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We recently downgraded our recommendation on Urban Outfitters Inc. (URBN - Analyst Report) to Neutral with a price target of $40.00, following its lower-than-expected third-quarter 2013 results and a premium valuation that limits the stock’s upside potential. Earlier, we had an Outperform rating on the stock.

Urban Outfitters posted quarterly earnings of 40 cents a share that missed the Zacks Consensus Estimate by a penny. On the other hand, total net sales of $692.9 million for the quarter fell short of the Zacks Consensus Estimate of $695 million.

Further, the stock is trading at a premium to the peer group based on its forward earnings estimate. Urban Outfitters is currently trading at a forward P/E of 24.22x, reflecting a 70.2% premium to the peer group average of 14.23x.

However, top and bottom line growth of 13.6% and 21.2%, respectively, provided cushion to the stock. We observe that gross margin expanded 222 basis points to 37.6% due to lower merchandise markdowns.

Management expects that the fourth quarter will present considerable opportunity for gross margin improvement than the third quarter. This will be attributable to product content, fall in markdowns and favorable year-over-year comparison.

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. The company remains committed to improve comparable-store sales performance, sustain investments in direct-to-consumer business, enhance productivity in existing channels, add new brands and optimize inventory level.

Further, to broaden its customer base, 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. Urban Outfitters entered into a multi-year agreement with World Co., Ltd for the distribution and marketing of its specialty clothing brand, Free People in Japan.

The above analysis supports our unbiased view on the stock. Urban Outfitters, which faces competition from Abercrombie & Fitch Co. (ANF - Analyst Report) and Gap Inc. (GPS - Analyst Report), holds a Zacks #3 Rank that translates into short-term Hold rating.

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