With its earnings released on Tuesday, Stitch Fix (SFIX 2.71%) posted declining profits that contrasted with strong revenue growth. And given management's guidance, the discrepancy between the company's growing revenue and shrinking adjusted EBITDA will continue. But this apparently negative development provides a long-term opportunity for shareholders.
Outstanding performance in the retail sector
Stitch Fix posted a solid 26% year-over-year revenue growth during its last quarter (excluding the impact of an extra week). Besides, management expects revenue to grow in a range of 23% to 25% over the next 12 months.
In comparison, market research estimates the U.S. apparel, footwear, and accessories market will grow 3.7% annually by 2023. And the eCommerce portion Stitch Fix addresses will grow 14.0% annually.
Stitch Fix's strong revenue growth is due to its expanding online business. The company sends personalized merchandise, based on customer-provided information and preferences, in a box it calls "Fix", and customers can return the non-desired items for free.
Image source: Getty Images.
Initially, Stitch Fix addressed women in the U.S. But the company expanded its customer base to men and kids. The company also started its geographic expansion in the U.K. a few months ago.
And this week, the online retailer announced the extension of its business model to a direct-buy format. Customers can now buy personalized items on the company's website instead of receiving a "Fix". This initiative represents an extra growth opportunity for the company provided sales from its direct-buy format won't cannibalize sales from its "Fix" business.
Despite its growth investments, Stitch Fix posted a positive operating income of $23.5 million during fiscal 2019.
The company's profitability comes from its gross margin. Since Stitch Fix doesn't have to support costs associated with a brick-and-mortar presence, its gross margin reached 44.6% over the last 12 months. In contrast, apparel retailers with a physical footpring such as Gap (GAP 0.85%) and Urban Outfitters (URBN 0.71%) generated a gross margin of 37.6% and 33.0%, respectively.
Increasing operating costs
But Stitch Fix's personalization business based on data science and human judgment involves extra costs compared to traditional apparel retailers. For instance, the company employed more than 5,100 stylists by the beginning of August, which represented more than 63.7% of its workforce. And these costs have been increasing faster than revenue over the last several years.
As a result, operating expenses, which include costs related to stylists and scientists, represented 43.1% of the company's revenue over the last 12 months. Legacy retailers such as Gap and Urban Outfitters reported lower operating expenses at 29.4% and 24.6% of their respective revenue.
Thus, because of the increase in its operating costs, Stitch Fix's adjusted EBITDA decreased from $60.6 million in fiscal 2017 to $39.6 million during fiscal 2019. And management expects adjusted EBITDA to decline in the range of $10 million to $30 million over the next 12 months.
The company's increasing operating costs as a percentage of revenue makes sense, though. For instance, the company has been investing in its U.K. business and its direct-sale platform. But these initiatives, launched in May and August this year, respectively, have yet to reach scale and contribute to the company's revenue.
Thus, I expect the company's operating margins to improve with scale over the long term.
Long-term opportunity
The market values the company at a modest Enterprise Value (EV)-to-sales ratio of 0.75, based on the midpoint of the revenue guidance at $1.915 billion.
Gap's and Urban Outfitters's EV-to-sales ratios stay higher at 0.77 and 0.92, respectively. But these two competitors posted a year-over-year comparable sales decline of 4% and 3%. Besides, Stitch Fix's debt-free capital structure is safer for shareholders as the company doesn't face the threat of a debt wall.
Investors probably take into account Stitch Fix's declining operating margin, but the company's operating margin should improve with scale over the long term. Increasing competition in the online personalized apparel segment may worries investors as well. For instance, Amazon recently announced its personal shopper offering. Depending on their success, these new entrants may threaten Stitch Fix's strong growth. But Stitch Fix will benefit from the expected growth of the online markets it addresses.
Thus, given Stitch Fix's valuation and potential, investors should consider the company as a long-term opportunity.
