Retail stocks have underperformed the broader market during the COVID-19 outbreak. Not surprisingly, April data from the U.S. Department of Commerce showed a colossal drop in sales at clothing stores of nearly 90% year over year. However, non-store sales were up 21% year over year, reflecting the advantage that e-commerce has in this environment.
Nike (NKE -11.81%) and Stitch Fix (SFIX 4.77%) are two retail stocks that should survive the shutdown and emerge stronger on the other side. Both companies have plenty of cash to cover near-term expenses, and both have a growing online presence. We'll compare these companies' competitive position to determine which stock investors should buy today.
The future of Nike is digital
Nike's competitive advantage is the iconic swoosh logo. The brand is so strong that Nike only had to increase marketing expense by 1% last quarter to drive a 5% increase in revenue.
However, Nike is vulnerable to a significant drop in revenue this quarter with many of its stores still closed. Nearly all of Nike's stores in Greater China and South Korea have reopened, but only 5% of its stores in North America are open.
While customers can't visit stores, some are turning to Nike.com and the SNKRS app. Management disclosed in a business update on May 14 that it continues to see strong conversion rates and high demand in its digital sales channels. Still, Nike's digital business comprises only 20% of total revenue.
The weight of store closures is evident in the current consensus earnings estimates from analysts. Wall Street analysts expect Nike to report a decrease in revenue of 0.7% for the May-ending fiscal year, while adjusted earnings are expected to decrease by 12%. Assuming stores reopen, growth should rebound next year. The current analysts' estimates have Nike growing revenue by 7.9% in fiscal 2021, with adjusted earnings improving to $2.74.
Before the outbreak, Nike was making great progress to improve its gross margin, mainly due to higher average selling prices and growth in Nike Direct. For the six-month period ending in November 2019, revenue and earnings were up 9% and 31%, respectively.
Nike has spent decades building its brand with sneakers, which generate two thirds of its annual revenue, but growth in apparel and Nike's digital strategy are two long-term growth drivers to watch. Digital sales were up 36% year over year last quarter adjusted for currency changes.
The coronavirus crisis could alter consumer shopping behavior, further boosting Nike's digital growth. But Stitch Fix may be better able to capitalize on the consumer shift to e-commerce, since its whole business is centered around a highly personalized online service.
Stitch Fix positioned to win share in a massive market
Before the outbreak, Stitch Fix was growing much faster than Nike. In the most recent quarter, pre-coronavirus, Stitch Fix reported a revenue increase of 22% year over year, while the number of active clients climbed 17% to 3.5 million.
Stitch Fix was founded in 2011 by CEO Katrina Lake. The goal was to offer consumers a new way to shop for clothes that saved time, while providing curated items based on each client's taste.
However, Stitch Fix is not immune to the effect of the outbreak. Lake disclosed in a business update in April that the shutdown was causing "significant constraints" on operations. Nonetheless, the service is still operating in this environment. For what it's worth, the consensus analyst estimate calls for Stitch Fix to grow revenue by 9.7% in fiscal 2020 and 13.3% in fiscal 2021 (which runs through July).
Stitch Fix will continue growing over the long term because of its expertise in data science, helping clients find the right outfit for nearly any occasion, even something small like finding a well-fitted pair of jeans. This makes the service very sticky for clients.
As Stitch Fix learns more about its clients, the service could become a powerful force in the $1.5 trillion apparel industry. Many retailers are struggling to stand out online in a sea of competitors, and it's even harder for physical stores to create a profitable online business because of the costs of returns. Stitch Fix's highly personalized recommendation service is designed to limit returns, which gives it an advantage.
New services, such as Direct Buy, could drive further growth in average spending per customer. With Direct Buy, Stitch Fix offers customers the ability to buy items directly from the company. These items are displayed based on feedback collected from Style Shuffle, where clients rate clothes the same way they would thumb up or thumb down a movie on Netflix. Stitch Fix has collected over 4 billion ratings, with over 80% of this data providing detailed feedback of what clients like and dislike.
Which stock should you buy?
Stitch Fix doesn't generate much profit, as it invests in hiring and technology to support growth. But the stock is potentially undervalued.
It sports a price-to-sales ratio of 1.13. That ratio is higher than struggling retail brands like Victoria's Secret owner L Brands, which has a P/S ratio of 0.22. Nike generates higher profit margins, so its P/S ratio is 3.28.
However, Stitch Fix is priced as if it will never earn a higher profit margin than the single digits. Its profit margin is currently 1.5% on a trailing 12-month basis. On the other side, Nike's profit margin is 10.5%, which is around the S&P 500 average.
If Stitch Fix's profit margin improves over time consistent with the average margin of most companies, earnings growth will accelerate and will fuel a rising stock price.
Nike is a safe choice, since it's an industry leader. But even after the recent sell-off, Nike trades at a high 35 times forward earnings estimates, and the sneaker giant has got an anchor in the short term with most of its sales generated through brick-and-mortar locations.
I believe Stitch Fix offers more growth potential than Nike, and investors are potentially underestimating its potential to increase margins, which is management's stated long-term goal.
All said, I would buy shares of the faster-growing digital clothing stylist over Nike today.