SFIX - Stitch Fix: Not Much Downside With Stock Just Above Book Value

2023-10-25 11:59:22 ET

Summary

• Shares of Stitch Fix have lost all of their year-to-date gains and are trading at a fraction of their pandemic highs.
• The stock's recent downward move has washed out its valuation premium above book, making it more attractive.
• Stitch Fix's focus on cost optimization and generating free cash flow is a positive, but its ability to remain relevant and sustain its customer base is uncertain.

The past few months have brought tremendous pain for holders of small- and mid-cap growth stocks, needless to say. As investors have assessed risk-free interest rates pushing beyond 5% and rotated more holdings into cash, it makes less and less sense to park money into speculative, unprofitable names.

Against this backdrop, shares of Stitch Fix ( SFIX ) - which earlier this year staged a broad recovery rally - have lost all of their gains. Though ~flat year to date, however, it's important to remember that Stitch Fix is still trading at a fraction of its pandemic highs above $80, having lost billions in market cap in the process.

I've been consistently bearish on Stitch Fix and last wrote a negative opinion on the stock in July . Since then, a number of factors have occurred: First, the stock has dropped by a fresh ~20%, and second, the company released better-than-expected results in the fourth quarter (that still nevertheless showcased a disappointing double-digit tumble in both revenue and clientele). Third, Stitch Fix also made the decision to exit its UK business, which will hopefully streamline its cost structure and help the company deliver greater cash flow even with a lower top line.

Considering all of the above, I'm now neutral on the stock.

A balanced bull and bear case, valuation just above book

The biggest consideration to the upside for Stitch Fix is that the stock's recent downward move has almost entirely washed out its valuation premium above book. At the same time, cost-reduction actions taken by the company's new leadership, as well as the company's UK exit and shrinking of its inventory base, is helping Stitch Fix to get to cash flow positive.

First, an update on valuation: At current share prices just above $3, Stitch Fix trades at a market cap of $374.3 million. The key thing to note here is the company's balance sheet, which has $257.6 million of cash and cash equivalents against no debt.

This puts Stitch Fix's enterprise value at just $116.7 million.

Against all assets and liabilities together, Stitch Fix's $374 million market cap against $247 million in total shareholders' equity puts its P/B ratio at just 1.5x. In short - investors aren't putting much of a premium on this business, despite the fact that Stitch Fix is now generating $50+ million in annual free cash flow.

That being said, there are still risks to be aware of, and key among them are:

• Is Stitch Fix relevant anymore, or is it just a passing fad? The idea of getting a "Fix" of five items and keeping only what you like was the whole selling point behind Stitch Fix in the first place. But declining active customers seem to be suggesting that people don't want this complexity in the shopping process. In fact, Stitch Fix introduced its direct-buy "Freestyle" program to mirror classic e- tailers : And in doing so, it lost its niche in the first place. Without much of a powerful brand to draw from, it's unclear how Stitch Fix plans to remain relevant.
• Sharp competition from fast casual clothiers. Uniqlo, Zara, and a number of upstart direct-to-consumer brands have exploded on the retail scene. Amid "basic convenience" buyers, it's unclear where Stitch Fix fits in.

All in all: I like Stitch Fix management's new approach of simplifying the business, focusing on domestic operations and focusing on free cash flow. At the same time, however, I don't see a long-term future for Stitch Fix's business model enough to warrant a bullish rating.

Q4 download

Let's now go through Stitch Fix's latest quarterly results to showcase the negative trends we've been seeing in the business. The company's fiscal fourth quarter (July quarter) results are shown below:

Stitch Fix's revenue declined -22% y/y in the quarter to $376.0 million, decelerating slightly vs. Q3's -20% y/y growth rate. Still, it's worth noting that the company came in ahead of both its own internal expectations as well as Wall Street, which had forecasted a consensus of $372.1 million in revenue.

Active clients continued to drop off, which is one of my chief concerns (as a reminder: Stitch Fix defines an active client as any person who has made an order in the trailing twelve months). The company shed 179k net clients in the quarter to land at 3.3 million in total, which is down -13% year-over-year.

The carve-out of the UK business is shown below. UK contributed $11 million, or roughly 3%, of the company's total revenue. Its gross margin of 17% in the most recent quarter, however, was substantially below the company total of 43%, and after netting off all SG&A expenses, this segment is overall a drag on profitability.

The key question for Stitch Fix to be able to answer is: If the company is focusing on domestic operations and geo expansion is not in its sights at least in the near future, how does the company propose to continue growing and remaining relevant - and can it sustain itself as a much smaller company?

At the moment, the company is wholly focused on cost optimization. Per CFO David Aufderhaar's remarks on the recent Q4 earnings call:

Additionally, the plan to consolidate from five US warehouse locations to three is on track to be completed this fiscal year. We believe the consolidation will have immediate cost savings and having inventory in fewer warehouses will make it easier for stylists to build more relevant assortments for clients and we will realize inventory efficiencies as we scale.

We continue to expect the combined annualized cost savings related to the closure of the UK operation and the US warehouse consolidation to be approximately $50 million. Q4 net revenue was $376 million, down 22% year-over-year, but above the high end of our prior guidance due to higher order volume. Revenue per active client declined 9% year-over-year in Q4 to $497 million."

These moves, in part, helped Stitch Fix generate $38.8 million in free cash flow in the fiscal year that just ended, up dramatically from $9 million in the prior year.

Still, this cash flow generation relies on a stable top line. If Stitch Fix continues to suffer double-digit revenue declines from here, its current margin profile may not be able to be sustained.

Key takeaways

With hundreds of millions of dollars having already been shaved off Stitch Fix's market cap over the past few months, I no longer see much downside left for the stock - especially with its current FCF-positive status and further catalysts for future savings coming from UK closures and warehouse consolidations. Still, however, I remain nervous about Stitch Fix's ability to continue drawing an active clientele - and if its customer base continues to shrink, Stitch Fix may no longer be able to survive on cost cuts and inventory shrinkage alone.

Don't rush in to buy here: The best move is to remain on the sidelines.

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