Please ensure Javascript is enabled for purposes of website accessibility

1 Reason I'm Not Worried About Stitch Fix After Its Big Drop

By Jeremy Bowman – Updated Oct 4, 2018 at 3:24PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The specialized clothing service's stock plunged after its fourth-quarter report, but this looks more like a correction for the recent run-up than anything else.

Shares of Stitch Fix Inc (SFIX 6.33%) were getting ripped apart after the personalized styling service's fourth-quarter earnings report came out on Monday. The stock plummeted 31% after hours even though the headline numbers were pretty good.

Revenue jumped 23.2% to $318.3 million, just shy of estimates at $318.6 million. However, its bottom-line result was much better than expected. With the help of a range of tax benefits, adjusted earnings per share flipped from a loss a year ago to a profit of $0.17, easily topping estimates at $0.04. Had the company had a more normal tax rate, it would have posted earnings per share around $0.06.

Stitch Fix's guidance for the coming fiscal year was solid as well. For fiscal 2019, management sees revenue growth of 20% to 25% to $1.47 billion to $1.53 billion, which compares to analyst expectations of $1.48 billion, and for the current quarter, the company expects modestly slower growth with the top line growing 20% to 22% to $354 million to $360 million, against estimates at $359.2 million.

What really seemed to cause the sell-off was disappointing growth in active clients, a key metric, as Stitch Fix needs to keep growing its customer base in order to drive revenue growth over the long term. In the fourth quarter, active clients grew 25% from the year before to 2.74 million, but that figure was up just 2% from the previous quarter, indicating a possible problem with customer retention. After the disaster in customer counts at Blue Apron, investors are especially sensitive to customer growth figures in on-demand services like Stitch Fix. 

A Stitch Fix box resting against a doorstep.

Image source: Stitch Fix.

Disappearing customer growth

Though analysts asked about the slowing customer growth on the earnings call, management didn't really offer an explanation for the slowdown, instead saying they were happy with the company's growth in the quarter.

Seasonality seems like one possible explanation. However, the only kind of seasonality the company acknowledged in its prospectus was that sales growth tends to lag during the holiday season, opposite the trend in the traditional clothing retail industry, which sees a spike in December as customers shop for holiday gifts. In its fourth quarter in 2017, active clients increased 5.8% from the previous quarter, so it seems unlikely that seasonality alone is to blame for the slowdown in customer growth. The company's fiscal fourth quarter ends in July.

A shift in advertising could also have been the culprit. As part of a marketing test, Stitch Fix suspended TV advertising for 10 weeks in the quarter, and management said that among the takeaways that the company gained from the test was that TV advertising was more effective than it had thought.

Therefore, the absence of TV advertising might have weighed on customer growth in the period. However, Stitch Fix still spent aggressively on advertising in the quarter, as advertising spending increased 15% sequentially to $28.9 million, or 9.1% of total revenue. Some of that advertising spending could have been geared toward driving orders in the current quarter, which has been the company's strongest seasonally, but it's unclear whether or how much the suspension in TV advertising affected customer growth.

Why I'm not worried

In a previous article, I compared Stitch Fix to Netflix (NFLX 0.76%). Though the two compete in different industries, they share a number of similarities. Like Netflix has done, Stitch Fix is seeking to disrupt a massive industry using e-commerce and data-driven recommendations, which have also led Stitch Fix to launch its own brands much in the way Netflix is increasingly dependent on original programming. Such a strategy led to a long tail of growth for Netflix, and it could do the same for Stitch Fix.

However, anyone who's followed Netflix knows that its subscriber growth has always been lumpy. The video streamer's stock regularly experiences double-digit sell-offs following weaker-than-expected subscriber growth. Netflix is never quite able to identify the reason for these misses, though they could be caused by competition, a weak programming slate, higher prices, or simply lumpiness in subscriber additions, as aggressive growth in one quarter might lead to slower growth in the next as subscribers who would have joined in one quarter were pulled in the previous quarter. Given that, it's not a surprise that Stitch Fix's sell-off comes after the stock surged on its previous earnings report in June.

In spite of those regular sell-offs, Netflix has been one of the biggest winners on the market over the last decade, with the stock up 9,000% during that time. Stitch Fix, it's worth remembering, is still up 22% year to date and has more than doubled from its IPO last November. Shares also looked as if they had become overheated after its rally over the last few months.

One quarter of weak sequential customer growth isn't nearly enough for me to change my investing thesis for a stock with the kind of long-term potential that Stitch Fix has. The company is executing on a number of its goals, including improving profitability, and it just announced its launch in the U.K. by the end of its current fiscal year, its first international expansion.  

I'd expect sequential customer growth to return in the current quarter, which is a seasonally stronger one, especially as the company sees revenue increasing 11% to 13% sequentially in a quarter that's already two-thirds over. If its active client count stalls for the second quarter in a row in its next report, then investors might have a good reason to question the company's long-term prospects.

Jeremy Bowman owns shares of Netflix and Stitch Fix. The Motley Fool owns shares of and recommends Netflix and Stitch Fix. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.