SFIX - Stitch Fix: An Overvalued Stock In A Challenging Market (Rating Downgrade)

2023-10-09 09:53:37 ET

Summary

• Bull case, Stitch Fix, Inc. recently achieved positive free cash flow in fiscal Q4 2023.
• However, this accomplishment is partly driven by management's stock-based compensation, which raises questions about its sustainability.
• The expectation of revenue shrinkage in fiscal 2024 further challenges the potential for significant free cash flow growth.

Investment Thesis

Stitch Fix, Inc. ( SFIX ) is a personalized fashion service that offers clients customized clothing recommendations through personalized shipments called "Fixes" or direct shopping on their app. They use a combination of data science and human stylists to tailor fashion choices to individual preferences, helping clients discover and buy clothing they love.

The bull case is this, Stitch Fix's objective is to assist clients in finding fashion choices that align with their unique styles and lifestyles.

However, as we move beyond its narrative, I find little reason to get bullish on this stock.

Stitch Fix Near-Term Prospects

Stitch Fix is a fashion service that offers personalized clothing and accessory recommendations, operating in the United States and the United Kingdom. Clients have two primary engagement options: personalized shipments called "Fixes," curated by Stitch Fix stylists based on client preferences, or direct shopping through their website or mobile app, referred to as "Freestyle," which provides outfit and item recommendations.

The company employs data science and human expertise to offer tailored fashion suggestions, leveraging an extensive dataset encompassing client and merchandise details for purchase prediction and inventory optimization.

Stitch Fix aims to deliver a personalized shopping experience by focusing on individual client preferences, distinguishing itself from traditional retail and standard e-commerce.

Here's a quote from the fiscal Q4 2023 earnings call that encompasses Stitch Fix's narrative:

In most instances shopping offline is cumbersome and shopping online can be overwhelming. The brick-and-mortar apparel shopping experience is time-consuming and at times, frustrating. And although the online experience has gotten better, it is still too focused on session-level conversion and lacks the inspiration and personalization that make great style, great fit and great value attainable.

And while the business clearly has an attractive narrative, I'm not sure that its narrative is resonating strongly with its customers.

As you can see above, over time, Stitch Fix is targeting its platform towards a shrinking base of customers. This speaks loudly to the value that customers find in its offering.

If that insight wasn't enough, let's now discuss Stitch Fix's growth revenue rates.

Revenue Growth Rates Tell the Whole Story

Stitch Fix is facing several challenges, including a decline in active clients, with negative growth expected in the near term, and reduced order frequency as clients remain cautious in the current economic environment.

All this is translating into yet another year of negative growth rates. I'm all for rooting for the underdog, but this is not a worthwhile investment. The business is clearly struggling to gain traction.

Every investor wants to buy a cheap stock. But the most important rule of investing is to try to avoid a loss of capital. It doesn't matter what the share price was two months ago or two years ago. All that matters is whether the business' intrinsic value is increasing or shrinking. And I believe that Stitch Fix's intrinsic value is shrinking.

Next, let's discuss its valuation.

Show Me Time for Stitch Fix

Stitch Fix's new management team is attempting to address the business' needs for operational changes, including restructuring and warehouse consolidation, plus its decision to exit the UK market, to drive cost savings.

Consequently, while its gross margin has improved, Stitch Fix must continue to navigate the competitive apparel market and ensure it offers customers a stable price all the while focusing on providing a personalized shopping experience to differentiate itself from other retail options.

In my opinion, investors should reassess Stitch Fix as a ''show me'' story. I recognize that bulls will continue to declare that the business is cheaply valued as it's already down more than 90% from its all-time highs. Also, bulls will argue that the business was able to turn free cash flow positive in fiscal Q4 2023 , and this should factor in.

But I remind investors that this figure includes management's stock-based compensation. Let me put it another way, it's entirely possible that Stitch Fix could end up reporting $50 million of free cash flow in fiscal 2024.

This would be a 28% increase y/y compared with fiscal 2023. A figure that I believe is highly unlikely given that Stitch Fix itself notes that its revenues are expected to shrink in fiscal 2024, not increase. And certainly not increase by close to 30% y/y. Nevertheless, even at $50 million of free cash flow, management's stock-based compensation will make up around $100 million (my estimate).

Admittedly, Stitch Fix has a very clean balance sheet with no debt. And yes, close to 70% of its market cap is made up of cash. But I believe that this cash will not suffice to turn around this business.

The Bottom Line

As I delve into Stitch Fix's narrative, it's challenging to find reasons for optimism about this stock.

While the company offers personalized fashion recommendations and emphasizes tailored shopping experiences, its near-term prospects are concerning. Stitch Fix is experiencing a decline in active clients and reduced order frequency, reflecting cautious consumer behavior in the current economic climate.

Revenue growth rates have been consistently negative, indicating ongoing struggles. The stock's low valuation may tempt some investors, but it's crucial to remember that intrinsic value matters most, and in this case, it appears to be diminishing.

Despite turning free cash flow positive in Q4 2023, I wonder if it will actually grow in fiscal 2024, especially as its revenues are expected to shrink in fiscal 2024. Stitch Fix's cash balance, while substantial, may not be enough to reverse its fortunes, making it a challenging investment choice.

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