Stich Fix Shows How Retailers Get Tech Status

(Bloomberg Gadfly) -- If you're a regular here, you know I've been confused about the phenomenon of not-really-tech startups achieving tech-like valuations. 

I asked for some help recently from Dayna Grayson, a partner at NEA, a venture-capital firm that backs some not-really-tech consumer startups including mattress seller Casper Sleep Inc. and anti-brand online grocer Brandless Inc. She agreed it's tough to succeed with traditional retail business models. If a startup buys jeans or blenders at wholesale prices and sells them at a markup, it can be hard to make anywhere close to tech-like profit margins or venture-like investment returns.  

But her take, which I found persuasive, was a consumer startup can succeed by becoming vertically integrated and doing something unique -- or squeezing out costs -- at one or more steps along the way.

Brandless creates a limited selection of its own packaged foods and consumer staples and sells them to people online. Another startup, M.Gemi, orders from the same Italian leather goods makers that manufacture for luxury brands. These companies still might flop, but they do give themselves a better shot by weeding out layers of middlemen and the associated costs. Brands that sell directly to their customers have better visibility into sales trends, and can change products on the fly. 

I was thinking about Dayna's point as Stitch Fix Inc., the online personal stylist company, approaches its initial public offering this week. I admire Stitch Fix's ability to generate $1 billion in annual sales with relatively little outside funding and the absence of cash bonfires typical for post-2010 startups. 

Stitch Fix is also a retailer, at least in part. But it definitely doesn't want to be valued like one, as my Bloomberg News colleague Alex Barinka has written. Gap Inc., L Brands Inc. and other clothing retailers have stock market values roughly equivalent to their annual revenue or lower. Amazon.com Inc. is valued at 3.4 times its annual sales for the last 12 months.

Stitch Fix does buy clothes from manufacturers and resells them -- just like Nordstrom Inc. But it also has its own brands, which generated more than 20 percent of revenue in its latest fiscal year. There's some of that sweet vertical integration. Those sales also generate better profit margins than Stitch Fix makes from selling other companies' clothes. Of course, that means nearly 80 percent of revenue comes from the traditional retail business model, or something close to it. 

And Stitch Fix also buys and holds inventory, an approach that hurt once-hot e-commerce startup Gilt Groupe. When a company buys clothes in advance, there is a chance it can't sell that truckload of $1,000 fur-lined loafers. Companies also have to carefully balance what is in stock versus what's going out the door in sales.

In its IPO document, Stitch Fix warned potential investors that the company has "not always predicted our clients' preferences and acceptance levels of our trend items with accuracy, which has resulted in significant inventory write offs and lower gross margins." This is the $1,000 fur-lined loafer problem. The company's gross margin -- revenue minus costs for merchandise, shipping orders and related expenses -- also is highly sensitive to how well Stitch Fix manages inventory. 

Technology does help Stitch Fix with inventory risk. Because it recommends clothing to people based on their personal tastes, it has a better sense of how many customers might like fur-lined loafers. (Hint: Not me.)

The company can also see what styles customers like, and make its own versions to sell at a higher profit margin. Stitch Fix also has trained its customers that its service is not subject to sales. Needing to rely on constant discounts to lure shoppers kills profit margins for retailers.

This would be a different conversation if Stitch Fix were valued at $10 billion instead of something like $2 billion. But because the company needed a modest amount of funding prior to its IPO, and didn't let valuation get out of hand, its flaws and retail-like characteristics aren't so glaring. Even if novelty fades, Stitch Fix is a solid business. That's not something you can say about many technology unicorns, nor about many retailers. 

A version of this column originally appeared in Bloomberg's Fully Charged technology newsletter. You can sign up here.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Shira Ovide is a Bloomberg Gadfly columnist covering technology. She previously was a reporter for the Wall Street Journal.

©2017 Bloomberg L.P.

Bloomberg
Stay Updated With Business News News On BloombergQuint