Stitch Fix: Paradigm Shift Warning (NASDAQ:SFIX)

Short opportunity to protect your portfolio

We produced this post to give readers who are at ease using short selling as a hedging technique a position to safeguard their portfolio during times of market instability in 2023. The reader may refer to an article we wrote about Stitch Fix (NASDAQ:SFIX) with a Sell rating on March 15, 2019, if they want to understand more about the fundamental analysis (high variable costs and plateau market). Since then, the stock has decreased by 85%.

Faulty business strategy

We believe Stitch Fix’s management made a critical blunder when it decided to stray from its initial designer pick-driven service, which was created to save customers’ time and effort, and added the option for customers to buy at their own discretion along with its subscription model.

Due of the company’s subscription business model, which assigns stylists to customers, it already has substantial variable costs. Investors should be concerned since they now have to manage the business using two whole distinct business models.

Additionally, the company concentrates on the apparel segment with subscription monetization, which is a relatively narrow market given how quickly customer tastes and purchasing habits change over the course of seasons or even months.

The below metrics, which suggest that the organization struggles to bring in new clients, show a sequential decline in the number of clients. Additionally, net revenue per active customer exhibits plateau, indicating that consumer loyalty is in doubt and that consumption power has also peaked.

Weak business efficiency

The company’s inventory turnover ratio has continued to decrease over time to around 5x(5.04x as of Oct 2022), according to statistics from finbox.com.

Retail and consumer discretionary have typical inventory turnover ratios of 10.8x and 6.7x, respectively, according to CSI Markets. Given that the apparel business typically experiences substantial inventory turnover, the company may already be performing below industry average. It means that the economic strategy for the company’s subscription services could not be as effective as the traditional clothing stores.

Risks

Potential acquisition target

The company produced free cash flow of around 9 million in 2022, which could pique the curiosity of a few prospective buyers. However, given the relatively small addressable market for clothing subscriptions and the poor brand awareness among consumers over time as seen by the Google trend below, we think that the likelihood of acquisition is very low.

Money looks for steady cash flow

Given the Fed’s promise to raise and keep rates at 5%, we believe in 2023, equity managers will lodge their funds in businesses that have consistent cash flow. Their first preference will be a company with a long-term contract, while a company with a consistent cash flow, such as one that operates on a subscription basis, may also be alluring. But we don’t think Stitch Fix succeeds in luring new clients or retaining old ones. Consequently, we believe it is one of the stocks with the worst subscription models. As a result, this risk is somewhat reduced.

Valuation

Cash and cash equivalents held by the corporation fell from $311 million in October 2021 to $203 million in the most recent quarter. In the most recent quarter, the trailing 12-month free cash flow decreased from $134 million to a negative $132 million. The corporation continued to buy back its stock every three months, which raised concerns among investors.

Our prediction is that the company will eventually delist or become worthless and that its short-term (3 to 6 month) price will most likely be below its book value of $200 million (assuming only cash and cash equivalents).

As the company has started a death spiral (negative cash flow and broken business model), we believe that the recent increase in its stock price from $2.77 (12/27/2022) to 6.005 (2/2/2023) as a result of the tech rally presents a strong short entry for this stock.

Potential short term return from today is 61%. The stock price may continue to decline as more money is spent in the ensuing quarters.

Costs of borrowing

The charge to short this stock, according to Stocksera, is 2.35% and has continuously averaged less than 1.5% over the last three months.

In light of the prospective return, borrowing expenses are therefore reasonable.

Time horizon of the trade

According to Stocksera, a total of 2.4 million shares (2.2% of the outstanding stock and 71% of the average daily volume over the previous three months) are available for short sale. There is limited short squeeze risk.

1. Short term – 3-6 months:

Earnings announcements, in our opinion, are excellent triggers for stock shorting by investors. The market would doubt the viability of the company’s business model if it showed (1) a reduction in revenue per user, (2) a decline in the number of active clients, (3) negative free cash flow, or (4) a decline in operating margin. As a result, it might trade at close to its book value of $200,000,000 ($1.8 per share). The rationale behind is probably the recent decreasing trend that led to a low of $2.6.

2. Long term:

We believe the company’s business model is unsustainable, and given the reasons we outlined in the risk paragraph above, an acquisition of the business seems improbable. In the long run, we believe the corporation is therefore likely to delist or declare bankruptcy.