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Stitch Fix Is Run Like A Software Company, And That's A Good Thing

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About: Stitch Fix, Inc. (SFIX), Includes: LULU
by: App Economy Insights
Summary

Stitch Fix continues growing its revenue in a way not matched by any companies in the apparel industry, not even by best-of-breed Lululemon.

While investing in data science personnel and increasing its advertising expenses, SFIX has remained profitable for the past five years.

The company has improved its CRM strategy for a decade and has a clear first mover advantage, thanks to its narrow industry focus.

Stitch Fix is approaching its business like a finely-tuned software company: analyzing cohorts, becoming smarter over time about how to acquire, retain, and monetize.

The market is incredibly bearish (almost a third of the float short) because most investors are too focused on competition and the false equivalence of Blue Apron.

Investment Thesis

Just by continuing on its already successful path, I believe Stitch Fix (NASDAQ:SFIX) can become a 10 bagger in the next decade thanks to four main leverages:

  • Continued revenue growth above 20% for most of the coming decade.
  • Margin expansion from 3% in FY19 to 10% or more through scalability.
  • Free cash flow accumulation on its already pristine balance sheet.
  • Valuation multiple expansion once Wall Street can recognize the fast-growing best-of-breed e-commerce company it already is.

Let's review the bearish case against Stitch Fix, why the business is run like a software company, and break down the four leverages mentioned above that could turn it into a fantastic long-term investment.

Source

Reviewing The Bearish Case

Stitch Fix is deeply misunderstood by the market, mostly because the bearish story is an easy one to tell. Most investors on Wall Street are missing the forest for the trees.

Stitch Fix currently has 29% of its float short. The other example I have in mind with such a negative treatment - despite the high growth and disruptive nature of its business - would be Match Group (NASDAQ:MTCH). MTCH has 46% of its float short.

My personal explanation is simple. Wall Street tends to bet on the status quo. If a business-to-consumer company represents a trend that has yet to impact their own life and is affecting only a subsection of the population, many investors regard it as a fad. It is still true today of Match Group, with many investors still not buying the idea that the majority of single individuals find their partners online - even though it's already the case.

I see the following kind of short-sighted arguments against Stitch Fix:

My partner tried it and stopped using it over time. I don't see myself ever using it. People don't like it.

Anecdotal evidence can create profound biases. But investors really need to let the numbers speak for themselves. When a product is growing above 25% over several years, it means it's finding an audience. More specifically, if existing clients are increasing their spending over time on average (+9% in the most recent quarter), it means the product is successful at retaining and monetizing its existing audience holistically.

Stitch Fix is the Blue Aron (NYSE:APRN) of clothing. Therefore it will follow APRN's path and is likely to be a bad investment.

You just have to open the 10-K of each company to clearly see that Blue Apron has been a loss-making company while Stitch Fix has been a profitable company over the past five years. The fact that both businesses deliver a box to your door is about the only thing they have in common. I discussed before how powerful representative heuristics are. We assume two things are similar because the information is easier to process that way.

It will never be mainstream.

And it doesn't have to. Wall Street seems to think that the company will hit a glass ceiling. Stitch Fix is already making $1.6 billion in revenue through 3.2 million active clients, resulting in $487 average revenue per active client. The average American spends $1,700 on clothes yearly, but if you look at women's fashion alone, the average rises to $4,800 yearly. Stitch Fix is still growing its active client at an accelerating rate (+18% Y/Y in Q4 FY19 vs. +17% Y/Y in Q3 FY19). Stitch Fix is expanding its user base and its revenue per user, all while remaining profitable. Its marketing flywheel should naturally keep on expanding its top line. And with only 3.2 million active clients in the world at this point, the runway ahead is obviously still gigantic.

Amazon Personal Shopper will destroy Stitch Fix.

I've also seen people saying that Facebook (NASDAQ:FB) would destroy Match Group with its dating feature. At the end of the day, when you have a flourishing business, competition is a fact of life. As long as the company keeps on delivering on its KPIs (active clients, revenue growth, gross margin, profitability), it means it's navigating its competitive landscape properly.

Stitch Fix is run like a software company through its CRM strategy

Founder-CEO Katrina Lake is focusing on the scalability of her company over the long term. She's focused on the next 10 years, not the next ten months, and that's what I like to see. She's increasing SG&A while maintaining a positive cash flow, expanding in-house knowledge and competency with new data science personnel and making efficient advertising bets with strong ROI.

As its core, Stitch Fix is running its business like a software company. That's a natural consequence of its treasure trove of user data, built thanks to a CRM strategy that was built on a thorough on-boarding process for new clients from the ground up.

Source

User acquisition is analyzed by cohorts of users. With each quarter that goes by, Stitch Fix is becoming smarter about what to put in its boxes and what the profiles of its high spending clients are. This internal data is an asset that has been 10 years in the making. This first mover advantage could give an edge to the company in conversion (marketing efficiency) and monetization (finding high spenders and maximizing their experience) over time.

While Stitch Fix does not disclose details on its monetization, the company explained in its 10-K:

A high proportion of our revenue comes from repeat purchases by existing clients, especially those existing clients who are highly engaged and purchase a significant amount of merchandise from us.

A revenue relying on a small number of heavy spenders is typical of the gaming industry. In free-to-play games, the vast majority of revenue is generated by 'whales' who make up a small percentage of the player base.

As a result, it only makes sense that Stitch Fix management is focused on finding and retaining a specific subsection of its active clients that drive the majority of its top line. The success of the company depends on a minority of 'super-users', not on the masses dabbling in the service with one box and never coming back. This is the very reason that most investors are missing on the real value of the company.

Now, let's review the leverages that could make SFIX a 10-bagger in the next decade.

Leverage 1) Continued Revenue Growth

The company has been growing its active clients (+18% in the last FY) and revenue per active clients (+9% in the last FY) with consistency over the years, resulting in a revenue growth of 29% in FY19.

If we look at the revenue growth quarterly Y/Y since going public, SFIX has grown with consistency far above 20%, recently reaching a high of 36% (though the last quarter included 13 weeks).

This is the sign of a true growth company.

Chart Data by YCharts

Need to see more? Over the past six years, the company has grown revenue at an 85% CAGR. That's right. Stitch Fix multiplied its revenue by more than 20x in a matter of six years (from $73 million in FY14 to $1.6 billion in FY19), all while remaining profitable.

Source: SFIX Form 10-K Q4 FY18 and Form 10-K Q4 FY19. Chart by author.

This kind of growth won't stop overnight. It will certainly slow down over time, but assuming a growth rate above 20% for the most part of the decade to come is perfectly reasonable, given the history of the company and its capacity to enter new verticals, new territories, and increasing wallet share of existing clients.

Leverage 2) Margin expansion

The company has maintained or grown a very healthy gross margin now at 45%. This is largely explained by the e-commerce nature of the company, combined with the fact the Stitch Fix is predominantly a "full-price channel" that helps labels grow their brands.

In the meantime, Stitch Fix has slowly increased its advertising expenses (included in SG&A) to a reasonable long-term target of 10%.

The rest of the administrative expenses have grown along with sales, as Stitch Fix is taking advantage of its fast growth to re-invest in itself, expanding its data science personnel to maintain its first mover advantage and continue to acquire and retain the best clients.

Source

Management has defined its long-term growth target at 11-13%, a target we know the company can achieve, because it did in the past (12% in FY15 and 10% in FY16).

This should naturally materialize once the company will have grown its data science teams to a satisfactory level.

Source

Adjusted EBITDA margin is 2.5% in FY19 (including stock-based compensation). Assuming that the company can eventually grow its margin back to the 11-13% range, the company is currently valued at about 9 times forward earnings even using FY19 revenue.

This is also reflected in the fact that Stitch Fix is currently valued at about 7 times its projected 2025 earnings.

Leverage 3) Free Cash Flow Accumulation

Stitch Fix has been growing its cash flow from operations with consistency over the years, reaching $79 million in FY19. Source

Thanks to its cash flow accretive business, Stitch Fix is likely to improve its already pristine balance sheet. As of end of FY19, Stitch Fix had $171 million in cash and cash equivalents and $197 million in short and long-term investments and no debt.

Source

Over time, Stitch Fix is likely to build a cash pile that could give the company optionality. And given that cash flow from operation has almost doubled over the past three years, it's easy to see a future where the company is justifying a much higher valuation just based on its cash accumulation.

Leverage 4) Valuation Multiple Expansion

The market is making a mistake by focusing on backward-looking PE. This is not the way to value a company in its growth phase, even more so when it's aggressively reinvesting in itself.

Despite two successful years as a public company, Stitch Fix still has a market cap under $2 billion and an Enterprise Value of $1.7 billion.

Chart Data by YCharts

As explained last month to the App Economy Portfolio members, you'll have a very hard time finding a company growing as fast as Stitch Fix in the apparel industry.

One that comes close is Lululemon Athletica (LULU), though Stitch Fix is clearly growing at a faster pace.

Chart Data by YCharts

Now, if we compare the valuation of these two companies on an EV to free cash flow basis, the difference is staggering.

Chart Data by YCharts

  • SFIX is valued at 36 times trailing FCF.
  • LULU has now reached a multiple of 80 in 2019, more than twice as much.

Beyond seeing its fundamentals improve quickly over the next few years, SFIX could also see its valuation multiple expand a la LULU in 2019, which could generate tremendous returns for those who will be patiently watching the story over time.

Bottom Line

I generally love companies that are considered "junk" by a big part of the market, because it creates amazing opportunities over the long term. And I believe Stitch Fix is currently presenting that kind of opportunity.

As revenue grows and margin expands, Stitch Fix is likely to accumulate cash and eventually justify the premium valuation that its successful growth story demands.

If you want to know how much bigger Stitch Fix can be if the company can maintain a 20% growth rate and expand its profit margin back to 10% in the next five years, look no further than Lululemon, a company valued at $25 billion today.

It might take time, and it could be a bumpy ride. But when all is said and done? I wouldn't be shocked if Stitch Fix is a ten-bagger from its current level under $2 billion market cap.

Disclosure: I am/we are long SFIX, MTCH. 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.