Stitch Fix (SFIX) is a service that aims to upgrade your wardrobe right at home. They have embellished the story by talking about "using AI and data science" to make "the future of retail" for clothing. The company is offering 10 million shares at $18-20 with Goldman Sachs and JP Morgan leading the charge. At the mid-point of the range SFIX will be capitalized at just under $2B. (You can refer to the Stitch Fix IPO slides and SFIX IPO roadshow transcript too.)

Unlike prior efforts in this market SFIX is successful with 2.4 million customers and $1B in revenue with good margins and positive cash flow. Some may remember the Trunk Club which started up in 2009 and was targeted to men. Nordstrom (NYSE: JWN) bought Trunk Club in 2014 for $350M. At the time Trunk Club was said to be closing in on $100M in revenue. Since then things haven't gone very well - Nordstrom recently wrote town their purchase by $200M to $150M. That came after growth was "slower than expected" and the company made moves to improve profitability which included layoffs.

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How did SFIX succeed where others have failed?

1. They have figured out how to scale designers - the people that make your fashion choices. On average a SFIX designer spends 15 minutes to make selections for you.
2. The service is priced for profitability. It's not cheap but for the right customer the value equation works. (see discussion below)
3. In-house "brands" help the company manage COGS to preserve their gross margins.
4. They are far better at marketing than most major apparel sellers.

As shown in the IV model the SFIX business is a good one in terms of returns - particularly for the retail apparel industry.

Even if we use the less optimistic scenario of 20% growth and a 10% operating margin the shares are still worth $30. That would put the shares at 2.5x sales which is much less than what Nordstrom paid for Trunk Club.

How does it work exactly? A recent customer invoice is attached below for reference. SFIX is a subscription service (though you can cancel or delay at any time). You sign up, answer a bunch of questions about your size and style preferences and then they send you a box with five pieces of clothing "selected just for you."

From a qualitative standpoint the selections are generally pretty good, even the first one. Of course the model is based around feedback that should allow selections to get better over time (and possibly create some degree of loyalty.)

The invoice shows the five items from one shipment. Here are a few things to note:

1. The starting prices are pretty much full retail. For example the Toms show is available for about $45 at Zappos. The incentives offered by SFIX to "take the whole box" bring the brand prices in line with what you might find elsewhere.
2. Much of the content is not premium branded. There is a huge difference in COGS between an item from an established brand and an "emerging brand" or an "in house label" from Stitch Fix. This is where the company makes huge (but undisclosed) margin.
3. Stitch Fix charges a $20 "styling fee" which helps to preserve margins. They roll it into a credit to encourage clients to purchase items. Another major incentive is the 25% discount customers are offered if they purchase all five items.
4. The purchase psychology can be compelling. Let's say a customer loves the shoes and the hoodie. The purchase cost on that is $180 minus the $20 styling fee. But with the 25% discount the two cheapest items are basically free. And assuming the jeans fit and are okay it creates a "why not?" and leads to a $237 purchase. Every customer and every shipment will have different dynamics but one can see the method at work.

So for many customers and many situations the service "works" and yields enough value for the customer to pay enough to generate good margins for SFIX.

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What could go wrong?

The biggest issue facing Stitch Fix is price. With millions of customers there are all types of reviews but most of them are very positive. One thing just about every positive review mentions is price. Here's one good example: My First Stitch Fix Review.

Stitch Fix works because they have positive unit economics. This is something they don't want to give up which means they have to compromise somewhere - recently that has been by lowering growth. SFIX understand they need to build a good business which means not compromising on margins to growth for the sake of it.

That means SFIX is more vulnerable than many to anything that causes weakness in discretionary spending. In terms of the US economy there has never been a better time for Stitch Fix. People are fully employed, every asset class has enjoyed a bull market and the brick and mortar retail experience is in turmoil.

Consumers are able to shrug off the feeling of "it's pretty expensive for what I got" right now. But leaner times will make them curtail purchases and/or focus more on sale outlets and price. Stitch Fix makes it easy for their customers to delay future purchases or make a change to how frequently they get shipments. This is definitely a plus for consumers but it could result in some "surprises."

There are some things Stitch Fix might do to create a better business. They have launched a more "premium" brand category and could also launch a lower-price service that is made up of all SFIX in-house brands and deeply-discounted branded/designer clothing.

It's not clear yet how management thinks about market segmentation beyond gender and size but we may find out in the next few quarters. For example here's how it might break out for a man looking for "quality casual clothing."

1. Neiman Marcus or boutique - Shirt $150, Pants $200, Shoes $300 for a total of around $750 but you can easily get to $1000.
2. Macy's, Lord & Taylor - Shirt $60, Pants $90, Shoes $150 or about $300.
3. Kohl's or TJ Maxx - Shirt $30, Pants $40, Shoes $80 or about $150.
4. Primark or H&M - Shirt $15, Pants $20, Shoes $30 or about $65.

Right now Stitch Fix would probably say they don't want the #3 or #4 business. But circumstances might cause them to rethink. SFIX also has a big advantage with no physical stores and their own brands. They could probably still make their GM target on a $80 "Fix."

The problem with the low end is paying designers. But years from now when their data is better they might be able to create a more automated solution that requires only 5 minutes of designer time versus the current 15 minutes.

Most consumers move between levels over their lifetime and many more quite often based on special occasions. Life events like jobs, marriage and pregnancy (Destination Maternity NASDAQ: DEST) all can change our buying habits and preferences. Stitch Fix may have to figure out how to adjust as well.

Conclusion

The IPO should be a success given the strong economics the company has. The IPO should also help with customer acquisition in that many more will hear about the service for the first time.

Stitch Fix will have their detractors and boosters but the execution speaks for itself. Nobody (so far) as done a better job with this type of business model than they have.

Our IV suggests substantial upside to the proposed price. Until we see more quarters of execution we'd focus on the "normal" model which gets us to a $30 stock price.