Personalized online apparel company Stitch Fix (NASDAQ:SFIX) reported largely better than expected first-quarter numbers after the bell on Monday. For all intents and purposes, it was a double-beat-and-raise report that sent SFIX stock 10% higher in after-hours trade.
Then, Stitch Fix stock sharply reversed course. On the call, management gave a dour Q2 guide. Specifically, EBITDA margins are expected to compress meaningfully and overall EBITDA is expected to come in much lower than expectations. Also, the company isn’t expecting its client base to grow at all during the holiday quarter.
Those are pretty big near-term negatives, and management delivered them against the backdrop of a volatile market. As such, SFIX stock turned a 10% after-hours gain into a 20% plunge the next day.
But, this selloff looks a typical reaction of Wall Street reading too much into a single quarter guide when the overall multi-year growth picture remains healthy. As such, this dip looks like a buying opportunity for investors who are willing to stomach near-term pain, and have their eyes set on where this stock could be in five to ten years.
A Weak Holiday Quarter Guide Will Keep SFIX Stock Depressed
The selloff in Stitch Fix stock following Q1 earnings makes sense. While Q1 numbers were pretty good, it’s tough to look past what was nothing short of an awful holiday quarter guide. This awful guide included some red flags, and so long as those red flags are around, bears will likely be in control of this stock.
Specifically, there were two red flags in the quarter. First, gross margins are expected to fall next quarter due to inventory clearing. Usually, retail operations with falling gross margins tend to have falling stocks, too. Second, the client base isn’t expected to grow at all sequentially because management is spending less on advertising. This sounds eerily similar to the Blue Apron (NASDAQ:APRN) story, wherein the user base collapsed after the company reeled back ad spend. At this point in time, Blue Apron is essentially a “go broke” operation, so any comparisons are a big negative for Stitch Fix.
Overall, these red flags make the near-term read on SFIX stock quite bearish. So long as these red flags stick around, Stitch Fix stock will likely be depressed.
There’s Not Much to Worry About in the Big Picture
But, if you zoom out and look at these red flags from a multi-year viewpoint, the read on Stitch Fix stock becomes much less bearish.
On the gross margin side, gross margins are expected to fall next quarter due to fall and winter inventory clearing. This headwind won’t last forever. That inventory will be cleared before spring 2019, meaning this gross margin compression issue will be gone by then, too. Moreover, if you look at the multi-year gross margin trend, it’s quite favorable. In 2015, this was a 42% gross margin business. Last quarter, gross margins were north of 45%.
On the stalled client base growth issue, there are other factors at work here besides lower ad spend. Typically, the holiday quarter is a weak quarter from a net adds standpoint for SFIX because Stitch Fix is a “shop for yourself” platform while the holiday season is more of a “shop for others” time of year. Thus, Stitch Fix almost never adds that many users in the holiday quarter. Last year, after adding over 200,000 clients in Q1, Stitch Fix added just over 100,00 clients in Q2, and then added nearly 200,000 clients again in Q3.
Thus, in anticipation of this low-growth period, Stitch Fix management is lowering ad spend to save on money and preserve margins. Naturally, this will have a negative impact on client growth. But, muted client growth during a typically weak quarter is a non-issue in the big picture. As such, if client growth comes roaring back in Q3, SFIX stock should bounce back in a big way.
There’s Still a $10 Billion Opportunity in SFIX
In the long term, this is still a company that could one day be worth more than $10 billion, versus a $2 billion market cap today.
Global apparel sales measured around $1.7 trillion in 2017. The U.S. accounted for over $340 billion of those sales. Everywhere else accounted for $1.36 trillion. As a U.S. exclusive operation, Stitch Fix reported sales of $1.2 billion last year. E-commerce penetration in the U.S. is roughly 20%, so that means Stitch Fix operated in a $70 billion addressable digital apparel sales market in America. Of that addressable market, Stitch Fix had 1.7% share.
That share will grow over time. Over the next five to ten years, it is reasonable to assume that its 1.7% share more than doubles to 3.5%. It is also reasonable to assume that U.S. apparel e-commerce penetration doubles, too, to around 40%, and that Stitch Fix expands internationally and grabs ~0.5% of that market. If you put all that together, then this is a company which could do about $7.5 billion in revenues in five to ten years.
Assuming SFIX maintains 45% gross margins and hits its long-term opex rate target of 35%, then $7.5 billion in revenue will turn into $750 million in operating profits. Taking out 15% for taxes, you are left with just under $640 million in net profits. A market-average 16x multiple on that implies a long-term valuation target for SFIX stock of over $10 billion.
Bottom Line on SFIX Stock
Stitch Fix stock is a long-term winner going through a near-term rough patch. This rough patch may not clear up any time soon. But, with time, it will pass, and this stock will march significantly higher.
As of this writing, Luke Lango was long SFIX.