Stitch Fix (NASDAQ:SFIX) is enjoying a bullish run since the company priced its IPO last month. And in this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by senior contributor Adam Levine-Weinberg as they dive into the company's business model.

Find out how Stitch Fix has established itself as a leader in the subscription-box industry, in addition to some of the biggest risks and opportunities investors should recognize before becoming a shareholder in this fast-growing apparel business.

A full transcript follows the video.

This video was recorded on Dec. 12, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, Dec. 12, and I'm your host, Vincent Shen. My esteemed guest today is none other than senior contributor, Adam Levine-Weinberg, who's connecting with the studio via Skype. I wanted to say from Sacramento, but you mentioned you were at your parents, so you're in town, no?

Adam Levine-Weinberg: No, it's in the New York City area.

Shen: OK, sorry about that. So, from the New York City area, connecting with us. Thanks for joining us, Adam!

Levine-Weinberg: Glad to be here!

Shen: I'm extra excited for the show today since we don't get the chance to talk about IPOs very often in this sector. Lucky for us, there was an interesting deal that priced last month, and the stock has traded up 60% since then. The company is called Stitch Fix, ticker SFIX. Everyone loves a good founder-led company, that's what we have here. CEO Katrina Lake founded Stitch Fix about six years ago and started the business in her apartment. If you've ever heard of Trunk Club or Birchbox, then you'll be familiar with Stitch Fix's overall business model. In essence, this is a subscription service for apparel, shoes, and accessories. Adam, can you explain how these kinds of services work, and some of the specifics behind what Stitch Fix offers?

Levine-Weinberg: Absolutely. Generally, a subscription-based service for apparel will send you a box as often as you want. In some cases, actually, you don't have to subscribe, you can just order à la carte. That includes Stitch Fix. Typically, you'll get maybe five or six items in a box, and you can look at the items and decide what you like and keep what you want and send back the rest. Generally, these companies have dedicated stylists who work with their customers. So you'll have somebody who works with you over and over again. Over time, if you continue to use the service, they'll get a better and better sense of what kind of things you're looking for, so it gives a personal touch while also being an e-commerce company, which helps out in terms of inventory management, and also is good for people who just don't have time or don't enjoy going to the mall and working with a sales rep at a department store.

Shen: Or dealing with the lines and crowds and everything else that comes along with it.

Levine-Weinberg: That's true, especially around this time of year.

Shen: Stitch Fix specifically can send automatic orders, or what they call Fixes. So each one contains five items. They can send them in almost any frequency you would like, or you can do it a la carte, as you mentioned. You keep what you like, and you send back what you don't free of charge. There's a $20 styling fee for each Fix or order you receive. But if you keep anything, that fee gets credited to your purchase. And if you keep your entire order, all five items, you get a 25% discount on the entire order. It's an interesting approach there.

The subscription model overall has grown a lot. It's gotten very popular over the last several years. I think at this point, there has to be hundreds of services that offer groceries, wine, I've heard of clothing ones, obviously, like this one, makeup, tons of other product categories, and they will send you a box of their items every week, month, however often you want. The main selling point is, of course, the convenience. There's also the discovery aspect, the exposure to new brands and products that you might not have encountered otherwise. Are you actually a member, Adam, of anything like that?

Levine-Weinberg: No, I've never used one of these services. I've definitely thought about it.

Shen: Maybe not completely in this vein but having signed up with Blue Apron, Green Chef, and a few others like that, you get a similar vibe. It's all part of this trend that we're seeing in terms of this specific subscription-style category. But the thing that really impressed and fascinated me about Stitch Fix in particular is they really try to combine apparel and retail, which is an industry that's been around for hundreds and hundreds of years, and the company has a huge focus on using data to best serve customers, to win their loyalty. When I was reading the company overview and description in the prospectus, it struck me almost immediately how often the company mentions data or data science. It feels like these words come up in almost every other sentence. I don't know if you noticed that, too, Adam.

Levine-Weinberg: I did. We can talk about this maybe a little bit more later, but it's definitely one of the things that's really interesting about the company. It's also a little worrisome. It makes me wonder if they're trying too hard to seem like a tech company when they're really just another retailer. You've seen this problem before, because tech companies are getting such high valuations in the market these days, everyone wants to seem like they're really just a tech company and everything else they do is incidental to that. So you definitely see Stitch Fix talking a lot about their data, but everything still goes to a human. The data is providing recommendations to the stylists for fitting and product choices, but the stylists are still interacting and deciding which five items go in the box to the customer. So the question is really: How much of this is the data science informing, and how much is the stylists using their own intuition?

Shen: Yeah. When you look at the breakdown you mentioned, they have 75 data scientists who help work on these algorithms, but they also have their team of over 3,400 human stylists who help finalize these orders. You have to wonder how much of it is, in terms of the promotional side, is actually driving their business. But right now, let's cover some of the stuff on their data before we get into the results that's actually generating in terms of financials.

We know a lot of, for example, brick-and-mortar retailers right now, they are rolling out things like royalty programs, they have mobile apps, they want to collect a lot of data on their customers. And I think Stitch Fix is definitely in an enviable position where their customers give them 100% voluntarily everything the company needs to optimize and curate their offerings for each person. I have a quote here from the company prospectus that gives you an idea of what tools and information they can leverage when assembling an order or a Fix, as they call it, for a customer. It's long, but it tells you a lot about what they have at their disposal:

On average, each client directly provides us with over 85 meaningful data points through his or her style profile, including detailed size, style, fit and price preferences, as well as unique input, such as how often he or she dresses for certain occasions, or which parts of his or her body the client likes to flaunt or cover up. Over time, through their feedback on Fixes they receive, clients share additional information about the preferences as well as detailed data about both the merchandise they keep and return. Historically, over 85% of our shipments have resulted in direct client feedback. This feedback loop drives important network effects, as our client-provided data informs not only our personalization capabilities for that specific client, but also helps us better serve other clients.

So you take all the information that company has on your sizing, your other preferences, and they also apply a similar mindset to all the product they have in inventory. They'll track a lot of things about each piece of clothing, for example, like the brand, the size, the color, the material, but they'll also supplement that with the item measurements, with the more qualitative descriptions, and some of the client feedback that they have received on that item when sending it out in previous Fixes. I guess some of the magic there is that Stitch Fix can plug all of that into their algorithms, the information they have on their customers and their products, and that algorithm will make suggestions on what to offer in each order, and it comes out with the probability that the item will match a specific customer. Again, as you mentioned, you have that probability number now, but that still gets fed through a human stylist, one of the team of 3,400 or so. They provide the finishing touches, and they will further curate or finalize that order for each person. 

So if we try and quantify how well the algorithms and stylists are picking products for customers, something I thought was pretty telling was, the number of items purchased per Fix was up 22% in 2017 over 2014. So definitely good progress to be seen there. The company overall takes the same kind of data-driven approach to forecast demand, plan its inventory. They use it to optimize the distribution to their five U.S. fulfillment centers. But again, the question becomes, how much of the data is really driving a business in terms of their profitability, their financials. We will get to that next. I'll pass the baton to you, Adam, to cover that.

Everything we've described about the business so far, Adam, is it actually making money for the company? How do the financials look?

Levine-Weinberg: The first thing we can say is, the growth has been phenomenal over the past several years. If you go back to fiscal 2014, this is a company with about $73 million in annual revenue. Over the two following years, by 2016, revenue had increased by 10x up to around $730 million, and it continued to grow in fiscal 2017, reaching almost $1 billion. So you've seen huge growth there. One of the interesting things about Stitch Fix compared to a lot of the other IPOs that you see is, this is a company that has been profitable for several years now. By 2015, it was starting to scale its business model and began to generate positive operating income. So, it definitely seems like a model that's more proven than some of the other, especially the tech IPOs that frequently come to market, and you're really betting on a company that has a lot of users, maybe, but uncertain prospects for long-term profitability.

With Stitch Fix, there's definitely a track record of profitability, so it's just a question of whether or not it can grow its profit margin over time and how well it can continue to scale in the next three to five years, let's say.

Shen: So the company, you mentioned, they were approaching $1 billion of revenue in fiscal 2017, so it's up 34% over the prior year. And as you can imagine, as the company grows, it scales in size, and that growth rate is decelerating. But their gross margin is between 44% and 45%, and that's better than what you'll see at major apparel retailers and department stores. Something else I thought was interesting for the most recent year was, the company actually swung from a positive GAAP earnings in 2016 of about $33 million, again, pretty rare for most recently IPO'd companies, to a small loss this year. A big part of that was the advertising and marketing costs, which shot up from $25 million to $70 million, obviously Stitch Fix trying to grow the business. But I think this presents us with a pretty familiar problem, and that's the need to spend very heavily to spread your brand awareness, to acquire new customers. That can become unsustainable. We saw that with another IPO this year that we talked about, Blue Apron. The market hammered Blue Apron for its high advertising and customer acquisition costs, and the stock only bounced back recently after the co-founder CEO was essentially pushed out and replaced.

In the prospectus, though, Stitch Fix does share some one-time data on its customers in terms of revenue per client over different periods of time that I think is really telling. What we see here, and the company acknowledges this, is that customers tend to spend more in their first six months than their second six months, more in the first year than the second year. But at the same time, average revenue over the first year for a customer, I believe this was for the 2016 customer base, came out to $489, which is pretty substantial. I think that gives the company some room in terms of pushing their advertising spending.

Blue Apron had the same problem, where we know that customers tend to reduce their order frequency over time, and that was a major criticism from a lot of investors. But with food, these customers are eating every single day, they're decreasing their order frequency and customer value, but they're just turning to competing services or traditional restaurants and grocery shopping for their needs instead. But with Stitch Fix, management makes the argument that with each successful order, and items that a customer keeps, customers are essentially filling their wardrobes, there's only so much closet space, it's natural for demand to become a little bit lumpy as customers essentially wear what they have until they decide to refresh their wardrobes and return to the service. They mention that from 2014 through 2017, 650,000 of their customers reengaged with Stitch Fix after more than four months of inactivity, to show how that proves out.

But there are definitely still risks and challenges here for the company that I want to cover now. Adam, when we were planning this episode, you brought up a comparison to Trunk Club, which offers, I would say, a more bearish view of the long-term prospects for subscription-style companies. What's the story there?

Levine-Weinberg: Trunk Club and Stitch Fix, if you looked at those two companies in 2014, they were basically mirror images of one another, with Stitch Fix serving women and Trunk Club serving men. In 2014, as I mentioned, during that fiscal year, Stitch Fix was a little under $100 million, around $73 million in revenue. And 2014, Trunk Club hit about $100 million of revenue.

In the middle of that year, Nordstrom came in and bought Trunk Club for about $350 million, made a really big bet on this subscription box business model. And at that point, when they made the acquisition, they stated that Trunk Club was already profitable -- so in that way, very similar to Stitch Fix -- that it was about to double its revenue in 2014, and that they expected to be able to double its revenue again in 2015. They had very grand ambitions for pushing into women's apparel, noting that the overall women's apparel market is much larger than men's apparel. So they saw a big opportunity both to continue growing that core men's business but also to push into women's business. It seemed like a really great acquisition at the time also, because Nordstrom has a network of over 100 full-line stores also selling very nice, upscale clothing. They could use those stores to provide services like tailoring that would be a lot harder for a pure e-commerce company to offer. Also, Nordstrom is a multi-billion dollar revenue company, so they have tons of inventory and relationships with basically every top brand, so you have much better inventory availability. So it seemed at the time like a potentially really successful acquisition. And it's just turned out to be a bit of a disaster for Nordstrom, albeit on a small scale. 

Last year, the company, Nordstrom, had to write down the value of this acquisition by $197 million, so by more than 50%. At the time, they stated that the revenue growth rate was still pretty strong, but they significantly reduced their estimates of profitability. And if you look at what they did prior to 2016, unlike Stitch Fix, you could order a Trunk Club Trunk without paying that styling fee up front. And the problem with that in this kind of business model is, people end up sending back the whole Trunk, and you lose a lot of money if that happens.

Shen: In terms of the fulfillment costs, yeah.

Levine-Weinberg: Yeah. They ended up putting in a styling fee to order the Trunk, and like with Stitch Fix, you can apply that to any purchases that you make. But once they did that, it seems like the revenue growth has really stalled out. The movement to the women's business just hasn't been nearly as successful as Nordstrom had expected. So Trunk Club is a cautionary sign for people interested in Stitch Fix, because it's a company that seemed like it was on the same high-growth, high-profit trajectory, and everything fell off the rails in the last couple of years.

And to be honest, Nordstrom hasn't provided that much in the way of details about the nitty gritty of just what happened there, so it's hard to say how close the parallel really is to Stitch Fix, but it's definitely concerning that Stitch Fix might also run into a wall with growth, and also find that the cost of acquiring customers becomes so great over time once you get past the people who can really easily fit into this model and are really looking for this kind of solution. The marketing costs can get so high that it eats up all the profitability. So that's why it's somewhat concerning, from an investing point of view, that you saw the big drop off in profitability in the most recent fiscal year at Stitch Fix. And at the same time as they were ramping up their marketing spending at such an incredible rate, almost tripling it, you saw that really big deceleration in their revenue growth. And even just during the past year, there's been a further deceleration. At the beginning of fiscal 2017, you had revenue growth still over 50% year over year. By the second half of the fiscal year, which is roughly the first half of the calendar year, their growth rate was down to 26%. So it's going to be really interesting to look at the upcoming earnings report that Stitch Fix is going to put out soon to see where the revenue trend is going, and also how high is marketing spending going. Because it's definitely worrisome that they're spending more and more on marketing and getting a smaller and smaller incremental revenue benefit from that.

Shen: Thanks, Adam. The earnings that you mentioned, I believe those are coming out on the 19th of December, so quite soon for investors to follow. The next challenge or potential headwind I want to cover, what consumer and retail episode of Industry Focus would be complete if we didn't at least mention Amazon one time, and the threat that it poses here? Amazon threw a major wrench into Blue Apron's IPO when it announced its acquisition of Whole Foods. Again, I'm seeing the parallel between these two deals, because obviously, Amazon has been investing a lot recently, over the past two years or so, to become a bigger player in apparel. Over the summer, the company unveiled Prime Wardrobe.

This is still in beta, they're testing it with a small number of customers, but the service will be free to Prime members. It allows you to personally choose the clothing and accessories that you want in a box. Then, those items get shipped to you at no charge. You try everything on, keep what you like, and send back everything else, and only then does Amazon actually charge you for the items you keep. In this case, it's still in the early stages, and we don't know how popular it'll become. But this is a clash of the curated products and discovery element that something like Stitch Fix offers versus the convenience and the pricing benefits that Amazon obviously has access to, and then the certainty of picking your own items. I feel like the Prime Wardrobe offering is getting you as close as you can to the traditional apparel shopping experience without actually going to a store. So it's definitely an interesting offering that they're expecting to ramp up in the next year. It'll definitely be interesting to see what kind of impact that has in terms of the subscription model and the curation vs. the customer choosing their own items.

Let's start wrapping up here, Adam, with just a few more things to cover. First, what does the road ahead for Stitch Fix look like in terms of growth? Is it just expanding its customer base as we've talked about? Is there anything else you think could be a lever for them to help drive growth?

Levine-Weinberg: In the past few years, you've seen Stitch Fix push beyond that core women's market that it started with into everything from plus sizes to expand within, still catering to females, but also moving into men's clothing, adding shoes and accessories beyond just apparel. They've tried to broaden their reach, and that's one potential area for growth, just trying to scale up in those newer areas. And then, it's really trying to use the data that they have to get their existing customer base to buy just a little bit more frequently, and then using the marketing spending that they have been rolling out to try to grow the customer base. Those are the three ways that Stitch Fix can potentially keep growing in the years ahead.

Shen: Yeah. They've expanded from that core women's category that they rolled out with originally in 2013 or 2011. They've expanded to men's, as you mentioned, petite, plus, maternity, shoes, and accessories. More recently, they've actually started getting into premium high-end brands as well, which will be interesting to watch. I'm definitely actually looking for updates about that in their next earnings call, which will be their first one.

Something else I wanted to cover was, the company currently has 700 brand partners that they get their inventory from. Stitch Fix is definitely, I think, in a strong place to grow that network, because one of the big value proposition that they can offer to apparel manufacturers and brands is, the company relies less on discounting, which means more full-price sell-through of inventory, and also serving as a way to introduce apparel brands to its 2.2 million customers.

Something I thought was interesting that I noted in their filing was, Stitch Fix also has a brief note that it's experimenting on a very small scale with making its own products. So potentially, another test that, if it proves suitable for them, that they will expand into. But they specifically caveat that there's no set plans for that to become a major part of the business. But clearly, management is thinking about the various avenues for growth going forward.

Let's close out here with our final thoughts. The stock is up 60%. Granted, it priced at $15 per share, that was down from its original IPO range of $18 to $20. What are your thoughts here? Are you a Stitch Fix bull, bear, somewhere in between?

Levine-Weinberg: I would probably classify myself as a bear on Stitch Fix right now, or at least neutral. I'm waiting for a lot more information from management. This is a company that, the valuation is now over $2 billion, and their operating income fell from this $65 million range two years ago in fiscal 2016, and it fell by half last year, so now it's just a little over $30 million. Paying almost 100x operating income, you need to see a lot of revenue growth and a lot of margin expansion over time. There's definitely a case to be made that that's going to happen. Bringing in the new exclusive brands that Stitch Fix makes itself, that's definitely one way the department stores have really bolstered their margins over time, by doing more and more exclusive stuff, because you're not competing on price and you also control more of the supply chain, so you're cutting out the middleman.

However, with this slowing growth that you've seen over the last several quarters in particular, it's definitely worrisome that maybe Stitch Fix is peaking in terms of its revenue potential, and you're going to see much slower growth going forward, and basically all the potential profit being eaten up by the marketing that it needs to just stay where it is in terms of revenue. So I would like to see the earnings report that's coming out next week, and probably a few more earnings reports, to see, is the revenue growth reaccelerating, or can they maintain a double-digit revenue growth while pulling back on that marketing spending? Because while they've said that their marketing is a lot less as a percentage of revenue than many of their competitors, it's still enough that it's a serious drag on profitability right now.

Shen: Thanks, Adam. I'll say I'm on the fence right now, maybe leaning a little closer to your side and that I, too, am waiting for more information. Originally, looking into this company, researching it, I was really enamored by the approach they take in terms of the curation for the boxes, the Fixes, that they send to their customers, in terms of the data side, having the human element to it. But, that also presents its own challenges. Otherwise, this is definitely a company that will be fun to watch going forward, and I'll be sure to have you on to provide updates. Thanks for hopping on the show today!

Levine-Weinberg: Absolutely.

Shen: One last announcement before we wrap up here, if you're a fan of The Motley Fool and interested in what life is like working at Fool HQ and our other offices around the world, we're hiring. You can check out our available positions, including the summer 2018 internship program over at Thanks for tuning in. Austin Morgan is the producer for Industry Focus. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.