In the earnings report it released on Tuesday, Stitch Fix (NASDAQ: SFIX) posted strong revenue growth even as its profits fell. Based on management's guidance, that discrepancy between rising sales and shrinking adjusted EBITDA will continue. But this apparently negative development provides a positive opportunity for long-term investors.
Outstanding performance in the retail sector
Stitch Fix posted a solid 26% year-over-year revenue growth during its fiscal fourth quarter (excluding the impact of an extra week compared to the prior-year period). Management further forecast that revenue would grow in a range of 23% to 25% over the next 12 months..
Those numbers signal that Stitch Fix is growing much faster than the overall market. Research estimates that the U.S. apparel, footwear, and accessories market will grow 3.7% annually through 2023, while the e-commerce segment where Stitch Fix operates will grow 14% annually.
Stitch Fix's strong revenue growth owes to its expanding customer base. Based on customers' preferences, the company ships boxes of apparel and accessories to its customers -- "Fixes" -- with personalized contents, at intervals or on demand. The recipients pay for what they keep, and can return items they don't want at no additional cost.
Image source: Getty Images.
Initially, Stitch Fix focused solely on women in the U.S. But the company has expanded its offerings to include men and kids, and a few months ago, it increased its geographic footprint with an expansion into the U.K.
This week, the online retailer announced a further extension of its business model with a direct-buy format. Customers can now buy personalized items on the company's website instead of receiving a "Fix." This initiative represents a growth opportunity for the company, provided that sales from the format don't cannibalize sales from its core business.
Increasing operating costs
Despite these growth investments, Stitch Fix posted operating income of $23.5 million during fiscal 2019. The company's profitability comes from its gross margin. Since, like other e-commerce retailers, it lacks the expenses of supporting a brick-and-mortar presence, it was able to earn a gross margin of 44.6% over the last 12 months. In contrast, apparel retailers with traditional physical footprints such as Gap (NYSE: GPS) and Urban Outfitters (NASDAQ: URBN) generated gross margins of 43.1% and 33.1%, respectively.
But the personalized nature of Stitch Fix's business, based on both data science and human judgment, entails extra costs beyond those incurred by traditional apparel retailers. For instance, it employed more than 5,100 stylists as of the beginning of August, a group that accounted for more than 63.7% of its workforce. And on the whole, 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 data analytics, represented 43.1% of the company's revenue over the last 12 months. By way of comparison, legacy retailers such as Gap and Urban Outfitters reported operating expenses at 34.5% and 24.6% of their respective revenues.
Those higher (and increasing) operating costs sank Stitch Fix's adjusted EBITDA from $60.6 million in fiscal 2017 to $39.6 million during fiscal 2019. And management expects adjusted EBITDA to decline to somewhere in the range of $10 million to $30 million over the next 12 months.
That increase in operating costs as a percentage of revenue makes sense, though. The company has been investing in its U.K. business and its direct-sales platform. But these initiatives, launched in May and August this year, respectively, have yet to reach scale or contribute meaningfully to revenue. As they do, I expect the company's operating margin to improve over the long term.
Stitch Fix trades at a modest forward enterprise-value-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 sit at 0.77 and 0.92, respectively. But these two apparel retailers posted year-over-year comparable sales declines of 4% and 3%, respectively. Besides, Stitch Fix's debt-free capital structure adds a cushion of safety for shareholders.
Investors should take Stitch Fix's declining operating margin into account, but that metric should improve over the long term. Increasing competition in the online personalized apparel segment may worries investors as well. For instance, Amazon recently announced a personal shopper offering. Depending on their success, new entrants offering similar services may threaten Stitch Fix's growth. But it still stands to benefit from the expected growth of online retail. Thus, given Stitch Fix's valuation and potential, investors should consider the company as a long-term opportunity.
10 stocks we like better than Gap
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*
David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Gap wasn't one of them! That's right -- they think these 10 stocks are even better buys.
*Stock Advisor returns as of June 1, 2019
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Stitch Fix. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.