Urban Outfitters, Inc. (NASDAQ: URBN) generated a below average return on equity of 8.3% over the past twelve months, while the Consumer Discretionary sector returned 9.4%. Even though URBN’s performance is subpar relative to its peers, it’s useful to understand what’s really driving the company’s low ROE and how it’s trending. Understanding these components may change your views on URBN and its future prospects.
URBN’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
URBN’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
Unfortunately for shareholders, URBN’s return on equity has decreased each year since 2016. ROE decreased from 18.2% to 17.8% in fiscal year 2017, decreased to 8.3% in 2018 and the LTM period is also its latest fiscal year. So what’s causing the steady decline?
What’s Driving URBN’s Declining Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving URBN’s returns.
URBN’s Net Profit Margin
Unfortunately for shareholders, URBN’s net profit margin has decreased each year since 2016. Margins decreased from 6.5% to 6.2% in fiscal year 2017, decreased to 3.0% in 2018 and the LTM period is also its latest fiscal year.
As a result, the company’s worsening margins help explain, at least in part, why ROE continues to decline. However, let’s also take a look at URBN’s efficiency.
URBN’s Asset Turnover
It appears that asset turnover of URBN has generally been declining over the last few years. Turnover increased from 1.85x to 1.90x in fiscal year 2017, decreased to 1.88x in 2018 and the LTM period is also its latest fiscal year.
source: data explorer – asset turnover
Therefore, the company’s decreasing asset turnover ratio helps explain, at least partially, why ROE is also decreasing.
Finally, the DuPont constituents that make up URBN’s ROE are shown in the table below. Note that the table also compares URBN to a peer group that includes American Eagle Outfitters, Inc. (NYSE: AEO), Abercrombie & Fitch Company (NYSE: ANF), Coach, Inc. (NYSE: TPR) and Michael Kors Holdings Limited (NYSE: KORS).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that URBN’s continuous fall in return on equity is the result of a steadily deteriorating net profit margin, a declining asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, URBN shareholders have reason to be concerned due to the company’s deteriorating profitability along with a general decline in operational efficiency and declining leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research URBN to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.