SFIX - Stitch Fix: Analyzing The Pitfalls That May Lead To Its Demise

2023-08-22 03:22:57 ET

Summary

• SFIX has experienced 5 consecutive quarters of negative growth, as macro conditions and its poor business model combine. We suspect a continuation of this, with little hope in sight.
• The business model fundamentally lacks a clear value proposition. Individuals can replace SFIX with social media scrolling, while other retailers are innovating to develop their marketing around outfits.
• Additionally, SFIX is restricted by the brands it stocks, limiting its attractiveness and breadth of choice. Also, recurring retail spending is usually impulsive and so a subscription model doesn't work.
• Capping these factors off is that we do not see a large enough market to target and even if it did exist, SFIX lacks any tangible moat from which to protect its position.

Investment thesis

Our current investment thesis is:

• SFIX's business model is not compelling in our view. It lacks a long-term value proposition for users, primarily due to social media being a superior alternative, its limitations based on brands stocked, and innovation by other retailers. Further, we struggle to see a large enough target market to allow for sufficient scale to be achieved (and thus margin improvement), as its approach is contradictory.
• SFIX has seen all growth evaporate, now declining at >10% while losses increase and cash is utilized to fund operations. We suspect revenue continues to fall, as Management attempts to improve margins while economic conditions bite. This negative loop will compound the weaknesses of the business model.

Company description

Stitch Fix ( SFIX ) is an online personal styling service that uses a combination of data science and human stylists to curate customized clothing and accessory recommendations for its customers.

Share price

SFIX's share price performance has been wild, with the stock returning over 500% at one point, followed by a dramatic decline. Like many, the business experienced a honeymoon period post-pandemic, with financial results subsequently reversing.

Financial analysis

Presented above is SFIX's financial results.

Revenue & Commercial Factors

SFIX's revenue has grown at a CAGR of 14% since FY16, with broadly consistent results in the lead-up to FY21. Following this year, SFIX has seen a reversal of fortunes, with a (1)% decline in FY22 and an additional (16)% during LTM Apr-23.

Business Model

SFIX offers a personalized styling service where customers fill out a style profile with their preferences, sizes, and budget. Using data analytics and algorithms, the company's stylists curate a customized selection of clothing and accessories for each customer.

The objective of the company is to support those who are unable to identify stylish/appropriate clothing, be it due to a busy lifestyle or ignorance of fashion trends. Further, SFIX states " Your style expert can help create easy-to-wear outfits, locate versatile looks, recommend pieces that fit your unique body, and incorporate your input into each item they send ." This creates a sense of expertise and a luxury experience for the user.

Customers can subscribe to receive regular "Fixes" which are boxes of clothing and accessories sent directly to their homes. They have the flexibility to choose the frequency of deliveries, and whether this is one-off or not. From an operational perspective, recurring revenue is highly attractive.

SFIX uses advanced data analytics and algorithms to analyze customer preferences, past purchases, and feedback. While technology plays a significant role, human stylists review the algorithm-generated selections to ensure that the items align with the customer's style and preferences. This data-driven approach helps stylists make more accurate recommendations over time, which is critical to success. The development of AI and machine learning should further support the company's ability to identify and respond to trends and reduce the human component.

Unlike traditional retailers, SFIX purchases inventory based on demand, reducing excess inventory and markdowns. Operationally, this approach allows for cost efficiency and cash maximization.

Finally, SFIX operates as a direct-to-consumer business, bypassing traditional brick-and-mortar retail channels. This model allows the company to have a closer relationship with its customers and minimize its costs, further ensuring efficiency within the business model.

Competitive Positioning

What we consider the following as key strengths (and thus inherent risks to our thesis):

• Trend generation. Social media, among other factors, have contributed to a harmonization of consumer interests around hype, high-fashion designs, and celebrity culture. This has encouraged many to seek fashionable products, widening the value proposition of those suggesting they can support a fashionable wardrobe.
• Personalization. The personalized shopping experience is appreciated by consumers, giving the perception of luxury and expertise.
• E-commerce Growth . The shift towards e-commerce and online shopping has benefited SFIX's business model, as more consumers seek to purchase clothing online. This trend was driven by choice and convenience, with SFIX enhancing this (or at least the latter) further.
• Convenience and Time-Saving . SFIX's model saves customers a significant amount of time, both for shopping around and getting the products delivered in one go. This convenience resonates with busy consumers seeking efficient shopping solutions.

These factors, however, at not overly impressive in the context of this highly competitive industry. We see the following fundamental flaws in the company's business model:

• Lack of moat. Although this approach is interesting, SFIX does not have a moat. If this strategy did take off, we would likely see a range of alternatives join the market, similar to the delivery app revolution.
• Customers will not be recurring. We also do not believe the approach actually works. Although many consumers will regularly buy clothing, this is usually impulsive, be it following shop visits, browsing the web, or based on social media. To subscribe or regularly use SFIX gives the impression of "organized fun", an activity the majority of the public will not engage with. If the recurring nature breaks down, SFIX essentially becomes a poor man's retailer from an investment perspective.
• Not a fashion universe. SFIX offers products from 1,000+ brands. This is a substantial amount but inherently means the majority of the market is not covered. The idea of aesthetic/style/design over brand (which is the whole purpose of a stylist) is not wholly true here and so the curation of an outfit is limited by what SFIX stocks. I imagine the alternative is not financially feasible but this does limit the idea that SFIX is a stylist.
• Who is the target market? A hypothetical user of SFIX, for whatever reason, is unable to buy their own clothing. Despite this, they are able to tell SFIX what they like and what they don't like. Finally, they care enough about fashion to use a product like SFIX (rather than just buying simple clothing or asking friends/family/Google/Store employees) but not enough to do their own research. This Venn diagram of individuals feels incredibly small to us, which is likely why growth has already ground to a halt.
• Social media and AI innovation will likely kill this business. If the above factors are not enough to contribute to the end of this business, technological development will. Firstly, social media has become incredibly useful for finding outfits, with influencers posting millions of outfits every day, with links to every product. Rather than paying SFIX, a consumer can just search Instagram. Secondly, retailers such as Zalando ( OTCPK:ZLNDY ) are innovating with the way they market to consumers, increasingly focused on outfit curation rather than single-product marketing. See "Get the look" on Zalando's website, it's fantastic. AI and machine learning will only make this better, one day getting to the point where they will generate millions of outfits based purely on the products Zalando stocks. Again, this is all free, so why do we need SFIX?

Economic & External Consideration

Current economic conditions are also weighing on the business, with inflation and interest rates contributing to softening discretionary purchases. As living costs rise, consumers will inevitably reduce spending where possible to protect finances. The current situation is slightly unique in that a recession has not been triggered and demand has not fallen off the cliff. This said, retail sales remain barely above 0%.

As the following data from Q3 illustrate, revenue is down YoY (and QoQ), with a reduction in active clients and revenue per client. This caps off 5 successive quarters of negative growth, 4 of which exceed (10)%.

Consumers are uninterested in maintaining their spending with SFIX with finances squeezed but the data suggests (which we will discuss later) this is disproportionately so relative to its peers. This implies a fundamental weakness in the business model relative to even a standard traditional retailer.

Margins

SFIX's margins are highly unattractive, with an unusual trend in that the company has become loss-making and increasingly so. This is compounded by the baffling fact FCF has been allowed to turn negative. We can only attribute this to poor management, as S&A spending has run wild. Management likely believed "growth at all costs" was the correct approach, which does not make sense given the lack of substantial growth runway (at least according to our analysis).

Margin improvement is imperative, as a higher cost of capital means investors are unwilling to finance this business. We suspect its weak commercial profile will mean growth responds elastically with reduced marketing activity.

Industry analysis

Presented above is a comparison of SFIX's growth and profitability to the average of its industry, as defined by Seeking Alpha (37 companies). Note, we usually remove loss-making businesses / outliers from this analysis to cleanly assess the industry but given SFIX's poor performance, only two wild outliers have been removed (>1000% rates).

SFIX is lacking in almost every key metric. Margins are less important as one could argue this is still a growth business but its revenue performance is dire. In the forecast period, retailers are forecast to maintain growth, while SFIX is expected to decline (21)%.

Valuation

SFIX is currently trading at 0.2x LTM Revenue and NTM Revenue. This is a deep discount to its historical average.

Given the losses, even at an EBITDA level, it is difficult to assess the company's profitability. It is trading at a substantial discount to both its historical average and peer group, reflecting its weak commercial and financial profile. At 0.2x revenue, investors are incredibly bearish that this business will ever be profitable.

We believe a good way to consider the attractiveness of SFIX is to consider its NTM FCF yield. For a risk such as this, we would be seeking >5-10%. SFIX is currently at 3.9%.

Final thoughts

SFIX's commercial profile is unattractive. With any business, investors should ask themselves 1) What is the value proposition? 2) How will this value proposition develop long term? These two questions can immediately help screen away 99% of the stocks that should be avoided. For SFIX, we struggle to answer this question.

If investors like the curation of outfits, consider Zalando. If investors are interested in exposure to fashion trends, consider LVMH ( OTCPK:LVMHF ). If investors want recurring revenue, look at technology, not retail.

With a short interest >8% and no route to financial improvement, we believe this company faces a difficult decade ahead, and unfortunately struggle to see how it exists at the end of this period.

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