Apparel retailer Urban Outfitters (click ticker for report: ) reported strong sales for its fiscal year 2013 fourth quarter. Revenue jumped 17% year-over-year to $856 million, exceeding consensus estimates. Earnings per share fell a penny shy of consensus estimates, but were more than twice as high as the year prior at $0.56 per share.
A quick look at metrics might suggest that the business is improving—it is—but the performance is still lagging what Urban achieved in fiscal year 2011. Gross margins improved 650 basis points year-over-year to 36.6% due to lower markdowns and an increase of 18% in regular priced comp sales. Still, the 36.6% gross margin remains 310 basis points lower than the fourth quarter of fiscal year 2011, suggesting the core business still hasn’t regained the traction it had a few years ago. Urban may be achieving sales growth, but we think it may be the growth at all costs mentality which can have disastrous effects on retailers.
On the positive side, SG&A fell 10 basis points year-over-year to 21.2%, and the company has steadily leveraged SG&A over the past two years, as it was down 50 basis points from its fiscal year 2011 level. The company has invested heavily in technology, which has resulted in strong sales growth to offset this rise in capital spending. Still, operating margins were down 260 basis points from 2011 at 15.4% of sales, and the company is running a less profitable business than it was just three years ago. For the full-year, operating margins were down 480 basis points compared to 2011 at 13.4% of sales. With SG&A expected to increase mid-teens, we doubt we shall see any operating margin expansion in fiscal year 2014 unless it’s driven on the product cost and pricing side.
Most of Urban’s growth was driven by strong online sales, as comparable direct-to-consumer revenue jumped 11% year-over-year, while physical same-store sales were flat. On a segment basis, Free People continues to be the standout store in Urban’s mix, with sales jumping 37% year-over-year to $97 million. The Free People brand has done an excellent job catching on to fashion trends, and we think the brand has nicely characterized itself as a separate entity from Urban Outfitters, giving consumers a better sense of differentiation. The Urban Outfitters performed well, with sales growing 11% year-over-year to $415 million. We still like the direction of the brand, but it simply isn’t the growth engine it was a few years ago. Anthropologie’s sales grew just 7% year-over-year to $334 million, but it could get a boost from a stronger housing market in fiscal year 2014.
Overall, we weren’t too surprised by results, but we saw nothing from the quarter that would cause us to materially change our fair value estimate. Co-founder and CEO Richard Hayne suggested some gross margin opportunity existed, but essentially said not to expect it, saying:
“Neely, this is Dick. When you look at it from a historic perspective, you might assume that there is some gross margin opportunity. And as we’ve said, we do believe there is gross margin opportunity. But you also have to remember that with some of the special product that we’re putting on the web, the IMUs are slightly less, and so that has a tendency to counteract what we see in the rest of the business, which is increased IMUs. And hopefully, we will achieve reduced markdowns.”
Hayne followed up by saying that the firm needs to drive stronger initial mark-ups (IMUs), but raising prices on a young, fickle customer base that continues to find its way in a weak economic landscape doesn’t sound like a profitable proposition, in our view. Shipping costs also have lowered the margin profile of the business, and with a younger, more tech savvy consumer base, we think this trend will continue. However, it looks like it will be a secular headwind, so Urban Outfitters in particular isn’t at much of a disadvantage to its peers.
Although we were a bit early in our put option position on shares of Urban, we believe the company continues to look a tad rich at current levels. However, it is now near the top end of our fair value range, so we will not look to open a put position in the portfolio of our Best Ideas Newsletter unless we see shares rise to the mid-high $40 range.