Thoughts on Stitch Fix as a Long-Term Investment
I’ve been reading and thinking about Stitch Fix lately. I bought a few shares in March when the valuation was dirt-cheap, but it subsequently has moved to my “too-hard” pile when I sold everything in September.
The company trades at a reasonable sales multiple (1.9x EV/sales LTM) when you consider:
They are growing clients and revenue at ~10% a year even with COVID headwinds
Gross margins sit at 45% and can expand at scale
They have no debt and are cash flow positive
You might be asking: wait, haven’t e-commerce companies benefitted during the pandemic? On the whole, they have. But within Stitch Fix’s niche (work, formal, and “going-out” wear) they have faced enormous headwinds. The company has been able to pivot, with women’s activewear growing 350% YoY last quarter, but they still face a tough industry environment. I’m confident this will end as social life gets back to normal post-COVID.
What I like About Stitch Fix
It Doesn’t Need to Grow to Realize its Current Valuation
At 45% gross margins, I think a conservative free cash flow estimate (FCF) for Stitch Fix, assuming they wanted to stop growing, would be 10% of sales. 1.9 divided by 10% would give an EV/FCF multiple of 19, which tells me the floor for the stock is high if revenue goes stagnant.
Now, do I think Stitch Fix is going to immediately stop growing? Not by a long-shot. But it is important to note that this is a high-floor/high-ceiling scenario. These don’t come around often, and it is prudent for investors to take advantage when they do.
As a disclosure, I want to note that no investment is a 100% lock, so there is a downside risk here. I just think it is minimal.
It Gets Better the More You Use It
What makes Stitch Fix unique, and gives them an advantage over any competitor, is their algorithm + human strategy for sourcing products. Users that sign-up for a fix have to take a styling quiz, which provides data for an algorithm to sort them into categories. From there, a human stylist (Stitch Fix employs thousands of them) uses that data to personalize a “fix” that they will send in the mail.
Each time someone gets a fix and leaves data points, either by keeping or sending back an item, the algorithm gets better. Consequently, every time a user leaves feedback on a fix to their stylist, they better understand what to send to them. This should increase the LTV of a customer by a) reducing churn, and b) increasing the amount spent per fix.
They Can Enter into Adjacent Categories
Stitch Fix started out solely as a styling service for clothing, but has and will expand to much more.
The company launched “Shoe” and “Accessory” categories a few years back. These have done well as add-ons to Fixes. Accessories can change with the trends, with one example being their current mask offerings.
Some of Stitch Fix’s accessories offerings.
The largest new category for Stitch Fix is their “Direct Buy” and “Trending for You” functions. Launched in 2019 or maybe early 2020, it allows users to browse a personalized collection of clothes and shoes to either build their own fixes or complete a look with one extra item. Users can’t search and only have 9-10 different collections to choose from, but it works because the algo + stylists know what the customers like and dislike. I think this can be a monster for Stitch Fix and wouldn’t be surprised if it was 30%+ of their sales in a few years.
Lastly, I think the Stitch Fix model can apply to more than just shirts, pants, and shoes. Beauty is the killer unlock here. There’s no reason the data + human process can’t work for makeup and other cosmetics, a $50 billion industry just in the United States. I could even see a world where you could outsource the “styling” of part of your house to Stitch Fix. These would involve more specific items, and maybe would only work with Direct Buy, but it is a big opportunity nonetheless.
My Personal Experience
Since I’ve been contemplating Stitch Fix as a core holding, I wanted to try the service myself. Some good old anecdotal evidence, as we like to say. On my first fix, 4 out of 5 items were something I’d wear, which I thought was a positive sign. The only problem was I put in the wrong sizes for a few things, which I assume is a big problem for first-time buyers. This will hopefully be solved on the next shipment as I noted it in the feedback survey.
The return process was easy and didn’t cost anything. I realize this adds a double-shipping cost to their business model and limits them to only higher-priced items, but think it is worth it for the friction-reducing customer experience.
The only problem I had with using Stitch Fix was the 3-day turnaround window. It is a little aggressive and may lead to some customer complaints. By no means is it a dealbreaker though.
What Concerns Me
High Upfront and Maintenance Costs
It takes a lot of upfront work for Stitch Fix and the user to get a fix out to ship. Don’t get me wrong, it ends up being worth it in the end, but the work and costs associated cannot be forgotten. Users have to spend a decent amount of time filling out a survey and getting their sizes down, while Stitch Fix has to spend money having their stylist work with the data analysts to pick the right clothes to ship.
This might make it so a customer isn’t profitable until their 3rd or 4th fix. If they keep churn low, this shouldn’t be a problem.
Overdoing it on the Data
Stitch Fix likes to brag about how many data scientists they employ. This concerns me because I know data scientists are expensive, and I don’t necessarily understand why 100 would be better than 60. It smells like bloat, and I hope the executive team isn’t wasting resources.
There is a lot to like about Stitch Fix. The risk/reward profile at the current trading price feels appetizing, and any lowlights I found were either low-probability or minor. I’m going to be closely following the company heading into the Q3 earnings season, and could definitely see myself adding shares in the near future.
Further Analysis on the company:
Disclosure: The author is not a financial advisor, and may have an interest in the companies talked about.