Strong Margin Profile


Thank you to everyone who filled out the social media survey last week. If you recall, I asked you what social media networks you use on a weekly basis. Here are the results:

80% of folks use Linkedin

60% of folks use Facebook

48% of folks use Instagram

36% of folks use Twitter. (This surprised me, I was expecting Twitter to be higher based on my addiction.)

9% of folks use Snapchat (I’m assuming this is slightly understated as some of you didn’t want to admit to using Snapchat regularly.)

A few people added Reddit and Slack as additional networks they use, and a few others said they use no social media at all.

Now, to the newsletter:

Topic of the Week: Strong Margin Profile

Yesterday, e-commerce business, Stitch Fix, filed to go public.  You can find their S-1 here.

In case you aren’t familiar with this company, Stitch Fix ships you a package of clothing, custom selected for your unique preferences.  You decide what you want to buy and then return what you don’t like.  To customize your experience, Stitch Fix has data algorithms and a team of over 3,400 stylists to match you to the right products.

For fiscal year-end July 29, 2017, the Company generated $977M of net revenue and lost $594K in net income.  Revenue grew 113% from 2015 to 2016 and 33% from 2016 to 2017.  Stitch Fix was marginally profitable for six straight quarters between 2015 & 2016.  Further, they accomplished all of this with only $47M in VC funding.

By nearly all accounts, this is a successful story and investors / management should make a lot of money in the IPO.

However, (C’mon, you knew there was going to be a “but” here), I’ve been confused by a message coming from most news publications on this story.  Many publishers refer to Stich Fix’s profitability profile as “strong.”

Hm.  Is it strong compared to many VC-backed companies that are bleeding cash? Sure.  But is it strong and how does it compare to similar businesses?

To answer this question, we first need to better understand the margin profile of the business.  Let’s dive in:

Adjusted Gross Margin %

Gross Margin is straightforward.  Revenue – Costs of Good Sold (“COGS”) = Gross Profit.  Gross Profit / Revenue = Gross Margin %

With $977M in Revenue and $542M in COGS, Stitch Fix has a 45% Gross Margin %.  This is a good margin for an e-commerce company.

However, every good analyst knows that you can’t take COGS at their word. You need to know what’s included in them and more importantly, what’s not.  COGS are supposed to be the direct costs attributable to the production of the goods sold by a company.  This is straightforward when you manufacture a good, less so when you have a more complicated business model.

When I dug into the composition of COGS for Stitch Fix, I noticed a few things.  First, none of the costs associated with delivering a customized experience to customers are included in COGS.  Remember the army of 3,400 “stylists” I referenced above?  Second, none of the “merchandising” or “fulfillment center” costs are included in COGS.

I’m sure someone can provide a good argument for why these aren’t COGS, but to me they are.  It’s not possible for Stitch Fix to produce a customized package of clothes and get it into a customer’s hands, without a stylist picking out clothes, data folks inputting new styles, a merchandising team deciding what clothes to offer, and fulfillment centers to execute the orders.

We have to adjust the stated Gross Margin.  So what is the Adjusted Gross Margin profile after you subtract out these additional costs?

I’d certainly like to know.  As of right now, we can’t calculate it.  Unlike many public retailers and e-commerce companies, Stitch Fix didn’t break out this information.

Contribution Margin %

The next metric to dig into is the Contribution Margin %

Contribution Margin = (Revenue – Variable Costs) / Revenue

Variable costs increase or decrease based on sales volume.  Contribution Margin % tells you how much profit from each dollar of revenue is available to cover fixed costs.

Why does it matter?

Instead of focusing on profitability, many growing businesses choose to reinvest their profits into future growth.  They invest in infrastructure, marketing, and corporate overhead, which eats at profitability now, but should yield a much larger and profitable business in the future.  Many of these investments are fixed costs and won’t scale as revenue does. (In theory).

We can’t calculate this for Stitch Fix, but we can talk through the calculation.

Calculating Contribution Margin:

Contribution Margin sounds simple, but it is highly nuanced and a pain in the butt to calculate.  Variable costs are often difficult to classify.

Some variable costs are clearly tied to revenue or sales volume.  For example, Sales Commissions are clearly variable. They are directly related to the amount of revenue generated.  The higher the revenue, the higher the commission.  Simple.

Then, there are partially variable costs.    These are costs that while fixed in nature, will ultimately change as revenue grows or declines.  For example: If a new customers requires a certain amount of data analysis to onboard, some of your data analyst costs should be allocated as a variable expense.

To calculate contribution margin, you need to go through every line item and make an assumption about what % of it is a variable cost.


Final Thoughts

Finally, for all us old fashion folks that still believe a business should eventually achieve profitability, the next two things we look at are EBITDA Margin and Free Cash Flow.  This email is getting a bit lengthy, so I’ll save detail on these for another day.

In summary, we don’t have enough information to determine whether Stitch Fix has a strong profitability profile compared to comparable e-commerce and retail businesses.

If Stitch Fix does have a strong profitability profile, I don’t know why they wouldn’t highlight it by providing a complete set of financial information.

Have a great weekend everyone.

About the author

Danielle O'Rourke

Recovering Investor. Mom. Wife.

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Danielle O'Rourke

Recovering Investor. Mom. Wife.

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