Earlier this month, online personal styling service Stitch Fix (SFIX +0.35%) released results for its fiscal third quarter 2020, which ended on May 2.

The company had a challenging quarter because of the COVID-19 pandemic. The crisis disrupted its supply chain, and consumers were largely concerned with more pressing matters than shopping for apparel. In the quarter, revenue fell 9% year over year and the company posted a net loss of $33.9 million, or $0.33 per share, compared with a net income of $7.0 million, or $0.07 per share, in the year-ago period.

One quarter is just one quarter. Long-term investors shouldn't judge any company by short-term results, especially when there are rare, extenuating circumstances.

Investors should, however, look at both bull and bear theses for the stocks they own and are considering buying. The crux of the bull thesis is that Stitch Fix's potential for growth is huge because consumers are increasingly shopping online for fashion-related items, which are still primarily purchased in physical stores. 

This article explores three key reasons that investors should be cautious when considering investing in Stitch Fix stock.

Image source: Stitch Fix.

1. Barriers to entry aren't that high, and competition is heating up

Stitch Fix does, indeed, have a potentially massive market share opportunity. In 2018, fashion e-commerce (which includes apparel, footwear, and accessories) accounted for only about 20% of the total fashion retail sales in the U.S., according to Statista. The online channel had been making steady gains before the pandemic, which has accelerated the transition in the way in which consumers shop for fashion items.

That said, investors should consider the possibility that Stitch Fix could have a hard time fending off competition -- notably from Amazon.com (AMZN +1.87%), but also from others. Barriers to entry to the space in which it operates aren't that high. They're not low, either, but somewhere in-between, though they should continue to fall as the cost of developing top artificial intelligence (AI) capabilities declines. 

Stitch Fix has some very valuable customer fashion preference data, thanks largely to its use of AI and its early-mover status. (The company was founded in 2011 and held its initial public offering, or IPO, in November 2017.) However, Amazon should have no issue catching up to the depth of the data that Stitch Fix possesses on some customers. Moreover, Amazon arguably already has some of this preference data on a larger number of people. 

Amazon launched its Personal Shopper by Prime Wardrobe service in late July 2019. The service is exclusively for Prime members. Currently, it's only available for women's fashions, though a men's launch is planned. This service is similar to Stitch Fix's flagship "fix" service -- which generates the bulk of its revenue -- though has some key differences. It's more flexible, so it has the potential to appeal to a wider number of consumers.

Both companies' services ask clients about their preferences, including style, fit, and budget. This data -- along with past purchase data -- trains their AI tools. 

Here's how Stitch Fix's "fix" service works:

Clients can sign up to receive a fix at some regular interval, such as monthly, and they can also request a fix on demand. A "fix" is composed of five items chosen for a customer by a human stylist, who uses an AI-generated group of selection possibilities. Clients must return the items they don't want to keep within three days using the prepaid return label. Fix customers pay the $20 styling fee if they don't keep any of the five items in a fix. If they keep at least one item, the stylist fee is deducted from the total price of the items in the fix. If they keep all five items, they receive a 25% discount.

Like Stitch Fix, Amazon's service involves a human stylist using AI tools. However, its service doesn't send customers items they didn't specifically choose. Customers select from one through eight items from a recommended list of selections generated from the stylist. The service costs $4.99 per month, which entitles a customer to one styling per month. Customers can cancel their membership at any time. 

In Amazon's service, customers have seven (rather than three) days to return items they don't want. It also provides a prepaid return label. 

Given the low trial cost and the humongous number of Prime members, this service has the potential to present a significant threat to Stitch Fix. Moreover, Amazon has an enormous and diverse empire, including a incredibly profitable cloud service business. So, it doesn't need to make money on its service and, in fact, doesn't need to consider its profitability for a long, long time. This is not true with Stitch Fix.

Image source: Amazon.com

In addition, a recently launched fashion e-commerce company has the potential to be quite successful: The Yes. The company was founded and is run by Stitch Fix's former Chief Operating Officer Julie Bornstein, whose retail resume before her four-year Stitch Fix gig is impressive. The Yes is currently privately held.

2. Business model could use a makeover

There's room for more than one fashion e-commerce company to do very well in such a growth market. However, my hunch is that The Yes' business model could appeal to a wider number of consumers than Stitch Fix's, particularly women. As Bornstein told Tech Crunch, "What ... our team is really focused on is the actual consumer shopping experience for consumers who want to shop. There's a strong percentage of the population who ... wants agency in their own selection." 

In other words, The Yes isn't sending items to consumers that they didn't select themselves. Its service doesn't have any fees. 

Like Stitch Fix, The Yes will heavily use AI. Its use of the tech, however, will be solely geared toward helping consumers select items that they like. 

Unlike Stitch Fix, The Yes isn't carrying inventory. It's drop-shipping to customers directly from the warehouses of the brands it carries. So it won't have money tied up in inventory and should be able to react faster than Stitch Fix to changes in consumer demand.

The pandemic-driven stay-at-home orders instituted across nearly all U.S. states and many other countries in March resulted in consumer demand pivoting very quickly away from more dressy apparel and toward comfortable casual attire. The crisis shone a light on the drawbacks of Stitch Fix's business model. 

A prediction: Stitch Fix will evolve to be more like The Yes. The core "fix" part of its business is either going to eventually disappear or be quite limited in size relative to its "direct buy" sales. In other words, consumers who want a fix will remain a niche market. 

3. Transparency needs an upgrade 

It's easier for investors to make solid investing decisions if a company's management regularly provides clear and relevant performance data. We can't expect companies to be as transparent as, say, a see-through loose mesh. However, investors should expect a chiffon-like (semi) transparency.

Stitch Fix provides a lot of information in its quarterly shareholder letters -- but it doesn't provide a couple key metrics that it arguably should (or at least would be very helpful) given its business type and model.  

First up is a customer retention measure. Stitch Fix's flagship "fix" service -- which generates the bulk of its revenue -- uses a subscription-like business model. Customer retention measures, like retention rate or churn, are critical metrics in any subscription business because they reflect customer satisfaction.

Secondly, Stitch Fix doesn't report metrics comparable to same-store sales, a key performance measure for brick-and-mortar retailers. The company's revenue in recent quarters has gotten a boost from its May 2019 launch in the United Kingdom. Without a same-store-like metric, investors don't know the year-over-year growth in revenue (or so-called "active clients") in just the U.S. This data would tell us how well the company is penetrating its core U.S. market. 

Stitch Fix's lack of providing the key metrics mentioned here could limit the number of investors willing to buy its stock. 

The bottom line

There's no doubt that Stitch Fix has a potentially huge growth opportunity. However, it has yet to prove that its business model can scale and remain profitable.

So, for now at least, there are currently better long-term ways to play the growth of e-commerce than Stitch Fix, with Amazon being one of the best.