Stitch Fix (NASDAQ:SFIX) announced several awful operating and financial metrics as part of its fiscal third-quarter earnings report this week. Key figures like sales growth, profitability, and cash flow all worsened as the online apparel retailer struggled through demand and supply challenges related to the COVID-19 pandemic.

There were a few bright spots in the announcement, though, that suggest this past quarter's slump had no enduring impact on Stitch Fix's competitive position in the industry.

A woman unpacks a cardboard box of clothes.

Image source: Getty Images.

Missing the delivery window

There was no denying that the business took a big step backwards in the three months that ended on May 2. Sales shrank 9% compared to a 20% increase in the prior quarter. Gross profit margin dropped to 41% of sales from 45% as the company cut prices to deal with excess inventory. At the same time, selling expenses jumped due to the temporary closure of several distribution centers and a boost in paid leave for employees.

These issues combined to push profits far lower, with adjusted losses landing at $40 million, or 11% of sales, compared to a break-even result a year ago. "We navigated unprecedented fulfillment challenges tied to COVID-19," CEO Katrina Lake said in a shareholder letter .

The good news

Lake and her team tried to emphasize several positive points to make the case that the business is only experiencing a temporary lull. Sales growth was running at about 20% in February and early March before the pandemic scrambled demand patterns around March 12. Temporary demand declines were amplified by supply challenges from distribution center shutdowns, and the company was forced to adjust by limiting marketing and the type of cross-promotions that usually yield much higher levels of repeat purchasing.

Management said supply and demand trends have both improved for just about each of the last five weeks and that its inventory bottlenecks are almost completely cleared up today. Stitch Fix is in "more of a position to play offense in the coming quarters," Lake said.

Looking ahead

But the best news out of the report is that client engagement isn't simply holding up -- it is rising. In fact, Stitch Fix reported that customers are now opting for automatic shipments at the highest rate the company has posted in several years. That's a strong sign that growth will pick right back up, especially when you consider that the active client base dipped slightly quarter to quarter, but rose 9% compared to the prior year.

Stitch Fix said it returned to sales growth in May and expects to report a positive figure for the fiscal fourth quarter. Gross profit margin will improve by at least 2 percentage points compared to the fiscal third quarter, too, as fulfillment and distribution trends return to normal. While the company still sees net losses ahead, it expects to return to positive cash flow in the current quarter.

The tech stock's most attractive characteristic is its potential to create a subscription-like service that can deliver steady sales and cash flow growth through all but the most intense economic swings. The COVID-19 pandemic qualifies as that type of unusual shock. Now it's up to the company to demonstrate that it can start climbing back toward the 20% sales growth it enjoyed before the virus erased its positive momentum.

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