The best investment opportunities often come in the form of bad news. The most recent example of such a case is Stitch Fix Inc. (SFIX, Financial), a provider of customized personal style services for men and women across various forms of merchandise such as shoes, clothing and accessories. The company recently announced weak customer growth in its quarterly results, causing the stock price to crash to less than half of its 52 week high. At the current levels, Stitch Fix presents an interesting short- to medium-term investment opportunity.
The advertising and revenue growth problem
Stitch Fix's sharp fall in price occurred at the beginning of October, when the company reported its results for the third quarter. The problem was it had only a nominal addition of close to 54,000 customers on its platform, compared to more than 180,000 in the previous quarter. There is an ongoing class action suit against management for not disclosing that they significantly reduced television advertisements during the quarter, which had an adverse effect on customer additions.
The results and the law suit were enough to make the stock price fall from above $50 to as low as $20. The insider selling at levels between $20 and $30 did not help the stock, either.
But one fact that needs to be considered is the seasonality of Stitch Fix's business. The company has traditionally had its best revenues in spring and autumn, and the management considers it a wise move to start reducing ad spending as the off-season time approaches, in order to maximize the yield per dollar spent. The period of winter from October to January had seen nominal sales growth in 2017 as well and the management must be expecting a deja-vu which is why the advertising spend was reduced beforehand. However, it must be noted that the company has sufficient financial bandwidth to carry out aggressive ad spending as the season time approaches.
Why is Stitch Fix a buy at current levels?
Unlike most online retailers, Stitch Fix is a profitable business with sizable margins. It has an operating margin of 3.42%, resulting in a return on equity of 12.50%, which is good given that management does not use any form of capital gearing to fund its growth. The level of inventory is also critical for a company like Stitch Fix, and its inventory days of 44.47 are certainly on the lower side, which is another positive point.
In terms of valuation, Stitch Fix was always valued at more than three times revenue but after the recent news, the stock plummeted to an EV-revenue multiple as low as 1.38. The company does not have any direct competitors that are listed but in general, the valuations of e-retail firms, including loss-making companies, are well above EV-revenue of 3. This means that Stitch Fix is actually quite cheap.
This is good news for opportunists as the company has abundant resources to push advertising expenditures and increase its customer acquisitions again. Another indicator of Stitch Fix’s fundamental strength is its Altman Z-Score, which has consistently been over 3 and is currently as high as 9.45. Not only does this show that the company is fundamentally solid, but it also gives a strong buy signal.
Conclusion
Stitch Fix’s customer growth numbers for the previous quarter may appear to be a problem, but its fundamental strength is not. Also in its favor is that investing guru Ron Baron (Trades, Portfolio) entered the stock in the previous quarter at an average price of around $36.35. The stock could start appreciating soon, once the management increases advertisement and goes back to delivering solid quarterly customer growth.
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