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Is Stitch Fix a Buy?

Stitch Fix (NASDAQ: SFIX) has reinvented online shopping, making it even easier. The company blends data science and the judgement of professional stylists to make personalized apparel recommendations for clients, helping them stay trendy and fashionable.

Since its 2017 IPO, the stock has surged 460%, easily outperforming the broad market and crushing the returns of competing retailers. Despite these incredible gains, investors haven't missed their chance -- here's why Stitch Fix is still a buy.

What makes Stitch Fix different

The retail apparel market is highly competitive, and profit margins tend to be low. Brand popularity and fashion trends can be fleeting, often changing rapidly and without warning. This means decisions regarding new product lines and inventory involve a certain amount of guesswork. But Stitch Fix has a solution for these problems.

Unlike the vast majority of apparel retailers, Stitch Fix uses customer data to curate personalized boxes of clothing, shoes, and accessories. These boxes (called Fixes) are shipped to clients, typically at regular intervals, which allows the client to try on the products at home prior to making a purchase. Stitch Fix has also introduced Direct Buy, a service that uses the same proprietary AI algorithms to make style recommendations, but in this case, clients purchase specific items rather than receiving a stylist-selected assortment.

Image source: Getty Images.

This data-driven approach provides incredible insight into consumer preferences, which should translate into operating efficiencies and customer satisfaction. For example, Style Shuffle is a web or mobile application that allows users to rate clothing with a thumbs up or thumbs down. Stitch Fix can trial new products in this application prior to stocking those items in fulfillment centers. This can help the company predict fashion trends, manage inventory efficiently, and market its business more effectively than traditional retailers. Over time, these benefits should make Stitch Fix more profitable than its competitors.

Another key differentiator is Stitch Fix's lack of brick-and-mortar stores. The company operates digitally, which means it doesn't need to buy as much real estate to scale its business. Its small physical footprint also means it needs fewer employees than many competitors. For example, as of their most recent annual SEC filings, Stitch Fix had roughly 8,000 employees, but Gap reported 129,000, Nordstrom had 75,000, and Macy's had 123,000. Based on revenue generated per employee, this means Stitch Fix can run its business more efficiently than many traditional retailers. And over time, this advantage should become more evident, helping the company achieve a higher level of profitability.

Competitive advantage

In contrast to traditional retailers, Stitch Fix's use of data science also creates a network effect that protects its business. Any time a new costumer joins, or an existing customer makes a decision, it generates more data. This improves the AI algorithms, making them more efficient at predicting fashion and style preferences, which benefits all Stitch Fix users.

Additionally, while shopping online is certainly easier that shopping in stores, Stitch Fix's ability to predict consumer preferences and auto-ship items further simplifies the experience. The appeal of this offering has supported strong customer growth for the company -- active clients have increased an average of 20% each quarter over the last three fiscal years.

Finally, Stitch Fix has built a network of fulfillment centers in the U.S. and the U.K. This creates a barrier to entry since any newcomer would have to first build its own distribution network before it could match the company's logistics capabilities. And while Stitch Fix does face competition from other data-driven retailers, none of them match the breadth of Stitch Fix's product categories. And even if this changes in the future, Stitch Fix will still have a first-mover advantage.

Data by YCharts.

So far, Stitch Fix appears to be capitalizing on its head start. Over the last three years, Stitch Fix has grown revenue more quickly than major rival retailers. Likewise, the company's gross margins have remained relatively flat over that time period -- ranging from 43% to 45% -- meaning Stitch Fix isn't sacrificing pricing power to juice its sales. That's a good indication that the company's differentiated business model is working.

A final word

Stitch Fix was not profitable over the trailing 12 months, due primarily to a rough third and fourth quarter in fiscal 2020. Investors should pay attention to Stitch Fix's revenue growth and profit margins in the coming quarters. If revenue growth fails to accelerate or profitability declines, it could be a sign that Stitch Fix is encountering hurdles as it seeks to scale its business and expand into new markets. Investors should also remember that Stitch Fix offers a luxury product, not a necessity, and this kind of discretionary expense is often the first thing to get cut from personal budgets during periods of economic hardship.

That being said, Stitch Fix has performed reasonably well throughout the pandemic. During the first quarter of fiscal 2021 (ended Oct. 31, 2020), the company reported revenue growth of 10%. That may not sound impressive, but the pandemic hit retailers hard, and many are still posting double-digit drops in sales. In that context, Stitch Fix's ability to move in a positive direction is very encouraging. And with its efficient, data-driven strategy, I think the company is well-positioned to continue capturing market share.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Stitch Fix. The Motley Fool has a disclosure policy.


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