Stitch Fix: Lock In Gains

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About: Stitch Fix, Inc. (SFIX)
by: Gary Alexander
Summary

Shares of Stitch Fix jumped more than 25% after reporting stellar Q2 results, one of the stock's best one-day performances yet.

Despite strong 25% y/y revenue growth, active clients growth continued to decelerate to just 18% y/y, suggesting that Stitch Fix's addressable market is beginning to saturate.

Margins also declined slightly in the quarter thanks to an uptick in sales costs.

Stitch Fix's enlarged valuation, especially versus other retailers, also puts it at risk of decline.

Stitch Fix (SFIX), the online e-tailer that specializes in delivering boxes of clothes and accessories to try on at home, has just posted one of its best quarters yet. After delivering 25% y/y revenue growth and strong EBITDA, shares of Stitch Fix rocketed up more than 25% - one of its best one-day performances yet and putting the stock up more than 2x year-to-date.

Chart Data by YCharts

The question now burning on investors' minds: does Stitch Fix have any further upside or is it a good time to lock in gains? In my view, the stock's massive Q2-driven upside will induce plenty of profit taking. While Q2 headline results were good, there were a lot of weaker data points underneath surrounding client growth as well as gross margin expansion that are worth digging into. We'll cover the puts and takes of the quarter in this article.

The bottom line on Stitch Fix shares: the stock's massive 25% jump has captured all the available upside. A further rally is highly unlikely due to Stitch Fix's bloated valuation. Investors should stay on the sidelines until prices come down.

Valuation check

One quick observation that we should make is that Stitch Fix's valuation has now reached sensitive heights. While Stitch Fix effectively marketed itself as a technology company during its IPO process and while many investors will bucket Stitch Fix alongside other marketplace and e-commerce companies, Stitch Fix ultimately is still a retailer and reseller of clothes. It's true that Stitch Fix's mid-40s gross margin gives it a premium over mall stocks like Macy's (M), but it's difficult to justify a technology-like multiple for this stock.

At its post-Q2 share price of ~$34, Stitch Fix has notched a market cap of $3.36 billion. Just to put that figure into perspective, that gives Stitch Fix a market cap of about half of Nordstrom (JWN) and Macy's, both giant retailers with a much larger scale and reach than Stitch Fix. For reference, these stocks trade at ~0.5x forward revenues:

Chart Data by YCharts

After netting off $343.6 million of cash on Stitch Fix's balance sheet, the company has an enterprise value of $3.02 billion. That represents a valuation multiple of approximately 2.0x EV/FY19 revenues, based on the midpoint of Stitch Fix's latest FY19 guidance:

Figure 1. Stitch Fix guidance

Source: Stitch Fix Q2 investor letter

This puts Stitch Fix's valuation much closer to that of Amazon (AMZN) and eBay (EBAY), both companies that derive a lion's share of their revenues from services. While putting Stitch Fix's valuation multiple between that of a traditional retailer and an e-commerce company isn't entirely ridiculous, we'd be more comfortable investing in Stitch Fix at under 2x revenues.

Negative points in the quarter you might have missed and implications on future growth

As previously noted, Stitch Fix's headline numbers in Q2 were fantastic. See the quarter summary below:

Figure 2. Stitch Fix 2Q19 results

Source: Stitch Fix Q2 investor letter

Revenues grew 25% y/y to $370.3 million, surpassing Wall Street's estimates of $364.9 million (+23% y/y) by a solid two-point margin. In addition, adjusted EBITDA of $19.2 million (shown below) came in well above consensus expectations of $11.3 million, while EPS of $0.12 smashed estimates of $0.05:

Figure 3. Stitch Fix adjusted EBITDA

Source: Stitch Fix Q2 investor letter

But now let's peel back some of the other metrics that investors may have glossed over after looking at the headline figures. Last quarter, I wrote that Stitch Fix saw a massive three-point decline in active clients growth to 22% y/y, one of the biggest disappointments in Q1. That weakness has continued into Q2, decelerating a further four points to just 18% y/y growth:

Figure 4. Stitch Fix active client growth

Source: Stitch Fix Q2 investor letter

The fact that Stitch Fix grew revenues at 25% y/y while only growing the active client base by 18% y/y means that average wallet share within the customer base is growing. This is actually a good thing - existing customers are far better and cheaper to retain, after all.

However, Stitch Fix is still a relatively small company that has yet to hit a $2 billion run rate (Macy's, on the other hand, did just under $26 billion in revenues over the trailing twelve months) and is just shy of 3 million customers or less than 1% of the U.S. population. Stitch Fix can stretch revenues by growing wallet share only by so much - the majority of its future growth must come from new clients.

Recall that over the past year, Stitch Fix had already expanded its addressable market to Men, Children, and Plus Size, so its period of client growth via category additions has already been achieved. We're unclear on how Stitch Fix can continue to grow revenues at >20% y/y in the long run if its client growth continues to slip into the teens. We should also be wary of Stitch Fix's ability to hit its 22-26% y/y revenue growth target in FY19 if active client growth continues to slip.

Another disappointment in the quarter to note: despite the large EBITDA beat, margin performance wasn't terribly inspiring either:

Figure 5. Stitch Fix margin trends

Source: Stitch Fix Q2 investor letter

Gross margins ticked up 110bps to 44.1%, up from 43.0% in the year-ago quarter. While this is still an improvement, note that it's a smaller improvement than the 140bps expansion that Stitch Fix achieved in Q1. Also, note that Stitch Fix's long-term operating model (found on page 19 of Stitch Fix's March shareholder letter) calls for only 45-46% in gross margins, implying that gross margin gains have little more to contribute to EBITDA growth.

Note also that whatever gains Stitch Fix achieved on gross margins, a two-point increase in SG&A costs wiped out those gains, as shown in the chart above. And despite the beat in adjusted EBITDA, EBITDA margins actually fell from 6% in the year-ago quarter to 5% in Q2.

How should investors react?

In my view, a 25% rally in Stitch Fix shares indicates that investors have built lofty expectations for this stock in the future. At the same time, Stitch Fix's growth hasn't been particularly impressive. While revenue growth accelerated one point this quarter, the continued slowdown in active client growth may foreshadow revenue deceleration in the coming few quarters. Stitch Fix's growth last year was driven by a string of impressive category expansions into Men, Children, and Plus size clothing. This year's growth plans consist of expansion to the UK - and it's unclear whether this market expansion can produce the same type of growth.

Steer clear of this stock until prices come down.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.