The tech company behind a retail façade – Stitch Fix

If you believe that personalization is the next wave, remember this name – Stitch Fix.

It has become humanely impossible to assimilate the copious amount of information that revolves around us today. To deal with the ginormous scale of information, companies are increasingly looking for different ways to connect with their users and customers on a personal level.

Social media companies are a pristine example where the trend has gravitated inexorably towards personalized and curated content. From the early days of Facebook’s newsfeed to Instagram’s explore page and now, TikTok, where the core offering leverages on a recommendation machine to auto play short videos.

While e-commerce companies are also increasingly tapping into their wealth of data to recommend products for customers, a company has emerged with its core offering revolving around personalization. This company is none other than Stitch Fix.

What does Stitch Fix do?

Stitch Fix is a company that resolves to create a personalized and fun shopping experience.

The business model is based off selling apparels, with data science. Sounds pretty sexy, I’ll have to admit. They started off with a focus on Women apparel but has since expanded into Men, Kids, Plus size, Maternity and Petite apparel range.

To begin, clients first fill out a style profile which captures dimensions such as measurements, colours, styles etc… Next, clients can then choose to schedule automatic or on-demand shipments of a box consisting of five to seven apparels, otherwise termed as a “Fix”. Each Fix is put together by pairing data science with human judgement. Using the data from the style profile and previous fixes, Stitch Fix’s data science algorithm generates a list of predictive recommendations which human stylists curate from, and individually select apparels for clients.

A curated box of apparels is subsequently sent over to the client. Clients can choose to purchase the items they like, and return the other items at no additional cost. Each Fix is priced at 20 USD and the fee can be credited towards items that the client purchases. After each Fix, clients are prompted to fill up a feedback form with relevant information that will help improve their subsequent fixes.

Stitch Fix Dual Flywheel

Feedback regarding fit, satisfaction, materials etc… received along with each Fix, creates a Flywheel effect which raises the quality of the next Fix for the client. Jake Singer, author of The Flywheel Substack, termed this as the “Single Player Flywheel” . The single player flywheel is relatively straightforward to understand and is the fabric of Stitch Fix value proposition of personalization.

Aside from generating recommendations for the next Fix, Stitch Fix also uses collected data for fulfuillment and inventory purposes. If you are interested in how the Stitch Fix algorithm works from generating recommendations to shipping out orders, the team at Stitch Fix has created a really cool visualization of the process. Check them out here.

Unfortunately, the problem with the single player flywheel is that it suffers from the chicken or egg dilemma. To make high quality recommendations, Stitch fix needs data from clients. But without any data from clients, how does Stitch fix makes good enough recommendations to convince clients to take time to provide quality feedback. There is simply too much effort involved for a new client to do so, especially when their initial Fix is going to be unsatisfactory and awkward!

Now, all hope is not lost. While there is a massive inertia within the single player flywheel, Stitch Fix has proven that single player flywheels are gaining momentum. Consider the metric from Stitch Fix 2019 annual shareholder letter,

The chart illustrates how much a client spends from their first Fix to their third Fix. (The first Fix is indexed at 100%). It is a positive sign that clients are spending more in subsequent Fixes which means that Stitch Fix is collecting more data from clients to drive the single player flywheel.

Now, this is where things start to get exciting.

Let me throw in a second flywheel into the picture, and let’s call it the Recommendation flywheel. The recommendation flywheel is fueled by thousands of tiny single player flywheels which constantly feeds it with new data points. As the recommendation flywheel grows, it becomes capable of making higher quality recommendations for new and existing clients, reducing awkward Fixes. This has two very important implications:

  1. Less awkward first Fixes make it easier to acquire new clients
  2. Higher quality recommendations enhance satisfaction rates amongst existing clients, lowering churn rate

With client acquisitions made easier, new single player flywheels are created with less friction and inertia. Coupled with the existing ecosystem of single player flywheels, new single player flywheels bolster the momentum of the recommendation flywheel, creating a symbiotic cycle of ever improving recommendations and ease of customer acquisitions.

Personalization Engine

At first glance, Stitch Fix appears to be just another retailer, incorporating data science in its business model. Afterall, any business who has developed a machine learning algorithm can claim that they have a “soon to be” powerful flywheel.

However, if things pan out the way the management has communicated, I see a massive growth runway ahead for the company. The Stitch Fix we know today, is just an online retailer façade, hiding behind is a supremely powerful recommendation muscle. Here are some quotes from the recent earnings call

“I would love to see a future where we’re really talking about Stitch Fix as the personalization engine”Katrina Lake

Katrina Lake, founder and CEO of Stitch Fix, mentioned in her recent interview with Invest Like the Best, that Stitch Fix is transitioning into their third act of leveraging on their recommendation muscle to build different products and help people to find the things that they love.

Imagine the possibilities Stitch Fix could do with their merchandise data, customer preferences, and recommendation muscle.

  1. It could work with merchants like Uniqlo, H&M, Nike etc… to better design apparels
  2. Create a highly personalized marketplace experience
  3. Expand into new verticals outside of apparels such as home & living products, books, TV Shows etc…
  4. Build a range of in-house apparels

In fact, Stitch Fix has begun to monetize the recommendation muscle. In June 2019, Stitch Fix launched Direct Buy which allows clients to purchase items directly outside of a Fix. This inevitably opens up Stitch Fix’s wallet share with Direct Buy serving as a new avenue for Stitch Fix to engage with clients.

Now, it would have been great if Stitch Fix reports DBNER numbers as this would allow us to assess the performance of the Direct Buy feature. (Wondering what DBNER stands for? – Check out my post here) However, Stitch Fix does not disclose such numbers. The best proxy for this would be net revenue per active client. From their latest earnings, net revenue per active client stands at 486USD, approximately flat on a year on year basis. However, this might be partially attributed to the Covid 19 pandemic which resulted in a dip in Q3 net revenues. Increasing net revenue per active client would be an imperative metric to watch in the coming quarters in order to assess the effectiveness of Stitch Fix’s recommendation muscle.

As Stitch Fix transits towards becoming a personalization engine, I believe that Stitch Fix will continue to explore new channels where they are able to leverage and monetize the recommendation muscle.

Challenges

In my opinion, Stitch Fix is years removed from being the personalization engine it aspires to be. There are still a number of challenges that it has to overcome.

Price Quality Trade Off

Stitch Fix has yet to break the price quality trade off, a concept that I learnt from the book, Blue Ocean Strategy. (Check out my post on Blue Ocean Strategy here) While researching about Stitch Fix, I frequently came across reviews that described Stitch Fix apparels as expensive and of poor quality. It comes as no surprise given that Stitch Fix focus on creating a personalized fun shopping experience consumes a substantial amount of resources. On the flip side, I struggle to convince myself of areas where Stitch Fix has reduced or eliminated from the conventional value curve of e-commerce.

Perhaps, a possible avenue for Stitch Fix to achieve an advantageous cost structure might stem from their ability to utilize their data to manage inventory and operations in a superior fashion relative to incumbent players. For now, I remain unconvinced that Stitch Fix has broken the price quality trade off.

Partnerships or no partnerships?

Second, partnerships are going to be a really tricky issue. Stitch Fix not only sells apparels from third party brands, they also produce their in house apparel line. Partnering with third-party brands offers variety, and builds credibility which is essential if Stitch Fix aims to launch a marketplace in the future. However, selling third party brands invariably cannibalizes their in-house brand. Furthermore, it is likely to create a conflict of interest between recommending higher margin, in- house brands or lower margin, third-party brands. Building an in-house brand and moving towards a marketplace in parallel, spreads resources thin and will require a fine balance between both.

When to Boost Customer Acquisition

As I have discussed above, Stitch Fix’s single player flywheels and recommendation flywheel work in unison. Stitch Fix has remained relatively conservative in terms of acquiring customers because of how clients are churning. Consider this from their 10k.

Our marketing initiatives may become increasingly expensive and generating a meaningful return on those initiatives may be difficult, such as the increased
costs we have seen in certain digital marketing channels
. We may also adjust our marketing activity from period to period as we launch new initiatives or
offerings, such as direct buy, run tests, or make decisions on marketing investments in response to anticipated rates of return, such as when we identify favorable cost per acquisition trends.”

However, the moment Stitch Fix is confident that the average new customer will be satisfied with their first Fix, it would make sense to raise the acquisition rate. This could be through reducing the initial styling cost or giving free Fixes to encourage new clients to sign up.

The question though, when and how does Stitch Fix determine if the recommendation engine is strong enough to achieve a high client retention rate. Flipping the customer acquisition switch too early might yield a negative return, while the longer they wait, the more likely someone else might do it.

Which Vertical to expand into?

In Act 3, Stitch Fix aims to leverage and monetize the recommendation muscle. Which vertical will they expand into next? What features will they introduce to expand their wallet share? Each new venture is highly uncertain and experimental with no guarantee of success. I personally would like to see Stitch Fix exploring new angles while showcasing the agility to exit new ventures quickly if they do not work out.

Conclusion

Stitch Fix owns an incredibly compelling, dual flywheel ecosystem where the single player and recommendation flywheel thrive off each other. Unlike conventional retailers, data is at the core of the business. The algorithms team, helmed by Eric Colson has developed algorithms that use collected data to personalize Fixes, improve inventory and fulfilment operations, assist in marketing effort, and even in the design of clothes. In my view, the shift towards personalization is inexorable and Stitch Fix has positioned itself astutely to ride the tailwinds of personalization. Nonetheless, it cannot be discounted that the journey towards becoming a personalization engine is relatively nascent and riddled with numerous challenges as I’ve discussed above.

Katrina Lake, founder of Stitch Fix has taken a relatively conservative approach towards growing the company. Stitch Fix only raised $42 million in venture capital before going public, and Katrina has clearly laid out the company’s priority of being profitable while growing. While this is no doubt a good sign that Stitch Fix is growing sustainably, it remains to be seen if Katrina and team is able to switch the flip and aggressively grow the business during Act 3.

As of today, Stitch Fix trades at a valuation of roughly 2x sales. Viewing the company through the lens of a retailer, results in a relatively expensive valuation given that the likes of American Eagle Outfitter, Urban Outfitter, and A&F command an average P/S valuation of 0.70. However, if you are convinced of the narrative that Stitch Fix is trail blazing the path of personalization, Stitch Fix is currently trading at a tremendous discount relative to the massive growth runway that lies ahead. It might still take a while before Stitch Fix attains that. However, if you’re in it for the long run, Stitch Fix might just be a company you want to have in your portfolio.


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2 thoughts on “The tech company behind a retail façade – Stitch Fix

  1. Excellent analysis
    Your thesis( if it unfolds positively
    over time) would lead to a large
    number of applications over time.
    Definitely worth monitoring
    Happy New Year

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