Investors cheered Stitch Fix's (NASDAQ:SFIX) latest earnings report, with shares of the personalized styling service trading up as much as 12% after hours on Monday.

The company beat both revenue and earnings expectations and raised its adjusted EBITDA guidance for the year.  While those results are the likely cause for the stock's bounce, there's a better reason for long-term investors to be excited about the stock. It's a new way of shopping on the site -- something the company calls direct buy.

Currently, direct buy takes two forms: Shop Your Looks and Shop New Colors. Shop Your Looks provides a highly curated selection of about 30 to 40 items based on customers' past preferences, while Shop New Colors allows customers to buy items that they've already purchased in different colors and patterns. Of these two, Shop Your Looks is the one to watch.

A woman holding a Stitch Fix box against a grassy background.

Image source: Stitch Fix.

Shop Your Looks could be huge

Management introduced Shop Your Looks in the October earnings call, characterizing it as a new way to reach customers and gain wallet share. Since then, it's become clear that the company likes what it's seen from the new platform. On the call, CEO Katrina Lake said shoppers "seem to really love it."

Shop Your Looks is now available to more than one-third of U.S. female clients, and the company expects it to be available for all U.S. female clients by the end of the fiscal year in July. It's also directed its engineering staff and other resources behind it, and the early data is promising.

Lake said Shop Your Looks has helped the company gain more non-apparel sales of products such as shoes, handbags, and accessories. While that category has historically made up less than 10% of Stitch Fix's sales, in Shop Your Looks it makes up more than 20%. Similarly, Shop Your Looks is correlated with increased customer satisfaction and fewer returns, which helps improve unit economics. About 60% of customers who used the platform purchased two items or more, Shop Your Looks helped drive active revenue per client up 9.5% in the quarter, as well as the increase in full-year adjusted EBITDA guidance.

What's special about Shop Your Looks and the more general direct-buy program is that it fills a need that Stitch Fix had previously ignored. While the company has built its business on selecting apparel for clients who then keep what they want and return the rest, the direct-buy offerings give customers a chance to buy clothes the way usually do -- looking at them first and selecting what they want.

Importantly, Shop Your Looks has a distinct advantage over other online apparel sellers. Since Stitch Fix knows its frequent customers so well, it has a good sense of what they want, which allows it to recommend just 30 to 40 items rather than the world of clothes available online. In this way, Shop Your Looks acts as a natural endgame for the company's data science and will only build more loyalty with its customers.

If you're a Stitch Fix customer, the company knows your fit, style, budget, and other preferences. If you can go on to Shop Your Looks and find what you want, why would you bother shopping anywhere else and take a risk, for example, that that item wouldn't fit? 

Optionality is key

One thing the bears and short sellers consistently overlook about Stitch Fix is its optionality, or its ability to branch out into new businesses in ways that can't really be predicted. Optionality is particularly valuable to investors because this type of potential growth isn't priced into the stock.

Stitch Fix has barely been public for two years, but during that time the company has launched a Kids offering; expanded into the U.K.; introduced Style Shuffle, a game that engages clients and gets information on their tastes; added Extras, which sells customers things such as socks and underwear along with their regular order; and is now growing its direct-buy programs. Exclusive Brands, or the company's private-label products, also remain an appealing opportunity, and in the first quarter the top sellers for both men and women were Exclusive Brands, another sign that the company's homegrown initiatives are paying off.

With Shop Your Looks, it's easy enough to imagine Stitch Fix layering on further direct-buy options. For instance, customers could search for an item the way they normally do online, by entering "black coat" or "skinny jeans" and getting an automatic recommendation or two based on their past purchases, saving them time and effort and eliminating the "paradox of choice" so common in online shopping.

On the call, Lake referred to this ability to curate for individual customers as the "promised land" of retail. It's clear that such knowledge is a competitive advantage, and investors should expect Stitch Fix to leverage its customer knowledge in more ways than just increasing the success rate of its standard five-item fix.

The path ahead

Over the long term, Stitch Fix believes it can grow revenue by 20%-25% and reach a 10%-12% operating margin.  With 46% of the float sold short, plenty of investors are still skeptical that Stitch Fix can reach that level of profitability, but if it executes on those goals, the company could have a $500 million annual operating profit within five years. That looks like a bargain for a growth stock that closed Monday with a market cap of just $2.5 billion.

Ideas like Shop Your Looks will help take the company to that next level of profitability, as improving client satisfaction will have a number of benefits, including improving unit economics by limiting returns on saving on labor and promoting positive of word of mouth. On the call, Lake touted the growth potential of the direct-buy offerings but was also stressed that the program was still in beta. She said Shop Your Looks would be incremental to the company's sales growth, but the new sales channel could be much more than that. By opening up new ways for Stitch Fix to do business and leverage the competitive advantage it's gained from years of gathering detailed information from client fixes, direct buying can best demonstrate the strength of the model, attract new customers, and encourage existing ones to spend even more.