After a Bad Quarter, Is the Story Going South at Urban Outfitters?

Teen and twenty-something retailer Urban Outfitters (NASDAQ: URBN  ) has been a cut above the competition lately; it has been reporting continued sales growth even though business has declined for competitors like American Eagle Outfitters (NYSE: AEO  ) and Aeropostale (NYSE: ARO  ) .  The company has benefited from a diverse mix of brands and favorable exposure to the wholesale channel, which has been a source of fast-growing sales for it due to the surging popularity of its Free People brand.

However, Urban Outfitters' performance slipped a bit in its latest fiscal quarter. Its operating profit showed a double-digit decline, and this led to a sharp subsequent drop in its share price. So after a price haircut, is the company still a good bet?

What's the value?
Urban Outfitters has built one of the strongest franchises in the teen-focused retail arena, with a network of more than 500 stores at last count, primarily by offering contemporary fashion apparel items at reasonable price points complemented by an eclectic mix of accessories and housewares. The company has also found success in the wholesale arena through its Free People casual apparel brand, a channel that now accounts for roughly 7% of its total sales. The net result for Urban Outfitters has been a highly profitable, two-legged business model which generates solid cash flow that easily funds its global expansion plans.

In its latest fiscal year, Urban Outfitters posted a 10.4% top-line gain that was a function of strength across its major segments, led by a 29.8% sales increase at its Free People brand. More importantly, the company's gross margin improved slightly because it marked down less inventory, which allowed it to maintain a double-digit operating margin.

Unfortunately, Urban Outfitters' results weakened considerably in its latest fiscal quarter. Its gross margin contracted, which led to a double-digit decline in its operating income. Worse, the company's core Urban Outfitters brand registered a 12% drop in comparable-store sales and is starting to look a bit like the other major players in the sector.

Birds of a feather
Those players include American Eagle Outfitters, a former sector darling that is coming off a poor fiscal 2013 campaign in which it posted a 6% comparable-store sales decline and a steep drop in its operating profitability, which fell to its lowest level in the past five years. More notably, the lower profitability has significantly crimped the company's cash flow, which has made it unable to internally fund its desired capital expenditures. The net result for American Eagle Outfitters has been a need to speed up its restructuring plans, which include shrinking its domestic store base and eliminating stand-alone stores in its Aerie intimates unit.

Also hurting in the current selling environment is Aeropostale, another former sector leader that has been blindsided by the general product price compression in the teen retailing sector. Its gross margin has seemingly fallen off a cliff, as it registered a 17.1% rate in its latest fiscal year. Not surprisingly, that level was insufficient to support Aeropostale's corporate overhead, which led it to report a large operating loss for the period. While management has acknowledged its shortcomings, as it recently secured a lifeline of $150 million in financing from retail-oriented investment firm Sycamore Partners, it remains to be seen what the company will look like going forward, though it is a good bet that Aeropostale will have a much smaller store footprint.

The bottom line
Urban Outfitters' business momentum undoubtedly downshifted in its latest financial update, with its operating margin dipping into the single-digit range. That being said, the company seems to have a gem in its Free People brand, which continued to grow at a strong, double-digit rate during the period, and this helped Urban Outfitters post an overall top-line increase. Investors need to be careful in the teen-oriented retail sector given falling profit levels, but Urban Outfitters looks like a long-term winner for those who want to play in the sector.

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