Stitch Fix (NASDAQ:SFIX) shareholders were left holding the bag again this week. For the second quarter in a row, the stock plunged following its earnings report as concerns about slowing user growth overshadowed better-than-expected earnings results.
In its first fiscal quarter of 2019, which it just reported, active clients grew 22.3% or 534,000 year over year, to 2.93 million, missing analyst estimates for 2.95 million. That follows the company's fourth quarter, when it reported 25% year-over-year growth in active clients to 2.74 million, missing expectations for 2.81 million. In the fourth quarter, investors were spooked by slowing sequential growth, as the company added just 54,000 active users.
Adding to those concerns was that Stitch Fix projected second-quarter active client growth to be "relatively flat" on a sequential basis as the company scales back on advertising during a seasonally slow quarter, when its customers are more focused on holiday-gift buying.
Considering that Stitch Fix shares have lost nearly two-thirds of their value since peaking in September, largely on two disappointing rounds of user growth and weak guidance, investors are likely wondering whether user growth is going to be a lasting problem for the online styling service, and if the stock can recover.
The curse of the growth stock
For the average stock, such modest user misses may not be so concerning, but Stitch Fix has been priced and treated like a growth stock since its IPO at $15 in November 2017. The company, which sends customers five items at a time based on their style, fit, and budget, and allows them to keep what they want and return the rest, is seen as a disruptor, threatening the traditional model of apparel shopping. In many ways the company is similar to Netflix, which has gradually upended the traditional pay-TV model through video streaming.
Following a breakout third-quarter earnings report in June, the company's stock surged, as the market seemed to believe it was the next big thing. However, those gains have quickly evaporated after the last two reports.
Part of the problem is that Wall Street doesn't know how to value Stitch Fix. It's a unique stock as the only pure-play online styling service on the market, though it has plenty of privately held peers like Trunk Club and Bombfell. It's part apparel retailer, part tech company, using algorithms and e-commerce to better serve its customers. No one really knows how much of the apparel market these types of services (specifically Stitch Fix) will eventually command, or if the concept has staying power. Some investors look to the meal-kit providers like Blue Apron that are currently struggling after commanding billion-dollar valuations not too long ago, and worry the same could happen to Stitch Fix.
The push and pull of promise and uncertainty has led the company to a volatile year-plus as a publicly traded business.
What the numbers say
Notably, Stitch Fix executives don't seem to believe that it has a user growth problem. Although management projected "relatively flat" active client growth for the current quarter, it offered a good explanation for doing so. Here's what they said:
As a reminder, the holiday season is during our second fiscal quarter. We do not expect seasonality in our business to follow that of traditional retailers, which often experience a concentration of revenue in the holiday season. Historically, we have experienced lower quarter-over-quarter net revenue growth in fiscal Q2 due to slower active client growth during the holiday season. We believe this is reflective of our clients' focus on buying gifts for others rather than themselves. We view our lack of seasonality as a positive; it makes staffing and planning easier and we don't need to compete on advertising spend for consumers' attention. As such, we expect our advertising as a percent of sales, as planned, will be lower in Q2 than it was in Q1, similar to our spending pattern last year. Given this cadence of advertising spend, we expect our Q2 active client count to be relatively flat quarter over quarter, while we expect revenue per client to grow.
Advertising rates spike along with demand during the holiday season so it makes sense for the company to take a break from putting out its message and wait for more opportune moments. In fiscal 2018, advertising spending fell from $28.2 million in the first quarter to $19.8 million in the second quarter, but Stitch Fix still managed to add 112,000 active clients in the second quarter. That was measurably less than the 202,000 active clients added in the first quarter, but represents solid growth nonetheless.
Investors should be put at ease a bit by the fact that the company was able to cut advertising expenses sequentially by about a third in the second quarter of 2018 and still add more than 100,000 users. Unfortunately for Stitch Fix, the flat guidance comes as there are swirling concerns over the company's ability to grow its user base.
Looking back, Stitch Fix added 188,000 active clients sequentially in Q1 2019 compared to 202,000 in Q1 2018. In Q4 2018, it added 54,000 users sequentially, much less than the 120,000 it added in Q4 2017.
Those numbers indicate user growth is indeed slowing, though it's unclear if this is a sustained slowdown or if investors should expect it to stabilize at the current level.
Management assuaged concerns about slowing user growth by pointing out that net revenue per client is increasing due to initiatives like Style Pass and Extras, as well as improved operations. In the first quarter, revenue per active client, which is their total spending over the past year, increased 2.3% to $443. The company also projected an increase in revenue per client for the second quarter, calling for overall revenue growth of 22%-24% to $360 million-$368 million, essentially in line with the first quarter. That shows that growth in revenue per client should be strong enough to offset weakness in user growth for now.
However, over the long term, gaining new customers is almost always a better way of building a retail business than coaxing current customers into spending more. While growth in revenue per client is certainly a positive, it's not enough alone to overcome concerns about a deceleration in user growth.
Stitch Fix's active client growth has slowed measurably, and it's become a red flag for Wall Street. Until that changes, investors should expect the stock to remain down. By calling for relatively flat growth in the current quarter, management may have given itself a low bar to hop over, but the company will eventually have to show that user growth is stabilizing in order for the stock to bounce back.