Investors briefly punished Stitch Fix (NASDAQ:SFIX) shares after the company unveiled its first public earnings report. The stock declined 10% only to recover before the extended holiday weekend. By all standard measurements, this was a solid report for the subscription box specialist. Let's look at the quarter and the key levers to a bright future for the company.

What made the headlines

Revenue increased 25.2% to $295.6 million, just edging past analyst estimates, while active customers jumped 29.7% to 2.4 million. Moving down the income statement, gross margin compressed 290 basis points to 43.7%. That would normally be a concerning development, but management explained that the decline was largely due to planned investments in new categories, primarily men's and plus, which have narrower margins than its core women's segment, as the purchases are smaller. The company is also working to build out those businesses, which should raise margins over time as they reach scale.

Investments in tech talent and advertising increased with adjusted net income shrinking to $4.4 million, but earnings per share of $0.05 still topped estimates by a penny. Looking ahead, the company sees solid revenue growth for the year with $1.17 to $1.22 billion of revenue, or 20% to 25% growth. But weaker than expected EBITDA guidance resulted in a bearish initial reaction from the market.

A Stitch Fix box sits on a doorstep against a yellow door.

Image source: Stitch Fix.

Making progress 

At this early juncture, investors should be looking for the company to hit its goals both financially and operationally. Customer count, which is a fundamental driver of the company's revenue, had its biggest jump in several quarters, which may be a reflection of the attention and free advertising the company got from its initial public offering. That's a promising sign for investors, and it should reassure them that Stitch Fix isn't likely to stumble like Blue Apron did shortly after its IPO.

But the other fundamental drivers of the company's business -- its brand and customer satisfaction -- will be harder to measure. Stitch Fix has no publicly-traded peers, and brand perception is key for online retailers who don't have stores that customers can stumble upon.

Based on the growing customer count, Stitch Fix seems to be succeeding on that measure. In its prospectus, the company acknowledged that customers tend to spend more in their first six months using the service than their second six months, and that they spend more in the first year than the second year. However, the company believes that decline is based on customers who were not satisfied with their first "Fix" or those who have been too satisfied in a sense, as they've sufficiently stocked up their wardrobes and no longer need new clothes in the short term.

The company has also increased the average number of items that are purchased in each order, or Fix, in each of the last three years, indicating that customer satisfaction with item selection is improving.

Big things ahead

Ultimately, Stitch Fix is chasing a huge opportunity with a long tail ahead of it. The U.S. apparel, footwear, and accessories market was estimated to be worth $353 billion last year and is set to grow to $421 billion by 2021. Meanwhile, the company is riding two big trends in apparel. First, e-commerce in the apparel sector is surging as Euromonitor expects the segment to grow annually by 11.4% from 2016 to 2021 to $94 billion, and Amazon is set to become the biggest apparel seller in the country, topping Macy's.

Second, personalization is becoming more popular, a differentiator that stands out from the traditional online shopping experience. Other companies like Nordstrom, Bonobos, and Warby Parker have tried to tap into this trend and enjoyed success with the model.

If Stitch Fix can capture even 1% of the overall apparel market or 5% of the e-commerce market over the next 10 years, it would have $4 billion in sales, about four times last year's total, representing 25% annual growth over that time.   

However, whether it can deliver that growth will depend on the company's ability to retain customers and spread awareness of the brand. If successful, margins and profit will take care of themselves.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Nordstrom. The Motley Fool has a disclosure policy.