The Stitch Fix Report
Is Stitch Fix tearing at the seams?
Goodmorning, investors!
Today’s Due Diligence report covers a former meme stock that’s plummeted back to reality: Stitch Fix.
In January, shares of Stitch Fix peaked at $113.76.
Yesterday, SFIX closed at $39.59.
Can the digital retailer stitch itself back together?
Before we get into the report, don’t forget to subscribe if you haven’t already!
Now, without further ado...
The Business
Founded in 2011, Stitch Fix is a digital retailer that caters to men, women, and kids in the U.S. and U.K. The company has employed a uniquely modern approach to retail for the last decade. Combining data science and stylistic recommendations, Stitch Fix delivers boxes of clothing and accessories to its customers. Each box (or “Fix”) contains five items, which are selected based on Stitch Fix’s algorithm and a stylist’s input.
When customers first join the platform, they take a Style Quiz, which then feeds into Stitch Fix’s robust database and assists the algorithm. I took the quiz (this is Due Diligence after all), and I must say — it’s an extensive assessment.
In essence, customers receive a mystery box of goods that are expected to be perfectly tailored to their size (based on data) and style preferences (based on data). The keyword is data. The company is constantly collecting feedback to improve its algorithm and the customer experience.
Customers can schedule automatic shipments or order a Fix on demand; regardless, there’s a $20 “styling fee” per box. If the customer elects to purchase one or more items, the $20 fee is applied to the order. If the customer doesn’t like any of the five items, they forfeit the $20 styling fee.
More recently, the company has rolled out new features called Direct Buy and Fix Preview.
What is Stitch Fix Direct Buy?
In 2019, Stitch Fix added direct-buy functionality to its platform: instead of ordering a random assortment of clothes, customers could buy previously purchased items in different colors, sizes, or prints. This feature has since evolved to allow customers to shop for personalized clothing based on their style profiles. This month, Stitch Fix announced that new customers can buy clothing directly from the company’s website without being active Fix subscribers. (There aren’t any styling fees for direct purchases.)
What is Stitch Fix Preview?
Before the rollout of Fix Preview, customers simply had to trust that the company’s stylists and algorithm would supply a worthwhile selection of desirable clothing. Now, Stitch Fix is allowing shoppers to preview their Fix before it ships.
Subscribers have 48 hours to review their Fix before it ships; if they don’t like an item, they can remove it and a stylist will add a replacement.
Does Stitch Fix have its own clothing line?
Yes, Stitch Fix offers third-party branded merchandise as well as its own “Exclusive Brands.” Naturally, the company’s clothing line has higher margins relative to other third-party brands. The ever-shifting merchandise mix, which is based on customer demand, can cause gross margin to shift from period to period.
Stitch Fix client growth
Although Stitch Fix has struggled to maintain profits, the company has continually increased its client growth. As of May 2021, Stitch Fix had 4.1 million active clients, good for 20% year-over-year growth relative to Q3 2020.
The Narrative
Thanks to a short squeeze, shares of SFIX soared to triple-digit heights in January (at its peak, SFIX was up 867% from its pandemic low). However, the digital retailer’s stay in the clouds was short-lived. Over the last six months, Stitch Fix has faced a number of obstacles, shrinking its share price to a more modest $39.59 as of Thursday; those obstacles include:
In March, Q2 sales results fell short of expectations.
In April, Katrina Lake announced she would step down as CEO.
This month, reports surfaced about stylist departures and culture concerns under new CEO, Elizabeth Spaulding.
We’re going to focus on the latter two because the sales miss wasn’t significant. The following quarter (Q3), net revenue increased 44% year over year and the company projects at least 20% year-over-year revenue growth for the fiscal year.
Earlier this month, according to one report, Stitch Fix expressed that it would emphasize live one-on-one styling sessions. To accomplish this, the company imposed new scheduling requirements for its hourly stylists. Stitch Fix offered a $1,000 voluntary severance payout to stylists who did not want to continue with the company. The report references a Wells Fargo analyst who covers Stitch Fix; according to the source, Stitch Fix likely underestimated the number of departures. Although job review boards tend to attract more grievances than praises, Stitch Fix has accumulated a growing stack of negative feedback on Glassdoor this month.
We won’t know the headcount impact until the next earnings release in September, but, for reference, the company had roughly 6,200 stylists as of May.
While a silver lining could be reduced overhead, we’ll have to see if this impacts Stitch Fix’s ability to consistently deliver high-quality, personalized clothing recommendations. One could argue that this is a sign that the company is leaning more on its algorithm, which has accumulated a decade of data, for style recommendations going forward.
Stock Overview
Last week, SFIX’s 50-day moving average fell below its 200-day moving average, which is a negative signal known as a “death cross.” SFIX is down 10% over its last five trading days. Note: many investors use the relationship between these averages as a technical indicator to gauge price trends.
Since Stitch Fix is not profitable, it does not have a P/E ratio. For companies that generate losses, it’s more appropriate to look at price-to-sales ratios; Stitch Fix’s P/S ratio is 2.2. For comparison, the Apparel and Shoes industry’s P/S ratio is 0.80 — so investors are willing to pay quite a lot more for Stitch Fix. Note: P/S essentially calculates the amount investors are willing to pay for $1 of a company’s sales. This is a common valuation metric for unprofitable companies to compare to peers and broader industry and index benchmarks.
Stitch Fix’s consensus price target relative to its last close implies a 57% increase.
The High-Level Finances
Revenue Highlights:
Stitch Fix had a fantastic third quarter (its fiscal year ends in July) partially thanks to the scaled availability of Fix Preview to the entire U.K. client base and to over half of its U.S. clients.
Management expects to surpass $2 billion of net revenue in FY21 (which would imply 21% year-over-year growth).
Profit Highlights:
At first glance, Stitch Fix’s bottom line is headed in the wrong direction. However, despite a decade of existence, Stitch Fix is still in growth mode — it’s not unusual to operate at a loss while expanding.
At second glance, while Stitch Fix’s $84 million operating loss through three quarters looks bad, the company has $95 million of non-cash expenses within its SG&A line item, including depreciation, amortization, and share-based compensation.
Another tidbit about the growth aspect: advertising expenses represented $142 million of that $766 million SG&A line item for YTD 2021. And I think I’m entitled to a percentage of that for outlining their business model to you fine people.
Balance Sheet & Cash Flow Highlights:
From a balance sheet perspective, Stitch Fix is healthy — the company has no outstanding debt, so interest expense isn’t eating away at its cash flow. (Stitch Fix does have access to a revolving line of credit though if it ever needed the capital.)
Stitch Fix had $124.7 million of cash on hand as of May 2021.
Historically, Stitch Fix has generated positive free cash flow on an annual basis: $12.7 million in FY20, $47.8 million in FY19, and $55.6 million in FY18.
Through three quarters of operations in FY21, free cash flow was negative $58.8 million — although it was negative $39.1 million last year at this point and they still wound up with positive FCF for the year. (Free cash flow is an important measurement because it shows how much money a company generates after general business expenses.)
Earnings Trends
SFIX’s EPS results have been all over the place for the last couple of years. As I mentioned above, that’s not uncommon for growth-oriented companies. So far this year, Stitch Fix has exceeded consensus estimates in each quarter.
The Primary Strengths
Customer growth. Stitch Fix has added roughly 1,400,000 active clients since the end of FY18. That’s impressive.
New features. Stitch Fix’s new features — Direct Buy and Preview — add diversity to the platform, which could help client acquisition, client retention, client lifetime value, and, ultimately, its bottom line.
Financial health. No debt? No problem. The company has historically generated positive free cash flow and doesn’t rely on debt to fund its business. That’s a plus.
The Primary Risks
(Un)profitability. Here’s the bottom line — the bottom line still matters. Growth is great, but can the company grow profitably? And then maintain those profits if it reaches that point? The next year will be telling.
Competitive market. Seizing market share is tough in the retail industry. Plain and simple. Stitch Fix’s customer growth is compelling, but maintaining an active client base isn’t guaranteed.
Consumer spending concerns. As a consumer goods company, Stitch Fix is susceptible to macroeconomic downturns since consumers often limit their spending when budgets are tight. A subscription for trendy clothes is a likely candidate for a personal budget cut.
The Street’s Opinion
SFIX registers a “Hold” consensus rating thanks to some starkly contrasting opinions of the company. SFIX’s average price target implies roughly 57% upside, while the lowest price target suggests that the stock has darker days ahead of it.
Bullish or Bearish?
At Due Diligence, we think long-term — we like companies that are well-positioned to be staples of their industries in the future. From a long-term perspective, we’re bullish on Stitch Fix. Its business model appears to be working, as it continues to appeal to (and acquire) active customers. Speaking from experience, the platform does its job, presenting personalized recommendations and streamlining the shopping experience.
In the near term, we’re cautious. On one side, the company could continue benefiting from pent-up demand and consumer eCommerce spending. If the company exceeds estimates in its next earnings release (scheduled for 9/21), don’t be surprised by a price bump. On the other side, concerns about stylist departures and operating efficiency make us wary. Any signs of Fix inaccuracy from customer feedback or customer activity declines would solidify our concerns.
Although SFIX appears to be trading at a discount relative to its 52-week high, keep this in mind: that peak was driven by a sudden burst of interest from meme stock chasers. It’s still up roughly 63% from a year ago.