In this episode of Industry Focus: Consumer Goods, Emily Flippen and Motley Fool contributor Asit Sharma take a closer look at Stitch Fix (SFIX 3.93%). They examine the company's income statement, operations, consumer growth numbers, and some recent changes in the company to understand its growth potential. They also discuss the recent sudden spike in the stock price and much more.
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This video was recorded on Dec. 15, 2020.
Emily Flippen: Welcome to Industry Focus. Today is Tuesday, Dec. 15, and I'm your host Emily Flippen. Today, we're going to be looking at a clothing retailer whose stock has gone up [laughs] nearly 70% in just the past week alone. No, I am not pulling your tail.
Here to talk with me about the latest news from fashion retailer Stitch Fix is Asit Sharma. Asit, thank you for joining.
Asit Sharma: Emily, thank you for having me again.
Flippen: So, Stitch Fix is a company that many investors, myself included, had really written off prior to last week's earnings. Stitch Fix, as you well know, is a company that sends personalized clothing and a subscription-style box. And it's really [laughs] seen its stock hammered from its previous highs; I think it was down something, like, 50% this year from its high in 2018.
I'm just curious, when you looked over the earnings announcement from this past quarter, if you read this as the turnaround that Stitch Fix really needed or if this was just a case of expectations that were clearly too low?
Sharma: Well, if you're looking at the stock price as any guide, you would probably see this as a case of Stitch Fix's cup just flowing over, but I'm going to revert to the tired, well-worn, beaten-down metaphor that it's [laughs] a glass half-empty/half-full type of earnings report for me. I'm going to read some notes from the earnings, and maybe we can work down some finer points after that. And then I think we can round out our opinions on this. And I'll be able to describe my take on it and really interested to hear your take.
So, just a few preliminary numbers, Emily. The company's topline, its net revenue, grew about 10% year-over-year to $490 million. Bottom-line looked fine, $9.5 million of net income. And if you like adjusted Earnings Before Interest Taxes Depreciation Amortization [EBITDA] as a guide, that was also positive at almost $7 million. They also showed customer growth of 10% year-over-year to $3.8 million; which I think investors were really excited about. So, this customer growth led to a decrease actually in year-over-year revenue growth per client. But management's comments in the conference call indicated that they think that that metric is going to improve over time as the customers that they are retaining are spending more than newer customers as time goes on.
Now, one of the metrics I think that caught your eye and mine as well, Emily, was this successful First Fix statistics. So, it's really important for Stitch Fix to make sure that new customers are going to buy something on that first receipt of a selection of fashion. So, they measure this, they call it, as I said, a successful First Fix, if you get your First Fix in the mail and buy something from it. They had an 80% success rate last quarter; and that's a really good number for them. And I know that, Emily, you had some ideas on why they had such a nice pop in this metric.
Flippen: Yeah, anybody who knows me as an investor knows that I've been a little bit of a Stitch Fix bear, not aggressively so, but I've never personally bought shares, in part because I didn't really buy into a lot of the metrics that Stitch Fix looks at for success. In this case, the First Fix is one that I think is a little bit troubling. And that's because you, as a new customer, have to pay to get styled. And that upfront fee that you pay, I think it's around $20, if you don't buy anything from your first box, you just lose that money, whereas if you get a box shipped to you, the $20 that you pay to get styled can be applied to an item or two in that box. So, there's a big incentive for first-time customers to not lose that upfront fee that they may have paid and get something from the box itself.
So, that success rate, while it is important that you want to see that trending upwards, you want to see people buying more from the boxes, I'm not sure it's a completely unbiased picture of just how successful they are in identifying clothing. But I will acknowledge that the overall success rate, as we saw in the previous quarter, was up beyond just the First Fix. So, it seems like the data and the algorithm, as well as, the stylist that they've been collecting on their consumers seems to be trending in the right direction; I will give them that. [laughs]
Sharma: [laughs] Yeah. And I think that for those listeners who follow this company, one of the things that you've heard management really talk about is how strong they are in data and analytics. So, at some point, they ought to see an appreciable return from all that investment in algorithms and understanding what people want. And I just, sort of, like management's focus here. I agree with you, Emily, that it's not a pure metric, I mean, it's not a big, what we would call, a key metric, and it's something that you drill down on, and it's sort of questionable how they are measuring it, but I do like management's focus. Because I think that it's difficult in business sometimes, especially for tech start-ups and innovators, to really key on what that second set of metrics is, I call them secondary metrics. I mean, everyone is focused on, we have to grow our topline, we have to get more customers, but what are the next things you look at? I like this because, in seeing that they haven't had the success rate they wanted, they can really turn their attention and resources to making sure that you or I are going to purchase something that first time around and not be disappointed. So, I give them points for that.
Maybe just a couple of other things from my side, a couple of points that caught my eye. I liked, in this quarter, that they showed really an improvement in how they handle inventory, they've been working on their inventory levels and how they stock different styles. Because at the end of the day, even though they're working off of preferences and they're also working off of a stylist's great knowledge base, they have to have the clothes in stock to be able to send out regular fixes, and to make sure that they are improving their sales quotient. So, I like that they have been improving their inventory.
They really rapidly shifted, during this COVID pandemic influence year, to categories that are moving fast. A 150% of their women's inventory this past quarter was -- if you look at a baseline versus this time last year -- I'm sorry, they had an increase of 150% in their athleisure wear; which is this really great category. Now, because we are home, sort of, top-half -- and we talked about this, Emily, top-half looking good, bottom-half in your PJs or in your yoga pants.
I also liked that they advanced a lot of cost efficiencies this quarter in some of the more qualitative things; I don't know if this really showed up as much on the income statement. But if you remember back in the Summer, they had put out what looked to me like maybe bad news, in that they were going to cut 1,400 stylist positions in California, because it's a really high labor state from a wage basis. And I was pleasantly surprised that they really quickly filled those positions at a target of hiring 2,000 stylists in cities like Dallas, Austin, Minneapolis, Pittsburgh and the like, and they filled those by September. So, I thought that was positive too. Sort of, the things you look at outside the numbers that indicate maybe the company is getting into that second gear that it needs to hit.
Flippen: It's funny you mentioned athleisure wear; I don't know about anybody else, but I haven't been in a pair of jeans since maybe March. There's a lot more give in athleisure [laughs] than there is in other forms of fashion. So, I'm not surprised to see that, in particular, increasing, especially given that the majority of Stitch Fix customers are women.
When I look at this business, I think one thing that provides me a level of confusion that many investors disagree with, they think it's strategy, is Stitch Fix's Direct Buy. This is a program that Stitch Fix rolled out, which allowed Stitch Fix customers, instead of just ordering through boxes, to be able to go online and purchase clothing directly. So, they can reorder a shirt or a pair of pants, some item that they bought previously that they want to get another set of, they can reorder those, or they can see a limited supply of other options based on their purchasing patterns in the past. Now, to me, I have to admit -- and I had this conversation with analyst, Aaron Bush; we debated this back-and-forth -- it almost struck me as a lack of strategy. You either buy into the box idea, that their algorithms and their stylists can find better suiting for individuals that they get on a monthly basis, or you're an e-commerce retailer -- like, Amazon or Etsy, I'm trying to think about other retailer, you know, Farfetch, whatever it may be -- where people can go and search for themselves and buy directly, which is it? To me, it was almost like acknowledging a lack of success in boxes by allowing people to buy individually.
But the stats show that my opinion [laughs] may be wrong here. The engagement they're having from people who are frequent customers of Stitch Fix on what they're calling Style Shuffle, the search algorithm that drives the recommendations people get, has seen amazing levels of engagement, which says, hey, people are not only getting boxes, but maybe actually engaging with this Direct Buy much more than somebody like myself may have assumed.
Sharma: Yeah, I confess also to being a skeptic on this Direct Buy channel, because I too thought that this is just really moving toward, I don't know, e-commerce like everyone else, so where is the differentiation? And maybe this proves the strength of the company's algorithms and the data that it's collecting, not just when customers buy, but when they click through the site and linger on certain items. Remember, Stitch Fix is gathering a ton of data on its customers this way. So, if they've got more efficiency in what they're showing customers, Direct Buy could be a profitable revenue stream over the long term. It's certainly early out of the gate, it's a lot more promising than I thought it would be.
Flippen: And when we look at some of the big moves the company is taking here, there was some surprising news I know, I was a little bit surprised to see how Stitch Fix this year, regarding some changes in the management structure, what can you tell us about some new appointments?
Sharma: Very surprisingly, in one way, the company has a new CFO now, that was expected because Stitch Fix has been operating with an interim CEO for a few months. But really out of leftfield in some ways to me, [laughs] Emily, I will confess, the company hired Dan Jedda who was formerly Amazon CFO of Digital Video Operations. Now, investors were super-excited about this. The company announced it on the same day it announced its earnings. Market really liked the pick. Video and fashion styling, two different things, but Dan Jedda comes from a company which is metrics-obsessed, algorithms-obsessed, data analytics-obsessed, [laughs] margin-obsessed. So, you know, when you look at the pedigree of being a key player in a really growing division within Amazon.com, I can see the logic of hiring Dan Jedda, he's an industry veteran, and he's a key person to help Stitch Fix scale into being a larger company. Remember, they're pretty small in terms of total revenue; we went over revenue numbers at the beginning of the podcast. So, I think it's a great move in that sense. It's not maybe the most obvious, but once you start considering how a veteran from Amazon can help this smaller business, it makes a lot of sense.
Flippen: I like it because, despite what you said at the offset, which is they had net income, I believe it was close to $10 million and adjusted EBITDA of $7 million; that sounds a little counterintuitive. But the reason why I like the fact that they're bringing in somebody who is metric-obsessed, is because this isn't, despite what this quarter showed, a consistently profitable business. The reason why their adjusted EBITDA is lower than their net income is because there was, I believe, nearly $30 million of positive income tax expense from the most recent quarter, which is not a part ...
Sharma: [laughs] Atypical.
Flippen: Yeah, atypical, obviously, not a part of continuing operations. So, despite the fact that this is a business that generates cash; for the most part they generate positive free cash flow. They're not consistently profitable; it's not particularly high margin. So, I like this movie because I hope that it shows an emphasis on expanding relationships with their most-engaged customers. Getting those most-engaged customers to spend even more and setting up margins to be really successful for investors. I've always been a believer in, despite the fact that Stitch Fix has a market, I'm not sure it's the entire market for clothing, so for me, with the customer only around 4 million people in the most recent quarter, it's really important to them that they retain those customers.
I do not think this is a product that every single person [laughs] in the United States or in the U.K. or these places they're expanding, I don't think this is going to be something that every single person is a consistent subscriber to. But I do think the people for whom it resonates with, should be focused upon, to be engaged to spend more money, because those are going to be the customers that are the most worthwhile for Stitch Fix. So, I like this appointment; I wasn't expecting it.
And we can talk a little bit about this crazy stock increase. [laughs] I mentioned at the offset that that was up something, like, 70% over the course of a week. None of the stuff we just mentioned, maybe, explains that crazy rise. There's only customer growth of 10%, only net revenue growth of 10%. I could make an argument that some of this was due to guidance. The company is guiding for 20% to 25% full fiscal 2021 revenue growth, largely driven by client growth, which is a great thing to be guiding for; an acceleration from where Stitch Fix has been previously. But there's probably a more [laughs] logical reason for this crazy price increase, right?
Sharma: Yes. Two words which will be familiar to anyone who's ever been in the pain of one of these things, a short squeeze. And Emily, I think you have a point. That guidance that Stitch Fix put out implies a lot of acceleration in the second part of the year just to make the numbers [laughs] that they're going to make for their full-year outlook. But maybe what's more going on here is that short sellers are covering. And notice I'm saying "are," because we're recording, it is a prerecord, this is the 14th of December. I think they're still covering [laughs] their shorts even as we speak.
And I guess we should explain maybe what we mean by covering a short, before we go any further. And so, I'll try to keep it simple, and you help me out in this. So, when you sell a stock short, you're hoping that that stock is going to go down. So, you are going to borrow shares from someone else, when the stock goes down, is selling at a lower price, you can then buy that stock on the open market, and you make the difference in what you sold it short for and the cost to really repurchase those shares. So, covering a short means, just closing out your short position.
So, Emily, did I get that right? And then what exactly is a short squeeze? [laughs]
Flippen: Yeah, you described it perfectly. It's almost like this feedback loop where the company that is largely sold short, meaning a large portion of its shares outstanding are shares that are shorts, so investors betting on the stock price decreasing, when any good news comes out of a company, it can cost people who are short to buy shares, to your point, Asit, cover their short positions. And the end result is that the stock price goes up really quickly, really dramatically as there is a rush to buying, which contributed, and are believed to, what was last week's crazy increase in Stitch Fix's stock price.
I put together a graph that obviously we can't share over a podcast, but I can read it. The share price of the company compared to the number of shares out of total shares sold short. And it's been wild over the course of this year, upwards of 24% of Stitch Fix's shares were sold short. Heading into this earnings announcement, it was closer to 20%, but that's still much, much larger than the industry average.
All of this is to say, don't read too much into short-term price movements, you never really know the mechanisms that are driving them up, such as this short squeeze, but more importantly, I'm a big believer in being a long-term "buy" investor, right? I like to be on the side of the equation that offers me the maximum upside with capped losses. If you are shorting companies, you flip that value proposition on its head. The most a company can go down to is zero, versus the most it can go up to is infinite. So, remember that. Even if you don't believe in the long-term prospects of a company, if it's Stitch Fix or otherwise, if there's good news, even if that good news [laughs] is only 10% revenue growth, you could be in a really bad situation that can cost you a lot of money.
So, in my opinion, it's better to own great companies that you love as opposed to short companies that you dislike.
Sharma: Totally agree. I want to point out one more point about short-selling, which many people don't realize until they actually get into this business of trying to profit from when a stock goes down. When you sell shares short, you're actually borrowing the money to do so, so your broker is going to charge you a rate of interest. And that is not a nominal [laughs] rate of interest, it's usually a high rate of interest, except for maybe a few brokerages. And obviously, the more capital you have, if you're a big fish, the better interest rate you get. So, over time, that's another way that selling stock short can eat into your returns. [laughs] In most propositions it's not a good idea.
Flippen: I completely agree. So, I'm kind of curious, before we wrap up today's pretty short show here about Stitch Fix, what are your thoughts on the company? I'd be lying if I haven't been trying to push myself more as an investor to give credit to companies that I may have written off; Stitch Fix is one of them. One of the portfolios I work on at The Motley Fool is the Blast Off portfolio, and alongside Aaron Bush, I discuss a lot of smaller cap companies that are operating in really big markets, that have the opportunity to disrupt industries and be great investments. And Stitch Fix is a company that we consistently go back and forth on. I don't think I'm sold, but I'm curious if you are?
Sharma: I'm not. So, I don't own the stock, Emily. I did make, very early on, I think after the IPO, a caps call in our Motley Fool's Cap Game, a positive call, because at the time I thought that if this technology proves itself out, this can have a pretty long way to run. Now, that's been a long [laughs] suffering caps call, I've been down on that position until just recently, and now it's looking OK, given this really huge run-up in the stock. But is it persuasive enough for me to invest in Stitch Fix? Not really.
One of the things I like to see, if I'm investing in a company for its technology, I want to see either really fast revenue growth or may be evidence of strong margin growth, hopefully gross profit margin growth. And if I see both of those together, I get really interested.
Now, of course, that pushes me toward a lot of high-tech Software-as-a-Service type stocks. If those are available out there and they have a really efficient capital model, it becomes harder for me to invest in a company that's a hybrid consumer goods stock. I have a lot of consumer goods stocks in my portfolio, but they're there for stability and for dividend income to build this revenue stream for when I retire, if I ever do.
Stitch Fix doesn't really fit either category for me. It's not the stable, big consumer goods titan that's got super-stable cash flows and is very profitable, nor is it a fast high double-digit grower with proven technology that is resulting in really awesome metrics in terms of customer growth and loyalty, etc. So, I find myself just not persuaded to pull the trigger and buy these shares.
Any more thoughts from your side on maybe on what I've just said in terms of your lack of enthusiasm to buy the stock?
Flippen: [laughs] Everything you just said is so reasonable, it's so reasonable. And the best bear case I can make is, I just don't really buy a lot of clothes, I don't get it.
Sharma: And I finally learned, Emily, now you'll be proud of me, you are not a fashion maven ...
Flippen: I'm not unfortunately.
Sharma: And I'm not either, so I can say that without sounding like I'm offending you, neither of us, right? I can't see myself using this service, but go ahead. [laughs]
Flippen: Exactly. It's hard for me as an investor to get excited about something that doesn't speak to me and my lifestyle and that has probably kicked me in the butt too many times over the course of my investing life. Maybe I'm making the same mistake here for Stitch Fix. But after your very reasonable response to my question, I now feel more vindicated in my unwarranted opinion than I did when we started the show. [laughs]
Sharma: When it doubles from here next year, we can revisit this episode and talk about how wrong we were.
Flippen: [laughs] We'll entitle the episode We're Sorry.
Sharma: Right. We're sorry, Stitch Fix and potential investors. [laughs]
Flippen: Well, Asit, hopefully that doesn't happen, but I do hope for all of our Stitch Fix shareholders that are listening, I hope it does happen for you. So, it's almost a win-win, right?
Sharma: That's right. Either way.
Flippen: Well, thank you, as always, for joining.
Sharma: This was really, really fun. Thanks, Emily.
Flippen: It always is. And listeners, that does it for this episode of Industry Focus. If you have any questions, you can always shoot us an email at [email protected] or tweet at us @MFIndustryFocus.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.
Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma, I'm Emily Flippen, thanks for listening and Fool on!
