In a recent edition of Value Investor Insight, Jenny Hubbard explained her short case on Urban Outfitters (URBN).

Describe one of your consumer-focused shorts, retailer Urban Outfitters (URBN).

Jenny Hubbard: We've been finding a lot of short ideas in the consumer sector, particularly in retail. The access to consumer credit over the last several years was unprecedented, leading to unsustainable levels of consumer spending. Coupled with aggressive expansion in the number of stores, that has left many retailers vulnerable as credit tightens. Despite these conditions, Urban Outfitters has delivered improved comp-store sales and margins over the past six months. It has three core retail concepts – Urban Outfitters, Anthropologie and Free People – which are primarily focused on fashion-forward apparel for women. They've done some things well in merchandising and have continued to grow.

At a time when we expect specialty retailers overall to be rationalizing their number of stores, Urban still expects to grow its store base more than 15% per year.

Given our views on discretionary consumer spending and a few company-specific issues we've identified, we think the growth expectations discounted in the current stock price are overly generous.

How do you quantify those growth expectations?

JH: In estimating intrinsic values, we focus on the top-line growth we think is reasonable over the next five years and then what terminal profit margin and multiple are reasonable at the end of that period. We also set a discount rate based on our assessment of things like the stability of revenues and profits, capital intensity and returns on capital. At around $32, we think Urban's share price is discounting 20% revenue growth over the next five years and terminal operating margins of around 20%. We use a 10.5% discount rate and for a multiple we're assuming around 15x, which is fair for what will be a maturing retail concept in five years.

What are the risks you see to those assumptions?

JH: One of the arguments made for top-line growth is that the company's retail concepts are far from saturated relative to other specialty retailers. In general that's true, but it's unlikely the company can get to the number of stores implicit in the top-line assumptions. The square footage of the Anthropologie and Urban Outfitters concepts is up to three times the typical specialty retail store. Average tickets are higher, especially at Anthropologie. They have specialized and unique merchandise, with fewer basic items like t-shirts and jeans for sale.

All of that limits their ability to match the 800-1,000 stores some specialty retailers have.

There's also risk to the assumption of 20% EBIT margins. Over the past three years, the company has earned margins of 14%, 15% and 19%, and this year's level is expected to be around 17%. They have improved their systems and sourcing, which should benefit margins, but it's going to be challenging to maintain 20% margins, especially given the fashion sensitivity to what they do. I can only think of one specialty retailer, Abercrombie & Fitch, that has been able to hold margins at 20% for five years, and it has a number of basic items that entail less mark-down risk and are less expensive to source.

Urban Outfitters also seems to be stretching itself thin. In addition to expanding the three existing retail concepts, they're rolling out a new wholesale apparel brand called Leifsdottir and are launching a new retail concept, Terrain, which is an upscale garden center. A long-term commitment to grow all these concepts is expensive and very hard to do at the same time, especially while maintaining expected margins that would be at the high end of all specialty retailers.

Versus a recent share price of around $31.80, what’s your current estimate of intrinsic value?

JH: Even if you assume they can generate over the next five years 17% annual revenue growth – 12% from new stores and 5% from increased same-stores sales – and that they get margins to what would be an historically high 18%, our estimate of per-share intrinsic value is in the mid-$20s. That still assumes things go quite well for them, which given their exposure to fashion trends and the headwinds from consumer spending, is not at all certain.

This is a relatively typical example in which we're shorting overvaluation. The company has performed fairly well recently, but given the challenges we see, the expectations built in here are just going to be very difficult to meet over time.

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