Apparel chains have had it particularly hard in this tough retail climate, but Urban Outfitters (URBN -0.11%) has seen significant momentum in its digital channels, which has helped its sales over the past few years. Teens continue to flock to the company's web site, and its Anthropologie and Free People brands in particular are excelling in the marketplace.

However, the company faces some serious threats, most notably weakness in its namesake Urban Outfitters brand. The retail climate, and specifically how it's impacting department stores, has been hurting the company's wholesale business, and the migration away from mall stores is affecting bricks-and-mortar sales. Is the company's digital strength enough to outweigh these challenges? 

Popular brands with an omni-channel experience

Urban Outfitters has always been about customer experience, even before that became a retail catchphrase. if you visit one of its stores, you'll see carefully planned decorative details designed to resonate with the customer base. You'll find this setup in all of the company brand stores -- Urban Outfitters as well as Anthropologie and Free People. Each store tells a narrative and changes its displays frequently to keep telling the story. There are three Urban Outfitters concept stores that incorporate other artistic elements into the shopping process, creating a complete customer experience.

This visceral customer focus is extended to its digital program as well. The digital is an extension of the physical, and digital customers can do much more than shop. There's an Urban Outfitters music segment of the company app, where customers can listen to a curated selection that's chosen to reflect the customer vibe and they can create a playlist to stay connected. There's a rewards program with exclusive offers that's easily tracked on a smartphone, and the company delivers news about sales and other company info when customers walk into a store. There's also Scan + Shop, where customers can scan product barcodes with a smartphone camera and take pictures for more info.

Each of the company brands offers a similar program that's tailored the the brand's niche customer base. Other brands under the Urban Outfitters umbrella include BHLDN, a wedding clothier; Terrain, a house and garden concept; and Nuuly, a clothing subscription rental service.

Teenagers looking at smartphones.

Image source: Getty Images.

A record holiday season

The digital strategy has been paying off, driving sales for many a quarter, culminating in an outstanding holiday season for digital. Total sales increased 2.9% and comps were up 3%, driven by digital growth. Fourth-quarter revenue increased 3.6% to a record $1.17 billion with a 4% increase in comps, partially offset by slowing store sales.

Free People continued to do well, with comps increasing 9% driven by full-price sales, and Anthropologie comps were up 6% but relied heavily on promotional activity. Urban Outfitters' comps, though, were flat for the fourth quarter. Wholesale decreased 10%.

Revenue over the full year was fueled by digital growth, partially offset by negative store sale growth. In the company's second quarter, the only one that had decreased comp growth, that number was offset by positive growth in digital.

Challenges lie ahead

While Urban Outfitters overall had a successful fourth quarter and full year, there are three main challenges that inhibit the company from maximizing its success.

1. The main brand: Urban Outfitters itself is suffering from slow sales. The niche brands are thriving, but the core brand is stuck. It needs to figure out how to connect with its audience or channel its strengths to meet a more specific need.

2. Wholesale: Today's trends are moving toward direct-to-consumer (DTC), and this has negatively affected Urban Outfitters' wholesale business. Promotions and leftover stock at department stores is hurting Urban Outfitters, and as many department stores are in a state of flux, the company will have to rethink its wholesale operations.

The flip side of that is that Urban Outfitters already has a strong DTC business, so downgrading or completely scrapping wholesale might cause some short-term losses but will benefit the company longer-term.

3. Thin margins: Fourth-quarter sales were helped by promotional activities, but that's going to come out in smaller margins and earnings. CEO Richard Hayne seemed pleased to clear shelves and make way for new spring arrivals, saying, "Promotional activity was higher than planned, which was necessary to ensure ending Retail segment inventories were clean at all three brands leaving them well positioned entering the spring season." But there are downsides to this, too.

A second part of this is that Urban Outfitters spent a costly sum on delivery and logistics to match customer expectations and fuel digital sales. This ties in to a strong digital strategy, but revenue from the digital channels along with the high cost of fulfillment is squeezing margins. In the long run, to keep riding the digital wave, the company must determine how to make this strategy more cost-effective. 

Is Urban Outfitters a buy?

Even though the company has a lot of potential with its healthy digital business, there are too many questions right now to say it's time to buy shares. The stock lost about 12% of its value in 2019 and was holding steady for 2020 until COVID-19 coronavirus fears wreaked havoc on retail stocks. Even when that gets sorted out, the company will have to make more progress before it can be considered a growth stock.