Shares of online styling service Stitch Fix (SFIX -2.28%) were down more than 28% on Tuesday after the company reported its second-quarter earnings results. The November-through-January period was not kind to the company, with shipping delays increasing expenses and causing revenue to grow at a slower rate than management expected. Guidance for the full fiscal year was also reduced from the last earnings release. Investors clearly did not like the news.
A 28% drop never feels good, but if you are an investor in Stitch Fix, there's no reason to panic. One quarter does not make or break a stock. What you should ask is whether Stitch Fix management is making the necessary investments to grow the business over the long term.
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Q2 results
For the second quarter (which ended in January), Stitch Fix had $504.6 million in net revenue, up 11.6% from last year, while active clients hit 3.9 million, up 11.8% year-over-year. These two headline numbers look solid, but once you move further down the income statement you realize this quarter had some major hiccups. Gross margin declined from 44.8% to 42.9% this quarter due to higher shipping costs, and operating expenses as a percentage of revenue grew from 42.9% to 50.9% due to an increase in wage compensation at the company's warehouses.
Expenses growing faster than revenue led Stitch Fix to realize a $40 million operating loss this quarter, compared to an $8.5 million operating profit in Q2 of last year. Guidance for revenue growth was also lowered from a range of 20%-25% to 18%-20% for the full year ending in July. This combination of rising expenses and lower growth expectations is what likely caused the stock to drop so sharply on Tuesday.
The big question
Like I mentioned above, the big question with Stitch Fix is where it should invest for future growth. The company started out in 2011 with its well-known "fixes", which combine data science and human stylists to ship clothing items tailored (no pun intended) to what each customer wants, but without the customer shopping or choosing any items beforehand. For years it has focused intensely on growing its fix offering, and has prided itself on this unique and differentiated experience.
But recently, the company has made major investments in adding more traditional shopping experiences to its app/website. Direct buy, which allows clients to buy individual clothing items without getting a fix, was launched in 2019 and has slowly added more features like "trending for you," "finish your looks," and "categories." All three features combine Stitch Fix's data capabilities, theoretically surfacing clothing items for each user based on their tastes, and giving customers more choices when looking for items to buy. It also has introduced fix previews, which allow clients to see what items they are getting before the box gets shipped to them if they elect to schedule a fix. While these features seem like solid value adds, the service is getting less unique and is looking more like a traditional e-commerce company each quarter. This might end up being good for Stitch Fix in the long run, but investors need to consider this slow change in Stitch Fix's business model, and how it could impact the company.
To add on, marketing spending is growing as a percentage of revenue, which indicates that either Stitch Fix is finding it difficult to acquire new clients, or that it is losing clients through churn faster than it has historically. With that in mind, investors need to ask whether the fix/styling model is working as well as management claims, and if future investments should be focused more on enhancing direct buy or shifting the fix model so it appeals to a broader audience that is used to the traditional shopping experience.
None of this is to say Stitch Fix's business is in shambles. Far from it. But with the company failing time and time again to generate consistent profits, it's possible that the market for the legacy fix business is not as large as management or investors assume. To alleviate these concerns, Stitch Fix may want to double down on direct buy and traditional e-commerce offerings -- but with an algorithmic touch -- as a more sustainable way to grow its business over the next few years and beyond.
