Sell Stitch Fix At Its Peak

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About: Stitch Fix, Inc. (SFIX)
by: LEL Investment LLC
Summary

The stock price rose after the earnings report, but for the wrong reason.

The purchasing power of Stitch Fix’ s women clients has reached a plateau, and the spending upside is limited. The market for men, women, and kids is not strong.

Stitch Fix’s valuation is therefore too high.

Company overview

Stitch Fix(SFIX) offers a styling subscription service to consumers. It targets consumers who do not know what they want, and price and delivery speed are not the primary decision drivers. The company employs a data algorithm to match clients’ preferences with inventory and hires stylists to provide a customization service per the consumer’s request. A stylist at the company picks five items to send to the customer. The customer schedules a date to receive their items, which is referred to as a "Fix". Once the shipment is received, the customer has three days to choose to keep the items or return some or all of them. If the customer keeps at least one item, the initial styling fee is credited towards the cost of the item. In addition to the styling fee being credited, if the customer decides to keep all five items, the customer receives 25% off the total cost of the items. Customers choose the shipping frequency, such as every two weeks, once a month, or every two months.

Source: Company’s report

Key takeaway from earnings calls:

On March 11, 2019, Stitch Fix released the second quarter of 2019 earnings. The stock popped up 30% the day after the report. We believe the stock price rose because the company has demonstrated accelerated revenues per average customer for two consecutive quarters and lower advertising expenses as a percentage of revenue compared to the same quarter in the previous year. The company attributes these improved metrics to strong customer retention as well as its expansion to the men’s and kid’s markets. Furthermore, Stitch Fix explains the accelerated client growth rate due to its plan to spend less on advertising in the next quarter given that seasonality in the fashion business does not follow the pattern of traditional retailers and based on the high cost of advertising due to the aggressive marketing activity of other retailers.

However, we believe that the market has responded for the wrong reason and the stock will show a correction soon.

Spending upside is limited

According to the Bureau of Labor, on average in 2016-2017, single women spent $1,068 ($673 on clothing and $395 on shoes and other items) per year on apparel and related services and products, $799 was spent by single men ($430 on clothing and $369 on shoes and other items) and $187 by kids aged 2-15).

Source: Bureau of Labor

Stitch Fix’s revenue per customer peaked at an annual $608 in 2015 and declined gradually to $497 in 2018. We think this decline can be attributed to the increased percentage of men and kids, who typically spend less. We think the peak of $608 is already very high, as it stands for 56% and 76% of the annual spending budget of single females and single men, respectively. Hence, we see the upside on spending per customer to be limited.

The business model has high variable costs

For each customer, the company hires expansive stylists to provide personalized experiences. In analyzing the company’s cost structure, we found that revenue grew dramatically from 73 million in 2014 to 1.2 billion in 2018, while the cost of revenue and SG&A costs, excluding advertising, are relatively flat, implying no leverage at scale so far.

Source: Company’s report

We believe a gross margin leverage opportunity is limited due to the company’s relatively small size and lack of bargaining power against other branded clothing suppliers. SG&A expense leverage opportunity is constraint due to the high variable cost of the personalized service. In analyzing Stitch Fix’s cost per average customer data (shown below), we see that the quarterly SG&A (mainly stylist compensation costs), excluding ad cost per average customer, reached a floor at around $40. There has been nearly no leverage at scale over the past couple years. The result is expected given the number of stylists should grow with the number of clients.

After deducting cost of revenue and SG&A expense, the company’s quarterly profit per average customer, before advertising expense, is $13.55, leaving very little room for further advertising spending. As the company chases the men’s and kids’ markets, their profit margin will further decrease due to the lower average spending of men and kids.

Source: Company’s report

In addition, Stitch Fix currently hires 3,900 stylists to support its personalized service. On average, a stylist should serve 759 clients. Even with the help of a data algorithm, we doubt that this personalization will be differentiated from other algorithm-only personalization services used by apparel retailers such as Nordstrom( JWN), Urban Outfitter( URBN) or Amazon( AMZN). .

The women’s market is likely to plateau

Although the company uses seasonality and competition as reasons to suspend advertising spending to acquire new customers, in looking at the company’s customer acquisition cost (CAC) and revenue per customer metrics, it is clear that the CAC costs have outpaced revenue per customer and are continuing to increase, not promising for the economics on new customer marketing. Hence, the company’s penetration rate in U.S. subscription clothing service market has likely plateaued.

Source: Company’s report

Profitability of the U.K. market remains in question

The U.K. has a lower GDP per capital at 39,720 compared to the U.S. at $59,531. Also, the style and dynamics of the U.K. fashion market are quite different from U.S. Therefore, we think Stitch Fix needs to hire a different stylist team in the U.K. In short, whether the U.K. market makes economic sense for Stitch Fix still remains questionable.

The valuation is too high

We compared the valuation for subscription service companies such as Amazon and Blue Apron(APRN), fashion selection retailers such as Urban Outfitters and Nordstrom and the discount retailers, Kohls(KSS) with Stitch Fix. It appears that Stitch Fix’s high valuation is supported by its historical high growth. However, we think as per the analysis above, the growth upside is limited and not sustainable because (1) the revenue per customer is already very high and (2) the customer acquisition cost is already higher than the profit. Hence, we recommend the investor to cash out at the current price.

Source: Yahoo finance

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.