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We recently upgraded our recommendation on Urban Outfitters Inc. (URBN - Analyst Report), the retailer of apparel, footwear and accessories, to Neutral with a price target of $30.00, given its initiatives to reposition itself as it enters into fiscal 2013. Earlier, we had an Underperform rating on the stock.

The Drivers

Being a multi-brand and multi-channel retailer, Urban Outfitters offers a flexible merchandising strategy. The company also has a significant domestic and international presence with rapidly expanding e-commerce activities. It remains committed to improve comparable-store sales performance, adding new brands and optimizing inventory level.

Further, to increase customer count, the company plans to augment store openings in North America and Europe, open retail outlets in Asia, enhance online and mobile marketing endeavors, increase wholesale distribution in Europe and Asia, and considerably expand direct-to-consumer business worldwide. Moreover, the company’s debt-free balance sheet also augurs well for future growth.

The company also remains rationale in opening new stores, having opened 33, 46 and 57 stores in fiscal 2010, 2011 and 2012, respectively. It now plans to open 55 to 60 stores in fiscal 2013. Urban Outfitters hinted that it is targeting a low double-digit square footage growth. With a current total store count of 429, there still exists room for more.

Top-Line Increasing

After registering a growth of 6.3% in the third quarter, Urban Outfitters said that total net sales climbed 9.3% to $730.6 million during the fourth quarter of 2012. Total net sales came almost in line with the Zacks Consensus Estimate of $731 million.

Net sales increased 9.6% to $699 million at the Retail Segment and 3.1% to $31.7 million at the Wholesale Segment. Within Retail Segment, Retail Stores sales rose 8.1% to $532 million, whereas Direct-to-Consumer sales soared 14.9% to $167 million. Direct-to-Consumer business continues to remain healthy in North America and Europe, propelled by expanded online assortments.

Net sales by brands grew 10.9% to $356.8 million at Urban Outfitters, 5.6% to $299.2 million at Anthropologie and 18.5% to $69.9 million at Free People.

Waning Margins & Bottom-Line

Despite the endeavors undertaken by Urban Outfitters, we prefer to a hold a cautious stance on the stock until margin expansion and bottom-line growth is witnessed.

Urban Outfitters noted that gross profit for the fourth quarter of 2012 fell 17% to $220 million, whereas gross margin contracted 955 basis points to 30.1% due to higher merchandise markdowns to sell the slow-moving stock of women's clothing at both Anthropologie and Urban Outfitters.

Fashion obsolescence remains the key concern for Urban Outfitters’ business model, which includes a sustained focus on product and design innovation. In the past, this has been a drag on the company’s comparable-store sales and operating margins.

The company is also currently inflicted by the same fashion risk. Women’s apparel, in particular, has been relatively weak this time around, and the company’s primary objective at present is to improve its performance. The company said that men’s and home businesses have been faring well.  

Coming to the bottom line, the company posted quarterly earnings of 27 cents a share that missed the Zacks Consensus Estimate of 30 cents, and dropped 40% from 45 cents earned in the prior-year quarter. Despite registering a growth in the top line, the company witnessed a drop in the bottom line due to a 26.6% rise in the cost of sales and an increase of 7.4% in selling, general and administrative (SG&A) expenses.

Closing Remark

Urban Outfitters has been trying to manage its inventory at an appropriate level, which has long weighed down on the company’s margins. The company in order to clear its inventory was compelled to offer discounts that hurt its margins.

Total inventories were $250.1 million at the end of fiscal 2012, which reflects an increase of 8.9% year over year, and appears to be in a much better shape. Further, management’s effort of driving traffic through store expansion, product enhancement, direct-to-consumer efforts and online initiatives bode well for the company.

Urban Outfitters, which competes with Gap Inc. (GPS - Analyst Report) and Abercrombie & Fitch Co. (ANF - Analyst Report) currently holds Zacks #3 Rank that translates into a short-term Hold rating, and correlates with our long-term recommendation.

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