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Contents – Urban Outfitters – Spring 2007 Executive Summary 2
Accounting Analysis 3 Ratio Analysis Forecast Financials 4 Intrinsic Evaluations 4
Overview of URBN and the Industry 5 Five Forces Model 7 Rivalry Among Existing Firms 8 Threat of New Entrants 12 Threat of Substitute Products 15 Bargaining Power of Buyers 16 Bargaining Power of Suppliers 16 Value Chain Analysis 17 Competitive Advantage Analysis 18
Accounting Analysis 19 Key Accounting Policies 20 Accounting Flexibility 22 Evaluating Accounting Strategy 23 Quality of Disclosure 26 Revenue Manipulation Diagnostics 29 Expense Manipulation Diagnostics 32 Potential “Red Flags” 34 Fixing Accounting Distortions 35
Financial Analysis 37 Liquidity Analysis 37 Profitability Analysis 45 Capital Structure Analysis 53 Ratio Analysis with Lease Capitalization 55 IGR and SGR Analysis 58 Forecasting 64 Cost of Capital 66
Intrinsic Valuation Analysis 69 Methods of Comparables 70 Intrinsic Valuation Models 73
Free Cash Flows 73 Long Run ROE Perpetuity 75 Residual Income 76 Abnormal Earnings Growth 77
Altman Z-Score 79 Analyst Recommendation 79
Appendix A - Valuation 81 Appendix B – Forecasted Ratio Analysis 85 Works Cited 86
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Executive Summary URBN Investment Recommendation: Overvalued, Sell (As of 04/01/2007) URBN – NYSE - $26.21 52 week range $13.65 – 27.75 Revenue (2006) $1,224,717 Market Capitalization $4.33 Billion Shares Outstanding 165,080,000 3-month Avg. Daily Trading Volume 3,347,150 Percent Institutional Ownership 73.00% Book Value Per Share (mrq) $4.093 ROE 18.80 % ROA 12.29% Est. 5 year EPS Growth Rate 4.09% Cost of Capital Est. R2 Beta Ke Ke Estimated 20.6% 5-year .2601 3.92 20.6% 1-Year .2630 3.93 20.6% 10-Year .2063 3.92 20.6% 3-month .2624 3.93 20.6% Published 2.51 Revised Ke: 14.8% Kd URBN: 5.60% WACC URBN: 19.77% revised: 15% Altman Z-Score URBN: 15.33
EPS Forecast FYE 01/31 2006(A) 2007(E) 2008(E) 2009(E) EPS 0.79 0.61 0.68 0.75 Ratio Comparison URBN ANF JCG Trailing P/E $38.04 $18.18 $27.92 Forward P/E $22.21 $13.88 $26.18 P/B $6.42 $5.30 $448.94 Valuation Estimates Actual Price (as of 04/01/2007) $26.20 Ratio Based Valuations P/E Trailing $17.02 P/E Forward $13.55 Enterprise Value $18.00 P/B $24.49 Price/ FCF N/A Price/ EBITDA $15.25 Intrinsic Valuations Actual Free Cash Flows $21.40 Residual Income $3.19 LR ROE $3.40 Abnormal Earnings Growth $17.85
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General Note:
For the remainder of this valuation, each company will be hereon
referred to by its ticker symbol. The following ticker symbols will represent
the following companies: URBN - Urban Outfitters, ANF - Abercrombie & Fitch,
and JCG - J Crew.
Recommendation-Overvalued Firm
Company, Industry Overview and Analysis
Urban Outfitters Inc. is a pioneering “lifestyle merchandising company” that
operates specialty retail stores under the Urban Outfitters, Anthropologie and Free
People brands. It was founded in 1970, near the University of Pennsylvania. It is a high
end apparel and furniture manufacturer in the highly fragmented apparel industry. Its
two main competitors are Abercrombie and Fitch and J Crew. Urban Outfitters has gained
a competitive advantage over its competitors by implementing a strategy focused on
product differentiation, brand prestige, and customer loyalty. The parent company has
been broken down into three separate brands to specifically cater to a different target
market. They also created a competitive advantage by offering eclectic merchandise and
a unique retail experience.
Accounting Analysis
Firms release financials at their fiscal year end which includes an Income
Statement, Balance Sheet, and Statement of Cash Flows. The Income Statement is an
annual measurement of a firm’s operations. The Balance Sheet is a statement of a firm’s
book value of all of the assets and liabilities (including equity) at a particular date. The
Statement of Cash Flows indicates a firm’s annual liquidity and takes into consideration
operating, investing, and financing activities. Firms are allotted generous flexibility in
regards to accounting for certain expenses. Urban Outfitters has benefited from such
generosity based on how they account for leases. While investigating their financials, we
found a $516 million off-balance sheet transaction which was created from operating
leases ranging from 5-15 years. Firms also are allotted generous flexibility in terms of
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disclosure. Upon further review of URBN’s financials, we were not satisfied with their
disclosure and rate it average at best.
To ensure firms are not guilty of accounting irregularities, expense and revenue
screening diagnostics are implemented. Based on these diagnostics, creditors and current
and potential investors can identify potential red flags. After conducting these screening
ratios, there were no indications of accounting irregularities for URBN.
Financial Ratio Analysis and Forecasting
Financial ratio analysis consists of a series of ratios that measures a firm’s
liquidity, profitability, and capital structure. These ratios illustrate how effective and
efficient a firm’s operations are compared to major competitors. As stated above, we
determined that ANF and JCG would best represent URBN’s competition. We also
conducted an analysis for certain ratios with the lease capitalization inclusion of $516
million.
Financial forecasting relates to finding certain growth trends amongst major line
items in a firm’s financials. We conducted Income Statement, Balance Sheet, and
Statement of Cash Flows forecasts for URBN thru 2016 based upon these trends. We
concluded by providing a cost of capital estimation by finding a cost of debt and equity.
First, Beta was found by running a regression analysis followed by a cost of equity
estimation. A revised cost of equity had to be found due to the inaccuracy it would cause
in the intrinsic valuations. We then found our cost of debt by measuring our current and
long term liabilities by published Moody rates. Moody’s is a credit rating agency
responsible for publishing ratings for business and other entities that reflect the likelihood
and probability of credit default.
Intrinsic Valuations
Four different methods were used in the intrinsic valuation section to determine
whether the stock price for URBN was undervalued, overvalued, or fairly valued. Every
method used produced different results and has different explanatory power when
estimating stock prices. The methods used were: Free Cash Flows, Abnormal Earnings
Growth, Long-Run ROE Perpetuity, and Residual Income. We believe that the AEG model
produces the most accurate share price of $17.85 compared to a listed share price of
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$24.93. Overall, each model found URBN to be a highly overvalued firm. We believe that
URBN should be valued lower than the observed share price. We recommend selling this
stock due to a constant intrinsic valuation of each model suggesting this firm is highly
overvalued.
Company Overview
Created near the University of Pennsylvania in 1970, URBN has 37 years of
experience creating and managing retail stores. These stores offer decidedly
“differentiated collections of fashion apparel, accessories and home goods to a highly
defined market niche.” Urban Outfitters is a pioneering “lifestyle merchandising
company” that operates specialty retail stores under the Urban Outfitters, Anthropologie
and Free People brands. Free People is based primarily online. All of these brands are
higher end products designed for a specific target market.
Although the apparel industry is highly competitive, Urban Outfitters’ highly
defined market niche is best marketed through differentiation, rather than cost
leadership, in order to achieve their competitive advantage. Examples of such
differentiation include offering eclectic home furnishings such as “tangerine apostrophe
chairs, velvet sofas, and spectrum chandlers.”
Urban Outfitters relies heavily on the Pareto principle: 20% of customers
represent 80% of sales. Based upon this, they strive to establish invaluable bonds
between their targeted customer audience which signifies their dependence to both
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improving and maintaining brand loyalty. In fact, they place such a significant emphasis
on image recognition that they have established a separate subsidiary that protects
against copyright infringement. In the following sections, we delve deeper into URBN’s
operating performance as well as introduce the five forces model.
Company Performance
Urban Outfitters has experienced an increase of sales volume from $349 million to
$1,092 million over the past five years, with an average sales growth of 33.43% per
year. As far as their competition, URBN has out performed their nearest competitor’s
sales growth by nearly 29% and the industry as a whole by nearly 22%. However, this
must be kept in perspective since URBN has experience such significant gains due to
their amateur status.
Competitor Performance
Urban Outfitters main competitors are ANF and JCG. Abercrombie has an average
sales growth of 20% while JCG has grown sales by 5% per year. It is to be noted that
JCG suffered negative sales growth of -1.5% and -13.8% in 2002 and 2003 respectively.
Abercrombie has rapidly expanded their operations by averaging 99 new store openings
per year during this five year span. On the contrary, JCG averaged almost 11 new store
openings due to lax sales from an operating subsidiary that went bankrupt within this
same span.
Company Information and Stock Performance:
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Urban Outfitters has a market capitalization of $4.27B. Their total asset value from
2002 to 2006 is as follows: $195,102M, $279,177M, $359,595M, $556,604M, and
$769,205M respectively. Shown here in this graph of the last five years, URBN’s stock
has outperformed their main competitor ANF yielding significant returns for investors.
Five Forces Model
The five forces model is the framework for determining the degree of competition
and profitability in an industry. According to the model, the intensity of the competition
determines the potential for creating abnormal profits by firms. Whether or not such
profits exist is determined by the relative bargaining power of the firms in the industry
and their customers and suppliers.
Urban Outfitters is in the apparel industry. This table characterizes the industry in
regards to the five forces.
Competitors High
Threat of New Entrants High
Substitute Products Relatively Low
Customer Power Low-Moderate
Supplier Power Relatively Low
The subsequent paragraphs describe the five forces in depth
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Rivalry among Existing Firms
In most industries, especially highly competitive ones, rivalry among existing firms
is a key determinant on how well firms generate revenue. The more intense rivalries
become the greater chance profit margins will decrease.
Industry Growth
The level of growth plays a key
role in how a firm can gain market
share. It is primarily measured by total
revenue and consumer spending as a
percentage of gross domestic product
(GDP). The graph to the left shows
2006 global apparel spending. The
U.S. has the highest per-capita GDP,
however, spends the lowest on
apparel compared to other leading
countries. This creates even steeper competition among existing competitors since it
makes it harder for firms to obtain market share.
Same-store sales are also used to determine industry growth. This is measured by
sales from those stores that have been open for at least a year and excludes store
closings and expansions. Urban Outfitters increased their store total by 16% to 206 in
their most recent fiscal year (January 31) while their main competitor, ANF, increased by
9% to 935.
Holiday shopping represents 50% of industry sales. However, the warm December
weather prevented many firms from reporting high fourth quarter earnings. Urban
Outfitters reported a 5% decline in same-store sales for December. However, total sales
increased 13% to $360.8 million due to their new (open less than one year) store sales
and internet and catalogue sales.
Abercrombie reported increases in total sales despite a 4% decrease in same-store
sales. This is synonymous with many apparel firms and puts pressure on firms without an
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online sector since internet sales outweighed same-store sales for December, potentially
the industry’s busiest sales month.
This industry is comprised of 52 apparel stores according to Yahoo Finance and
generated $101.7 billion in revenues for 2006. Based on revenues, URBN controls 1.16%
of the market ($1.18 billion) while the top three revenue leaders, The Gap, Limited
Brands, and Nordstrom Inc., control one third of the market. This makes it extremely
difficult for the remainder of the industry to obtain sales and illustrates the steep
competition.
In conclusion, there is and will continue to be a high degree of competition in this
industry. However, industry growth based on revenues will be relatively low since this
industry has reached the “long run stage” of its monopolistically competitive structure
where new firms enter and take market share away from current firms. This is also
supported by the decrease in December same-store sales and a 33% market share
controlled by three firms.
Concentration and Balance of Competitors
Concentration and balance of
competitors determines the amount
of competition in an industry. The
industry is fragmented since it
competes more on product
differentiation and assortment than
price due to high labor costs and
lack of monopoly presence.
Concentration of competitors has
grown since department stores and their “affordable fashion” marketing campaigns have
lured away current and potential consumers. For instance, Kohl’s department store chain
announced in August 2006 that they would carry $69 dresses and $99 handbags from
fashion designer Vera Wang. Wang previously catered to a specific market niche that
primarily consisted of celebrities. In addition, Isaac Mizrahi, a fashion designer for
0
400
800
1200
1600
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2006
Total Assets (2006)in millions
URBN
ANF
JCG
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Bergdorf Goodman (Neiman Marcus subsidiary), introduced a line of women’s apparel at
Target stores in 2003 and has since introduced a line of home furnishings in 2005.
Kohl’s and Target’s pursuit to lure apparel customers away has proved to be
effective thus far from recent announcements from both firms. However, this will be
duplicated in the near future by other department stores. Furthermore, the advent of e-
commerce has created a growing number of internet retailers who can afford to sell
similar fashions at lower prices due to smaller overhead and inventory costs. Both of
these factors will begin to deflate the consumer basis held by specialty apparel stores if
their consumer switching costs are low (mentioned in detail in the subsequent
paragraph) and further increase the already high concentration amongst apparel
competitors.
Degree of Differentiation and Switching Cost
The level of product differentiation in an industry determines the willingness or
ability of the consumer to switch between firms. It is important to note that product
differentiation lies in the mind of the consumer. In fact, two products may be identical,
but are presented in such a way that one is superior to the other. In order to create such
distinctions, firms have created image differentiation based on branding. Differentiation
strategies allow for products to command brand loyalty and a corresponding reduction in
price sensitivity. Brands are of increasing worth since they are intangible assets that are
difficult for competitors to understand and imitate.
There are 16 registered service and trademarks for URBN. Urban Outfitters heavily
relies on product differentiation and has established a separate subsidiary that solely
maintains and manages future and existing marks and defends against infringement.
This is synonymous with URBN’s competitors since their sales are based upon product
differentiation, name recognition and reputation.
There are two forms of switching costs: consumer switching costs and firm
switching costs. Consumer switching costs refers to all costs and inconveniences incurred
in order to switch between apparel providers. Firm switching costs refers to all costs and
inconveniences incurred in order to switch industries. Apparel stores, on average, have
made consumer switching costs high in order to retain customers. Expanding on degrees
of concentration from above, when firms have achieved differentiation, they have made
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consumer switching costs high. This is so since consumers are victims of their own
individuality, especially college students. Polo charges high dollar for a homogenous
collared or tee shirt that displays their logo in the upper right corner of most clothing.
However, students are inclined to pay a price premium since they view Polo as an elite
status symbol; thus, Polo has achieved high switching consumer switching costs due to
their quality, name recognition and reputation. In summary, the more customer
retention, the easier firms can increase prices without the risk of losing them to
competitors.
Apparel firms have high switching costs since the industry most often entered into
is consumer goods. Although home furnishings and recreational equipment is both labor
and capital intensive, firms have offered an extension to their apparel lines since it
stimulates a bond between them and consumers. Anthropolgie, subsidiary of URBN, sells
eclectic home furnishing items along with their apparel such as tangerine apostrophe
chairs, velvet sofas, and spectrum chandlers.
High differentiation and high consumer and firm switching costs provide this
industry with customer retention and relieve current competitors from facing new
entrants and competitors from adjoining industries.
Ratio of Fixed to Variable Costs
This ratio affects the flexibility of firms’ pricing structures. Urban Outfitters stores
are financed through off-balance sheet leases ranging from 5-15 years. Additionally,
there are 10 Urban Outfitters locations where a percentage of sales are paid in lieu of a
fixed minimum rent. Including Urban Outfitters two subsidiaries, Anthropolgie and Free
People, there are 212 stores with total selling space of over 1,756,000 square feet. Urban
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Outfitters typically carry 30,000 to 35,000 products per store, Anthropolgie 20,000 to
25,000, and Free People approximately 1,600.
They have two primary distribution centers located in Lancaster County,
Pennsylvania and Edgefield County, South Carolina with combined square footage of
650,000.
Firms in any industry must turn over large amounts of products for fixed cost to
cover variable cost or exit the industry. The apparel industry has leaner inventories
compared to other industries so their inventory turnover rate is higher. This allows
apparel firms to consume more fixed costs at higher rates and ultimately decrease the
bargaining power of consumers (discussed in subsequent paragraphs).
Exit Barriers
Exit barriers determine whether the firm leaves the industry in the short or long
run. Small barriers allow for immediate exit while large barriers prevent the firm from
leaving in the short run and force it to continue to sustain losses until it can depart in the
long run. The apparel industry consists of few barriers which makes it appealing to new
entrants and, ultimately, raises competition amongst firms.
Five Forces Conclusion
Overall, URBN operates in a highly competitive industry that includes a high threat
of entry from potential players. This industry is highly fragmented since apparel is based
more upon tastes and preferences given the ongoing fashion trends that mold this
sporadic industry. Since more firms fall under the product differentiated category,
customers have relatively low bargaining power. Given the possibilities of manufacturing
abroad, suppliers have relatively low power as well since competition is primarily derived
from low costs.
Threat of New Entrants
The threat of new entrants will ultimately increase competition amongst existing
firms by deflating the learning curve and becoming more price conscious.
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Economies of Scale
Economies of scale describe a production process in which an increase in the
number of units produced causes a decrease in the average cost of each unit. The
graphs above were designed so as to spot economies of scale. Abercrombie seemed to
achieve this during 2003 thru 2004 when total assets increased while operating expenses
decreased.
In an industry where economies of scale possibly exist, new entrants must
compete at a disadvantage with large, more established firms that have lowered
production costs. Mature firms have achieved moderate economies of scale from their
reputable status resulting in greater operating leverage for price competition.
Furthermore, some firms have accomplished economies of scale through acquisitions and
mergers. For instance, Gap Inc. has achieved significant economies of scale due to their
significant store base and prior acquisitions of Old Navy and Banana Republic. The
possession of multiple brand names allows Gap Inc. to produce more units at a lower
average fixed cost. Gap Inc. can also produce products for all of its brands in the same
manufacturing facilities rather than requiring separate facilities for each brand. These
benefits allow Gap Inc. to offer the lowest prices amongst its competitors, including
URBN, but its recent failures can be attributed to its creative deficiencies.
Due to the nature of the industry, being overtly accessible tends to dilute brand
image. Consumers tend to be individualists when it comes to fashion, and become
Total Assetsin millions
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2002 2003 2004 2005 2006
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ANF
JCG
Operating Expensesin millions
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JCG
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cynical when a store appears in every shopping mall. In summary, the bulk of the
industry does not operate under economies of scale given the high variances of
consumer preferences.
First Mover Advantage
The first mover advantage relates to the concept of a company gaining a serious
advantage over the competition by being the first significant company to enter into a
new market. Due to the oversaturated and highly fragmented nature of the apparel
industry, this advantage no longer seems to exist. Historically, apparel firms have had to
innovate and take risks, expanding their product assortment in order to gain a
competitive advantage. Firms have already responded to competition by creating
specialized segments to appeal to a target customer base. For instance, Gap’s brand has
expanded from one brand into five that focuses on capturing a different target market.
Apparel stores have become so diverse in their merchandise and product offerings that
the first mover advantage has nearly been eliminated.
Access to Channels of Distribution and Relationships
If a firm can lower its production costs sufficiently, it can safeguard itself against
the possibility of new entrants. This goal can be achieved by maintaining a solid
relationship with suppliers in order to reduce material costs. Production costs can also be
reduced by streamlining distribution efforts between factories, warehouses, storage
facilities, and retail stores. With an efficient system in place, firms can maintain lean
inventories which lowers storage costs which in turns lowers overall production costs. In
terms of lean inventories, many firms have established automated distribution centers.
Merchandise purchased from manufacturers for the firms’ retail and wholesale operations
are shipped directly to the distribution centers. Regional stores then communicate with
the centers on the appropriate demand needed which alleviates demand uncertainty.
Communication is achieved through technologies such as product bar codes, point of sale
scanners, and electronic data interchange, which makes apparel sales figures accessible
to manufacturers.
Most apparel stores, including URBN, receive a considerable portion of their
apparel and other merchandise from foreign sources, both purchased directly in foreign
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markets and indirectly through domestic vendors with foreign sources. Access to
channels of distribution can be adversely affected by financial or political instability.
Trade restrictions in the form of tariffs, applicable to apparel products, could affect the
importation of those products and could increase the cost and reduce the supply of
product availability. In addition, decreases in the value of the dollar against foreign
currencies could increase the cost of products purchased from vendors abroad. In
summary, microeconomics weighs heavily on whether entry is achievable.
Legal Barriers
The retail apparel industry has little to no legal barriers that prevent new entrants.
Trademarks protect against infringement and prevent consumer confusion between
similar apparel branding. Both incumbents and new entrants are forced to abide by the
trademark regulations. However, no legal barriers necessarily prevent new entrants into
the industry.
Threat of Substitute Products
This industry is competitively divided on either price or differentiation. Firms that
have lower consumer switching costs will compete more on price and less on
differentiation. Abercrombie and JCG sell apparel that is homogenous in some regards
which indicates that consumers will likely buy based on price. As a result, this increases
their buying power amongst relative competitors. These firms face threat of substitute
products from department stores and factory outlets.
Firms that have higher switching costs will compete more on
differentiation and quality than price. Urban Outfitters can afford to
sell a plaid flannel shirt (pictured left) for $44 since they have
achieved product differentiation and variety. As mentioned before,
they have formed invaluable bonds with customers from the Pareto
principle: 20% of customers are responsible for 80% of sales.
Therefore, for firms with high degrees of differentiation, substitution
really is not a relevant factor.
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Bargaining Power of Buyers
Buyers in any industry would love to be able to buy a particular product at a low
cost. The harder that it is to accomplish this goal, the less advantage they have against
the industry. This industry consists more of specialty stores with a unique set of
products. Buyers are less sensitive on price when the product is differentiated. For
instance, if a particular product was the same as another product, except that it was
made by a different company and had a higher price; customers would be more likely to
choose the product that was the cheapest. On the other hand, if the product was
different in some way and had certain features that other products did not then
customers might be more inclined to accept the higher priced product. Urban Outfitters
produces a unique clothing line that separates itself from a competitive market.
Also, this industry is suited for a wide range of customers, from ages 18-40.
When you focus on a wider range of customers rather than one particular age group you
will have more buyers in the industry creating more demand for the products. The
switching costs in this industry are both high and low. Switching cost are low in the
apparel industry due to an undifferentiated product. If URBN raises their price on jeans
but American Eagle has a sale on them, then buyers might be more inclined to shop at
American Eagle. On the other hand, this industry can also have high switching costs due
to differentiated products.
This industry is based upon tastes and preferences. Given that firms do not offer
identical apparel lines for the sole purpose of attracting their targeted consumer basis
identifies the aforementioned high consumer switching costs. Urban Outfitters sales
unique products that cannot be found at any other apparel store. In conclusion, buyers
have low bargaining power due to high switching cost, high number of buyers, and a
differentiated industry.
Bargaining Power of Suppliers
Suppliers bargaining power is the analysis of the number of suppliers to the
number of firms in the industry. The analysis of suppliers is a mirror image of buyers. A
dream industry for suppliers would be an industry that contained few companies and few
substitutes available to their customers. This would give suppliers an advantage over
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companies and they could raise the price on retailers. But unfortunately, there are close
to 2000 suppliers in this industry; due to this switching costs are low. In this competitive
industry you have to have an edge. If a company can purchase their retail items for a
cheaper cost through one supplier versus another they will do so. This causes suppliers
to compete in the industry.
Urban Outfitters on the other hand, is a store that is divided into two sections;
one section is retail and the other is wholesale of goods. They have labeled their
wholesale goods with the term “Free People”. Urban Outfitters sales their wholesale line
in many different stores throughout the nation, and because of this they have an
advantage at selling certain goods cheaper than their competitors. Most of the industry
imports all of their retail from various foreign suppliers. In most of these countries labor
cost is cheap as opposed to domestic suppliers. Due to a high number of suppliers, low
switching cost, and cheap foreign labor cost, bargaining power of suppliers is low in this
industry.
Value Chain Analysis
The retail apparel industry has continuously become more and more competitive
since the economic boom of the 1990s. Retail is the second largest industry in the United
States in terms of employee and firm volume. Many competitors in this industry try to
differentiate themselves through store environment, brand recognition, and customer
service. To be profitable in the high end retail industry, a firm must maintain a strong
brand image and offer unique and distinct products. These two objectives can be
accomplished through a strategy based on differentiation. By providing superior product
quality, product variety, and exceptional customer service, a firm can distinguish itself
from its competitors and develop a loyal customer base. The profitability of a firm in the
retail industry is determined by how that firm chooses to strategically position itself
within that market by offering a unique mix of the three.
As well as the in-store strategies listed above in today’s ever increasing electronic
world, all of the competitors in this industry use some form of e-commerce or online
shopping. Each firm offers all of their products online through company websites. Online
shopping also increases brand recognition and brand awareness for each firm in the
retail industry. Each online store is unique to each firm, but all attempt to be as
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consumer friendly as possible. The retail industry is a massive industry that will continue
to grow as times goes on. With so much competition present in the industry, firms must
utilize innovative approaches to how they market their merchandise to customers and
create brand awareness and prestige.
Competitive Advantage Analysis
Urban Outfitters operates in a highly competitive industry that is very fragmented,
to say the least. By nature, the industry possesses a huge potential for differentiation,
since any company with the necessary equipment can manufacture clothing and
accessories. Urban Outfitters has adopted several strategies to capitalize on its
competencies and create value for the firm. The three key success factors on which the
firm succeeds in creating competitive advantages for itself are designing labels to cater
towards a specific market segment, maintaining a strong brand image, and by offering
unique and distinct products and retail stores. Through these strategies of differentiation,
URBN has succeeded in boosting their annual sales at a rate of 33% over the last five
years.
Urban Outfitters is a parent company that governs Urban Outfitters,
Anthropologie, and Free People. Each of these business segments is designed and
marketed to meet the needs of a different customer base. Urban Outfitters strives to be
“the brand of choice for well-educated, urban-minded young adults,” in the 18 to 30 age
group. It offers merchandise for both men and women, and also sells accessories,
footwear, and home furnishings. By separating this segment of the firm, URBN can
design and market these stores to capture the business of the most sought after and
fashion conscience age group in the market.
The next segment of the parent company is Anthropologie, which “tailors its
merchandise and inviting store environment to sophisticated and contemporary women
aged 30 to 45.” This segment of the firm is geared towards the older and more mature
female crowd and distinguishes itself from the URBN segment by focusing on the middle-
aged women. They offer clothing and apparel but focus mostly on home furnishings. By
differentiating the 30 to 45 age group from the younger, more hip 18 to 30 group,
Anthropologie successfully meets the needs of the customer “focused on family, home,
and career.” They can customize the merchandise and store atmosphere to capture the
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market that has more money to potentially spend and doesn’t respond to the same
merchandise as the 18 to 30 group.
The third segment is the Free People subdivision, which is a wholesale goods
distributor that does business with specialty and department stores. This segment only
sells merchandise for women and operates several boutiques throughout the country.
The Free People brand URBN is the only segment that does the bulk of its business
through online and catalog shopping.
Another strategy that grants URBN a competitive advantage is its strong brand
image and loyal customer base. All of the firm’s labels are synonymous with hip, trendy,
and designer products with a price tag to match. The typical URBN customer is willing to
pay more for merchandise than they would at a non-specialty store in order to stand out
in a crowd.
Offering eclectic products and a unique retail experience is the third strategy
employed by the firm. On their website, URBN claims that they “design innovative stores
that resonate with the target audience,” and “construct unique product displays that
incorporate found objects into creative selling vignettes.” For this experience, the loyal
customers of URBN are more inclined to pay the premium price tags. The firm focuses on
creativity and individualism “offering a product assortment and an environment so
compelling and distinctive that the customer feels an empathetic connection to the brand
and is persuaded to buy.”
In the following section, we discuss the accounting analysis for URBN. This is
based on the following elements: accounting flexibility, strategy, and quality of disclosure
along with revenue and expense diagnostics to serve as check figures for accounting
irregularities.
Accounting Analysis
The importance of accounting analysis is to evaluate the degree to which a firm’s
accounting captures its underlying business reality. By identifying places where there is
accounting flexibility, and by evaluating the appropriateness of the firm’s accounting
policies and estimates, analysts can assess the degree of distortion in a firm’s accounting
numbers.
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Key Accounting Policies
Identifying key accounting policies is important since it identifies and evaluates the
policies and estimates the firm uses to measure its critical factors and risks. Urban
Outfitters is in the apparel industry. Factors affecting the growth, profitability, and
valuation of this industry include: the condition of the economy and level of consumer
confidence, desire for apparel in comparison to other goods and services, product
distinction, and competitive pricing. Urban Outfitters primary success factors are:
1. Designing labels to cater towards a specific market niche
2. Maintaining a strong brand image
3. Offering unique and distinct products
All three are dependent on each other, yet URBN provides a separate discussion on
each factor scattered throughout their financials. We have provided a brief assessment
for each success factor below:
Designing labels to cater towards a specific market niche
Urban Outfitters ensures their labels cater towards a specific market niche with
“merchandise managers regularly attending national and regional trade shows and
staying current with mass media influence such as music, video, and film1.”
Maintaining a strong brand image
Urban Outfitters regards their image as their foundation to success, with their
image being derived from trademarks. In order to effectively protect them from
infringement and defend against claims of infringement, URBN has established a
separate subsidiary whose primary purpose is to maintain and manage current and
future marks, therefore, increasing their value and maintaining a strong brand image2.”
1 “Merchandise” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006 2 “Trademarks and Service Marks” Urban Outfitters, Inc. Form 10-K 31 Jan. 2006
21
Offering unique and distinct products
Offering distinct products such as private labels has yielded higher gross margins
than brand name merchandise for URBN3. The vast product variety available to their
customers allows them to adapt their merchandise to prevailing fashion trends, and,
together with the unique atmosphere of their stores, signifies their product distinction.
Each of these factors was discussed adequately in their annual report. However, it
was not consolidated into one section, but scattered throughout. Our assessment
concludes that URBN should consolidate these factors into one section for future reports
to indicate their true importance and illustrate their dependence amongst each other.
In this section, we discuss two prime components, inventories and leasehold
improvements, and how URBN estimates them. Urban Outfitters value their inventories,
which consist primarily of general consumer merchandise held for sale, at the lower of
cost or market. Cost is determined on the first-in, first-out method (FIFO) which results
in a more accurate Balance Sheet and a less accurate Income Statement for the
following reason: Under FIFO, old costs are reported as COGS on the Income Statement
and new costs are reported as inventory on the Balance Sheet (and vice versa for LIFO).
If LIFO was used, both assets and liabilities would be understated on the Balance Sheet,
but Owners’ Equity would not be affected. Therefore, by using FIFO, URBN is overstating
net income since older inventory are used to value COGS, which works against them
since it increases their tax expense, yet they are still able to report a higher net income
in comparison to LIFO.
Historically, URBN recorded rent expense on a straight-line basis over the lease
period commencing on the date the store opened4. The lease period did not include the
construction period to make the leased space suitable for operating during which time
URBN was not permitted to occupy the space. In fiscal year 2005, the SEC added the
construction period in its calculation of rent expense that equals or exceeds the time
frame used for depreciation. Therefore, for purposes of calculating straight-line rent
expense, the commencement date of the lease term reflects the date URBN takes
possession of the building for initial construction and setup. Overall, the SEC’s intention
was to deflate earnings since ignoring the construction phase resulted in overstating net
3 “Merchandise” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006 4 “Fiscal 2005 compared to Fiscal 2004.” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006.
22
income by 4 percent5. Urban Outfitters recorded a cumulative adjustment of $4.6 million,
which reduced net income in the fourth quarter of fiscal 2005.
Urban Outfitters operates three separate distribution facilities to help store and
ship inventory6. In terms of accounting disclosure, URBN does not mention their
distribution costs while their prime competitor, ANF, does. Abercrombie has reported
their distribution costs as a percentage of net sales. As a result, we will hold URBN
accountable for this when our final valuation is complete.
Accounting Flexibility
All U.S. companies are required to comply with GAAP policies. However, GAAP
allows significant flexibility in terms of how companies account for their operations. Some
areas where companies can choose which way to report are inventory, depreciation, and
leases.
Urban Outfitters policy on depreciation is similar to that of other companies in this
industry. They calculate it on a straight-line basis with different lives depending on the
asset. Store leases are depreciated over 10 years, whereas furniture and fixtures are
depreciated over 5 years. Both are included in the “Property and equipment, net” line
item on their balance sheet. Net property and equipment at the end of fiscal 2006 and
2005 totaled $299.3 million and $192.8 million, representing 27.4% and 23.3% of net
sales, respectively7.
Operating leases, which decrease liabilities and increase expenses, is ideal for
companies who have debt covenants. Urban Outfitters operating leases are between 5-
15 years. If they were to capitalize these operating leases, it would create a total liability
of $516 million. Abercrombie uses this same accounting approach and if they were to
capitalize their operating leases, it would create a total liability of $1.1 billion. Urban and
Abercrombie are not the only guilty parties to understate liabilities since this is an
industry norm. Given this significant discrepancy in net income distortion, this is another
prime example of URBN employing aggressive accounting tactics. The tables below
illustrate the aggregate present value amounts of long term liabilities that both firms are
not reporting. We also made several assumptions to account for the lack of disclosure by
5 “SEC Staff Accounting Bulletin: No. 99 – Materiality.” Securities and Exchange Commission. 6 “Properties” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006. 7 “Long-lived assets” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006.
23
both firms. First, we assumed a discount rate of 5.625% which is the going rate for 15
year mortgages. Second, since both firms noted that their leases last between 5 to 15
years, we assumed 10 year leases. Both firms list their operating lease amounts as multi-
year totals, so to calculate the expense for one year, we simply divided the aggregate
amount by the amount of years included. The following tables illustrate these
assumptions.
URBN ANF
Year OL 5.625% PV Year OL 5.625% PV
01 $78,761 .947 $74,567 01 $187,674 .947 $177,680
02 82,115 .896 73,601 02 182,996 .896 164,024
03 82,115 .849 69,682 03 182,996 .849 155,289
04 71,807 .803 57,690 04 162,763 .803 130,764
05 71,807 .761 54,617 05 162,763 .761 123,800
06 57,435 .720 41,360 06 107,727 .720 77,575
07 57,435 .682 39,157 07 107,727 .682 73,444
08 57,435 .645 37,072 08 107,727 .645 69,533
09 57,435 .611 35,098 09 107,727 .611 65,830
10 57,435 .579 33,229 10 107,727 .579 62,324
516,072 1,100,265
Urban Outfitters reported $208 million of long term liabilities for fiscal 2006. If this is
added to the $516 million present value above, their long term liabilities would triple to
$724 million. This adjustment would significantly alter their current financial condition in
the eyes of potential investors and current shareholders. This change would also impact
ratios such as net profit margin, return on assets, and debt service margin.
Evaluating Accounting Strategy
The trouble with accounting flexibility is that it gives the power to managers to
distort true performance. For that reason, it is extremely crucial to evaluate a company’s
accounting strategy and provide an analysis. As stated earlier, we have found URBN
guilty of using aggressive accounting.
24
The most evident source of this strategy stems from URBN’s policy on cash
bonuses. The firm’s executive officers are eligible to receive cash incentive bonuses
under their Executive Incentive Plan based on the achievement of criteria and
performance targets established in advance. Criteria for compensation includes: profit,
earnings per share, and total shareholder return, to name a few, and ultimately
encourages them to overstate net income8.
The graph below comes from URBN’s Proxy statement.
Seen here is the rapid growth of URBN’s stock performance in comparison to the
industry. This growth results from several factors. First, as discussed earlier, URBN has
failed to capitalize their operating leases which have led them to understate liabilities by
$516 million. Second, the SEC has recently mandated all companies to commence
depreciation expense during the initial construction and setup phase. This previously
allowed URBN to understate depreciation costs, which ultimately led to a $4.6 million
adjustment that reduced net income in the fourth quarter of fiscal 2005. Third, URBN’s
FIFO method dilutes their inventory costs by using old prices to assess new costs. This
overestimates net income which again positively affects cash bonuses.
8 “Cash Bonuses” Urban Outfitters, Inc. Proxy Statement 19 Apr. 2005.
25
The table below comes from URBN’s Proxy statement.
Annual Compensation
Long-Term
Compensation
Name and Principal Position
Year(1)
Salary
Bonus
Securities Underlying
Options
All Other Compensation(2)
Richard A. Hayne Chairman and President,
Urban Outfitters, Inc.
2006
2005
2004
$
363,404
345,000
278,509
$
105,000
155,000
105,000
—
—
—
$
30,530
26,800
28,678
Glen T. Senk President, Anthropologie,
Inc.
2006
2005
2004
$
571,423
530,016
483,468
$
255,000
681,100
655,000
100,000
1,600,000
—
$
11,857
10,136
8,101
Tedford A. Marlow President, Urban Outfitters
Retail
2006
2005
2004
$
432,539
404,918
373,432
$
410,000
415,000
405,000
100,000
—
—
$
138
138
—
John E. Kyees Chief Financial Officer
Urban Outfitters, Inc.
2006
2005
2004
$
406,654
390,000
72,120
$
85,000
185,000
187,500 600,000
200,000
$
3,435
6,590
22
Glen A. Bodzy Secretary and General
Counsel Urban Outfitters, Inc.
2006
2005
2004
$
278,596
265,000
238,385
$
45,000
80,000
80,000
80,000
—
160,000
$
5,247
3,380
2,905
Shown here are the bonuses and other compensations received by URBN’s top
executives for the last three fiscal years. This becomes relevant when you compare this
table to the fact that insiders account for over 30% of beneficial ownership9.
9 “Beneficial Ownership” Urban Outfitters, Inc. Proxy Statement 19 Apr. 2005.
26
Evaluate the Quality of Disclosure
The quality of disclosure for a company’s financial statements determines how
transparent the company communicates their business reality. High quality levels
increases disclosure value and diminishes the barriers of uncertainty amongst outsiders
of the firm. Therefore, the quality of disclosure for a company’s financial statements is
highly imperative in assessing the true value of their operations.
In assessing a firm’s accounting analysis, analysts heavily rely on discussions and
footnotes within financial statements. We assessed URBN’s disclosure quality based on
the following criteria:
1. Business strategy
2. Current performance analysis
3. Accounting for key success factors
4. Accounting for multiple business segments
1. Business Strategy
Companies use a Letter to the Shareholders discussion in the beginning of their
annual report to discuss management’s short and long term goals, competitive strategies,
and current performance. It is intended to provide shareholders with a general overview
of the company for their last fiscal period. Urban Outfitters has never supplied a Letter to
the Shareholders in their financial reports. The industry norm has been to include a
Letter to the Shareholder’s, however, firms have since replaced it with a “Business”
heading, which is synonymous with Letter to the Shareholders in terms of disclosure on
current operations.
Besides stating their current performance in the last fiscal period, URBN’s
disclosure in regards to assessing the industry and their prime competitors is vague. Its
“Competition” heading does not mention their prime competitors by name and disregards
the fact that many shareholders lack knowledge of URBN and the industry as a whole.
For instance, their lack of disclosure is illustrated in the following sentence, “Many of our
competitors have substantially greater name recognition as well as financial, marketing
27
and other resources10.” In conclusion, URBN lacks quality disclosure in their analysis of
both the industry and their prime competitors.
2. Current performance analysis
Current performance is discussed under The Management Discussion and Analysis
section of the annual report. It is regarded as the most important section since it sums
up the company’s performance for the last fiscal period. Urban Outfitters is highly
deceptive in terms of reporting occupancy costs. Occupancy costs are the direct costs of
occupying a building such as building and equipment depreciation, insurance, and
utilities, to name a few. Urban Outfitters reports occupancy costs as part of its COGS. By
doing this, they are understating their occupancy costs since they have reported them as
product costs instead of period costs. This is synonymous with the FIFO method since
they use old prices to assess new costs. Instead of reporting occupancy costs at 100%,
they dilute these costs and as a result, overstate net income.
3. Key Success Factors
Key success factors are what the company depends upon to distinguish
themselves from competitors. If the firm can not estimate their measurement, they
account for them in other ways. Urban Outfitters relies on three success factors listed
below:
Designing labels to cater towards a specific market niche
Maintaining a strong brand image
Offering unique and distinct products
Urban Outfitters does not ignore these success factors and provides relevant and
resourceful discussions on how they account for and manage them in their annual report.
Designing labels to cater towards a specific market niche
Maintaining a constant flow of fashionable merchandise from designing private labels to
offering national brands is critical to URBN’s performance. Urban Outfitters ensures their
10 “Competition” Urban Outfitters, Inc. Form 10-K 31 Jan. 2006.
28
labels cater towards a specific market niche with “merchandise managers regularly
attending national and regional trade shows and staying current with mass media
influences such as music, video, and film11.”
Maintaining a strong brand image
Urban Outfitters regards their image as their foundation to success, with their image
being derived from trademarks. In order to effectively protect them from infringement
and defend against claims of infringement, URBN has established a separate subsidiary
whose primary purpose is to maintain and manage current and future marks, therefore,
increasing their value and maintaining a strong brand image12.
Offering unique and distinct products
Offering distinct products such as private labels has yielded higher gross margins than
brand name merchandise for URBN13. The vast product variety available to their
customers allows them to adapt their merchandise to prevailing fashion trends, and,
together with the unique atmosphere of their stores, signifies their product distinction.
Each of these factors was discussed adequately in their annual report. However, it was
not combined into a separate section as their prime competitors, ANF and JCG, did, but
scattered throughout. Urban Outfitters should include these factors together instead of
separately in future reports to illustrate their true importance.
4. Multiple Business Segments
A multiple business segment is a business that is divided into different
channels, providing a different line of products than other channels. Urban Outfitters is
considered to have multiple business segments and has divided their operations into two
reportable operating segments, retail and wholesale operations. Urban Outfitters has
provided a consolidated income statement that illustrates the amount of sales generated
from each segment. They also separate their domestic from foreign sales on the same
statement.
11 “Merchandise” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006 12 “Trademarks and Service Marks” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006 13 “Merchandise” Urban Outfitters, Inc. Form 10-K. 31 Jan. 2006
29
As the above information fails to indicate, quality rather than the quantity of
disclosure enhances financial statement reporting. We find that URBN’s disclosure is
deceiving and overall, lacks quality in comparison to its competitors and, of course, we
will take this into full account when our final valuation is complete.
Revenue and Expense Diagnostics
The following sections represent the core measurements of detecting possible
accounting inconsistencies regarding revenues and expenses. Since URBN is in the retail
industry, inventory would be a potential roadblock in regards to meeting their annual
quotas. Due to the sporadic nature of this industry, retail firms do experience periods of
lax sales which correlates to more inventory on hand. We will examine this and other
revenue diagnostics in the following sections. In regards to expense diagnostics, URBN is
a growing firm who has experienced solid sales growth. Sales increases most likely
translate into more store openings which would increase depreciation and amortization
expenses. If these expenses do not proportionally correlate with sales increases, this, in
all likelihood, would indicate an accounting irregularity. We will examine this and other
expense diagnostics in the following sections.
Revenue Diagnostics
All three firms do not offer long-term contracts or warranty coverage which is why
Net Sales/Unearned Revenues and Net Sales/Warranty Liabilities are not applicable. Also,
JCG does not disclose Receivables on their financials which is why we can not derive
diagnostics for Net Sales/Cash from Sales and Net Sales/A/R.
30
URBN 2002 2003 2004 2005 2006 Net Sales/Cash from Sales 1.00 1.00 1.01 1.00 1.01Net Sales/Net A/R 84.43 129.6 81.71 98.97 76.24Net Sales/Unearned Revenues N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/ANet Sales/Inventory 7.78 8.35 8.67 8.66 8.49ANF Net Sales/Cash from Sales 1.02 1.10 1.11 1.02 1.02Net Sales/Net A/R 39.96 92.75 150.5 35.52 44.23Net Sales/Unearned Revenues N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/ANet Sales/Inventory 12.73 14.66 11.84 11.84 13.19JCG Net Sales/Cash from Sales N/A N/A N/A N/A N/ANet Sales/Net A/R N/A N/A N/A N/A N/ANet Sales/Unearned Revenues N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/ANet Sales/Inventory 5.34 6.82 10.01 8.83 7.95
This diagnostic reveals the amount of
A/R a firm accrues in a given year
matched up against sales. High
receivables in repeating years signify
that the firm is increasing the
probability on not collecting those
receivables. Firms aim for a ratio near
one since it signifies A/R are not
taking up a considerable portion of
sales. Urban Outfitters has achieved this, but ANF has not. The sharp increase in 2003
and continuing into 2004 is the aftermath of opening 209 new stores. No sales
manipulation appears to be present for this diagnostic.
Net Sales/Cash from Sales
1
1.02
1.04
1.06
1.08
1.1
1.12
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
31
This diagnostic is synonymous with
receivables turnover with the
exception of netting receivables
against bad debt expense. Firms aim
to achieve a high ratio since it
signifies more liquidity assurance.
However, this can be deceptive
since firms with significant bad debt
expenses produce high ratios as
well. Upon further review, URBN does indicate their bad debt expense within their
financials, but ANF does not. This graph displays high variances for both URBN and ANF
and is the result of such a sporadic industry. Since both firms generate healthy sales, this
would lead one to believe both firms are not involved in understating receivables. No
sales manipulation appears to be present for this diagnostic.
This diagnostic can be deceptive by
using the FIFO method instead of
LIFO. If FIFO is used, then firms
experiencing lax sales would not be
harmed by an inventory surplus
since the bulk of inventory costs
would represent old costs. However,
this is an acceptable accounting
practice which is why firms prefer to
account for inventory costs using FIFO. Since this is an acceptable accounting practice,
we will not refer to it as sales manipulation. Therefore, the sole possibility of
manipulating this diagnostic would be to underreport inventory to adjust for lax sales.
Urban Outfitters has been fairly stable during this period which eliminates the possibility
of sales manipulation.
Net Sales/Net A/R
35
55
75
95
115
135
155
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
Net Sales/Inventory
5
8
11
14
17
20
2002 2003 2004 2005 2006
Years
Out
put URBN
ANF
JCG
32
Revenue Summary
Based upon these diagnostics, URBN is not susceptible to accounting irregularities.
The high variance produced from Net Sales/Net A/R is the aftermath of industry volatility.
In conclusion, URBN is not guilty of revenue manipulation.
Expense Diagnostics
All expense diagnostics will be measured except for Pension Expense/SG&A and
Other Employment Expenses/SG&A due to inadequate information.
URBN 2002 2003 2004 2005 2006 Declining Asset Turnover 1.42 1.49 1.52 1.52 1.79Changes in CFFO/OI 1.28 1.07 .99 1.01 .72Changes in CFFO/NOA .46 .66 .60 .60 .88Total Accruals/Change in Sales .33 .20 .25 .21 .07Pension Expense/SG&A N/A N/A N/A N/A N/AOther Employment Expenses/SG&A N/A N/A N/A N/A N/AANF Declining Asset Turnover 1.77 1.60 1.42 1.50 1.56Changes in CFFO/OI .86 1.11 1.03 1.22 .84Changes in CFFO/NOA .72 .56 .60 .51 .74Total Accruals/Change in Sales .51 .43 1.20 .66 .16Pension Expense/SG&A N/A N/A N/A N/A N/AOther Employment Expenses/SG&A N/A N/A N/A N/A N/AJCG Declining Asset Turnover 1.85 2.10 2.20 2.80 2.74Changes in CFFO/OI 1.29 -8.29 -0.59 1.56 .71Changes in CFFO/NOA -.42 -1.27 -2.75 -0.19 .07Total Accruals/Change in Sales N/A N/A N/A N/A N/APension Expense/SG&A N/A N/A N/A N/A N/AOther Employment Expenses/SG&A N/A N/A N/A N/A N/A
Declining Asset Turnover is an
expense diagnostic measurement of
sales over total assets. Firms in the
apparel industry have the option to
underreport assets with operating
leases. This enables a ratio such as
this to be higher since its taking less
Declining Asset Turnover
0
0.5
1
1.5
2
2.5
3
2002 2003 2004 2005 2006
Years
Out
put URBN
ANF
JCG
33
assets to generate sales. It is to be noted that this manipulation is fairly simple to
identify since a firm with decreasing sales should have a declining asset turnover. If this
is not the case, firms are manipulating this diagnostic by underreporting assets, most
notably inventories and/or property and equipment. There is no evidence from this graph
that URBN has underreported assets given that they have moderately expanded as
opposed to the rapid expansion of ANF. If ANF were to have an increasing diagnostic,
then this would raise concerns about the integrity of their financial reporting.
Cash Flows from Operations over
Operating Income is a measure of a
firm’s operating liquidity over
Operating Income which is Gross
Profit minus Operating Expenses.
Examples of Operating Expenses
include depreciation and SG&A
costs. An indicator that signifies
whether firms are manipulating
expenses for the purpose of overstating income would be an unexpected decrease in
depreciation expense over capital expenditures. Based on this graph, URBN and ANF
seem to be identical while JCG produced a sharp drop in 2003. Upon further review,
sales decreased, COGS increased, and Operating Expenses remained constant which
explains their operating loss. However, on their Statement of Cash Flows, it would seem
that they improperly capitalized merchandise inventories to induce a positive operating
cash flow and, therefore, manipulated inventory costs to overstate CFFO.
This diagnostic is an extension of
CFFO/OI which is used to measure
the return on operating assets. An
indicator that signifies whether firms
are manipulating expenses for the
purpose of overstating income would
be by improperly capitalizing
CFFO/OI
-10
-8
-6
-4
-2
0
2
2002 2003 2004 2005 2006
Years
Out
put URBN
ANF
JCG
CFFO/NOA
-3
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
2002 2003 2004 2005 2006
Years
Out
put URBN
ANF
JCG
34
expenses. As previously illustrated, JCG was guilty of capitalizing merchandise inventories
which prompted CFFO to be overstated.
Total accruals over change in sales
is an expense diagnostic based upon
adjustments made to Net Income in
the Statement of Cash Flows. An
indicator that signifies whether firms
are manipulating expenses for the
purpose of overstating net income
would be a significant increase in
sales (hence, the denominator)
while depreciation and inventory costs remain constant. In all likelihood, significant
increases in sales would indicate expansion and increase depreciation and inventory costs
and, therefore, indicate the firm is manipulating expenses to overstate net income. Based
on the above graph, URBN is not susceptible to such accounting irregularities.
Abercrombie was responsible for rapid expansion during this period which explains why
they accrued higher costs compared to change in sales.
Expense Summary
Analysis of the above diagnostics suggests that URBN is not susceptible to
accounting irregularities. However, this is based upon what URBN disclosed and excludes
Pension Expense/SG&A and Other Employment Expenses/SG&A. A possible interpretation
as to why all three firms chose not to disclose this data could be expense manipulation,
but since there is not sufficient evidence, we will not draw that conclusion. Overall, the
expense diagnostics for URBN indicate that they are not guilty of expense manipulation.
Identify Potential “Red Flags”
When analyzing accounting policies for a firm, one must constantly be skeptical of
a firm’s accounting disclosure since firms are aiming to lure potential investors with some
form of deceptive accounting. The revenue and expense diagnostics above provide a
check figure for such manipulation and will identify potential “red flags.” Based upon
Total Accruals/Change in Sales
0
0.35
0.7
1.05
1.4
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
35
these diagnostics, we are assured that URBN is not responsible for misleading the
investor by hiding expenses to overstate income. Therefore, no “red flags” were
identified within their financials.
Undo Accounting Distortions
In order to compensate for potential red flags, we must undo the accounting
distortions to realize the effect these distortions have on the firm’s financial condition. As
was discussed in the accounting flexibility section above, one distortion that we identified
was that URBN records leases under the operating rather than capital method. By
capitalizing their leases, we can recognize the amount of liabilities URBN has hidden from
their balance sheet. Also, we can identify the appropriate interest and depreciation
expenses that coincide with lease capitalization.
To begin converting the leases, we had to make several assumptions to account
for the lack of information disclosed by the firm. First, we assumed a discount rate of
5.625% which is the going rate on a 15 year mortgage. Second, we assumed 10 year
leases since the firm disclosed that their leases range between 5 – 15 years. Third, the
firm groups their operating leases in multi-year totals so to calculate an annual expense,
we simply divided the multi-year totals by the amount of years mentioned. Based upon
these assumptions, we created the following table (reported in thousands):
T FV PV Factor PV BB Int. Pay EB Depr.1 $78,761 0.947 $74,567 516,072 29,029 78,761 466,340 51,6072 82,115 0.896 73,601 466,340 26,232 82,115 410,457 51,6073 82,115 0.849 69,682 410,457 23,088 82,115 351,430 51,6074 71,807 0.803 57,690 351,430 19,768 71,807 299,392 51,6075 71,807 0.761 54,617 299,392 16,841 71,807 244,426 51,6076 57,435 0.720 41,360 244,426 13,749 57,435 200,740 51,6077 57,435 0.682 39,157 200,740 11,292 57,435 154,596 51,6078 57,435 0.645 37,072 154,596 8,696 57,435 105,857 51,6079 57,435 0.611 35,098 105,857 5,954 57,435 54,377 51,607
10 57,435 0.579 33,229 54,377 3,059 57,435 0 51,607 Total PV 516,072 Total 157,707 Total 516,072
As depicted above, URBN is hiding $516 million from its balance sheet and
avoiding $158 million in interest expenses. The following illustrates the before and after
effect of lease capitalization on their most recent balance sheet (reported in thousands):
36
Before AfterAssets $769,205 $1,285,277
Liabilities 208,325 724,397Owners’ Equity 560,880 560,880Debt to Equity .37 1.29
As the above graphs illustrate, GAAP is extremely lenient as far as allowing firms
to decipher between operating versus capital leases. In the long run, the only difference
lies in interest expense since the PV of operating leases and depreciation expense cancel
out. The benefit of lease capitalization suggests that URBN is allowed to add depreciation
back in their Statement of Cash Flows which increases CFFO. However, they have opted
to report higher net income on their income statement which is primarily what investors
notice. In addition, lease capitalization, as illustrated above, distorts financial ratios such
as debt to equity which creditors analyze. Overall, URBN is not in violation with GAAP.
Conclusion
Urban Outfitters is fairly aggressive in their accounting practices for several
reasons. First, they report inventory under the FIFO method which nets inventory against
older costs and translates to higher net income. Second, URBN uses operating leases
which hide liabilities and expenses from their financials. Both are in accordance with
GAAP and the norm throughout this industry. Urban Outfitters is also allotted a favorable
amount of flexibility as far as disclosure. Overall, we rate URBN average, at best, as far
as their quality of disclosure since their competitors’ quality is identical.
Revenue and expense diagnostics serve as check figures in regards to
manipulating a firm’s operating figures. Although we were unable to compute several
diagnostics, it is evident that URBN is not guilty of revenue or expense manipulation.
37
Financial Analysis
The third stage in the firm valuation process involves computing and analyzing a
set of financial ratios for these components: liquidity, profitability, and capital structure.
These ratios will establish a benchmark for the given industry and allow the firm a clearer
perspective as to how effective and efficient their operations, past and present, are and
have been. Financial forecasting is conducted after all ratios have been computed and
interpreted. Forecasting relates to obtaining future operating numbers for a firm based
upon prior results. We have provided forecasts to the following financials ten years
ahead for URBN: income statement, balance sheet, and statement of cash flows.
Following these respective forecasts are sound explanations as to how we established
these estimates based on such factors as: industry structure, current and future financial
position of URBN, and micro and macroeconomic factors. We concluded by providing a
cost of capital and beta estimation.
Liquidity ratios
Liquidity refers to the cash equivalence of assets and the firm’s capacity to
maintain sufficient near-cash resources to satisfy its short term financial obligations. The
ratios used to analyze liquidity are evaluated as a group. The following comparative
ratios provide a composite basis for evaluating liquidity.
Current ratio
The current ratio is a value that is calculated by dividing current assets by current
liabilities; both of these amounts are found on the balance sheet. This ratio can be
interpreted as followed: For every dollar of liabilities, there exists a certain amount of
current assets. Current assets represent cash and cash equivalents, marketable
securities, accounts receivable (net of allowance for doubtful accounts), inventories,
prepaid expenses, and deferred taxes. Cash and cash equivalents are defined as cash
and highly liquid investments with maturities of less than three months. Deferred taxes
represent the increase in taxes refundable in future years as a result of deductible
temporary differences existing at the end of the current year.
38
2002 2003 2004 2005 2006 URBN 2.01 3.29 3.04 2.93 2.89ANF 2.48 2.32 2.42 1.56 1.93JCG 1.27 1.32 1.46 1.09 1.51
The higher this ratio, the more liquid the firm is. This indicates that the firm can
meet its short term financial obligations without having to increase its long term debt or
equity. A current ratio well above industry average signifies inefficiency since the firm has
an excess of inventory. The quick asset ratio in this case would supply a clearer
indication of the firm’s liquidity since it only takes into account cash, securities, and
accounts receivable (net of allowances).
This a cross-sectional analysis graph
which plots the industry average
against URBN, ANF, and JCG. The
industry average was computed by
taking ANF and JCG totals only for
the specified time frame. The
following interpretations can be
concluded from this graph: First,
ANF and JCG possessed ratios below
2 in 2005 while URBN possessed a ratio near 3. The explanation for ANF is primarily due
to increases in accounts payable and accrued expenses due to the settlement of three
discrimination lawsuits and rent due to the net addition of 88 stores. The lawsuits
collectively accrued a non-recurring expense of $49.1 million while rent expense totaled
$150 million, which combined is 36% of current liabilities14. The explanation for JCG is
different from ANF in that their current assets decreased while current liabilities
increased from 2004 to 2005. JCG increased their aggregate operations by one store in
fiscal 2005 and overall, they reported a net operating loss of $100.3 million. Their
declining current ratio can also be attributed to an increase in accounts payable of 39%
in 2005 since lax sales failed to cover fixed costs15.
14 “Accrued Expenses” Abercrombie & Fitch 10-K. 2005 Apr. 14 15 “Index to Financial Statements” J. Crew 10-K. 2005 Apr. 29.
Current ratio
00.5
11.5
22.5
33.5
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
39
Second, URBN had a significant increase in their current ratio from 2002 to 2003.
During this time, URBN operated under economies of scale given both COGS and SGA
expenses decreased while achieving an increase in net sales. The end result signifies a
155% increase in cash and cash equivalents in 2003 due to an increase in net income of
83% from 2002 to 2003. This provides sufficient evidence as to why their current ratio
increased significantly from 2002 to 2003.
Quick asset ratio
2002 2003 2004 2005 2006 URBN .79 1.87 1.63 1.67 1.44
ANF 1.59 1.62 1.70 .88 1.02JCG .11 .16 .50 .18 .43
In the quick asset ratio, every dollar of liabilities is compared to a certain amount
of quick assets which include: cash, accounts receivables, and marketable securities.
From the chart above you can tell that quick assets for URBN have remained stable
during 2003 to 2006. From 2002 to 2003, URBN experienced a 108 point increase in this
ratio due to the following reason: both cash and marketable securities increased
dramatically in 2003. Cash and marketable securities increased 155% and 22,959%,
respectively, from 2002. First, $20.2 million from their cash and cash equivalents balance
at the end of fiscal 2003 was from the sale of available-for-sale securities which
represented 28% of their cash. Second, they purchased $17.9 million of municipal bonds
during fiscal 2003. Their prior balance in this account totaled $32,000 and, therefore,
illustrates the 22,959% increase in this balance sheet account. This also justifies why
they report interest income on the income statement instead of interest expense since
the bulk of their financing is from equity and not debt.
40
This graph depicts the quick asset
ratio for URBN and their two
competitors, ANF and JCG. J Crew
has produced a below average
output for the past five years. This is
due to their heavy reliance on debt
financing and as a result, their
current liabilities reflect their current
portion of long term debt. They also
did not disclose balances in their account receivables and marketable securities accounts
so their ratio is really comparing their current cash with their current liabilities. On the
contrary, URBN has kept an above average output disregarding fiscal 2002. Overall, this
ratio indicates that URBN can rely on their liquidity to meet their current debt obligations
due primarily to their investment strategy in available for sale securities. By relying on
equity financing as opposed to debt, this eliminates interest expense and consequently,
lowers their current liabilities.
Accounts receivables turnover
2002 2003 2004 2005 2006 URBN 84.51 129.59 81.71 98.97 76.24ANF 39.96 92.75 150.50 35.52 44.23
Accounts receivable turnover is computed by dividing sales by accounts receivables. This
indicates how much potential cash is tied up in accounts receivable. Firms aim to achieve
a high accounts receivables turnover since this indicates that more receivables are
becoming liquid.
Days Sales Outstanding (DSO)
2002 2003 2004 2005 2006 URBN 4.32 2.87 4.47 3.69 4.79ANF 9.14 3.94 2.43 10.28 8.25The above tables exclude JCG since they do not disclose accounts receivable on their financials.
Quick asset ratio
0
0.5
1
1.5
2
2002 2003 2004 2005 2006
Years
Out
put
URBNANFJCGAVG
41
Day Sales Outstanding is inversely related to accounts receivables turnover and is
computed by dividing 365 by the turnover ratio. This ratio indicates the length of time a
firm will collect their receivables. The higher this amount, the higher the probability
becomes that receivables will not be collected and transferred to bad debt on the income
statement.
Both URBN and ANF had sporadic turnover ratios for the past five years. Upon
further review, ANF failed to mention either an allowance for doubtful accounts estimate
on their balance sheet nor a footnote stating their bad debt in their income statement.
Urban Outfitters provided balances for their allowance for doubtful accounts for the
duration of every fiscal year and closed these accounts by transferring ascertained
amounts onto the income statement as bad debt expense at the close of each fiscal
period, a standard practice used by all firms to close out the allowance account. The
following tables provide a visual illustration to their ratio inconsistencies:
Inventory turnover ratio
This ratio signifies the number of times inventory is cleared out and reordered
throughout the course of a year. Firms aim to achieve high inventory turnover ratios for
the following reason: The faster inventory is cleared out due to sales, the shorter cash to
cash cycle which increases liquidity and working capital. This is since the firm is
experiencing a greater “money merry-go-round” effect due to less money tie ups in
inventory.
A/R Turnover
20
40
60
80
100
120
140
160
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
DSO
0
2
4
6
8
10
12
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
42
Inventory turnover
2002 2003 2004 2005 2006 URBN 5.73 5.44 5.29 4.94 4.58ANF 5.03 4.29 3.66 3.22 2.57JCG 3.27 4.40 6.67 5.44 4.78
Days supply of inventory (DSI)
2002 2003 2004 2005 2006 URBN 63.73 67.11 68.93 73.89 79.62ANF 72.58 85.02 99.75 113.36 141.78JCG 111.62 82.95 54.72 67.10 76.36
As the above tables indicate, URBN possesses
a five year average of 5.2 which translates
into inventory repurchases of 5.2 times per
year or every 71 days. It is essential to note
that this industry is highly sporadic and will
experience periods of lax sales which, for the
most part, explains why firms order leaner
inventories compared to other commodity
industries.
The DSI graph is adversely affected by
the inventory turnover graph. The lower
the turnover ratio, the higher the DSI
and vice versa. Both URBN and ANF
experienced lower turnover ratios
throughout this time frame while JCG
peaked at 6.67 in 2004 for the following
reason: JCG opened an aggregate of 2
stores during fiscal 2004 due to
stagnant sales. Cost of goods sold slightly increased while inventories remained fairly
constant between fiscal 2003 and 2004.
During 2002 to 2006 URBN experienced an increase in DSI, from 64 days to 80
days. This is considered a slight increase in comparison to ANF’s 73 days in 2002 to 142
in 2006. Abercrombie’s dramatic increase during 2002 to 2006 was caused by their
Inventory turnover
0
1.5
3
4.5
6
7.5
9
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
Days supply of inv.
0
30
60
90
120
150
180
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
43
significant expansion, opening an aggregate of 360 new stores. This directly correlates to
increases in inventory which ANF could not offset by sales. In conclusion, most firms can
compare their current and quick ratios to inventory turnover. This comparison indicates if
inventory is the cause of a major variation. If a firm experiences high inventory turnover
then this would have a direct correlation with a low current ratio since inventory is apart
of current assets. This will also signify a low DSI which is what firms aim to achieve to
ensure money is not tied up in inventory.
Working Capital turnover ratio
Working capital turnover is a measure of the capacity of a dollar of working capital
(current assets – current liabilities) to generate sales. The desirable amount for a firm
would be a high ratio since it is indicative of high sales revenue for every dollar of
working capital.
2002 2003 2004 2005 2006 URBN 8.45 4.16 4.64 4.37 4.34ANF 3.38 2.74 2.45 5.55 4.06JCG 19.86 20.21 14.93 66.09 13.11
As visible from the above table, URBN and ANF maintain fairly consistent ratios
compared to JCG. In 2005, JCG possessed an unusually high ratio for the following
reason: JCG had almost identical current assets and liabilities totals which produced a
current ratio of 1.09. This indicates that they have an extremely large portion of their
financing from debt and
consequently, a significant payables
balance. At the end of fiscal 2005
(01/31/95), payables represented
52% of current liabilities for JCG.
Beginning in the third quarter of
fiscal 2006 (10/05), they
renegotiated terms on their notes
payable and financed it through an
initial public offering of their common stock. This indicates that they are attempting to
Working Capital turnover
0
10
20
30
40
50
60
70
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
44
eliminate further financing from debt and therefore, generate higher amounts of working
capital. It is to be noted that not only in the case of JCG but any firm who relies heavily
on debt financing requires a significant portion of liquidity (i.e. cash flow from
operations) to pay interest and principal on debt. As a result, this reduces the funds
accessible to working capital. In conclusion, a high working capital turnover ratio signifies
higher sales, higher current assets and lower current liabilities which are what firms aim
to achieve. However, situations such as JCG would signify inefficient operations and place
such firms at competitive disadvantages.
Overall Liquidity Evaluation
The decrease in receivables turnover coupled with the decrease in inventory
turnover are the main issues URBN should be concerned about. The liquidity effect of a
decrease in receivables turnover is that it takes longer for URBN to convert receivables
into cash. To ensure URBN was not affected by this, we computed a quick asset ratio
that omits accounts receivables as a current asset. The table below illustrates our results.
2002 2003 2004 2005 2006 Quick Asset w/o A/R 0.69 1.80 1.51 1.58 1.44
This graph can be interpreted as follows: if URBN hypothetically could not collect
from their accounts receivables balance, they still can satisfy their short term liabilities
obligation disregarding 2002. With that being said, we are confident that their decreasing
receivables turnover will not have an effect on their operations and therefore, eliminate
any emergency measures such as using short-term debt to sustain operations.
Liquidity 2002 2003 2004 2005 2006 Opinion Current 2.01 3.29 3.04 2.93 2.89 Positive
Quick 0.79 1.87 1.63 1.67 1.44 Positive Receivables turnover 84.51 129.59 81.71 98.97 76.24 Negative
DSO 4.32 2.87 4.47 3.69 4.79 Negative Inventory turnover 5.73 5.44 5.29 4.94 4.58 Negative
DSI 63.73 67.11 68.93 73.89 79.62 Negative Working Capital 8.45 4.16 4.64 4.37 4.34 Positive
45
Profitability ratios
The principal objectives of profitability analysis are to evaluate four critical factors
related to profits: 1) operating efficiency; 2) asset productivity; 3) rate of return on
assets; and 4) rate of return on equity.
Operating Efficiency
A firm should attempt to achieve a given sales volume with the minimum possible
cost. Operating efficiency results are measured by relating expense items on the income
statement to sales on a percentage basis. With amounts converted to a percentage
basis, it is easier to pinpoint areas of improvement or deterioration in profitability.
Gross Profit Margin
To calculate gross profit, you subtract the cost of goods sold from your total sales.
Then to find your gross profit margin, you would divide your gross profit by sales. The
higher the margin, the better because it indicates that the company is trying to decrease
their costs of goods sold to achieve a higher profit.
2002 2003 2004 2005 2006 URBN 32.50% 35.66% 38.92% 40.92% 41.07%
ANF 59.88% 61.45% 63.42% 66.36% 41.08%JCG 41.58% 38.54% 36.19% 40.46% 41.75%
Urban Outfitters margin has
steadily increased over the past five
years and is a solid indictor of
operating efficiency. Both ANF and
JCG have experienced decreases in
their gross profit margins.
Abercrombie experienced a 25% drop
in their margin from 2005 to 2006, meaning that they went from $0.66 of every dollar to
$0.41 of every dollar that flowed into gross profits. J Crew experienced a steady decline
from 2002 to 2004 which can be attributed to their inefficient operations and,
Gross Profit Margin
30%
40%
50%
60%
70%
2002 2003 2004 2005 2006
URBN
ANF
JCG
AVG
46
consequently, reported net losses for each of the three fiscal periods. From 2004 to
2006, they managed to turn things around and produce a margin near 42% in fiscal
2006 due primarily to the following reason: JCG changed their operating strategy to
focus primarily on customer retention rather than growth and development. The graph
below provides a visual illustration.
Fiscal year Stores at beginning of year Stores at end of year2002 105 1362003 136 1522004 152 1542005 154 1562006 156 159
By limiting expansion, they were able to stabilize inventory costs which are directly
related to COGS. Given their increase in sales during fiscal 2004 to 2006 explains why
this ratio increased during the specified period. As a whole, apparel firms have
experienced declining gross profit margins during 2002 to 2006 which justifies the
volatile nature of this industry.
Operating Expense Margin
2002 2003 2004 2005 2006 URBN 25% 25% 24% 23% 22%
ANF 40% 42% 44% 49% 47%JCG 39% 39% 41% 36% 33%AVG 39.50% 40.50% 42.50% 42.50% 40%
The operating expense margin is the measure of expenses that occur when there
is a dollar of sales. Firms want this particular ratio to decrease over time because it
would indicate that management is striving to control costs which in turn increases
profits. This ratio for URBN has declined steadily during 2002 thru 2006 for the following
reason: sales increased at a greater rate than operating costs. The table below provides
a visual illustration of the percentage change in sales and operating costs from year to
year.
47
2002-2003 2003-2004 2004-2005 2005-2006% change in sales 21.15% 29.71% 50.95% 31.94%% change in operating costs 19.56% 25.97% 43.40% 26.54%
From 2002 to 2004 both ANF and JCG experienced a steady increase in their
operating expense ratios. This means that they were earning fewer profits as their
operating expenses increased. After 2004, JCG managed to turn things around which led
to a significant drop in their operating expense ratio for the following reason: they
changed their operating strategy mentioned above to avoid expansion and concentrate
on customer retention. Abercrombie experienced just the opposite when they continued
to experience an even sharper increase in their operating expense ratio following 2004.
Since ANF opened an average of 99 stores during this span, this provides sufficient
evidence as to why their operating costs increased until 2006 when they opened their
least number of stores (63). The table below provides a visual illustration.
Fiscal year Stores at beginning of year Stores at end of year2002 354 4912003 491 5972004 597 7002005 700 7882006 788 851
As a whole, this ratio was stable for
firms within this industry for the
following reason: this industry is
mature, highly competitive, and,
therefore, has slim prospects for
growth. Given these factors, this
ratio will remain constant since
growth signifies higher operating
expenses.
Operating Expense Ratio
20%
30%
40%
50%
60%
2002 2003 2004 2005 2006
URBN
ANF
JCG
AVG
48
Net Profit Margin
2002 2003 2004 2005 2006 URBN 4.30% 6.48% 8.82% 10.93% 11.97%
ANF 12.21% 12.20% 11.99% 10.71% 11.99%JCG -1.41% -5.28% -7.27% -12.47% 0.40%AVG 5.54% 3.46% 2.36% -0.88% 6.20%
Net profit margin is basically the bottom line for a lot of firms. This ratio
unforgiving shows what percentage of every sales dollar makes its way all the way to net
income. In a competitive apparel industry where brand image is paramount, URBN does
a superior job maintaining and improving its net profit margin. In fact, URBN managed to
nearly triple their net profit margin from 4% to 12% over the last 5 years. Something
very important to keep in mind is the fact that URBN is relatively new to the market, and
it is easier to grow a small business versus an established one. Nevertheless, URBN is off
to a great start, and this rapid increase in their net profit margin has yet to level off.
Abercrombie has maintained a somewhat steady net profit margin. There was a slight
decrease from 2002 to 2005 before they turned it around in 2006. J Crew has been
experiencing major problems in this area. From 2002 to 2005 they were operating at a
loss that became heavier as time progressed. This was due to decreases in sales both in
2003 and 2004 of 1.5% and 13.8%, respectively. In 2006 they remedied this problem by
altering their operating strategy discussed above to bring their net profit margin back in
the black. As an industry average, it is hard to draw any conclusions in relation to URBN
due to the lackluster and sporadic performance of JCG which skews the data downwards.
Urban Outfitters net profit margin will eventually reach its pinnacle then level off and
report fairly consistent margins thereafter.
49
Net Profit Margin
-15%
-10%
-5%
0%
5%
10%
15%
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
Asset Productivity
Sales divided by assets measures the revenue productivity of resources employed
by a firm. The revenue productivity of total resources is an important factor in evaluating
profitability. Asset productivity is measured by asset turnover which is computed as sales
divided by total assets.
Asset Turnover
This ratio states the following: for each dollar of the firm’s assets, it generates a
return equal to the asset turnover. In other words, this will explain if management is
efficiently using its assets to generate sales. Firms aim to achieve a ratio greater than
one since it indicates sales are greater than the assets used to generate such sales.
2002 2003 2004 2005 2006 URBN 1.79 1.51 1.43 1.49 1.42ANF 1.77 1.36 1.23 3.63 3.62JCG 1.94 2.2 2.22 2.75 2.74AVG 1.86 1.78 1.73 3.19 3.18
Urban Outfitters operates at a lower asset turnover ratio than its competitors. This
is a natural effect due to the relatively smaller size of URBN in relation to its competitors.
Their ratio experiences a slight decrease over this period which indicates a slight inability
to match their sales growth with their asset growth. Abercrombie was facing the same
problem as URBN until 2005 when they purchased 88 new stores. Consequently, this
generated more sales which are represented in their asset turnover ratio. J Crew
50
experienced a steady increase in their asset turnover which is ideal for management
since this indicates that they are steadily generating more sales based on their asset
basis and provides justification to their revised operating strategy. As a whole, this
industry experienced a steady increase in asset turnover since firms operate under leaner
inventories given the ambiguity in fashion trends.
Asset Turnover
0
1
2
3
4
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
Return on Assets (ROA)
Profitability is affected by operating efficiency and asset productivity. Return on
assets is a ratio that measures profitability using both the profits earned and assets used
by a firm. Return on assets is computed as net income divided by total assets.
2002 2003 2004 2005 2006 URBN 7.69% 9.82% 12.58% 16.26% 17%ANF 21.62% 16.60% 14.80% 15.60% 18.66%JCG -3% -12% -17% -36% 1%
This ratio has increased annually for URBN since sales have grown at a greater
proportion than costs. The gross profit and operating expense margin outputs are
directly associated with this ratio. The three ratios are graphically presented below
followed by the ROA graph.
URBN 2002 2003 2004 2005 2006 Gross profit margin 32.50% 35.66% 38.92% 40.92% 41.07%Operating expense margin 25% 25% 24% 23% 22%
ROA 7.69% 9.82% 12.58% 16.26% 17.00%
51
ROA
-40%
-30%
-20%
-10%
0%
10%
20%
30%
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
Abercrombie leads the industry with the highest ROA over the past five years, but
URBN with exception to the first two years is a mirror image. J Crew has generated a loss
from 2002 to 2005 due to decreasing sales. Abercrombie hit a five year low in 2004 with
a 14.8% ROA, a 6.82% decrease from 2002. This was due to the following reason: net
income as a percentage of net sales slightly decreased (from 12.4% in 2002 to 12% in
2004) while total assets increased, primarily due to opening an aggregate of 346 new
stores during 2002 thru 2004. Abercrombie was able to increase their ROA following this
decrease to 18.66% in 2006 due to opening fewer stores while achieving a 38% increase
in net sales from 2005 to 2006, their biggest increase in net sales during this time frame.
J Crew reported negative returns primarily due to their decrease in net sales during 2002
thru 2004. They were able to increase sales by 20.6% in 2006 which justifies their only
positive return during the five year span. Overall, this industry reports positive returns on
average since apparel firms operate under leaner inventories which allow them to
decrease their asset basis. However, it is possible for firms to operate under lean
inventories but still report a negative return since this industry is highly fragmented and
the only way to achieve positive results is to establish a market niche. J Crew, given the
above results, is still trying to find theirs.
52
Return on Equity (ROE)
Another rate of return measure that is significant to the financial management of a
firm is ROE. This ratio is computed as net income divided by owner’s equity and
measures the profitability of the owners’ interest in total assets. Return on equity is
influenced by profit margin, asset turnover, and the relationship between total debt and
owners’ equity. If a firm increases its assets with debt financing, this would have an
adverse effect on owner’s equity since it would represent a smaller percentage of assets
funded by equity. As profits increase in this case, ROE would also increase.
2002 2003 2004 2005 2006 URBN 10.29% 12.22% 16.67% 22.50% 23.32%ANF 27.97% 26.45% 23.88% 32.33% 33.56%JCG 3% 10% 11% 17% -1%
This table illustrates mixed results for all three firms. First, URBN increased their
ROE in each of the last five years. This is interesting since they rely heavily upon equity
financing which will lower this return. However, since URBN is highly dependent upon
equity financing as opposed to debt, this eliminates reporting interest expense on the
income statement. Even though their taxes slightly increase given higher operating
income, they still report higher net income totals which are greater than total owner’s
equity. Abercrombie reported decreases in ROE during 2002 thru 2004, and then
increased almost ten percentage points from 2004 to 2006. This is due to the following
reason: ANF increased their net income by over 54% from 2005 to 2006 since they were
able to stretch their operating costs over a larger asset basis given their 140% increase
in new stores during 2002 to 2006. Their 56% increase in operating income from 2005 to
2006 provides justification as to the implied economies of scale mentioned previously. J
Crew’s return is highly deceptive since they reported net losses until 2006. Also, their
owner’s equity for this entire duration was negative which indicates that they relied
heavily on debt financing. Both negatives would result in a positive which misleads
potential investors. Starting in 2005, they acquired treasury stock to increase stock price
and provide compensation for current shareholders for their previous net losses. Below is
a graphical illustration of all three firms.
53
ROE
-10%
0%
10%
20%
30%
40%
2002 2003 2004 2005 2006
Years
Out
put
URBN
ANF
JCG
AVG
Overall Profitability Evaluation
As an overall evaluation, URBN’s operating efficiency has increased during this
time period due primarily to this: operating costs declined while gross profit increased.
Asset turnover decreased slightly which indicates their asset basis generated fewer sales.
However, this is minimal when compared to return on assets which increased every year.
Profitability 2002 2003 2004 2005 2006 Opinion Gross Profit Margin 32.50% 35.66% 38.92% 40.92% 41.07% Positive
Operating Exp. Margin 25% 25% 24% 23% 22% Positive Net Profit Margin 4.30% 6.48% 8.82% 10.93% 11.97% Positive
Asset turnover 1.79 1.51 1.43 1.49 1.42 Steady ROA 7.69% 9.82% 12.58% 16.26% 17% Positive ROE 10.29% 12.22% 16.67% 22.50% 23.32% Positive
Capital Structure ratios
The capital structure of a firm refers to the sources of financing used to acquire
assets and is shown by the liabilities and owners’ equity section of the balance sheet. In
analyzing capital structure, there are two primary concerns: the amount of debt relative
to owners’ equity and the ability to service the principal and the interest requirements on
debt. The following ratios are useful in evaluating these considerations: debt to equity,
times interest earned, and debt service margin. Since URBN does not have interest
expense nor notes payable, we will only provide an analysis for debt to equity.
54
Debt to Equity
The proportion of total debt relative to equity is a crucial indication of the credit
risk to which a firm is exposed. Credit risk is the possibility that interest and debt
repayment cannot be satisfied with available cash flows.
2002 2003 2004 2005 2006 URBN .34 .24 .33 .38 .37ANF .29 .59 .61 1.07 .80JCG -5.53 -3.73 -1.79 -1.32 -1.42
For URBN, this ratio for 2002 indicates that they have $0.34 of liabilities for every
dollar of owners’ equity. Decreases in this ratio indicate that debt has become a smaller
proportion of total financing and vice versa. Urban Outfitters has maintained a low and
constant debt to equity ratio throughout this time period which signifies that they rely
heavily on equity financing. This heavy reliance is evident in their annual reporting of
interest income which accounts for the interest accrued on their securities. This also
provides justification as to why they do not disclose pertinent interest rates on their debt
financing since their reliance on it is nearly obsolete. This will become relevant in the cost
of capital discussion presented later.
Debt to Equity
-6
-5
-4
-3
-2
-1
0
1
2002 2003 2004 2005 2006
Years
Out
put URBN
ANF
JCG
Abercrombie increased their total liabilities by over 36% while their owners’ equity
decreased by 22% in 2005 and provides justification as to their sharp debt to equity
increase in 2005. This is due to the following reason: ANF used excess cash to
repurchase 11.2 million shares of common stock for $434.7 million which is 65% of
55
owners’ equity. They also opened 88 new stores during fiscal 2005 which had a
significant impact on their payables account given increases in merchandise costs. J Crew
is the misfit of the group which reported negative ratios for all five years due to the
following reason: they rely heavily on debt financing, so much so that their total liabilities
are greater than total assets which indicate owners’ equity has to be negative to account
for this discrepancy.
Capital Structure 2002 2003 2004 2005 2006 Opinion Debt to Equity 0.34 0.24 0.33 0.38 0.37 Steady
Ratio Analysis with Inclusion of $516 Million as Capital Lease
When URBN capitalizes their leases, it creates an excess expense of $516 million.
This simply translates into an increase in depreciation and interest expenses.
Depreciation expense is reported on the income statement, but has a permanent
Accumulated Depreciation account on the balance sheet. Accumulated depreciation is a
contra, non- current asset. Interest expense is deducted from income from operations on
the income statement, but since URBN reports interest income instead, this expense will
be netted against interest income and consequently, decrease net income and retained
earnings. Also, this inclusion increases current liabilities given the current portion of long
term debt. Interest expense for 2005, the initiation for lease capitalization, totaled $29
million and decreases accordingly since payments are going towards more principal and
less interest. Given this minor effect, we will not analyze any liquidity ratios, but instead
provide analysis for the following: net profit margin, return on assets (ROA), and debt
service margin ratios.
56
Net profit margin with $516M
This ratio indicates the amount of every sales dollar that is retained as net income.
Urban Outfitters retained $.11 and $.12 cents of 2005 and 2006 sales dollars,
respectively before lease capitalization recognition. When the $516M is included, URBN
retains $.09 and $.107 cents of 2005 and 2006 sales dollars, respectively. This inclusion
had the following effect on this ratio: interest expense for both years was netted against
interest income to create a net interest expense of $26.45M in 2005 and $20.74M in
2006. This was deducted from income from operations and consequently, produced a
lower income before taxes total. Assuming a 39% tax rate in both years, net income
totaled $75.48M and $116.9 in 2005 and 2006, respectively. Compared to net income
before this inclusion, this lowered
net income by 16.6% and 10.6% in
2005 and 2006, respectively.
The graphical illustration to
the left is due to the following: since
URBN does not pay dividends, net
income totals for 2005 and 2006 will
flow into retained earnings. Given
lower retained earnings, URBN will
have less liquidity and consequently, fewer options for growth and development.
Net Profit Margin with $516M
8%
9%
10%
11%
12%
13%
2005 2006
Years
Out
put
Before
After
57
ROA with $516M
This ratio indicates how much of every dollar of total assets is retained as net
income. It is derived by taking net income from the current year divided by total assets
from the previous year. Urban Outfitters retained $.16 and $.17 cents of 2005 and 2006
total asset amounts, respectively before lease capitalization recognition. When the $516M
is included, URBN retains $.245 and $.23 cents of 2005 and 2006 total asset amounts,
respectively. The graph to the right provides a
visual illustration. This inclusion had the
following effect on this ratio: accumulated
depreciation is netted against total assets to
produce a lower total. Since net income is
divided by a lower total asset amount, it
indicates a higher percentage of total assets that
is retained in net income. This actually benefits
URBN since this indicates they are operating
more efficiently by accruing a larger return on their asset basis.
Debt Service Margin with $516M
This ratio measures the cash flow
generating abilities of a firm versus
its current portion of notes payable.
This inclusion will positively affect
this ratio since depreciation is added
back while interest expense is
deducted. Annual depreciation totals
$51.6 million while interest expense
is $29 million and $26 million for
2005 and 2006, respectively. Consequently, net operating cash flows become $172.57
million and $174.56 million which increases net operating cash flows by 15% and 17%
for 2005 and 2006, respectively. The graph to the left is a visual illustration. This
indicates that URBN can pay their current portion of long term debt from operating cash
flows easier than before. Under this situation, it would benefit them to capitalize their
ROA with $516M
15%
18%
21%
24%
27%
30%
2005 2006
Years
Out
put
Before
After
Debt Service Margin with $516M
3
3.5
4
4.5
5
2005 2006
Years
Out
put
Before
After
58
leases since this ratio is what creditors primarily rely upon before loaning funds for the
following reason: this ratio is an indicator of the ability, or lack thereof, of a firm to cover
its day to day operations and pay short term debts and interest.
Internal and Sustainable Growth Rates
A firm’s internal growth rate (IGR) is the maximum growth rate possible while
keeping its profitability and financial structure constant. A firm’s sustainable growth
rate (SGR) is the maximum rate of growth without borrowing additional equity. Internal
and sustainable growth rates are used as benchmarks for a firm’s growth and
development and, therefore, are necessary for firm valuation since a firm’s growth rate
considers several financial ratios in order to conduct an accurate valuation. To compute
IGR, multiply the firm’s ROA by the dividend payout ratio. To compute SGR, take IGR
and multiply by the leverage which is (1 + D/E). The following are URBN’s IGR and SGR.
2002 2003 2004 2005 2006 IGR .08 .10 .13 .16 .17SGR .11 .12 .17 .18 .19
If a firm’s debt to equity ratio is below one, SGR will always be greater than IGR.
This graph indicates that URBN has increased net income compared to total assets in
each year. The graph below displays their net income and operating costs as
percentages of net sales.
2002 2003 2004 2005 2006 Net income 4.30% 6.48% 8.82% 10.93% 11.98% Operating costs 25.26% 24.93% 24.21% 23.00% 22.06%
This illustrates that they have decreased their operating costs in direct proportion
to increasing their sales, and consequently, net income totals. In conclusion, URBN’s IGR
and SGR for 2002 thru 2006 have increased due to achieving economies of scale.
59
Common Size Income StatementUrban Outfitters Forecast Financial Statements
2002 2003 2004 2005 2006 AVG. ASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%COGS 67.43% 64.33% 61.07% 59.08% 58.92% 62.97% 62.62% 62.27% 61.92% 61.57% 61.21% 60.86% 60.51% 60.16% 59.81%Gross profit 32.57% 35.67% 38.93% 40.92% 41.08% 37.03% 37.38% 37.73% 38.08% 38.43% 38.79% 39.14% 39.49% 39.84% 40.19%Operating expenses 25.26% 24.93% 24.21% 23.00% 22.06% 23.09% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00% 23.00%Operating Income 7.31% 10.74% 14.72% 17.92% 19.02% 14.03% 14.38% 14.73% 15.08% 15.43% 15.79% 16.14% 16.49% 16.84% 17.19%Income before income taxes 7.23% 10.90% 14.83% 18.14% 19.45%Income taxes 2.93% 4.41% 6.00% 7.21% 7.47% 5.53% 5.67% 5.80% 5.94% 6.08% 6.22% 6.36% 6.50% 6.64% 6.77%Net income 4.30% 6.48% 8.82% 10.93% 11.98% 8.50% 8.50% 8.71% 8.93% 9.14% 9.35% 9.57% 9.78% 9.99% 10.21% 10.42%% change from yr to yr 2.18% 2.34% 2.11% 1.04% 1.92% 0.21%
URBNIncome Statement Data: Forecast Financial Statements
2002 2003 2004 2005 2006 ASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Net sales 348,958,000 422,754,000 548,361,000 827,750,000 1,092,107,000 822,739,333 8.28% 1,182,494,567 1,280,363,005 1,386,331,464 1,501,070,338 1,625,305,504 1,759,822,918 1,905,473,583 2,063,178,937 2,233,936,677 2,418,827,077COGS 235,311,000 271,963,000 334,888,000 489,000,000 643,501,000 744,654,716 801,780,521 863,261,447 929,427,084 1,000,631,746 1,077,256,304 1,159,710,161 1,248,433,358 1,343,898,848 1,446,614,925Gross profit 113,647,000 150,791,000 213,473,000 338,750,000 448,606,000 437,839,850 478,582,484 523,070,017 571,643,254 624,673,759 682,566,614 745,763,423 814,745,579 890,037,829 972,212,151Operating expenses 88,149,000 105,392,000 132,767,000 190,384,000 240,907,000 271,973,750 294,483,491 318,856,237 345,246,178 373,820,266 404,759,271 438,258,924 474,531,155 513,805,436 556,330,228Operating Income 25,498,000 45,399,000 80,706,000 148,366,000 207,699,000 165,866,100 184,098,992 204,213,780 226,397,076 250,853,493 277,807,343 307,504,498 340,214,423 376,232,393 415,881,924Income before income taxes 25,222,000 46,073,000 81,304,000 150,192,000 212,397,000Income taxes 10,215,000 18,660,000 32,928,000 59,703,000 81,601,000 65,354,062 72,538,131 80,463,699 89,204,295 98,840,539 109,460,813 121,161,997 134,050,264 148,241,956 163,864,545Net income 15,007,000 27,413,000 48,376,000 90,489,000 130,796,000 100,512,038 111,560,861 123,750,081 137,192,781 152,012,954 168,346,529 186,342,501 206,164,160 227,990,437 252,017,379OI/NI 1.70 1.66 1.67 1.64 1.59 1.65
2004 20.00% 548,361,000 109,672,2002005 35.00% 827,750,000 289,712,5002006 45.00% 1,092,107,000 491,448,150
Total: 890,832,850 8.28%
Figure 1-1
60
BALANCE SHEET Forecast Financial Statements2002 2003 2004 2005 2006 AVERAGEASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
AssetsCurrent assets:Cash and cash equivalents 28,251,000 72,127,000 67,194,000 29,731,000 49,912,000 82,507,435 89,336,113 96,729,961 104,735,757 113,404,148 122,789,973 132,952,609 143,956,351 155,870,810 168,771,362Marketable securities 32,000 7,379,000 19,979,000 125,953,000 141,883,000 130,263,215 141,044,370 152,717,821 165,357,417 179,043,123 193,861,517 209,906,347 227,279,117 246,089,734 266,457,200Acct. Recievables 4,129,000 3,262,000 6,711,000 8,364,000 14,324,000 14,387,088 15,577,826 16,867,116 18,263,112 19,774,647 21,411,284 23,183,376 25,102,134 27,179,696 29,429,207Inventories 41,086,000 50,006,000 63,247,000 98,996,000 140,377,000 147,760,718 165,603,622 180,916,868 191,839,213 206,655,915 225,725,666 246,214,629 265,084,811 285,360,618 310,117,411Prepaid expenses and other c.a. 5,870,000 8,633,000 13,872,000 20,123,000 33,993,000Deferred taxes 2,781,000 4,358,000 4,832,000 4,701,000 4,694,000Total current assets 82,149,000 145,765,000 175,835,000 287,868,000 385,183,000 415,329,405 455,317,467 494,608,703 531,493,560 574,421,546 623,929,194 677,375,227 731,930,152 790,844,128 857,436,953
Noncurrent Assets:Property and equipment 105,505,000 108,847,000 146,826,000 192,792,000 299,291,000Marketable securities 0 15,640,000 52,315,000 63,457,000 64,748,000Deferred income taxes and other 7,448,000 8,925,000 9,526,000 12,567,000 19,983,000Total Non Current Assets 112,953,000 133,412,000 208,667,000 268,816,000 384,022,000 429,309,571 459,227,536 495,628,057 540,699,539 586,510,957 633,087,176 683,677,332 741,769,089 804,824,927 870,296,673Total Assets 195,102,000 279,177,000 384,502,000 556,684,000 769,205,000 844,638,976 914,545,003 990,236,760 1,072,193,098 1,160,932,503 1,257,016,370 1,361,052,560 1,473,699,241 1,595,669,055 1,727,733,626
Liabililties Current liabilities:Accts. Payable 20,838,000 19,186,000 27,353,000 39,102,000 41,291,000 55,212,751 59,782,400 64,730,254 70,087,613 75,888,372 82,169,226 88,969,912 96,333,452 104,306,431 112,939,289Accrued compensation 3,928,000 5,197,000 7,756,000 9,584,000 12,673,000Accrued expenses and other C.L. 16,064,000 19,870,000 22,653,000 49,585,000 79,544,000Total current liabilities 40,830,000 44,253,000 57,762,000 98,271,000 133,508,000 140,724,954 152,371,968 164,982,941 178,637,653 193,422,489 209,430,982 226,764,409 245,532,426 265,853,767 287,856,991
Non Current Liabilities:Defferred rent 8,384,000 10,539,000 36,610,000 56,169,000 74,817,000Total LT Liabilities 8,384,000 10,539,000 36,610,000 56,169,000 74,817,000 82,738,257 89,586,038 97,000,571 105,028,764 113,721,405 123,133,488 133,324,555 144,359,080 156,306,871 169,243,514Total Liabilities 49,214,000 54,792,000 94,372,000 154,440,000 208,325,000 223,463,210 241,958,006 261,983,512 283,666,417 307,143,894 332,564,470 360,088,965 389,891,507 422,160,639 457,100,505
O/ECommon stock 2,000 4,000 8,000 16,000 16,000Additional Paid-in-cap 17,872,000 67,160,000 83,279,000 109,422,000 138,051,000Retained Earnings 129,116,000 156,529,000 204,905,000 295,394,000 426,190,000Accum. Other comp. income -1,102,000 692,000 1,938,000 2,470,000 528,000Total O/E 145,888,000 224,385,000 290,130,000 402,244,000 560,880,000 621,175,766 672,586,997 728,253,248 788,526,682 853,788,609 924,451,900 1,000,963,595 1,083,807,734 1,173,508,416 1,270,633,121Total Liabilities + O/E 195,102,000 279,177,000 384,502,000 556,684,000 769,205,000 844,638,976 914,545,003 990,236,760 1,072,193,098 1,160,932,503 1,257,016,370 1,361,052,560 1,473,699,241 1,595,669,055 1,727,733,626
Debt to Equity 0.34 0.24 0.33 0.38 0.37 0.36TL to TA 0.25 0.20 0.25 0.28 0.27 0.26
Figure 1-2
61
Common Size Balance Sheet Forecast Financial Statements
2002 2003 2004 2005 2006 AVERAGEASSUME 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016AssetsCurrent assets:Cash and cash equivalents 14% 26% 17% 5% 6% 14% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%Marketable securities 0% 3% 5% 23% 18% 10% 15% 15% 15% 15% 15% 15% 15% 15% 15% 15%Acct. Revievables 2% 1% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2%Inventories 21% 18% 16% 18% 18% 18% 17% 18% 18% 18% 18% 18% 18% 18% 18% 18%Prepaid expenses and other c.a. 3% 3% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4%Deferred taxes 1% 2% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1%Total current assets 42% 52% 46% 52% 50% 48% 49% 50% 50% 50% 49% 50% 50% 50% 50% 50%
Non Current Assets:Property and equipment 54% 39% 38% 35% 39% 41% 37% 37% 37% 37% 37% 37% 37% 37% 37% 37%Marketable securities 0% 6% 14% 11% 8% 8% 11% 11% 11% 11% 11% 11% 11% 11% 11% 11%Deferred income taxes and other 4% 3% 2% 2% 3% 3% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2%Total Assets 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Liabililties Current liabilities:Accts. Payable 42% 35% 29% 25% 20% 30% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25%Accrued compensation 8% 9% 8% 6% 6% 8% 7% 7% 7% 7% 7% 7% 7% 7% 7% 7%Accrued expenses and other C.L. 33% 36% 24% 32% 38% 33% 31% 31% 31% 31% 31% 31% 31% 31% 31% 31%Total current liabilities 83% 81% 61% 64% 64% 71% 63% 63% 63% 63% 63% 63% 63% 63% 63% 63%
Non Current Liabilities:Defferred rent 17% 19% 39% 36% 36% 29% 37% 37% 37% 37% 37% 37% 37% 37% 37% 37%Total Liabilities 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Stockholders Equitycommon stock 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%Additional Paid-in-cap 12% 30% 29% 27% 25% 25% 27% 27% 27% 27% 27% 27% 27% 27% 27% 27%Retained Earnings 89% 70% 71% 73% 76% 76% 73% 73% 73% 73% 73% 73% 73% 73% 73% 73%Accum. Other comp. income -1% 0% 1% 1% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%Total stockholders equity 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Figure 1-3
62
Consolidated Statement of Cash FlowsURBN Forecast Financial Statements
2002 2003 2004 2005 2006 AVERAGE 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Cash flows from operating activities:Net income 15,007 27,413 48,376 90,489 130,796 62,416 100,512,038 111,560,861 123,750,081 137,192,781 152,012,954 168,346,529 186,342,501 206,164,160 227,990,437 252,017,379Adjustments to reconcile net income tonet cash provided by operating activities:Depreciation and amortization 15,462 19,950 25,010 31,858 39,340 26,324Provision for deferred income taxes (1,274) (3,079) (1,132) (2,884) (6,870) (3,048)Tax benefit of stock option exercises 323 2,248 7,581 13,468 13,399 7,404
Changes in assets and liabilities:Increase in receivables (691) 887 (3,437) (1,635) (6,002) (2,176)Increase in inventories (6,348) (8,735) (13,125) (35,651) (41,597) (21,091)Increase in prepaid expenses and other assets 1,120 (2,718) (5,148) (6,231) (14,201) (5,436)Increase in accounts payable, accruedexpenses and other liabilities 9,141 12,464 22,028 59,873 33,804 27,462
NET CASH PROVIDED BY OPERATING ACTIVITIES 32,740 48,430 80,153 149,995 149,191 92,102 176,336,909 195,720,809 217,105,405 240,689,090 266,689,393 295,344,788 326,916,668 361,691,508 399,983,223 442,135,753
Cash flows from investing activities:Capital expenditures (22,309) (28,886) (43,455) (75,141) (127,730) (59,504)Purchases of marketable securities (119,065) (406,098) (586,093) (416,018) (381,819)Sales and maturities of marketable securities 307 56,710 330,652 530,301 396,304 262,855
NET CASH USED IN INVESTING ACTIVITIES (22,002) (91,241) (118,901) (130,933) (143,675) (101,350)FCF Actual 10,738 (42,811) (38,748) 19,062 5,516
Cash flows from financing activities:Exercise of stock options 1,281 5,496 8,542 6,917 15,230 7,493Issuance of common shares, net of issuance costs 41,546 41,546
NET CASH PROVIDED BY FINANCING ACTIVITES 1,281 47,042 8,542 6,917 15,230 15,802
Effect of exchange rate changes on cash and cash equival (54) 645 398 433 (565) 171Increase (decrease) in cash and cash equivalents 11,965 4,876 (29,808) 26,412 20,181 6,725Cash and cash equivalents at beginning period 16,286 28,251 33,127 3,319 29,731 22,143
CASH AND CASH EQUIVALENTS AT END OF PERIOD 28,251 33,127 3,319 29,731 49,912 28,868
Supplemental cash flow information:Cash paid during the year for:Interest 31 152 126 18 82Income taxes 9,417 20,146 28,003 44,970 79,182 36,344
Figure 1-4
63
Common Size Statement of Cash FlowsURBN Forecast Financial Statements
2002 2003 2004 2005 2006 AVERAGE 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Cash flows from operating activities:Net income 46% 57% 60% 60% 88% 62% 57% 57% 57% 57% 57% 57% 57% 57% 57% 57%Adjustments to reconcile net income tonet cash provided by operating activities:Depreciation and amortization 47% 41% 31% 21% 26% 33%Provision for deferred income taxes -4% -6% -1% -2% -5% -4%Tax benefit of stock option exercises 1% 5% 9% 9% 9% 7%
Changes in assets and liabilities:Increase in receivables -2% 2% -4% -1% -4% -2%Increase in inventories -19% -18% -16% -24% -28% -21%Increase in prepaid expenses and other assets 3% -6% -6% -4% -10% -4%Increase in accounts payable, accruedexpenses and other liabilities 28% 26% 27% 40% 23% 29%
NET CASH PROVIDED BY OPERATING ACTIVITIES 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Figure 1-5
64
The figures listed above correlate with the following discussions:
Forecasting Methodology
In order to add another source to the valuation process, we forecasted ten years
of financials to help support our final valuation of URBN. To do this accurately and
effectively, we were forced to make some key assumptions in order to predict future
performance. We only forecasted out main line items that would be relevant to our final
valuation decision. We also disregarded any line items that were not forecast-able, too
volatile, or simply irrelevant. The following paragraphs will serve as a walkthrough, as
well as provide a brief explanation of our thought processes while making these
assumptions.
Income Statement
Refer to Figure 1 – 1
To begin forecasting ten years’ worth of financials, we decided to do the income
statement first because many of the line items would be independent of the other
statements. For many of the line items, we simply took a 5 year average growth rate
based on the common sized income statement. Net Sales was forecasted by taking a
weighted average of URBN’s sales for the last three years. The table below depicts this.
2004 20% 548,361,000 109,672,200 2005 35% 827,750,000 289,712,500 2006 45% 1,092,107,000 491,448,150
Total 890,832,850
Then, we derived a percentage change in sales from this total and the average sales
during 2004 to 2006 (8.28%) which was used to grow sales per year thru 2016. Next, we
worked backwards and forecasted Net Income. Since this industry is sporadic, we took a
conservative approach. First, we started with a net profit margin of 8.5% in 2007 which
was the average for the five previous years. Second, we chose to grow net profit margin
by .21% for the duration of the forecast. We came up with this growth rate by taking the
percentage point increase in net profit margin for the previous five years. Then, we
65
derived an average (1.92%) and divided it by 9 since the first growth year would be
2008. The table below depicts this:
2002 2003 2004 2005 2006 AverageNet income 4.30% 6.48% 8.82% 10.93% 11.98% 8.50%% increase(decrease) 2.18% 2.34% 2.11% 1.04% 1.92%
Continuing to work backwards, our next line item forecast was Operating Income. We
computed a multiplier of 1.65 from taking the average of Operating Income over Net
Income for the five previous years. The table below depicts this:
Operating and Net Income reported in thousands.
2002 2003 2004 2005 2006 Operating Income 25,498 45,399 80,706 148,366 207,699Net Income 15,007 27,413 48,376 90,489 130,796OI/NI 1.70 1.66 1.67 1.64 1.59
Consequently, to compute Operating Income, we multiplied 1.65 by forecasted Net
Income for each year. We found Income Taxes by subtracting Operating Income from
Net Income.
Our third line item forecast was Operating Expenses. Given that Operating Expenses as a
percentage of Net Sales decreased each year, we used an average for the five previous
years of 23% for all forecasted years. From these second and third forecasted line items,
we were able to derive Gross Profit. Finally, since our initial forecasted line item was Net
Sales, we deducted Gross Profit from Net Sales to derive COGS.
Balance Sheet
Refer to Figures 1 – 2, 1 – 3
Now that we had forecasted out Net Income for ten years, we conducted a
balance sheet forecast. We used on average from our common sized Balance Sheet on
most of our major line items that are included in ratio analysis with exception to: Total
Assets and Total Liabilities. We viewed our Total Assets as the gateway of our Balance
66
Sheet forecast and for that reason, forecasted Total Assets by dividing forecasted Net
Sales for each year by Asset Turnover for 2006 which was 1.4. Second, we derived a
Total Liabilities to Total Assets ratio to initiate our forecasting for Total Liabilities. The
table below depicts this:
Total Assets and Liabilities reported in thousands.
2002 2003 2004 2005 2006 Total Liabilities 49,214 54,792 94,372 154,440 208,325Total Assets 195,102 279,177 384,502 556,684 769,205TL to TA 0.25 0.20 0.25 0.28 0.27
From this, the average for Total Liabilities to Total Assets was .26 which was multiplied
by forecasted Total Assets each year to represent our forecasted Total Liabilities. By
forecasting Total Assets and Total Liabilities, we were able to forecast Owners’ Equity. As
stated above, the remaining major line items were forecasted from the common sized
Balance Sheet.
Statement of Cash Flows
Refer to Figures 1 – 4, 1 – 5
When forecasting out the line items on the Statement of Cash Flows, the only item
that we felt would be possible to forecast was CFFO. Our approach to determining this
number was to take the lowest NI/CFFO percentage from the Statement of Cash Flows.
We decided to rule out 2002’s percentage of 46% due to the proximity to the economic
downturn of 9/11. We were left with 57% which was the percentage in 2003, and flat
lined it through all ten years to provide a conservative forecast in a highly volatile
industry. Then we took the forecasted Net Income for each year over 57% in order to
get the CFFO for each year. We felt that no other trends among the line items could be
identified; therefore, no other line items could be forecasted.
Cost of Capital
We can derive the price of a firm’s stock by using various valuation methods. But
first we need to calculate the inputs for these models which include the cost of equity
and the cost of debt. When combined, they give us the WACC for the firm.
67
Certain calculations are necessary in order to find the cost of equity and the cost
of debt. Regressions were ran to find the cost of equity, but provided an unreasonable
percentage for URBN. We then decided to use the P/B multiple to find our cost of equity.
To find the cost of debt we used the primary rate listed on the Federal Reserve. We also
took into account a revised version based upon lease capitalization to see if we would
come out with a significant difference for our cost of debt.
Our main objective was to calculate WACC in order to determine the overall
profitability for the firm and, also, be an important input for subsequent valuation
models. Shown below is the basic formula to find WACC. The WACC formula includes:
market value of equity (Ve), market value of debt (Vd), market value of the firm
(Vd+Ve), cost of debt (Rd), cost of equity (Re), and the tax rate (T).
( )WACCV
V Vr T
VV V
rd
d ed
e
d ee=
+− +
+( )1
Cost of Debt (Kd)
To find a cost of debt for URBN, we first separated current against long term
liabilities. Our current liabilities consist of the following: Accounts Payable, Accrued
Compensation, and Other Current Liabilities. We used a 3-Month AA Financial
Commercial Paper Rate (5.22%) for Current Liabilities since it takes URBN, on average,
90 days to collect on their Receivables. We used Moody’s Seasoned Baa Corporate Bond
Yield (6.27%) since it represents minimum investment grade status that reflects a low
average default rate. Second, we computed an interest rate by multiplying the respective
percentage of Total Liabilities for each line item by either 5.22% or 6.27%. Based on
this, our Weighted Average Cost of Debt (WACD) came to 5.597%. We also found our
WACD based on lease capitalization. We used the current 15 year mortgage rate
(5.625%) since URBN leases in 15 year intervals. Our lease capitalization WACD came to
5.604%. Based on this fairly identical WACD for both, we will not include lease
capitalization as part of our WACC.
68
Cost of Equity (Ke)
The cost of equity can determine the profitability of a firm’s investments. The
CAPM model along with a statistical analysis of URBN was used to calculate the cost of
equity. This is important for each firm and must be calculated as accurately as possible in
order to value a firm correctly. Also, cost of equity is considered to be the required rate
or return for investors. For instance, any potential projects that the firm considers must
be greater than or equal to the cost of equity or required rate of return so as to satisfy
investors.
Capital Asset Pricing Model (CAPM) & Revised Ke
Ke = Risk Free Rate + Beta(MRP)
Ke for URBN: 20.63% = 5.05% + 3.929(5.25%)
Long-run ROE: P/B = 1 + (ROE-Ke/Ke-g)
Solve for Ke: 6.14 = 1 + (.1880-Ke/Ke-.14)
First, a risk-free rate of 5.05% was chosen based on the most current interest rate of a
1-year constant maturity T-bill. We based it on a one year T-bill because it produced the
highest r-squared for our regression. Regressions using historical stock prices for 24, 36,
48, 60, and 72 months were ran with the monthly returns of the market by observing the
S&P 500 with a risk free rate. After regressions were ran a Beta was found based on the
highest adjusted r squared. We estimated a Beta of 3.929 with an adjusted r squared of
.263. Next, we selected a market risk premium of 5.25 given the instability of the market
and the volatility within our industry. Putting all these calculations together, we found Ke
to be 20.6%.
Revised Ke using P/B multiple
We felt that the estimated cost of equity was an unreasonable value and would
not be an accurate estimate to use in our valuations. Instead, we used the published P/B
multiple to find our cost of equity. We simply found all of our variables from Yahoo
Finance. Our listed price per share was $25.14 and book value per share was listed as
$4.09 to give us a P/B multiple of 6.14. We also found a listed ROE of 18.80% and
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growth rate of 14%. Shown as bullets above, we simply solved for Ke, which we found
to be 14.8%.
Weighted Average Cost of Capital (WACC)
( )WACCV
V Vr T
VV V
rd
d ed
e
d ee=
+− +
+( )1
Before revision: 19.77% = ((223,968,000/4,653,949,500)*.56)*(60.1) + ((4,429,981,500/4,653,949,500)*.206)
After revision:
14.9% = ((223,968,000/4,653,949,500)*.56)*(60.1) + ((4,429,981,500/4,653,949,500)*.148)
First, we assumed that the market value of debt was equal to the book value of liabilities
which was stated as $223,968,000. We also needed to find the market value of equity
which was determined by taking the current share price of URBN and multiplying it by
the current shares outstanding which gave us a value of $4,429,981,500. Then, to
calculate the value of the firm we added both the market value of debt and equity which
gave us a value of $4,653,949,500. From the revision stated above, you can see that we
simply plugged in the numbers that we estimated and used our cost of debt and equity
to find WACC.
Revised WACC
We then estimated a WACC using our revised Ke which came out as 14.9%, which
is lower than our WACC before using regression analysis. We believe that this will provide
a more accurate valuation for free cash flows in the Valuation Analysis section.
Intrinsic Valuation Analysis
We used four intrinsic valuation models to provide the most accurate share price
estimation as of April 1, 2007 which were: Free Cash Flows, Abnormal Earnings Growth
(AEG), Long-Run ROE Perpetuity, and Residual Income (also included were method of
70
comparables). In these valuations we felt it was not appropriate to include revised
estimations based on lease capitalization since WACC differed by 7/1000 of a percent.
Overall, we found that the AEG model provided the most accurate intrinsic
valuation. AEG is based on the idea of increased future earnings, with respect to cost of
equity. For instance, if a firm is about to enter a new industry or specific sector of an
industry, they might measure their future earnings based upon speculation and not
actual earnings. The AEG model would be able to incorporate this idea of speculated
future increases in earnings. Based on this idea, we believe that URBN’s share price is
based more on incremental future earnings than current cash in their possession. (Refer
to Appendix A- Valuations for each model used)
Method of Comparables
The simplest and easiest valuation method to implement is method of
comparables. This method focuses on certain ratios such as price to earnings and price
to book value. In this method, you take averages from the firm’s competitors and use
them to calculate an intrinsic share price for the firm. This method is very inaccurate
because it uses the performance of a firm’s competitors and then applies that average to
the firm, which assumes that each firm is experiencing and operating under the exact
same circumstances.
It is useful because it is quick and easy to calculate, which can allow a potential
investor to easily gauge a firm’s performance without the complications of the other
valuation methods. In order to increase accuracy, negative ratios are excluded from the
calculations. When we used the method of comparables to price URBN, we found that
some of JCG’s ratios were negative and had to be excluded. Therefore, those
comparables that did not include JCG’s ratios were run using ANF’s ratios as the industry
average. Also, we did not calculate the dividend per share (DPS) comparable since URBN
does not pay dividends.
71
PPS EPS BPS EBITDA Shares Outstanding
URBN 26.2 0.79 3.4 219,700,000 165,080,000
ANF 81.81 3.81 11.35 818,300,000 87,690,000
JCG 39.42 0.07 -10.1 162,040,000 58,180,000
Trailing Price/ Earnings
ANF 21.48 JCG N/A(Negative) URBN 17.02 AVG 21.48
The Trailing P/E comparable values URBN at $17.02, which implies that the firm’s shares
are overvalued at $26.20. This value was calculated by taking the current year’s price per
share and dividing it by the EPS from the last period. This average was then multiplied by
URBN’s EPS to calculate the price stated above.
Forward Price/ Earnings
ANF 17.32 JCG 27.17 URBN 13.55 AVG 22.25
The Forward P/E comparable values URBN at $13.55, which indicates that URBN is
overvalued at its current price of $26.20. This price was calculated by taking the current
price per share and dividing it by the forecasted EPS for the next period. Then you take
the industry average and multiply it by URBN’s EPS to get the price listed above.
Price/ Book
ANF 7.21 JCG N/A URBN 24.49 AVG 7.21
72
The Price to Book ratio values URBN at $24.49, which implies that URBN is slightly
overvalued at $26.20. To calculate this number we divided the price per share by the
current book value of equity per share. This number was then multiplied by URBN’s book
value of equity per share to estimate the price.
P.E.G Ratio
ANF 9.76 JCG 0.13 URBN -7.57 AVG 4.94
The Price Earnings Growth Ratio values URBN at -$7.57, which is impossible since a
firm’s stock cannot have a negative value. We will not discuss this comparable in further
detail because it is completely irrelevant in valuing URBN.
Enterprise Value/ EBITDA
ANF 9.08 JCG 18.25 URBN 18 AVG 13.66
The Enterprise Value over EBITDA comparable values URBN at $18.00, saying that URBN
is overvalued at its current price of $26.20. This price was calculated by first computing
the Enterprise Value and then dividing it by EBITDA. Enterprise value is calculated by
taking the market value of equity, adding long term debt and preferred stock and then
subtracting cash equivalents. This number was then multiplied by URBN’s EBITDA and
then divided by the current number of shares outstanding.
Price/ Free Cash Flow
ANF 434.97 JCG 139.63 URBN -5.70 AVG 287.30
73
The Price over Free Cash Flow comparable values URBN at -$5.70, which is impossible
since a firm’s stock cannot have a negative value. We will not discuss this comparable in
further detail because it is completely irrelevant in valuing URBN.
Price/ EBITDA
ANF 8.77 JCG 14.15 URBN 15.25 AVG 11.46
The Price over EBITDA comparable valued URBN at $15.25, which says that URBN is
overvalued at the current price $26.20. This price was calculated by taking the current
share price and dividing it by the firm’s EBITDA. The average of ANF and JCG was then
multiplied by URBN’s EBITDA and then divided by the current number of shares
outstanding.
Free Cash Flows (FCF) Free cash flows represent the cash that a firm is able to generate after laying out
the money required to maintain or expand its asset base. This is important because it
allows a firm to pursue opportunities that enhance shareholder value. If FCF appears to
be negative this could indicate that the firm is making large investments and the
investments presumably will pay off in the long-run. The discounted FCF model used
involves calculating forecasted cash from operations minus forecasted cash from
investments to get FCF to the firm for the 9 forecasted years. The forecasted FCF were
then discounted back to 2006 by multiplying each number by 1/(1+WACC)^t. In the
equation, ‘’t’ stands for the number of years that the FCF is discounted.
After discounting back the FCF we then added all the values to find the total
present value of annual FCF. We then determined a terminal value for our perpetuity.
Terminal value is the future FCF that we believe the firm will gain forever. To determine
a terminal value we first needed to measure FCF growth to help decide what our terminal
value would be. We decided that since there was a constant growth rate of 11-12%, FCF
would grow by 11%. After determining a terminal value for our perpetuity we discounted
it back by 1/(1+WACC)^9. We then needed to find the present value of this perpetuity
74
by discounting it back by using the forecasted year nine factor. Finally, we added the
total present value of FCF plus the present value of the perpetuity to find the value of the
firm.
We subtracted the book value of liabilities to find the value of equity and divided it
by the number of shares outstanding to find the estimated value per share.
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42 (the legend on the right represents different WACC’s)
The sensitivity analysis points out different estimated share prices with varying WACC’s
and growth rates. Based on the graph, the lower the WACC coupled with high growth
rates implies higher share prices. (The observed share price on April 23, 2007 was
$24.93.) Also, this chart implies that the only prices to come close to the observed share
price are when WACC is 13.5% and growth is 10%, and when WACC is 15% and growth
is 12%. The FCF model seems to estimate URBN fairly well, but is very sensitive to
varying WACC’s and growth rates.
Sensitivity Analysis
$0
$10
$20
$30
$40
$50
$60
$70
$80
Growth rate
Shar
e pr
ice 0.135
0.140.150.160.18
0.135 $18.08 $25.37 $33.39 $52.11 $75.51
0.14 $16.35 $21.95 $27.55 $38.74 $49.94
0.15 $13.65 $17.17 $20.24 $25.37 $29.48
0.16 $11.63 $13.98 $15.86 $18.68 $20.70
0.18 $8.82 $10.01 $10.86 $11.99 $12.71
0.08 0.1 0.11 0.12 0.13
75
LR ROE Perpetuity
The long-run residual income perpetuity model calculates the perpetuity of URBN’s
residual income to estimate the intrinsic value of the current stock price. First, we found
the return on equity and growth of book value of equity for each forecasted year. We
then found the averages of ROE and book value growth to determine our perpetuity. We
were then able to plug this into our calculations along with our cost of equity which is
illustrated below:
Intrinsic value = BVE0 (1+ (ROE-Ke)/(Ke-g))
From this equation, you can see that the intrinsic value is directly related to
book value of equity, return on equity, and cost of equity and growth rates. We found an
intrinsic value of $3.40 compared to an observed share value of $24.93 which indicates
URBN is extremely overvalued. We conducted three separate sensitivity analysis while
holding a variable constant for each.
Sensitivity Analysis Constant ROE
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42
Sensitivity Analysis Constant Ke
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42
G -0.04 -0.0551 -0.06 -0.08 -0.1Ke 0.1 $4.45 $4.45 $4.42 $4.31 $4.22
0.13 3.73 3.73 3.72 3.69 3.67 0.148 3.44 3.43 3.43 3.43 3.43 0.16 3.20 3.21 3.21 3.23 3.24 0.18 2.91 2.94 2.95 2.98 3.01
G -0.04 -0.0551 -0.06 -0.08 -0.1ROE 0.12 $2.92 $2.96 $2.97 $3.01 $3.04
0.148 3.44 3.43 3.43 3.43 3.43 0.2 4.39 4.31 4.29 4.21 4.15
0.22 4.75 4.65 4.62 4.51 4.42 0.25 5.30 5.16 5.12 4.96 4.84
76
Sensitivity Analysis Constant G
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42
From the above graphs, you can see that each analysis has URBN highly
overvalued. This model is presumably an accurate measure of share price, but has not
accurately estimated URBN’s observed share price because of a high cost of equity and a
low growth rate.
Residual Income
The residual income model estimates a share price for the firm by discounting the
residual income for each forecasted year. To be able to find residual income for each
forecasted year we first had to find the ending book value of equity for each year by
taking our beginning book value of equity for the current year and adding our EPS.
Normally, you would also subtract DPS as well, but since URBN does not pay dividends it
was not necessary to include it in this equation. After finding the ending book value of
equity for each forecasted year, we then found the normal income, or benchmark, for
residual income by multiplying our beginning book value of equity in the current year (or
ending book value of equity in the past year) by our cost of equity. Next, to find residual
income we subtracted our current year EPS by our normal income for each forecasted
year. We then discounted each residual income value by 1/(1+Ke)^t. We then added up
all of the present values of residual income to find the total present value of residual
income. Next, we found a constant growth rate near -20% for the terminal value of the
perpetuity. We then discounted that back by taking the terminal value over the cost of
equity minus the growth rate to find the ending 2016 dollars, which we then discounted
back by using the 2016 discount rate to find the present value of the perpetuity at the
end of 2006.
ROE .12 .15 .20 .22 .25Ke 0.10 $3.84 $4.50 $5.59 $6.03 $6.69
0.13 3.22 3.77 4.69 5.05 5.60 .148 2.96 3.47 4.31 4.65 5.16 0.16 2.77 3.24 4.03 4.35 4.82 0.18 2.53 2.97 3.69 3.98 4.41
77
Finally to find an estimated share price value we added our beginning book value of
equity per share plus the total present value of residual income plus the present value of
the perpetuity.
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42 (the legend on the right represents different WACC’s)
From the chart above, you can tell that the residual income model found URBN to
be extremely overvalued compared to their observed share price due to high cost of
equity and growth rates. We will not use this model given this high discrepancy amongst
their observed share price and intrinsic value.
AEG
This intrinsic valuation measures increasing earnings with respect to the cost of
equity. First, to find the cumulative dividend earnings, take the previous years dividend
reinvestment rate (DRIP) and add current year EPS. Since URBN does not pay dividends,
we disregarded this. We then calculated normal earnings by growing last years EPS by
the cost of equity for each forecasted year. Finally, to calculate AEG, we subtracted the
cumulative dividend earnings, or in our case EPS, by normal earnings for each forecasted
Sensitivity Analysis
$0
$1
$2
$3
$4
$5
$6
$7
$8
Growth rates
Shar
e pr
ice 0.09
0.10.120.1480.16
0.09 $6.94 $6.51 $6.30 $6.18 $6.10
0.1 $5.99 $5.73 $5.60 $5.52 $5.47
0.12 $4.52 $4.47 $4.44 $4.42 $4.41
0.148 $3.10 $3.19 $3.23 $3.26 $3.28
0.16 $2.65 $2.77 $2.83 $2.87 $2.90
-0.1 -0.2 -0.3 -0.4 -0.5
78
year. We then discounted each of those values by 1/(1+Ke)^t. We then added each
discounted value to find the total present value of AEG.
We had to determine a terminal value for our perpetuity by identifying a trend in
AEG. We estimated that the terminal value for the perpetuity would be -$.06 because the
AEG had been decreasing very slowly throughout the forecast. We then discounted the
terminal value by dividing it by the cost of equity minus the growth rate to calculate the
value of the perpetuity at the end of 2016. Next, we discounted the value of the
perpetuity in 2016 by multiplying it by the forecasted year nine discount rate to find the
present value of the perpetuity for 2007. We then added core EPS (2006 EPS), present
value of AEG, and the present value of the terminal value to find the total average EPS
perpetuity. Finally, to find the intrinsic value, we divided the total average EPS perpetuity
by the capitalization rate which is the cost of equity. Based upon a 14.8% cost of equity
and -20% growth rate, we derived an estimated share price of $17.85.
Overvalued < $ 22.44 Fair valued +/- 10% Undervalued > $27.42 (the legend on the right represents different WACC’s)
Based on the chart above, you can tell that URBN’s share price is slightly overvalued
compared to the observed share price of $24.93. The lower the cost of equity and
growth rates, the closer the observed share price becomes. Like the previous models,
Sensitivity Analysis
$0
$5
$10
$15
$20
$25
$30
Growth rate
Shar
e pr
ice 0.11
0.1350.1480.160.18
0.11 $22.01 $23.64 $24.48 $24.99 $25.33
0.135 $18.37 $19.47 $20.07 $20.44 $20.70
0.148 $16.94 $17.85 $18.36 $18.68 $18.90
0.16 $15.80 $16.58 $17.03 $17.31 $17.51
0.18 $14.22 $14.84 $15.19 $15.43 $15.59
-0.1 -0.2 -0.3 -0.4 -0.5
79
this model implies that URBN is an overvalued firm, but since it comes closest to the
observed share price, we will base our valuation on this model.
Altman Z-scores
Z-score = 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) +
3.3(Earnings before Interest and Taxes/Total Assets) + 0.6(Market Value of Equity/ Book
Value of Liabilities) + 1.0(Sales/Total Assets)
2002 2003 2004 2005 2006 Altman Z-scores 53.57 48.34 29.40 19.51 15.33
It is essential to note that Market Value of Equity was derived by multiplying URBN’s
current share price ($24.93) by number of shares outstanding (165.08 million). This can
be attributed to their declining score performance.
The Altman-Z score is the model we used to assess the credit risk of URBN. As noted
above, it weights Earnings before Interest and Taxes/Total Assets the heaviest since it
clearly reveals how efficiently a firm is operating. The model predicts bankruptcy when
Z<1.81. The range between 1.81 and 2.67 is termed the “gray area.” Urban Outfitters
has a decreasing score throughout the five year duration. This indicates a greater risk to
lenders, but still a score of 15.33 is well above bankruptcy level. If URBN continues to
produce a decreasing score, they will increase their risk for default and increase their
borrowing rate. This is a perfect indicator of apparel firms given the volatility present and
explains our initial Beta estimate close to four.
Analyst Recommendation
Given our in-depth research, analysis, and interpretations of URBN, its
competitors, and the apparel industry, we are well aware and able to provide sound
advice in regards to investment opportunities in URBN. Urban Outfitters has found their
market niche in the apparel industry and are more of a product differentiated than cost
leadership firm. Urban Outfitters has further differentiated itself from competitors by
offering home furnishings and accessories as well as their unique lines of apparel. They
80
intend to establish invaluable bonds between them and their customer basis who
primarily consist of liberal, individualistic teenagers and college aged students who fondly
value fashion. Urban Outfitters operates with two subsidiaries, Anthropologie and Free
People, with Anthropologie targeting middle-aged women. They have invested heavily in
the Pareto principle which implies 20% of customers represent 80% of sales.
Based upon their past five years, they have induced significant growth and expect
to continue this trend. Despite high expectations, this industry is highly fragmented and
competitive. We believe URBN has solidified their market niche and will reach its pinnacle
within the upcoming years, then gradually level off.
Based upon our intrinsic valuations, there is a high degree of certainty that URBN
is significantly overvalued from nearly every model we implemented. Abnormal Earnings
and Long-run Residual Income, the valuation models that are most reliable given their
high r², even indicated URBN was overvalued. Both these models base their valuations
on incremental growth. However, we have come to the conclusion that URBN has
structured their operations to grow unbounded since they invest a significant portion into
growth and development. Most will term what they do as a gamble since investing such
portions into continuing operations is just that given their amateur standing. On the
contrary, there are analysts that would suggest URBN is a solid buy. However, we
strongly oppose this and strongly recommend URBN as a sell option.
In conclusion, we would select the AEG model based upon its close proximity
($17.85) to URBN’s observed share price of $24.93. Again, we insist URBN is an
overvalued firm with a sell opportunity.
81
Appendix A -Valuation AEG
1 2 3 4 5 6 7 8 9 PerpJan 31 2007 Forecast Financial Statements
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016EPS 0.79 0.61 0.68 0.75 0.83 0.92 1.02 1.13 1.25 1.38 1.53Cum-Dividend Earnings 0.68 0.75 0.83 0.92 1.02 1.13 1.25 1.38 1.53Normal Earnings 0.70 0.78 0.86 0.95 1.06 1.17 1.30 1.43 1.59Abnormal Earnings Growth (AEG) -0.02 -0.03 -0.03 -0.03 -0.04 -0.04 -0.05 -0.05 -0.06 -0.06
PV Factor 0.87 0.76 0.66 0.58 0.50 0.44 0.38 0.33 0.29PV of AEG -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02
Core EPS 0.61Toatal YBY PV of AEG -0.17 SENSITIVITY ANALYSISContinuing Terminal Value -0.17241PV of Terminal Value -0.05 GTotal PV of AG -0.22 -0.1 -0.2 -0.3 -0.4 -0.5Total Avg EPS Perp (t+1) 2.64 0.11 $22.01 $23.64 $24.48 24.99$ $25.33Capitalization Rate (Perp) 0.148 0.135 $18.37 $19.47 $20.07 20.44$ $20.70
Ke 0.148 $16.94 $17.85 $18.36 18.68$ $18.900.16 $15.80 $16.58 $17.03 $17.31 $17.51
Intrinsic Value Per Share 17.85 0.18 $14.22 $14.84 $15.19 $15.43 $15.59Oberserved Price 24.93
Overvalued < 22.44Fair valued +/- 10%
Ke 14.8% Undervalued > 27.42growth -20%
Observed share price $24.93
Residual Income
1 2 3 4 5 6 7 8 9 10 11Jan 31 2007 Forecast Financial Statements Perp
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017BBVE(per share) 3.40$ 4.01$ 4.69$ 5.44$ 6.27$ 7.18$ 8.20$ 9.33$ 10.58$ 11.96$ EPS 0.61$ 0.68$ 0.75$ 0.83$ 0.92$ 1.02$ 1.13$ 1.25$ 1.38$ 1.53$ EBVE(per share) 3.40$ 4.01$ 4.69$ 5.44$ 6.27$ 7.19$ 8.20$ 9.33$ 10.58$ 11.96$ 13.49$ Ke 14.8%"Normal" Income 0.50$ 0.59$ 0.69$ 0.81$ 0.93$ 1.06$ 1.21$ 1.38$ 1.57$ 1.77$ Residual Income 0.11$ 0.09$ 0.06$ 0.02$ (0.01)$ (0.04)$ (0.08)$ (0.13)$ (0.19)$ (0.24)$ (0.29)$ Discount Factor 0.87 0.76 0.66 0.58 0.50 0.44 0.38 0.33 0.29 0.25 Present value of RI 0.09$ 0.07$ 0.04$ 0.01$ (0.00)$ (0.02)$ (0.03)$ (0.04)$ (0.05)$ (0.06)$
BV Equity (per share)2006 3.40$ Total PV of RI (0.00)$ Continuation (terminal) value Sensitivity AnaG (0.84)PV of Terminal Value (end 20 (0.21)$ -0.1 -0.2 -0.3 -0.4 -0.5Estimated Value (2006) 3.19$ Ke 0.09 $6.94 $6.51 $6.30 6.18$ $6.10Observed share price $24.93 0.1 $5.99 $5.73 $5.60 5.52$ $5.47
0.12 $4.52 $4.47 $4.44 4.42$ $4.41Actual Price per share 3.19$ 0.148 $3.10 $3.19 $3.23 $3.26 $3.28Growth -20% 0.16 $2.65 $2.77 $2.83 $2.87 $2.90Ke 14.8%
Observed share pr $24.93
Overvalued < 22.44Fair valued +/- 10%Undervalued > 27.42
82
LR ROE Perpetuity ROE 23.00% 17.94% 16.96% 15.99% 15.26% 14.67% 14.21% 13.78% 13.40% 13.04% 12.79%gr -21.99% -5.48% -5.70% -4.59% -3.83% -3.18% -3.00% -2.78% -2.64% -1.92%Avg ROE 14.8%Avg Growth in BE -5.51% Sensitivity analysROEIntrinsic share price value 3.40 G -0.04 -0.0551 -0.06 -0.08 -0.1ROE 14.8% 0.1 $4.45 $4.45 $4.42 4.31$ $4.22gr -5.51% 0.13 $3.73 $3.73 $3.72 3.69$ $3.67 Overvalued < 22.44Estimated value 3.40 Ke 0.148 $3.40 $3.40 $3.40 3.40$ $3.40 Fair valued +/- 10%
0.16 $3.20 $3.21 $3.21 3.23$ $3.24 Undervalued > 27.420.18 $2.91 $2.94 $2.95 2.98$ $3.01
Sensitivity analysisKeG -0.04 -0.0551 -0.06 -0.08 -0.1
ROE 0.12 $2.92 $2.96 $2.97 3.01$ $3.04Actual Price per share $24.93 0.148 $3.44 $3.43 $3.43 3.43$ $3.43
0.2 $4.39 $4.31 $4.29 4.21$ $4.150.22 $4.75 $4.65 $4.62 4.51$ $4.420.25 $5.30 $5.16 $5.12 4.96$ $4.84
Sensitivity analysisGROE 0.12 0.15 0.20 0.22 0.25
0.1 $3.84 $4.50 $5.59 6.03$ $6.69Ke 0.13 $3.22 $3.77 $4.69 5.05$ $5.60
0.148 $2.96 $3.47 $4.31 4.65$ $5.160.16 $2.77 $3.24 $4.03 4.35$ $4.820.18 $2.53 $2.97 $3.69 3.98$ $4.41
Free Cash Flows
Jan 31 2007 1 2 3 4 5 6 7 8 9 10 112006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
CFFO 176,336,909 195,720,809 217,105,405 240,689,090 266,689,393 295,344,788 326,916,668 361,691,508 399,983,223 442,135,753CFFI 86,277,871 33,310,502 40,073,840 49,048,820 50,117,939 51,239,166 55,639,028 63,558,496 68,975,029 71,880,835 FCF 90,059,038 162,410,307 177,031,565 191,640,270 216,571,454 244,105,622 271,277,640 298,133,012 331,008,194 370,254,918 411082997
FCF growth 80% 9% 8% 13% 13% 11% 10% 11% 12% 11%
PV Factor 0.87 0.76 0.66 0.58 0.50 0.44 0.38 0.33 0.29 0.25PV of FCF 78,448,639 123,233,792 117,010,556 110,336,504 108,615,492 106,641,551 103,233,531 98,826,852 95,578,839 93,128,360Total PV of Annual FCF 1,035,054,117 Sensitivity analysisContinuing (Terminal) Value G 10,817,973,598.57 PV of Terminal Value Perpetuity 2,720,990,569 0.08 0.1 0.11 0.12 0.125Value of Firm 3,756,044,687 0.135 $18.08 $25.37 $33.39 52.11$ $75.51Book value of Liabilities 223,968,000 0.14 $16.35 $21.95 $27.55 38.74$ $49.94Value of Equity (end of 2006) 3,532,076,687 0.15 $13.65 $17.17 $20.24 25.37$ $29.48Estimated value per share 21.40$ WACC 0.16 $11.63 $13.98 $15.86 18.68$ $20.70Actual price per share 24.93$ 0.18 $8.82 $10.01 $10.86 11.99$ $12.71WACC 14.8%terminal growth 11.0% Observed share price 24.93$ # of shares 165,080,000
Overvalued < 22.44Fair valued +/- 10%Undervalued > 27.42
83
Cost of Equity (CAPM) 10-Year Constant Maturity Risk Free Rate 1-Year Constant Maturity Risk Free Rate
Months Beta R^2 Ke72 1.853544842 0.131194521 0.097311104 Months Beta R^2 Ke60 1.720180692 0.110155424 0.090309486 72 1.874436 0.134263261 0.09840786848 3.929463949 0.258408604 0.206296857 60 1.744295 0.113357444 0.09157550436 3.628203126 0.181678533 0.190480664 48 3.929267 0.263026774 0.20628651624 2.895738339 0.093966609 0.152026263 36 3.702613 0.187422677 0.194387173
24 2.920902 0.095044268 0.153347334
5-Year Constant Maturity Risk Free Rate 3-month Constant Maturity Risk Free RateMonths Beta R^2 Ke Months Beta R^2 Ke
72 1.857032856 0.13182969 0.097494225 72 1.87396 0.134172304 0.09838291160 1.726008665 0.111050809 0.090615455 60 1.745406 0.113365 0.09163381848 3.92880617 0.260132528 0.206262324 48 3.930324 0.262485374 0.20634201336 3.652200554 0.183640635 0.191740529 36 3.701841 0.186799029 0.19434666424 2.901666448 0.094280815 0.152337489 24 2.91702 0.094205977 0.15314355
Cost of Debt
Cost of debt With Lease Capitalization
CL % OF T.L.
INT RATE COMPUTED INT RATE
A/P $41,291 14.65% 5.22% 0.00765 ACCRUED COMPENSATION $12,673 4.50% 5.22% 0.00235 ACCRUED EXP./OTHER CL $79,544 28.21% 5.22% 0.01473 CURRENT PORTION OF L.C. $73,601 26.11% 5.63% 0.01468 TOTAL CL $207,109 LT DEBT $74,817 26.54% 6.27% 0.01664 TOTAL LIABILITIES $281,926 100.00% WACD 0.05604 Without Lease Capitalization $208,325 19.82% 0.01035 6.08% 0.00318 38.18% 0.01993 35.91% 0.02252 100.00% WACD 0.05597
84
Method of Comparables
2006PPS NI BVE Sales Shares Outsta EPS BPS SPS Earnings G.R.
URBN 26.20 130,796,000 560,880,000 1,092,107,000 165,080,000 0.79 3.40 6.62 -0.23ANF 81.81 333,986,000 995,117,000 2,784,711,000 87,690,000 3.81 11.35 31.76 0.26JCG 39.42 3,794,000 -587,843,000 924,129,000 58,180,000 0.07 -10.10 15.88 19.50
2007URBN 25.19 100,512,038 425,217,438 1,182,494,567 165,080,000 0.61 2.58ANF 83.39 422,186,000 1,405,297,000 3,318,158,000 87,690,000 4.81 16.03JCG 36.33 77,782,000 -587,843,000 953,188,000 58,180,000 1.34 -10.10
P/E Trailing (2006)ANF 21.48JCG N/A URBN 17.02AVG 21.48
P/E Forward (2007)ANF 17.32JCG 27.17 URBN 13.55AVG 22.25
P/BANF 7.21JCG N/A URBN 24.49AVG 7.21
P.E.G (Price/Sales)/ 1 yr ahead Earning Growth RateANF 9.76JCG 0.13 URBN -7.57AVG 4.94
URBN ANF JCGEnterprise Value/ EBITDA MVE 4,325,096,000 7,173,918,900 2,293,455,600ANF 9.08 LT Debt 74,817,000 303,047,000 631,867,000JCG 18.25 URBN 18 Cash 49,912,000 50,687,000 61,275,000AVG 13.66 PF Stock N/A N/A 92,800,000
EBITDA 219,700,000 818,300,000 162,040,000
Price/ FCFANF 434.97JCG 139.63 URBN -5.70AVG 287.30
Price/ EBITDAANF 8.77JCG 14.15 URBN 15.25AVG 11.46
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Appendix B- Forecasted Ratio Analysis URBAN OUTFITTERS Ratio Forecast
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016LiquidityCurrent 2.01 3.29 3.04 2.93 2.89 2.95 2.99 3.00 2.98 2.97 2.98 2.99 2.98 2.97 2.98Quick asset 0.66 1.51 0.99 1.06 0.99 1.02 1.02 1.02 1.02 1.02 1.02 1.02 1.02 1.02 1.02Inventory turnover 5.73 5.44 5.29 4.94 4.58 5.04 4.84 4.77 4.84 4.84 4.77 4.71 4.71 4.71 4.66Days supply of inventory 63.73 67.11 68.93 73.89 79.62 72.43 75.39 76.49 75.34 75.38 76.48 77.49 77.50 77.50 78.25Recievables turnover 84.51 129.60 81.71 98.97 76.24 82.19 82.19 82.19 82.19 82.19 82.19 82.19 82.19 82.19 82.19Day supply of receivables 4.32 2.82 4.47 3.69 4.79 4.44 4.44 4.44 4.44 4.44 4.44 4.44 4.44 4.44 4.44Working capital turnover 8.45 4.16 4.64 4.37 4.34 4.31 4.23 4.21 4.25 4.27 4.25 4.23 4.24 4.26 4.25
ProfitabilityGross profit margin 0.33 0.36 0.39 0.41 0.41 0.37 0.37 0.38 0.38 0.38 0.39 0.39 0.39 0.40 0.40Operating exp ratio 0.25 0.25 0.24 0.23 0.22 0.23 0.23 0.23 0.23 0.23 0.23 0.23 0.23 0.23 0.23Net profit margin 0.04 0.06 0.09 0.11 0.12 0.09 0.09 0.09 0.09 0.09 0.10 0.10 0.10 0.10 0.10Asset turnover 1.79 1.51 1.43 1.49 1.42 1.40 1.40 1.40 1.40 1.40 1.40 1.40 1.40 1.40 1.40ROA 0.08 0.10 0.13 0.16 0.17 0.12 0.12 0.12 0.13 0.13 0.13 0.14 0.14 0.14 0.15ROE 0.10 0.12 0.17 0.22 0.23 0.16 0.17 0.17 0.17 0.18 0.18 0.19 0.19 0.19 0.20
Capital StructureDebt to Equity 0.34 0.24 0.33 0.38 0.37 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36
86
Works Cited
Abercrombie Website: abercrombieandfitch.com EdgarScan, Price Waterhouse Coopers: edgarscan.pwcglobal.com J Crew Website: jcrew.com Moore, Mark. Class Handout Packet. 2/15/2007 Moore, Mark. Forecasting Workshop. 2/27/2007 Moore, Mark. Regression Workshop. 3/8/2007 St. Louis Federal Reserve: research.stlouisfed.org Urban Outfitters Inc. Website: urbanoutfittersinc.com Yahoo! Finance finance.yahoo.com