February 27 2020 - Stitch Fix: Excellence At Work

Stitch Fix is a fast growing online fashion retailer in the US with recent expansion in the UK market.

The company is very data-centric.

It is run by an excellent management team making excellent use of the data gathered.

I believe SFIX is a long-term hold with excellent risk/return prosepcts.

The Business Model

Essentially, Stitch Fix (SFIX) is an online retailer for apparel, footwear and accessories, serving women, men, and children. However, it would be more precise to call SFIX a curating retailer: before making the first order, clients need to answer some 80 questions covering aspects like measures, price levels and styles. Based on this information, SFIX-employed stylists create “Fixes”, i.e. boxes with 5 items (pair of shoes, skirt, blouse etc.) which are sent to the customer. Customers can keep all five items or return all or some of them at no additional cost. SFIX charges a fee for composing the Fix, but this fee is netted against the purchase price of the items bought.

These Fixes are the core of SFIX’ customer relationship. One thing I like is that the company provides quite some flexibility with regards to the frequency of Fixes being sent. While this reduces the predictability of Revenue to some degree, it puts the customers first, and this is the attitude that makes a difference in the long-term. Always.

For quite some time, this was all I knew about SFIX. And thus I did not consider the company an interesting investment – simply because I am not much into investing into retail and not much at all into apparel shopping myself.

BIG mistake.

This was a mistake for two main reasons: First, after learning just a little more about the company, I figured how well run it is (generally a very good reason for an investment). And, second, it turned out that retail is definitely the wrong box (pun intended) to put SFIX in. Instead, this is a tech company – and a great one, I believe.

The Data

The key to SFIX’ success is data. The best way of collecting data is to get it from your customers after explicitly asking them for it (I will talk about their data handling in the next section). This is where SFIX’ success story starts, since this is the core of running an online styling business: In order for the stylist to make the right choices, customers have to tell them what they like and what they don’t like. And once the stylists made their choice, customers will provide further feedback by returning items they don’t like and keeping those they do like (they have to pay for those, which even a fashion moron like myself can identify as customer consent with the selection).

But it goes even further: Do you remember these little games on Facebook (FB) and elsewhere? You answer 10 questions and then the website tells you something like: “If you were born an animal, you’d be turtle.” Or: “A weekend city trip is your favourite type of holiday.” While quite a few people I know really enjoyed these little questionnaires, many of them had no clue how much information they gave away about their beliefs, attitudes etc.

Well, SFIX has the “Tinder for Clothes”: Its “Style Shuffle” app shows customers item after item and all its users have to do is to choose between thumps-up and thumps-down. According to users, this exercise is addictive.

I like this customer friendly and essentially transparent way of getting the information that is needed for providing the service requested (and presumably little information beyond). But what I like even more, is how smart SFIX is with using the data collected.

Data Handling

There is one pretty obvious application of all the data collected by SFIX: To find the right item for each customer. SFIX’ track record of retaining and adding customers proves their skills in using the data for this purpose.

(Source: 1q20-SH-Letter)

The much more interesting aspect in my view is how well it works the other way around: Finding, for a given item of inventory, the right customer (without, of course, giving up too much of the previous aspect). And this is where SFIX’ most recent innovation comes into play (1q20-SH-Letter):

In Q 2 19 we announced the implementation of an inventory optimization algorithm that helps allocate inventory more effectively across our U S Women’s clients As a reminder, the algorithm considers the preferences of a broader universe of clients in our styling queue (rather than one client at a time) as it determines what inventory should be made available to stylists as they style each client.

(…)

As of the end of Q 1 20 our inventory optimization algorithm contributed to an increase in average items purchased per Fix, bolstering our gross margins In addition, we’ve seen higher client satisfaction levels where this algorithm was applied and received feedback from clients that their Fixes were more personalized. The updated algorithm also shortened average styling time, further improving our unit economics.

This is a very powerful tool: Not only will happy customers shop again and more with SFIX – reduced return fees and in particular reduced stock of unsellable items is the basis for the excellent gross margin that SFIX operates on (see below for further discussion). So effective inventory management helps both the top-line and the bottom-line, thus significantly strengthening margins.

But SFIX isn’t done yet with smartly improving their business model to further boost profitability.

New Offerings

Again, quoting from the 1q20-SH-Letter (emphasis added):

In Q 4 19 we introduced our direct buy capability, which allows clients to select and purchase items outside of a Fix directly from our website or mobile app. In doing so, we’ve begun taking steps on what will be a multi-year process of evolving our offering so that our personalization service can be accessed in more flexible ways.

So essentially, SFIX is broadening its client relationship and is moving away from being strictly linked to Fixes (i.e. boxes with pre-selected content). To date, two initiatives have been implemented:

First, Shop Your Look offers the customer online a curated selection of items that are expected to match. Again, I’ll let CEO Katrina Lake explain the offering (1q20-SH-Letter):

While we have tens of thousands of items available in our assortment that we could show clients, our personalization capabilities are strong enough that we can reduce this paradox of choice and show clients only a small subset of our inventory. For example, today we present clients an average of 30 to 40 shoppable items at one time. This radical e-commerce experience is working, and we’re encouraged by early signs that Shop Your Looks is both complementary and additive to the Fix experience.

I like it when companies are not dogmatic about their business model. Yes, everything started with boxes of 5 items that the customer had to get home first, but some may feel totally happy to order online – with the noise of thousands of items also available being removed.

Second, Shop New Colors offers previously purchased items in new colors, prints, and sizes. To me, this sounds like a no-brainer to use: If you like a blue shirt that was part of Fix because of its fit and fabric and you got that invitation to a wedding – why not buy the white one, too?!

This is revenue with very little risk of disappointment for the customer and very little risk of returns for SFIX. Not surprisingly, management is very satisfied with the first results from the gradual roll-out (1q20-SH-Letter):

The early momentum we’ve built thus far across both Shop Your Looks and Shop New Colors demonstrates how successful we can be when we expand our personalization capabilities in new and incremental ways.

Suppliers

Real success in retail is linked to the connection with the suppliers. Quoting from the FY-19-10K-Report:

We offer merchandise across multiple price points and styles from established and emerging brands, as well as our own private labels, which we call Exclusive Brands. Many of our brand partners also design and supply items exclusively for our clients.

None of this is overly surprising: SFIX tries to address an as wide as possible range of customers, by offering among other things different price levels and a wide brand selection. And, SFIX made the deliberate decision to stock and deliver all items themselves, rather than (partially) outsourcing the shipment to the manufacturers. This is assumed to assure the best customer service and brand awareness by avoiding that e.g. a customer receives a single Fix in three boxes from three different senders.

More relevant are two other aspects. First, SFIX complements the available offering from third party apparel designers whenever it identifies a need based on the information available from its customers (i.e. shoppers). This aims to provide the best possible coverage of items included in the Fixes (or the accompanying offerings discussed above).

And second, SFIX is in the position to give in-depth feedback to the apparel firms about what items sold well or not so well and – most importantly – why. This is fundamentally different to fashion retailers with less granular data gathering and customer interaction. So it creates a strong incentive for both parties to enter into a discussion of how items should be designed etc.

I believe it makes sense to take a step back to fully appreciate the way SFIX makes use of the data they collect from their customers, be it by directly asking, by looking at customer’s Pinterest (PINS) sites, or by analyzing the items kept and returned: These data are being used to serve the customers well today by finding the right item, serve the customers well tomorrow by helping to design the right items tomorrow, and help the own gross margin by reducing inventory that can’t be sold at regular prices.

If you hear that SFIX is a tech / data company, not mainly a fashion retailer: This is why.

Competition

There is an easy-scare for any SFIX-investor: Amazon (AMZN), a company with quite some standing in the online retail world. A company with a lot of data and a lot of data handling competency. And, with deep, deep pockets. And as such, Amazon will take its share of the online apparel cake. But will they be able to threaten SFIX’ or similar business models?

I don’t think so, and mainly for two reasons, which are essentially linked: One is that clothes, shoes, and accessories actively help express many people how they feel and how they want to be perceived. Tiny things can make a difference and it is SFIX that is collecting data on almost any possible aspect of skirts, shirts, Jeans etc. The other reason is that, in fact, it is a different thing to receive the newest summer outfit from a company that aims to care about your style versus from a company that also sends staples, dog food and kitchen paper.

Shopping through SFIX essentially represents a different level of ((self)) appreciation. And as a side remark, at least for some, I believe the explicit involvement of flesh-and-blood stylists will contribute to this perception.

Obviously, there are loads of other competitors as well (both offline and online) and discussing this whole landscape is way beyond the scope of this article. One name often mentioned when discussing SFIX is Revolve (RVLV), an online retailer also claiming a “customer experience from a vast yet curated offering totaling over 45,000 apparel, footwear, accessories and beauty styles”.

The Revolve offering is taking a different approach by heavily involving “influencers” and it is potentially more tied to a certain generation. Overall, I find the long-term role of influencers much harder to predict than the long-term benefits of smart use of data. This is why I prefer SFIX over RVLV.

My overall conclusion regarding SFIX’ market position at the end of this very brief discussion is close to the following statement from the FY-19-10K-Report:

We compete primarily on the basis of client experience, brand, product selection, quality, convenience, and price. We believe that we are able to compete effectively because we offer clients a personalized and fun shopping experience that our competitors are unable to match.

International Expansion

In May 2019, SFIX launched its service in the UK. It seem more natural for a US company to take its service to Canada first, but management decided to go across the pond. Management has indicated that “UK shoppers are fairly tech-savvy and more used to online shopping compared to their US counterparts”

As I said, I am not an expert for Retail business, but I trust management’s assessment to find the right entry point into the international expansion. My trust stems in particular from the smart decision SFIX’ CEO Katrina Lake made when starting her business: She addressed female customers, unlike many competitors which start from the assumption that men on average like apparel shopping much less and have a stronger incentive to find lower-effort solutions. As can be seen from SFIX’ success, this strategic decision was wise.

That said, international expansion carries a lot of risks. Investors will want to closely follow the progress being made, as it will not only decide over short term expenses and management attention, but also about the very long-term growth prospects.

Valuation

At a share price of around USD 28, SFIX trades at around 1.6 P/S on a TTM basis. (We did observe some volatility recently, didn’t we, so it is hard to predict where the share price will stand at the date of publication of this article…)

SFIX’ management made the following statement about the long-term financials of the company, see this slide from the Investor Presentation:

(Source: 1q20-SH-Letter)

A target range for operating profit of 10-12% appears absolutely realistic, in particular given that SFIX management has proved for many years now that they can manage the gross margin at the forecasted level (and they may get even better – as discussed above for inventory management). Advertising Expenses seem to be set rather conservatively, while my view is that other SG&A are expected to benefit significantly from scale over time. This latter item will be key and is the one for which management still needs to show that they can deliver.

I do also assume that management will maintain their strict cash management, thereby avoiding any (substantial) net interest expense. Historically, SFIX had no easy access to capital, apparently due to concerns about the viability of the business model. As a result, they had to – and managed to – build a capital intensive business generating more than 1.6 billion of Revenue with zero debt and pre-IPO external funding of just USD 43 million. By any means, this management team knows how to run a business.

Assuming an 11% operating margin (mid-point of range, zero financial contribution) and an average tax burden of 30%, one ends up with 7.7% long-term after-tax margin on Revenue. Applying a P/E-multiple of 18 yields at a long-term P/S-multiple of just some 1.39.

The implied annual compound return prospects are excellent, if SFIX’ growth continues anywhere near current rates of 20+%. The following tables provide an overview of annualized returns over a given time horizon (horizontal - in years) assuming certain levels of CAGRs for Revenue (vertical – in percent over the respective time horizon):

(Source: Calculation by Author)

For example, in the left table assuming revenue growth of 16% p.a. over a 9 year time horizon would yield annual compound returns of 12.4% (assuming that the target operating margin is achieved by the end of this time frame). The right table shows the same calculations assuming a reduced long-term margin of 10%, i.e. at the lower end of management’s range.

To put the range of analyzed Revenue growth assumptions into more perspective, here is some information from SFIX’ management about the apparel, footwear and accessories market in the US and the UK, i.e. the markets where SFIX is currently offering its service. I believe that SFIX will be able to gain further share within the online sales market, that is grow even faster than 13.8% p.a. over the next couple of years.

(Source: 1q20-SH-Letter)

From my discussion of the company’s operational excellence and prospects above, it is probably no surprise that I believe the most likely scenario to be located in the highlighted cells in the left table. I consider the implied returns a very reasonable price for the risks of this business and that’s why I am long SFIX.

Conclusion

Stich Fix is an excellently run company in a growing market. This alone is a hard to reject investment thesis.

Admittedly, the general barriers of entry are not extremely high and there are financially strong actual and potential competitors. But I think that SFIX’ management has proven to be very conscious of what its customers want – and how to run the operation efficiently at each end of the value chain.

Thus, even after the recent 20% stock price advance the valuation still seems attractive to me. I believe SFIX to be a very good long-term investment, even though there will probably continue to be a lot of volatility in the share price.

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.