On June 7, online styling service Stitch Fix (SFIX -2.43%) released its fiscal 2021 third quarter results. The company beat analysts' expectations on earnings and revenue, sending the stock up over 10% in the last few trading days. Stitch Fix is clearly building some momentum with the easing of COVID-19 lockdowns. But does it belong in your portfolio? Let's take a look.
In Stitch Fix's fiscal third quarter (the three-month period ended May 1, 2021), revenue grew 44% year over year to $536 million. This was an impressive showing, but investors should remember this report is lapping the spring 2020 quarter when revenue dropped 9%. If we compare the third quarter of fiscal 2021 to the same period in fiscal 2019, revenue only increased 31% on a two-year basis. That is still solid growth but not quite what the headline numbers suggest.
An important metric for Stitch Fix's business is active clients, which tracks the number of Stitch Fix shoppers active over the past 12 months. In the latest quarter, active clients grew 20% year over year to 4.1 million, while also growing 234,000 from the previous quarter, marking its second-highest quarter-on-quarter client growth ever.
While Stitch Fix's top line and user numbers look solid, the company is still struggling to generate profits. Over the last nine months, Stitch Fix had an operating loss of $84 million. Some of this loss likely came from one-time expenses due to the pandemic and supply chain issues over the winter, but the company will have to turn profitable at some point.
Still some questions on the business model
Stitch Fix's operating model is unique with its algorithms and stylists working together to curate "fixes" for clients. This personalized service has fueled Stitch Fix's growing popularity over the past decade. However, I have a few concerns around the cost structure that other investors should consider.
For one, the company employs a lot of stylists: more than 6,000 according to the latest investor presentation. With wage pressure hitting the labor market, Stitch Fix is at risk of having to raise its wages to attract new stylists. It also has a worrying amount of marketing spend compared to its growth and expense structure. In the fiscal third quarter, advertising expense was around $48 million, or 9% of total revenue. This is down from 10% of revenue in the prior-year period, but with a gross margin of only 46% and the high fulfillment expenses that come with being an e-commerce business, spending 9% to 10% of revenue on marketing each year could really hurt the company's potential to generate profits.
While these expenses are a concern, one way Stitch Fix is aiming to improve its profitability is with Direct Buy. Direct Buy is for current Stitch Fix users, and it is still fairly new at just a year old. The service includes an algorithmically-generated feed of products based on a user's buying and style history, allowing customers to bypass the tedious parts of the traditional fix offering. If Direct Buy can get to scale, it has the potential to lower Stitch Fix's costs by reducing the need for so many stylists while also lowering marketing costs by improving engagement and reducing churn among existing clients. Investors should watch Direct Buy closely -- it may be the key to Stitch Fix's future.
Valuation looks reasonable
Currently, Stitch Fix has a market cap of around $6.9 billion. Management is guiding for $2.075 billion of revenue (at the midpoint) in the current fiscal year that ends in July. That means Stitch Fix has a forward price-to-sales ratio of 3.3. Management has also guided for its long-term operating margin to be around 10% or slightly higher.
If Stitch Fix had these profit margins right now (it is unclear if it ever will), its price-to-operating-income would be around 30. This isn't overly expensive, but it isn't cheap either. But what it implies is that most investors are still discounting Stitch Fix's ability to grow sales and clients or achieve these profit margin goals, leaving an opportunity out there for anyone that does. If Stitch Fix can maintain its double-digit growth and hit its margin goals, the stock could outperform the market over the next decade.