ballooned, the company was forced to mark down goods. They have since returned to a point where customers seem willing to pay a premium for its brand.  

A flare for failure
In addition to its firm pricing strategy, the retailer's inventories grew by 9% as Urban took on more merchandise to stock new stores and promote online growth. Despite lackluster sales at its current stores, Urban Outfitters plans to open 23 new stores globally this year while the Free People brand will welcome 16 new locations and Anthropology will open 14 for the year. In my opinion, management is making one bad decision after another.

On the earnings call, Urban put a lot of emphasis on the company's plan to make a greater investment in their direct-to-consumer channel. While e-commerce is important for any retailer in today's market, I'd prefer management take bolder steps to differentiate their product from the competition before investing in new store openings and online offerings.

Winning retailers know how to create value for both customers and shareholders, and sadly I'm not confident in Urban's ability to do either. Despite the stock's recent decline, shares still look pricey around $27.95. I think the company will continue to struggle throughout 2012, which is why I'm giving the stock an underperform rating on my profile in Motley Fool CAPS. Don't forget to add these stocks to My Watchlist -- The Motley Fool's free tool for tracking the market.

Foolish contributor Tamara Rutter does not own shares of any companies mentioned in this column. Follow her on Twitter, where she uses the handle @TamaraRutter, for more Foolish thoughts on investing. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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