Stitch Fix, Inc.’s (SFIX) stock price has dropped to unjustified lows, but strong balance sheet and company fundamentals promise great price appreciation potential. At the same time, the company might enjoy social distancing tailwinds as an online retailer.
The coronavirus pandemic caused lots of apparel retailers to close their stores temporarily. The “stay at home” policy might end soon, but the virus fears will probably exist longer; thus, the majority of people might prefer to stay at home and to do their shopping from e-commerce providers. The situation might emerge tremendous tailwinds for those retailers which have a well-developed e-commerce network.
As every brick-and-mortar apparel seller bears substantial challenges due to social distancing measures, there is a company that can strengthen its position: Stitch Fix, Inc. Unlike most apparel companies, Stitch Fix doesn’t have any physical stores; therefore, it hasn’t stopped any part of its everyday business activity.
The stock declined by about 50% during the February-April period. The decline is a consequence of market hysteria and isn’t related to company fundamentals at all. Stitch Fix is a great growth company operating in a very fast-growing industry. The company’s balance sheet is very safe as lots of cash and 0 debt protect the company against short-term demand shocks.
We need to be sure that the company’s position is safe enough to protect our investment from economic deterioration. The company has a large cash balance against its current liabilities. Its short-term liabilities stand at about $220 million, while the company owns $166 million in cash and $134 million in short-term investments. At the same time, there is about $97 million invested in long-term financial assets that can be used to cover short-term liabilities. So, only cash and cash equivalent assets are enough to cover current liabilities about two times. A big part of long-term financial assets is invested in corporate bonds. Since the Fed Reserve has started its unlimited quantitative easing program, interest rates will go down, and bond prices will increase. So the long-term investments stated in the balance sheet might be underestimated, and the real number should be higher.
To have a more precise picture, we will compare Stitch Fix’s cash balance with some of its peers’ cash balances. Exploring the chart below, we notice that brick-and-mortar apparel sellers have significant problems concerning their short-term liquidity, as quick ratios are rather low. At the same time, the biggest part of physical stores is closed temporarily, and we expect that lots of people will change their shopping behavior after the virus, increasing e-commerce shopping.
Physical stores have another problem also as they carry large amounts of inventories relative to Stitch Fix. Days Inventory Outstanding is an efficiency metric used to measure the average number of days a company holds inventory before selling it. The stores are closed and sales decrease, so the number will skyrocket, and the brick-and-mortar companies need to liquidate their inventories in discounts.
Apparel stores’ offerings change substantially over the course of the year. Now, retailers possess a vast amount of spring and winter collections. So they need to get rid of these items to be able to prepare for the summer. Stitch Fix is relatively well-positioned against its competitors as its Days Inventory Outstanding is only 42.
Therefore, we might expect that physical store operators will concede some part of their industry stake to e-commerce operators.
Essentially, the company’s business model is quite different from other e-commerce providers. The company proposes its clients to answer some 80 questions concerning their preferences, price levels, etc. Based on the answers, the stylists of the company create Fixes (boxes) with five items and send them to consumers. Customers decide to buy some items or return all at no additional cost. If a consumer returns items, she gives some feedback, which helps the company to gather enormous amounts of data. Then the company uses these data to identify some regional preferences and manage inventories more prudently.
Simultaneously, the company is moving away from being strictly linked to these boxes. It offers consumers online platforms (websites), where the company suggests 30-40 items based on consumers’ preferences.
Stitch Fix delivers all items itself, unlike other e-commerce businesses that prefer to outsource shipment to manufacturers. The approach assures the best customer service and increases brand awareness.
The biggest risk any company faces today is related to the coronavirus crisis. The macroenvironment might worsen as lots of analysts expect deep recession after the virus. Every week we see millions of new jobless claims, declining economic activity figures worldwide, etc. Generally, the consumer discretionary sector experiences difficulties during recessionary periods, as people cut their extra spending. The fashion industry is particularly vulnerable this time, as social distancing keeps people away from each other, people gather rarely, so spend less on dresses, and consequently, the demand for the industry might bear some shocks.
The company has another big problem, as it hasn’t diversified the business geographically. The biggest part of the business is concentrated in the USA, which is the most adversely affected country by the virus. The government of the USA is trying to reopen the economy, but it is rather a difficult process as the virus continues to spread rapidly.
The company started to operate in the UK in 2019, investing about $12 million to develop the business in the Kingdom. But the UK also suffers heavily due to the virus, as there are more than 100,000 active cases today. So we might expect that in 2020 the UK branch of the business won’t yield any noticeable benefit for the company.
Stitch Fix is undeniably a growth company since its revenue was growing more than 20% YoY before the coronavirus crisis. The growth potential of the company is high enough because it is operating in the e-commerce retail apparel industry, which is growing rapidly and is expected to continue its fast-growing pace. Analysts anticipate that the industry will grow more than 10% annually in the upcoming five years.
The company is spending lots of money on advertising, aimed to create a well-known brand and to attract new clients. In Q2 2020, advertising expense was $35.6 million or 7.9% of net revenue. In Q2 2019, advertising expense was $23.9 million or 6.5% of net revenue. Though significant advertising expenses result in weak accounting profits, the management continues the same path, building long-term value for investors. The company grew its active client count to 3.5 million as of February 1, 2020, an increase of 504,000 or 17.0% YoY. The increase resulted in a 22% net revenue growth YoY. The trend promises a winning future for the company, but there is a big problem: the company generates weak profitability. The main issue is high SG&A expenses: in 2018 and in 2019, the SG&A costs were more than 40% of net revenue. The high number is justified because the company is in its development stage and focuses on growth over profitability. Though the costs are rather high, we believe that the management will be able to lower the costs to its target 35%.
The reduction allows the management to record 10-12% operating income. The operating profit should be translated into 8-9% net profit margin considering a 25% tax rate and 0 debt service cost. Based on analysts’ fiscal 2020 revenue estimate of $1.76 billion, 8% long-term net profit margin, and 20 P/E multiple (it is quite a conservative ratio since analysts estimate 10-15% yearly revenue growth), we might expect the stock value to be about $27. The $1.76 billion is a relatively conservative prediction since the management expects $1.81 to 1.84 billion revenue in fiscal 2020.
Considering the 2020 revenue estimate of $1.76 billion and S&P 500 historical average P/S ratio of 1.55, we have a stock value of $26, which means that the stock has 75% price appreciation potential. We need to notice that historical multiples are fairly conservative since the company is used to do much better than the market and is deemed to be a growth company.
Exploring the chart, we see that Stitch’s P/S ratio dropped from 2 to 0.93, while its brick-and-mortar competitors used to trade at a range of 1-1.5 or even higher. The company should trade at higher multiples than its competitors since it is not only a retail company, but it can also be considered as a tech company.
Amazon (AMZN) is another e-commerce company that has more than 4 P/S ratio; we might consider it as a more comparable multiple for Stitch Fix. Since Amazon has a huge scale, we might expect it to trade at a higher multiple than Stitch, that is why we will assume 2 P/S ratio as reliable and conservative multiple for the company. Thus, we have a 100% or more price appreciation opportunity for the stock.
We will value the company using a DCF model to have a clearer picture. The company is in its growth stage and hasn’t recorded stable cash flow history yet, so the DCF model isn’t the best valuation method for the stock but we will try to find a reliable value considering quite conservative inputs.
So, we will assume a 6% annual growth rate for Cash from operations in upcoming 10 years (3 times lower than revenue growth in the last 4 years) and 2% growth thereafter, 1.05 beta coefficient, 6.81% 6-month average market risk premium and 10-year US treasury yield. So we have about $2.3 billion market valuation for the company, which translates into a 45% price appreciation opportunity.
We have a great company, which possesses enormous cash cushion, 0 debt, grows its revenue more than 20% yearly, operates in a fast-growing industry, spends heavily in marketing and advertisement, and suggests interesting business solutions. The stock is considerably undervalued since analysts’ estimates suggest more than 45% stock price appreciation opportunity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.