This was originally sent to subscribers of TheStreet.com Breakout Stocks on March 14 at 2:55 p.m. EST. For more information on this newsletter, click here.With retail chains like the Gap (GPS:NYSE) and the Limited (LTD:NYSE) falling out of favor with consumers, a new generation of apparel sellers is dramatically expanding their store bases and taking market share from these giants. With this trend in mind, shares of Urban Outfitters (URBN:Nasdaq) look set to outperform over the long term. We already have two retailers in the model portfolio, but otherwise would be adding a small position in Urban Outfitters and then doubling it on a 10% pullback. The bears have been quite vocal on the retail sector, insisting that high energy prices and a slowing housing market would hurt consumers' spending power. While this may be true, our newsletter uncovers the companies shaking up markets and taking share, rather than focusing on the overall market size. Urban Outfitters is just such a company, and we believe its slice of the retail pie will keep growing. Urban Outfitters operates 175 stores in the U.S., U.K. and Canada under two primary storefront names -- the Urban Outfitters flagship brand and Anthropologie, which focuses exclusively on women's apparel and accessories. In addition, Urban's wholesale brand, Free People, is sold through department stores, and the company began opening stores under the Free People brand name in November 2002. The company also sells its wares through the Internet and catalogs. Urban Outfitters distinguishes itself from other retailers like the Gap and Abercrombie & Fitch (ANF:NYSE) by focusing on funkier, edgier and trendier urban styles. Also, the company is free to carry whatever new styles are popular, no matter what the brand. For example, Urban Outfitters sells hot items like True Religion (TRLG:Nasdaq) jeans and Puma sneakers that can't be found in stores like the Gap. Such vertically-oriented chains must carry products that bear the company name, so they can only produce replicas of the hot stuff.
This merchandising strategy prevents Urban Outfitters from being closely associated with a specific style, which adds to its staying power. Abercrombie, for example, is linked with a frat boy/sorority girl look, and the Gap is associated with khakis and t-shirts. Although Urban is associated with the funky styles that fashion-forward young people in cities wear, this look is always changing. As for Urban's fundamentals, the company has historically produced strong cash flow, with operating cash flow outpacing net income in each of the past five years, a sign of solid earnings quality. Margins are near the top of the industry, and capital expenditures have been reasonable considering the company's strong annual revenue growth. Compounded annual revenue growth was 37% over the past three-year period ending in January 2006, and revenue grew 32% in fiscal 2006, which ended in January. The company also has $192 million in cash and zero debt on the balance sheet. Days inventory outstanding, which measures how long it would take to turn over inventory, is high at 68 days -- 12% higher than last year at this time because of some fashion misses in the fourth quarter that led to a slump in the stock. But we believe the company is marking down merchandise aggressively to clear out the excess and will quickly move to stock stores with more popular items, including dresses. Gross margins also weakened to 39.5% in the fourth quarter, from 39.9% in the year-ago period. However, we are focused on the company's long-term expansion potential and view these growing pains as par for the course in the retail industry. From a revenue standpoint, Urban is relatively tiny, with just $1.1 billion in sales over the past 12 months, compared with $2.8 billion for Abercrombie and $16 billion for the Gap. And with only 175 stores, Urban has a long way to go before it matures. For example, Abercrombie has about 800 stores, and it still hasn't saturated the U.S. Abercrombie went from 156 stores at the beginning of 1998 to nearly 500 by the beginning of 2002, according to Capital IQ. Urban plans to expand its store base by 20% in 2006, to about 210 stores.
The company also has two new concepts for its store lineup in the works, with a store based on one of them scheduled to open within 15 months. Taking a look at the store base state by state, we see plenty of room for expansion in Texas, Connecticut, Colorado, Arizona, Massachusetts and Nevada, not to mention Canada and possibly Europe. If we assume Urban's store count rises by 18% annually, we believe a level of about 500 by 2011-12 is achievable. The company's founder and CEO is also banking on Urban's prospects for continued growth. We are happy to see that CEO Richard Hayne still holds about 31% of shares outstanding, according to Capital IQ. And on the institutional shareholder list, savvy growth investors like Calamos Asset Management and Fidelity are among the top 10 holders of the stock. At the same time, some very large fund companies, like Legg Mason and T. Rowe Price, are not on the top 10 list of institutional shareholders, which suggests there is room for them to add to their positions as Urban continues to grow. On the surface, Urban may appear expensive at 26 times forward earnings of 96 cents a share. But given the company's organic sales momentum, which we believe can hit 20%-plus over the next few years, and earnings growth that could be slightly higher than that with margin improvements, we believe shares are attractive.