Stitch Fix (NASDAQ:SFIX) is one of the more exciting retail stocks to come on to the market in recent years. The company does something different from most retailers. Stitch Fix doesn't let you choose your clothes directly. Instead, it operates as a styling service, sending customers five items at intervals of their choosing based on their style preferences, budget, needs, and fit.

The strength of such a model is clear. By collecting data on its user preferences, Stitch Fix has information that the average brick-and-mortar apparel retailer doesn't, and it can use that to not only hone its choices for individual customers, but also to better serve its broader customer base and even design its own clothes. The company cites "data science" dozens of times in its prospectus and even claims it as a source of "competitive advantage," so it's clear it sees that as a key strength.  

Aside from the data, Stitch Fix also provides value to the customer by saving the time and energy normally spent shopping for clothes in a store or online. But does the company have a competitive advantage? It's a key question for investors in the recent IPO, since a competitive advantage is a core component in the bull thesis for most stocks. Let's dive in and take a closer look at Stitch Fix to see if it can truly claim an economic moat.    

A Stitch Fix sits on a doorstep.

Image source: Stitch Fix.

Different, but not unique

While Stitch Fix's styling service separates it from most apparel retailers online and off, it's not the only company using that model. There are dozens of other similar styling services out there including Trunk Club, now owned by Nordstrom (NYSE:JWN), Bombfell, Rent the Runway, and Le Tote. Some offer different hooks to draw in new customers, but almost all promise the same value proposition, clothing selected for you by personal stylists.

Stitch Fix is the only company of the bunch that's publicly traded, and with a valuation around $2 billion is the most valuable of the group. By comparison, Nordstrom acquired Trunk Club in 2014 for $350 million, but wrote down $197 million of its value in 2016 as it lowered its estimates for future growth.  At the time of the purchase, Trunk Club was valued at 3.5 times forward revenue, compared to 1.7 times trailing revenue at Stitch Fix now. In other words, the challenges at Trunk Club could serve as a cautionary tale for Stitch Fix.

The New York Times' product review site, Wirecutter, reviewed about a dozen clothing box subscription services and chose Stitch Fix as the winner. Though it acknowledged that Stitch Fix was not perfect, it said, "It was more likely to get it right more often than any of the others," and also said the service worked well for those on a budget. It called Trunk Club a close runner-up. Reviewers on other websites said they preferred Trunk Club. 

Like most markets, personal tastes and experiences seem to have driven one set of customers to one business and another to its competitors.  

The Amazon effect 

No discussion about online retail, especially competitive advantages, is complete without mentioning Amazon (NASDAQ:AMZN). At Recode's recent Code Conference, Stitch Fix CEO Katrina Lake addressed concerns about competition from Amazon, which have increased since it launched Prime Wardrobe, a "try-before-you-buy" service -- one that has drawn comparisons to Stitch Fix but notably lacks a stylist. 

Lake didn't seem to see Amazon as a threat, saying its value proposition was "fundamentally different," explaining that Amazon's attraction was in its broad range and choice of clothes available, while Stitch Fix essentially offers no choice as it chooses the clothes for you. She also said that her company hadn't had any serious talks about combining with Amazon. 

The threat from Prime Wardrobe appears to be exaggerated as the service seems little different from buying clothes on Amazon and returning what you don't like. The styling service is what separates companies like Stitch Fix and Trunk Club from conventional clothing retail.

Still, retail investors are always wary of the Amazon threat, and the e-commerce giant could be weighing on Stitch Fix's valuation. The stock is significantly cheaper than Amazon on a price-to-sales basis; Amazon trades at 4.1 to 1.7 for Stitch Fix, though Amazon is more profitable than the upstart, which is still operating around breakeven.

So is there an advantage?

There are several different ways a company can achieve a sustainable competitive advantage, and there are several degrees of competitive advantage.

In the case of Stitch Fix, it does seem to have some competitive advantages. As the largest subscription box service, the company presumably has more data and brand awareness than its competitors, which should help it attract and keep more new customers than competing styling services. Online styling services also create switching costs as shoppers have to spend a fair amount of time filling out forms explaining their style, preference, and fit. Further, once you start using a service, it collects more information about your tastes, making it more valuable to the user. Therefore, customers are unlikely to switch to a competitor unless they are dissatisfied with the service they're using.

Those elements explain why Stitch Fix is spending heavily on marketing, as attracting new customers can lead to thousands of dollars of lifetime value if they stay with the service for years. If Stitch Fix loses them to a competitor, that income is likely gone for good.

Finally, styling services like Stitch Fix do seem to have competitive advantages over conventional retailers, because the data they collect should help them better cater to customers and know what clothes to design.

However, a competitive advantage alone isn't enough to make a company successful. Stitch Fix must execute in delighting customers, and the online styling industry itself, which is still unproven, needs to consistently grow and take market share from conventional apparel retail.

In its most recent quarter, Stitch Fix's revenue grew 24% -- a solid rate, but not one that suggests endless growth.

We'll learn more when the company reports third-quarter earnings next week on June 7; however, it may be years before we know if Stitch Fix can convert those competitive advantages into sizable returns for investors.

 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Stitch Fix. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Stitch Fix. The Motley Fool recommends Nordstrom. The Motley Fool has a disclosure policy.