The Stitch Fix (NASDAQ:SFIX) third-quarter results are in, and they're not pretty.

At a time when most e-commerce companies were seeing sales surge, the online personalized styling service was moving in the opposite direction. Revenue fell 9.1% in the quarter ended May 2 to $371.7 million, badly missing estimates at $406.7 million. The bottom line wasn't any better as the company posted a per-share loss of $0.33, down from a profit per share of $0.07 in the quarter a year ago and worse than expectations at a loss of $0.16. 

Wall Street, which seems to be sending almost every stock to the moon these days, gave the report a thumbs-down, with the stock falling 5.5% Tuesday.

Yet despite missing the analyst consensus, the quarter was stronger than the numbers indicate. Here's why.

A customer looking at Stitch Fix style cards next to an open box

Image source: Stitch Fix.

Demand is still solid

If there was ever a time for Americans to give up on clothes shopping, it was during the lockdowns. People are stuck at home with no social occasions to plan for or even an office to go to, giving them little need to buy new clothes. Meanwhile, the shock of the pandemic led consumers to focus on more pressing matters like stocking up on essential goods and helping their kids with remote learning. Clothes shopping, like other discretionary spending, fell by the wayside. According to the Census Bureau, sales at clothing stores declined 50% in March on a year-over-year basis and plunged 89% in April.  

At Stitch Fix, demand didn't suddenly shrivel up when the pandemic struck. Rather, the company was burdened by supply side issues as it shut down three of its six warehouses, leading to order backlogs. By the end of March, it had lost 70% of its fulfillment capacity. At that point, the company began reopening the affected warehouses on an opt-in basis for employees who wanted to work, and slowly began ramping up fulfillment. By the end of the quarter, it had about two-thirds of its regular capacity and now is back up to full capacity. Management said that by the end of June, it expects to have eliminated the order backlog. 

The first half of the quarter, which was before the pandemic started, saw revenue grow roughly 20%, and management believes that without the warehouse disruptions from COVID-19 , it would have posted positive revenue growth for the full quarter.

Stitch Fix has not broken down the percentage of business that comes from its auto-ship clients, or those who order Fixes at pre-scheduled intervals, but management said that a "large majority" of its clients use the auto-ship function. After seeing some cancellations of regular orders in the third week of March, auto-ship retention had reached its highest level in three years by the end of April. That shows that the customers who make up Stitch Fix's base, as well as the majority of its revenue, are sticky, and will stay with the service even during recessions and shocks like the pandemic. That gives the company a significant competitive advantage. 

Direct buy could be huge

Stitch Fix's most important initiative since its 2017 IPO is its direct buy program, which allows customers to shop from a curated selection of clothes on the site based on their past orders. Traditionally, the company has only sold clothes through stylist-selected "Fixes," or five items in a box, but direct buy opens up a much bigger market for the company.

Based on the company's enthusiasm for direct buy, it sees extraordinary potential in the platform, and said that revenue from direct buy tripled in the third quarter on a quarter-over-quarter basis, even with the challenges from COVID-19. It also shared that penetration among its existing base of women's clients rose from 5% in February to 13% in May, and it's found direct buy to be incremental to its Fixes, meaning it's getting existing customers to spend more money on the platform.

Up until now, direct buy has only been available to customers who have ordered Fixes, but that's about to change. The company has just started testing a program called "Trending for you," which allows customers to shop through direct buy with just a style profile, without having had to order and purchase an item from a Fix. This eliminates a sometimes-cumbersome step and allows the company to use its data science and algorithms to curate outfits directly for a new customer, helping it acquire customers who aren't interested in receiving Fixes. The company also said it is aggressively hiring engineers to build the product experience.

Direct buy is still less than a year old, and it's too early to know what kind of effect this will have on the business, but based on the results and momentum thus far, it could be a major driver of the company's growth over the coming years as well as a source of competitive advantage.

What's next

Many of the challenges from COVID-19 facing Stitch Fix and the rest of the apparel industry still remain. Office workers continue to work from home, and social distancing protocols mean that large gatherings are still banned, at least formally.

Brick-and-mortar apparel retailers are still reopening their stores, but Stitch Fix said it returned to sales growth in May, and expects revenue growth for the full fourth quarter. The company also forecast gross margin to improve by 200 to 300 basis points from the third quarter, though that would still represent a slight decline from a year ago.

Depending on how the pandemic plays out, it may take a few quarters for the company to get back to its long-term revenue growth target of 20% to 25%, but Stitch Fix is clearly moving in the right direction, and is in much better shape than its brick-and-mortar rivals. That sets up a long-term opportunity for the company, as it should be able to accelerate its market share gains over the coming months.