Stitch Fix (SFIX -4.15%) is grabbing market share in the clothing business, but its industry is shrinking. The online apparel retailer recently closed out its fiscal 2020 in strong fashion, with a return to growth in both sales and profitability.

However, CEO Katrina Lake and her team sounded cautious in their early 2021 growth outlook and described a "forever changed" apparel selling environment. That new industry picture should support Stitch Fix over the long term -- but shareholders will first have to endure some short-term pain.

A young woman removes clothes from a box.

Image source: Getty Images.

Getting back to growth

Stitch Fix's business improved by several key measures in its fiscal fourth quarter, a result that supported management's assertion back in June that shoppers were staying highly engaged with its service despite pandemic-related disruptions that resulted in some ugly Q3 numbers. This time around, company added nearly 300,000 active clients year over year, and returned to user growth on a quarter-over-quarter basis after fiscal Q3's unusual decline.

Stitch Fix saw strength in its direct-buy option, and its algorithm-driven suggestions also propelled rising demand in the core women's category as well as in newer niches like menswear and kids. These wins pushed sales up by almost 11% -- a quick rebound from last quarter's 9% drop.

"These results are all the more notable," management noted in a shareholder letter, "compared to many apparel retailers reporting double-digit declines for the same period."

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Stitch Fix saw some of its best new-user growth on record in July and August as the company resumed its marketing spending. Most of that outflow was paused during fiscal Q3 quarter due to supply chain challenges, but when the company reopened the spigots in fiscal Q4, it did so with a vengeance. Advertising spending rose to 9.9% of revenue compared to 9% a year earlier.

That increase was a key factor behind the company's adjusted loss for the period, but its overall finances are strong. Gross profit margin rebounded right back to 45% of sales, growing on both a year-over-year and sequential basis. The business generated more than $50 million of free cash flow, and ended the quarter with no debt and just under $400 million on the books.

Short-term pain

Wall Street chose to look past most of that good news and focus instead on management's conservative outlook for the next few quarters. Sales in the first half of fiscal 2021 will be pressured by a weak retailing environment for apparel, the company said, and by lingering aftereffects from that earlier pause in marketing. Management also anticipated that shoppers may continue to tilt their spending away from certain types of fashionable apparel, and toward activewear and leisurewear, which will require changes to its inventory.

Lake said Stitch Fix is positioned to "capitalize on a forever changed apparel retail environment," especially as more brick-and-mortar stores close over the next year or so. Without issuing a specific outlook, executives predicted that sales growth will accelerate in the second half of 2021.

The implication that the next six months might be weak convinced some traders to sell Stitch Fix stock immediately following this report. That choice only makes sense if you believe the company has permanently lost its competitive advantage.

Sure, it could be a year or more before Stitch Fix approaches the 20%-plus growth rates it was delivering just before the pandemic struck. But the business is still bringing in new customers and pushing into new categories, geographies, and demographics. Those trends suggest that in a few years, this will be a much larger business than the one that just booked $1.7 billion of revenue in fiscal 2020.