1. First things first. What is Stitch Fix?
Stitch Fix describes itself as “the world’s leading online personal styling service”. Customers fill out a Style Profile (over 85 data points) and, combining data science and human judgment, a personal stylist handpicks the appropriate curated selection of items and mails them right to customers’ homes. The customer will try the items and keep desired ones, sending back the rest in a prepaid envelope.
2. Great! But what is Stitch Fix’s real value proposition?
Following with its own quotes (this time from its S-1 document), Stitch Fix considers itself as the company that “is transforming the way people find what they love”. In the words of Steve Vafier, in his article “Untangling the Threads: Stitch Fix is a Bargain”: “they have reinvented the shopping experience and democratized personal styling”. It sounds good! but what does this really mean?
Within the retail landscape, the Internet era brought an initial challenge that was to move all the existing items from the physical world (brick-and-mortar retail) to online stores. This supposed the creation of huge online marketplaces, being Amazon the archetypical example. Amazon has been able to put basically all existing items in the same place at the same time, ready to be purchased by any client from home.
However, as it usually happens, a new solution begets new problems. Amazon (and many other online marketplaces) is an amazing business but works better when the customer has clear (or almost clear) the item intended to buy (e.g. a customer that needs a shirt and have clear the style, the size, the brand, even the color, etc.).
The problem arise when the customer has a generic need whose specific characteristics are pending to be decided (e.g. a customer that needs a shirt but he/she has not yet decided the style, the color, etc… any characteristic that defines the final shirt). That’s when these huge marketplaces emerge as messy places and frequently useless, making the customer even to go back to the physical store.
And here is where the value proposition of Stitch Fix resides: once all the items are available online, Stitch Fix curates the most suitable for the customer. Stitch Fix orients its services to fill this gap and it has a broad base of potential customers: from people that like shopping but have no time to those that need help with styling, or people looking for a surprise or someone wanting to discover a new style, and of course the ones that don’t care or don’t like shopping (but unfortunately for them need clothes).
3. Great again! But is Stitch Fix also a good business?
During the last years many companies have jumped into the online scene trying to exploit this niche in the apparel market. Many online retailers (e.g. Zalando, Waifair Inc, ASOS Plc, Revolve Group Inc.) but additionally many new entrants that are trying to compete directly providing similar services as Stitch Fix’s (e.g. Trunk Club, Le Tote, Wantable).
At the same time the big players in the online landscape are also starting to be interested on this gap and creating their own personalize services. Amazon has recently launched Amazon’s Personal Shopper (July 2019), as part of its Amazon’s Primer Wardrobe, and Walmart has partnered with Kidbox to create a sort of “Stitch Fix for kids” (April 2019).
The competitive landscape is getting crowded… so the question is what makes Stitch Fix to be well positioned to win this race? Several reasons invite to think that, if not the absolute winner, at least it will probably be among the winners.
The first reason is Stitch Fix’s first-mover advantage. Stitch Fix started in 2011 and it was the first one really focused on clothing selection and styling personalization. This has provided the company with both strong brand recognition and relevant experience. Most of the new players will need some time to acquire those features and by then Stitch Fix will be again on a higher level.
The second reason is the strong bet on data science that Stitch Fix has done from the very beginning. Indeed, being Stitch Fix an apparel company, it might be considered closer to a tech company in its mindset and culture. Most of Stitch Fix’s management team comes from tech companies (Google, Netflix, Salesforce, Yahoo!) and the company is steadily investing on its technological structure:
- It has strongly increased the number of its “tech” employees: it has doubled the amount of engineers from 95 to 180 and increased its data scientist from 75 to 100 (FY17 vs. FY18), and it is committed to continue investing on technology talent.
- It works permanently on fine tuning its algorithms to provide a better service and improve operational efficiency (e.g. in Q2 2019 it launched a new inventory optimization algorithm to improve the allocation of the inventory across the clients).
- It is constantly trying to improve data gathering and analysis (e.g. Style Shuffle launched in March 2018, see below).
- It uses data science throughout all its business, not only to match customers with apparel but to optimize inventory and improve warehouse efficiency; to reduce shrinkage; to predict purchase behavior and forecast demand; to design new apparel; to improve in-house marketing strategies, etc.
Third, Stitch Fix is permanently trying to reinforce customers’ engagement, improve client retention and satisfaction and grew average revenue per client through product and marketing initiatives. These are just two examples of recent initiatives:
- Style Shuffle (launched in March 2018) which is some sort of game where customers see different pieces of clothing and accessories, and share whether it's their style or not. This helps Stitch Fix to learn more about style preferences and provides relevant information to improve its algorithms and therefore its keep rates. During the Q3 2019 earnings call it was mentioned that, till then, 80% of the clients had been playing with the app and had generated 2 billion ratings.
- Style Pass (launched in December 2017) which offers unlimited styling for an annual $49 membership fee. This initiative is currently just being used by a minority of Stitch Fix’s clients (select Men’s and Women’s clients), but it is providing valuable results (one-year renewal rates over 70%) and it is expected to increase its diffusion in the following years.
The fourth reason is the existence of data network effects. As Steve Vafier states in his article (see link above): “Stitch Fix has a very unique relationship with users” that allows it to gather many “meaningful data points” and provides himself with a “tremendous potential if they can use data to nail both the style and fit to help clients discover new products”, creating a positive feedback loop. Stitch Fix constantly gathers relevant information and data from its clients. This is really valuable information that helps to improve its own systems and the service provided, but also allows the company to explore additional business segments where those data might be used (e.g. create new brands to fill potential gaps, collaborate with its suppliers for them to adapt its offer to customers’ needs, etc.). In relation to this, in a recent interview Stitch Fix CEO Katrina Lake (talking about the idea of personalization) mentioned: “That’s an example of a new way to engage, but I think the idea is that with personalization, we can actually take this capability, and it doesn’t have to be five things, it doesn’t have be in the box, and to your point, it doesn’t even have to be apparel. I think that’s the really special part about this company, that we’ll be thinking about how do we use that capability to grow over the next 10-20 years”. This can provide an idea of Stitch Fix’s horizons and its CEO’s mindset.
Fifth, Stitch Fix is constantly expanding its product assortment by broadening its brands offering and price points. Indeed its seamlessly gathering of data helps the company to create new brands to fill potential gaps. The company can rapidly detect underserved market areas and react to this need. Stitch Fix started with a focus on Women’s apparel but rapidly extended its capabilities (see next paragraph).
Sixth, Stitch Fix is currently the company that is serving more different sub-segments as they serve clients in all the following categories: Women’s, Petite, Maternity, Men’s, Plus, Kids and Extras. Most of its competitors are still covering fewer segments and many of them just one segment (e.g. currently Amazon only covers the women’s segment).
Seventh, Stitch Fix has already started its international expansion. It has recently launched its UK offering and it is planning to expand to Germany in the near future. The company mentioned that they are not “interested in expanding at all costs, it’s important to pace the growth, take time to learn and make sure if or when (they) do expand further, (they) are ready to make it a success”, but seems to be ready to conquer international markets.
Is this not enough? Ok. Let’s then summarize some other reasons that make Stitch Fix to be a great business: generates positive net income and free cash flow; is an asset-light and capital-efficient business model; funds its growth with internally generated cash flow; presents net cash and no debt; is scalable; has a good management with skin in the game and committed with the project; presents a huge opportunity on international expansion; enjoys the tailwinds of the online market penetration…
4. So Stitch Fix seems to be a great company but then the market should have already reflected this… what has been the evolution of its stock price?
Stitch Fix’s IPO was on November 2017 and it was launched at $15. Since that date the stock price remained rather stable until June 2018 when the shares started to soar moving from $19 to peak on September 2018 at around $50. However, since then the price has declined almost until its IPO initial price of $15 (by the moment of writing this article the stock price moves around $19).
What is behind this decline? And, more importantly, might be these circumstances considered temporary?
There are 3 main factors that may explain the recent decline:
The first one is the highly competitive landscape as many companies are trying to get their slice of the pie. Indeed by September 2018 started both the rumors about Amazon thinking about jumping into the sector and Stitch Fix’s share price decline.
There is no doubt that increasing competition is always a threat for the incumbents in any sector and, if Amazon is involved in, the threat becomes a really serious risk. However Stitch Fix’s current position might be considered solidly enough at least for the following 3 reasons:
- The abovementioned first-mover advantage. Stitch Fix was founded 8 years ago and since then it has been gathering data and improving its algorithms and its styling practices. It is right now many years ahead of most of its competitors (even of Amazon). This might be compared with the first-mover advantage that Netflix enjoys in relation with the new players in the SOVD sector.
- As also previously commented, Stitch Fix currently provides a much broader product offer, covering the most relevant segments, unlike most of its competitors.
- Its tech nature makes Stitch Fix a strong competitor in the online marketplace. For Amazon this kind of competition is much harder than the one coming from the brick-and-mortar stores. Stitch Fix is a digital native with a lot of capacity and experience gathering and using data.
All in all this is a structural risk that it is here to stay and something that needs to be closely monitored, but Stitch Fix seems to be in a healthy position to compete.
Besides, being unquestionable the threats arising from competition, all these recent movements made by the competitors have also a positive interpretation: this may just be confirming that the future is expected to be favorable for this market niche and this is why the different players are taking positions to surf the wave.
4.2. Low growth
The second factor may be the lower-than-expected growth. Stitch Fix’s net active clients growth rate has been steadily declining during the last quarters. Specifically, in the last quarter (Q3 2019) the growth rate fell till 16.6% year-over-year, compared with 30.6% a year ago (Q2 2018). As Steve Vafier states in his article (see the link above), “Stitch Fix found instant product market fit with a subset of clients, but it seems to be difficult to rapidly expand beyond this core group. This is a new way to shop and changing user behavior is hard”.
This issue is a permanent matter of concern for the analysts but it shouldn’t be forgotten the boldness of the company. Stitch Fix has been continually trying to improve the engagement with its clients and expand its client base through different initiatives (see above). Additionally the company continues to grow its net revenue and, more importantly, its net revenue per active client, which is one of the key metrics for this kind of companies. Regardless of its constant expansion into new segments with lower purchase frequency (e.g. Men’s or Kid’s) and new territories that are still not in full performance, the company has been able to constantly grow its net revenue per active client.
So, again, the company may be below analysts’ current expectations but there is no doubt that it is making the right decisions to create the basis for a healthy growth (see all the reasons mention above).
4.3. Low margins
The third factor might be the fact that during the last years Stitch Fix has been steadily reducing its adjusted EBITDA, in absolute terms and in terms of margin, even recording in the last quarter (Q3 2019) a negative adjusted EBITDA of $(0.3) million. However before making hurried conclusions it is important to contextualize those figures.
Stitch Fix is a company that is still in the growing phase of its life cycle and focused on expanding its footprint to different segments and geographies. As it is common in the growing phase, this kind of expansion requires upfront costs and investments. This is clearly stated in Stitch Fix’s Q3 2019 10-Q: “To effectively manage our growth, we must continue to implement our operational plans and strategies, improve and expand our infrastructure of people and information systems, and expand, train, and manage our employee base”… “moreover, our expenses have increased in recent periods, and we expect expenses to increase substantially in the near term, particularly as we make significant investments in our marketing initiatives; expand our geographic markets, operations, and infrastructure; develop and introduce new merchandise offerings; and hire additional personnel”. The problem is that in some companies the impact on margins can be mitigated by the capitalization of these investments, but this is not the case of Stitch Fix. Within Stitch Fix’s financial statements, most of the investments flow through the income statement (and are not capitalized) and therefore have a direct and relevant impact on margins, regardless of being expected to produce positive impact in future periods.
There are two main components within these cost structure that explain this (expected) temporary reduction of margins and that have led the SG&A expenses to represent 43% of the revenue (well above Stitch Fix’s long term objective of 33%/37%). On the one hand, labor costs. Stitch Fix is making a relevant effort on investing in technology talent and on expanding its data science and engineering teams (+33% and +90% employees from FY17 to FY18, respectively). Those teams are expected to keep algorithms improving, which in the end should bring higher efficiency, engagement and profitability. However these positive outcomes require some time to be visible.
On the other hand, the other relevant part of this impact on margins comes from the increase of marketing and advertising expenses. Again this is clearly stated in the last 10-Q: “Starting in calendar year 2017, we began to increase our paid marketing expenses by investing more in digital marketing and launching our first television advertising campaigns. We expect to increase our spending on these and other paid marketing channels in the future…”. These are costs with direct negative impact on profitability and on margins but with potential positive outcomes over a longer timeframe. Indeed the negative adjusted EBITDA recorded in Q3 2019 is a consequence of an extraordinary brand campaign.
So in summary, again, this is something that requires a constant follow up because it is true that the negative impact is a real cost and the expected profitability is something still to be achieved. However it is important to avoid a myopic perspective and contextualize this kind of investments within the whole company’s life cycle, and within this cycle the situation seems not uncommon.
Stitch Fix is a company that is “reinventing the shopping experience” but this requires some time in terms of investments and of customers adaptation.
Being a new sector, there is a clear risk of the customers not adopting this new way of purchasing. However the tendency seems to be on Stitch Fix’s side and the company is making a lot of effort to help on this transition.
Anyway, what seems clear is that, if finally this risk does not materialize and this kind of “shopping experience” is adopted by the customers, Stitch Fix will be probably one of the best positioned companies (if not the best) to take advantage of this new potential huge market.
Disclosure: I am/we are long SFIX.
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.