Urban Outfitters Can Sustain Margins Despite Pressure from Rising Cotton Prices

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Urban Outfitters Inc. ( URBN ) is a leading lifestyle specialty retail company that operates under its Urban Outfitters, Anthropologie, Free People and Terrain brands and sells fashion apparel, accessories and home goods. It competes with J.Crew Group ( JCG ), Ann Taylor ( ANN ), Gap ( GPS ) and Abercrombie & Fitch ( ANF ).

Urban Outfitters and Anthropologie stores each constitute about 28-29% of our $39.72 price estimate for Urban Outfitters stock, with internet and catalog orders adding an incremental 24%. Our price estimate is roughly 7% ahead of market price.

We've previously examined the impact that rising cotton prices could have on competitor Aeropostale's profit margins (see Downside to Aeropostale From Increasing Raw Material Prices ). Here we apply a similar analysis to assess the affect rising commodity costs could have on Urban Outfitters.

Rising Cotton Prices

U.S. cotton prices have grown 45% so far in 2011, to above $2 per pound. The price increase has largely been a result of supply-demand imbalance, with a sharp rise in demand from China and limited supply due to export restrictions in India and low output from cotton crops in Pakistan.

As cotton prices are expected to increase further going forward, major clothing retailers in the U.S. are expected to meet the rise in input costs by raising prices. In the U.S., consumer prices for clothing in January increased an estimated 1% from December.

Urban Outfitters Strong Through 2010

Through all this, Urban Outfitters recorded strong sales during the holiday season. Its November and December sales increased 15% vs. the same period in 2009. For the 11-month period between February and December 2010, Urban Outfitters' net sales increased 18% YOY.

We believe Urban Outfitters' success during 2010, despite increasing raw material prices and weak consumer trends, was largely a function of its target demographic and the nature of its operations.

Marketing and Inventory Management Bolster Growth Prospects

Urban Outfitters has two major up-market brands, Urban Outfitters and Anthropologie. The Urban Outfitters brand targets young adults aged 18 to 30 years and the Anthropologie brand targets women aged 30 to 45 years. The company designed its marketing strategy to create a unique in-store experience and emphasize customer relationship management rather than direct advertising. These initiatives have bolstered sales during the economic downturn.

Maintaining lean inventories enables Urban Outfitters to generate sales without resorting to excessive discounting as lean inventories lower the chances of  surplus products existing into another season, for which the company would have to resort to discounts and promotions.

A high product turnover rate means that the company introduces new products into its stores every few weeks instead of every few months, a standard for many retailers. This strategy gives customers reason to enter stores more frequently as there is often new products to see.

We believe that Urban Outfitters' ability to sustain sales growth without resorting to heavy discounting should contribute towards profit margin improvement in the years ahead. Still, the prevailing headwind of increasing cotton prices could mitigate the company's ability to grow margins and raise profitability.

Drag the trend line in the modifiable chart above to see the affect that various Urban Outfitter brand store EBITDA margin scenarios could have on the company's stock value.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: ANF , ANN , GPS , JCG , URBN

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