Why Stitch Fix Could Be on a Tear

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Stitch Fix (NASDAQ: SFIX) delivered an impressive set of quarterly results Tuesday and the market took its stock off the discount rack, pushing it 25% higher. Its roster of active clients grew 18%, revenue grew 25%, its profit of $0.12 per share beat estimates, and the guidance was solid. But as MarketFoolery host Mac Greer and senior analysts Ron Gross and Andy Cross note, that share price gain has to be put in context, because last quarter the growth wasn't quite as good, and the stock got whacked.

In this segment of the podcast, they discuss the apparel seller's accelerating revenue growth, its rising costs, the impact that a raft of short-sellers are having, whether the business model for Stitch Fix really can thrive broadly, and more.

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A full transcript follows the video.

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This video was recorded on March 12, 2019.

Mac Greer: Let's begin with the world of high fashion. We're all fashionable guys.

Ron Gross: [laughs] Yeah, OK.

Greer: OK, maybe not. But let's talk personalized apparel, let's talk Stitch Fix. Shares up more than 25% at the time of our taping on stronger-than-expected earnings and some upbeat guidance. Guys, Stitch Fix now has almost 3 million active clients. That's up 18% year over year. Andy and Ron, what do you think?

Andy Cross: It was a good quarter. As you mentioned, active clients grew 18%. Revenues grew 25%. We talked about this at the YouTube Live last week. I said anything above 24% would be pretty well-received by the investors and the Street. Clearly, today, it was. Profit came in at $0.12 per share. That was more than $0.07 last quarter and far above estimates. Their guidance for the quarter was pretty good.

Overall, a pretty nice quarter for Stitch Fix. We have to remember, last quarter, they reported growth that wasn't quite as well-received, and the stock really got hit. This is a lot of rebounding off of those lows. The stock has climbed back from those lows, but this was a continuation of that. The talk and the conversation with Katrina Lake, who owns more than 13% of the company, she's the co-founder of the business, a lot of the conversation was that the year is looking pretty good and that revenue growth for the year is somewhere in that 25%-26% range, which is an acceleration off the last couple of quarters. Growth picture, really pretty healthy.

The cost side is what I was watching. The sales and general administration costs really exploded during the quarter. That kept profits about flat. But investors are really much more focused on the revenue growth.

Greer: Ron, this stock is heavily shorted, meaning that there are a lot of shares that essentially are betting against the stock. When we look at a run-up like this, how much of this do we think is because the business is really improving? How much of this is people covering those short positions? People who are like, "Wow, probably should not bet against this stock."

Gross: If you see things improving and you're short, you're betting against the stock, then you want to cover. You want to stop betting against the stock. An influx of buying happens as a result of that. It's commonly known as a short squeeze. You don't want to be on the other end of that, holding short the stock when the stock is skyrocketing up 25%. Now, it depends on a case-by-case basis how much a stock's increase is caused by short squeezes. It's almost a guess, we won't know until we see how many shares held short decrease. But I would guess in a case like this, 75%-plus of the increase in the stock is a result of short sellers covering their shorts.

Cross: For reference sake, the number of shares sold short compared to the companies float -- that's basically the shares that are available for trading -- was 30%. That's a very high number, which tells us that there were a lot of investors betting against Stitch Fix running up to this quarter. When the stock starts to move, if they have to go out and cover those shorts, they have to buy the stock in the market, that continues to put more and more pressure on the short, so more and more people bidding up the stock, and that continues to send the stock higher and higher.

I think Ron's right. A good part of today's move was because of that short squeeze. I just looked at the numbers and I say, "hey, it was a really nice quarter." The growth is continuing for Katrina Lake and for Stitch Fix. There's a lot of competition there, too. Amazon Wardrobe is out there now, they're doing a lot more advertisement. But Stitch Fix, the algorithms they're building, they have more than 100 data scientists out there, they are continuing to build out their offerings in the United Kingdom, which is adding to their cost structure. They continue to make the investments that they need to be able to compete in a very competitive marketplace.

Gross: Remember, shorting can be a pretty risky proposition. A stock can theoretically go up to infinity, but if you're long, a stock can only go down to zero. You theoretically have an unlimited loss potential if you're short a stock. That's why you don't want to let things get too far out of hand. You end up seeing people come back into the market, closing their shorts, and buying the stock.

Greer: Let's talk about the business a bit more. I confess that I'm a bit of a Stitch Fix skeptic. I know it's kind of unfair, but I think of it a little in the same vein as I think of Blue Apron. You're delivering stuff to me. Sometimes I'm not going to use it, I have to send it back -- not the case with Blue Apron. But, is there really a big enough market here? The other thing is, you have this whole "simplicity/does it bring me joy?" movement, and Stitch Fix is in the business of getting you to buy more stuff.

Gross: Yeah. I'm a skeptic as well. Andy, correct me if I'm wrong, because I'm not an expert on the stock, but I think it's all really about proving out this algorithm that they have. It's a technology. The technology could actually be used to sell anything, probably. But I think investors, once they feel comfortable with this algorithm, you could see the stock really start to move. Until that happens, everybody's just in wait-and-see mode.

Cross: Yeah. I think if this was Costco Stitch Fix, Mac would be all over it. Generally, you're right. It's a very large market. We still buy about a third of our apparel online. What they're trying to do is, as they get more and more of these 3 million active customers, and these are people who have used Stitch Fix in the past year, continuing to put in more and more data, the data and the algorithm get smarter and smarter, the revenue per user -- which, by the way, continues to see some acceleration and growth, which is really good. As you use Stitch Fix more and more, you spend more and more with them. So, yes, Mac, it is a little bit of getting us to spend more. I mean, that's what retail does, basically. That's their job. They're trying to get us to spend more and more. You think Amazon's not sitting out there trying to get us to spend more and more? Of course they are! Stitch Fix's algorithms are doing that.

They're having some success. They continue to see very healthy retention rates. In the marketplace, data is going to win this game. I think when you look out five, 10 years, we'll be spending more and more of our dollars, when we have to buy clothes, using more sophisticated algorithms than just getting in our car and going to Costco. But Costco is still obviously a great company and great stock.

Greer: As we wrap up here, one of the ways that they arrive at that algorithm is, they actually ask you questions as you're filling out your profile about your fashion sense. In that vein, I'm curious, how would you characterize your fashion sense? Ron Gross, in a word. And Andy Cross, I want you to be thinking about that as well.

Gross: [laughs] Unexciting.

Greer: OK. Interesting.

Cross: '90s with an edge.

Greer: Oh, I like that! I like that!

Gross: Nice. You?

Cross: How about you, Mac?

Greer: I had three words. I had predictable, uninspired, and blue.

Gross: And Kirkland. [laughs]

Greer: [laughs] That's the other problem. I think Stitch Fix would be more appealing to me if they would just send me five blue shirts every month.

Gross: [laughs] I bet they'll do that.

Cross: [laughs] Yes, they will! You can give them 90 data points when you sign up, Mac, and they'll send you lots of blue shirts.

Greer: [laughs] OK. And when we look at the stock, it has been a total roller coaster. Went public in 2017 around $15, got as high as $50, and then fell all the way down to $17. Today, on this pop, trading in the mid-$30s. So, going forward in the next five years, does this stock beat the market?

Cross: I think it does. Ron had mentioned a little bit about the danger of being short. I will say, Stitch Fix's volatility is about three times as volatile as the regular stock market. You have to be able to sit through the ups and the downs. But I think long-term, over the next five years, Stitch Fix is a winner.

Greer: But maybe not a good fit for all investors.

Gross: [laughs] Oh, man!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Andy Cross has no position in any of the stocks mentioned. Mac Greer owns shares of AMZN and COST. Ron Gross owns shares of AMZN and COST. The Motley Fool owns shares of and recommends AMZN and Stitch Fix. The Motley Fool recommends COST. The Motley Fool has a disclosure policy.