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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

2000

Out

put

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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2000

2002 2003 2004 2005 2006

Years

Out

put URBN

ANF

JCG

Operating Expensesin millions

50100150200250300350400

2002 2003 2004 2005 2006

Years

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put URBN

ANF

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

69

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

85

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