Research Notes: Too-Big Tech
Tech companies have started cutting costs. But that may be only the first step
The era of the growth-at-any-cost “MoviePass economy” has clearly ended.
Widespread layoffs and cost controls across tech are focused on increasing profitability by reducing operating expenses.
But for some companies, the answer might be in shrinking not just costs, but revenue, and accepting the reality of being a niche business.
With the market pricing in SG&A cuts, the next opportunity might be in finding companies focussed on gross margin instead.
On Tuesday afternoon, clothing subscription platform Stitch Fix SFIX 0.00 released earnings for the second quarter of fiscal 2023 (ending July). On its face, the report looks like a disaster. Revenue fell 20%, and the number of active clients dropped 11%. Meanwhile, even on an Adjusted EBITDA basis, Stitch Fix was barely profitable in the quarter.
This seems like a business clearly headed in the wrong direction. Yet in that press release founder and interim chief executive officer Katrina Lake seemed to argue the company would simply double down on the strategy that had brought it to this point:
Looking forward, we will continue to invest in the advanced data science and machine learning capabilities combined with personalized styling expertise that have set us apart for more than a decade.
I admit that when I first read that quote, I was filled with the kind of condescending scorn one shouldn’t admit to in public. It’s worth emphasizing that Lake’s quote comes from the press release. That sentence didn’t come in the flow of conversation on the conference call. It isn’t taken out of context. Lake and Stitch Fix put that sentence in the release (and up front!) with intent.
My initial reaction was: really, Ms. Lake? After this quarter, you’re going to talk up your plan to “continue to invest” in the same thing that obviously isn’t working? Bear in mind SFIX stock has a history of underperformance too. The company’s IPO priced at $15 in November 2017; the stock closed Wednesday at $4.95.
Revenue is falling sharply. Stitch Fix still isn’t close to profitable on any real basis. Adjusted EBITDA in the quarter was $3.8 million; it’s guided to $0-$10 million for full-year FY23. Capex was nearly $12 million in the first half of FY23 (it appears that figure might moderate, per commentary from the Q2 call, but that’s not 100% clear) and stock-based compensation (excluded from Adjusted EBITDA, of course) is at a $100 million-plus run rate.
But if you take a step back, Lake’s focus on what has “set us apart” might make a little more sense. Stitch Fix was founded in 2011. It’s guiding for 2023 revenue over $1.6 billion. Gross profit should be close to $700 million. The company has almost 8,000 employees.
In the broad sense, that’s real success. As a result, it’s possible to at least consider the fact that, despite the SFIX stock price, there’s logic to what Lake is saying, and logic in sticking with what got Stitch Fix to this point.
That logic is underpinning current strategies in a lot of tech, and particularly in consumer-facing tech. The emphasis on growth at any cost has disappeared over the past twelve months, replaced by a focus on profitable growth — or, in some cases, just profits. What’s interesting about the shift is that it’s only in the first stage — and Stitch Fix provides an interesting template for where the trend might head from here.
Looking Back On Growth At Any Cost
Back in 2018, Kevin Roose in the New York Times wrote about the “MoviePass economy”. MoviePass, of course, was the money-losing movie subscription business that never actually detailed how it was supposed to become profitable (something about selling data seems to be the core of the publicly disclosed plan). Shares of Helios and Matheson Analytics, which owned the platform, were something of a “meme stock” before GameStop GME 0.00 and its ilk defined that term.
Here’s how Roose, with some sarcasm, framed the mentality at the time:
It used to be that in order to survive, businesses had to sell goods or services above cost. But that model is so 20th century. The new way to make it in business is to spend big, grow fast and use Kilimanjaro-size piles of investor cash to subsidize your losses, with a plan to become profitable somewhere down the road.
It’s tempting to look back at the MoviePass economy with the same kind of condescending scorn usually reserved for earnings releases from online shopping companies. Many investors, looking backward, blame the Federal Reserve for keeping interest rates at zero, creating the yield-chasing incentives that fueled tens of billions of dollars’ worth of aggressive yet ineffectual spending.
But in actuality, there was, and still is, some logic to tech companies subsidizing their own customers and running massive losses in the process. So many end markets in the modern economy, particularly in consumer-facing tech, are “winner-take-most”. Network effects generally suggest that the biggest company will have dominant or near-dominant market share. That share is exceptionally valuable, and at least in theory justifies the early-stage spending of so much cash (as well as the risk that the spending won’t, you know, actually create much market share).
But those network effects and the potential for big share of big markets also led seemingly every young company in tech, public or private, to talk up its ability to be big. Stitch Fix itself started its 2017 prospectus by saying it was “transforming the way people find what they love,” and later in the document said it was “reinventing the shopping experience.”
That kind of commentary was par for the course. WeWork WE 0.00, a company whose business model was arbitraging short-term and long-term office leases, wrote in an initial public offering prospectus (the IPO never occurred) that "our mission is to elevate the world's consciousness.” By the time of the SPAC (special purpose acquisition company) craze of 2020-2021, trillion-dollar addressable markets and similar promises to “transform” and “reinvent” entire industries were commonplace. Simply put, that was what investors, whether via private venture capital funds or in speculative public stocks, wanted to hear.
Tech Pivots From Growth
But those investors suddenly ran out of patience, and begun to insist on at least some level of profitability. The impact of that shift is blindingly apparent. Seemingly every tech company, public and private, is laying workers off. An equal number are catering to the U-turn in shareholders demands from an increasing top line to a positive bottom line (if only on a heavily adjusted basis).
Stitch Fix itself is a perfect example of this pivot. On the Q3 FY21 call in June 2021, an analyst asked about what profitability might look like in FY22. Here’s the answer from chief financial officer Dan Jedda [emphasis ours]:
Yes, so again, we're in a unique position to expand our addressable market, as we talked about. So we are in growth mode, we see an incredible opportunity with us in expanding our addressable market with the launch with direct buy [allowing customers to buy single pieces] and we're excited about that.
SFIX stock gained 14% after that earnings report, and finished the next trading session with a market capitalization of about $6.7 billion. If a tech CFO said that on a conference call this year, he or she would be fired for cause before the call was over.
Here’s Jedda again in the Q&A of the Q1 FY22 call six months later [emphasis ours]:
And so I would not say that we’re optimizing for profitability over growth. What we are optimizing for is an amazing client experience that will ultimately lead to higher growth rates and long-term free cash flow. And the unit economics that we have – the order economics, the unit economics and the overall contribution profit that we generate allows us to invest heavily in the customer experience, which will accelerate growth on a forward-looking basis.
This answer still rests on the pillars of the MoviePass economy. There’s the focus on unit economics over broader measures, and the idea that “an amazing client experience” will drive growth which will drive investment which, to quote Roose, will allow Stitch Fix to “become profitable somewhere down the road”.
But by late 2021, this was not the answer investors wanted to hear. SFIX closed the following day down 24%, and 71% below where it finished after the fiscal Q3 release roughly six months earlier.
Come the Q3 FY22 release in June, the tune became different. Former chief executive officer Elizabeth Spaulding addressed in her prepared remarks her company’s newfound emphasis on costs:
Additionally, as we promised in our last call, our team has taken a deep look at our business and our cost structure. We have done a detailed review of how we deliver our experience, and we’ve begun to take action to become more efficient and deliver profitable growth over time. Both Dan and I will spend time on this momentarily.
Even this, however, was somewhat qualified. “Profitable growth over time” is not the same thing as “profitable next year”.
The next quarter, Spaulding again addressed profitability — but the qualifications were gone [emphasis ours]:
We learned a lot over the course of FY '22 and we are building on our areas of progress. In this challenging macroeconomic environment, and as we continue to work through our transformation, we recognize that returning to profitability is of utmost importance. This is our top priority. This will happen by both returning to active client growth and by optimizing our cost base.
Less than four months after that, Spaulding too was gone.
Will Cost Cuts Work?
But some businesses have shown an impressive ability to quickly grow the bottom line by focusing more intently on costs. Sea Ltd. SE 0.00 just posted adjusted EPS in Q4 of $0.72; the Street was expecting a loss of 55 cents. Salesforce.com CRM 0.00, the 2010s poster childfor growth being rewarded by the public markets, soared after earnings thanks to improved operating margin guidance. One analyst wrote approvingly that "management has clearly gotten the message" concerning the importance of the bottom line.
The most-watched cost-cutter might well be Twitter. For all the social, political, and legal drama surrounding that company, the most interesting aspect of private Twitter right now could be the very public experiment it’s running in real time. Elon Musk is asking whether tech companies can run in an astonishingly leaner fashion — one report claimed 80% of employees have been let go — and executives and VCs across Silicon Valley are closely awaiting the answer.
Even if cost-cutting can't get quite that extreme, the question going forward for tech is if there are even more dollars to find under the proverbial couch cushions. Meta Platforms META 0.00 saw its stock crushed last year amid chief executive officer Mark Zuckerberg's insistence on spending billions of dollars on the "metaverse". It's now more than doubled off November lows, adding ~$230 billion in market cap in the process, in part because of a newfound emphasis on cost controls elsewhere.
Meta reportedly is letting thousands more workers go this week. Should Meta, Twitter, and others succeed in maintaining revenue on a sharply lower cost base, that might suggest (depending on one’s sentiment toward the current user experience on Twitter) that a lot of engineers in Silicon Valley are superfluous.
That in turn could allow other tech companies to enact second and third rounds of layoffs, and potentially create higher earnings and higher stock prices. In recent months, we’ve already seen private equity be surprisingly aggressive given the interest rate environment, and cost cuts no doubt are a greater part of those firms’ calculus than they already were.
If there is that much fat to cut, more companies likely go private. Those that stay public and show the ability to create a leaner cost structure with acceptable impact on revenue will likely see their stocks rally.
Those that can’t show profitability or growth, however, are probably in big trouble.
The MoviePass Economy Had Two Flaws
Right now, Stitch Fix is one of those companies in trouble. Management’s full-year outlook suggests that, adjusted for dilution, free cash flow margins should be in the range of negative 8%. The high end of guidance implies a ~20% decline in revenue year-over-year — following a 1.4% fall in fiscal 2022. The combination of negative profit margins and declining growth is not one that can be repaired by laying off employees, though Stitch Fix is trying: in January, the company cut about 20% of its workforce.
Those layoffs, and so many others across tech, are based on the idea that the flaw in the MoviePass economy simply was ignoring costs and profitability.
Even accepting that premise, however, the MoviePass economy had another significant flaw: there aren’t that many industries where being the winner is necessarily that great. Looking back at the 2010s, a golden age for startups in terms of size, coverage, and reach, how many of those businesses truly had the chance to be transformative? Uber UBER 0.00, which more aggressively subsidized its customers than perhaps any business in history, clearly was one. Airbnb ABNB 0.00 was another. Some investors saw WeWork WE 0.00 as that kind of business. Blue-sky scenarios for financial startups like Stripe or SoFi SOFI 0.00 would qualify. If you squint, maybe DoorDash DASH 0.00 fits.
But niche markets — say a concierge for online fashion — don’t have the same ceiling as those businesses. Stitch Fix is a nice business: again, it’s doing ~$1.6 billion in revenue this year. It's not transformative, however. It’s not replacing department stores or upending Amazon.
Look too at Rover ROVR 0.00, which we shorted last year. In its February 2021 merger presentation, the pet-sitting platform estimated its total addressable market in the U.S. at $79 billion, or something like $600 for every single household in the country. That’s a bananas argument and readers will not be stunned to know that the short worked out well. A pet-sitting platform is a fine business. But it’s not addressing a $79 billion or even $7.9 billion market.
To be fair, some tech niche businesses can expand their reach dramatically. We know because it’s been done already. A company founded to sell books — hard copy books! — over the Internet now has a digital infrastructure business critical to the global economy that literally might be worth trillions. Another company that began by shipping DVDs is now perhaps the dominant media business in the world. Both Amazon AMZN 0.00 and Netflix NFLX 0.00 proved that a company could grow from a niche business to a giant.
But that is an exceptionally narrow and unlikely path to take. Both companies easily could have veered off their successful paths at multiple points. And in trying to maintain the optionality of being "transformative" or "reinventing" their industries, one wonders if a lot of smaller, niche tech companies are squandering very real opportunities to be better.
Cutting Customers, Not Costs
Again, consumer-facing tech companies are in the process of changing focus from the top line to the bottom line. So far that focus has mostly been on operating expenses, and in particular labor spend. But where businesses like Stitch Fix and its ilk might get really interesting is when the focus moves beyond SG&A (ie, layoffs) to cost of revenue.
In the MoviePass economy, consumer-facing tech companies — private or public — had a simple formula. Get customers, get funding. No doubt executives at Stitch Fix created CAC/LTV (customer acquisition cost to lifetime value) models that showed the long-term value of current marketing investments. But those models (like all others) are highly subject to the “garbage in, garbage out” problem. More than anything, they simply provided cover (for both executives and investors) for the spend, rather than accurately projecting future growth.
For Stitch Fix, focus on the customer hasn’t necessarily changed. Here are the next two lines from Lake in the Q2 earnings release:
This strategic re-focusing on our styling-first model will deliver clarity to the client experience and drive efficiency in our marketing spend. We’re proud to have helped millions of clients find clothes that make them feel their best, and we’re confident that this path will ensure that we’re attracting long-term clients to Stitch Fix and paving the way for a return to growth.
The MoviePass-era ethos of spending wildly for growth is starting to change. The ethos of focusing on the “client experience,” however, has not.
Indeed, Lake’s strategy, for now, is to (eventually) get more customers. That assumes, however, that the market is big enough that there are more profitable customers out there to find. There may not be. The curated fashion niche simply might not be that large.
Again, this is a company posting -8% free cash flow margins and -20% revenue growth. There are three possible explanations for those two metrics combined.
The first is that the company is dealing with a recession. Given where consumer spending is (even in apparel more broadly), that seems unlikely.
The second is that the business simply isn’t viable. Stitch Fix has ~$1.6 billion in revenue because it is selling dollars for 92 cents. This, too, seems unlikely. There’s literally no possible way Stitch Fix is losing 8 cents for every dollar.
The third — and most likely — is that Stitch Fix is serving customers that aren’t profitable to serve. There are customers who adore the platform and would probably pay an even higher price for what they get. There are many who are lukewarm at best, were acquired through promotions/discounting/short-term offers, and aren’t going to post the LTV required to justify the cost spent to acquire them.
As a result, is it not at least possible that the answer for Stitch Fix is to get smaller? Does the 80/20 rule come into play here, with too many resources going to satisfy the customers most likely to churn?
One analyst actually asked precisely this question five quarters ago. On the Q2 call, Wells Fargo analyst Ike Boruchow pointed out that Stitch Fix had its highest operating margins when its customer base was a little over 1 million (it’s currently 3.5 million). When asked to clarify his question, here’s how Boruchow put it [emphasis ours]:
Yes, and it’s a high-level question. It’s just basically looking at the -- as your active customers have gone up, the margins have come down. And I’m looking over a multiyear period…it’s very high level, just to think about -- do you ever think about maybe this business would be more profitable, more successful, whatever the word is, if you focused on maybe a smaller subgroup of the active subs that are loyal and spend more and have a better margin and a lower CAC.
Spaulding responded by arguing that “we feel really good about the kind of customers we’ve been acquiring.” But, 15 months later, FY22 results and FY23 guidance sure make it seem like Spaulding was wrong.
How Does A Public Company Shrink?
The catch for Stitch Fix and others like it (and we will take a look at some of those others next week) is that it’s really, really difficult to take the path outlined by Boruchow. Stitch Fix went public less than six years ago with a plan to reinvent its industry. It’s a tough sell to employees, not to mention to investors, to then say “Actually, we figured out we’re just a niche business and as a result we think it’s a good idea to halve our customer base.”
But some management teams will find a way to take that path. If they don’t, P-E firms no doubt will. Can a Stitch Fix focusing on the best half of its customers move free cash flow margins to, say, 6%? If so, a go-private here is an absolute steal.
At Wednesday’s close, Stitch Fix has a market cap of $518 million, cash and investments of $223 million, and no debt. Let’s spitball a takeout at $7, a 40% premium to Wednesday’s close.
That’s a purchase price of ~$730 million, and an enterprise value of $507 million. At 6% FCF margins, the business when halved is generating $50 million of free cash flow. Lever up that 10x multiple and P-E firm can model pretty substantial returns.
To be clear, we’re not saying that 6% margins are possible, or that Stitch Fix is a takeover target, or that every struggling consumer-facing tech company is ripe for a buyout.
What we are saying is that the adjustment from the MoviePass economy to a more rational focus on cash flow and shareholder value is only just beginning. There’s an opportunity for companies to truly understand what this new normal requires, and an opportunity for investors to find the companies best-suited to adapt.
As of this writing, Vince Martin has no positions in any securities mentioned.
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During the 2010s, CRM stock rose 782%. In FY20 (ending January), excluding stock-based comp and gains on strategic investments, net margins were less than 3%, and shares traded for ~320x earnings.
We don’t necessarily agree that it might be worth trillions, but the fact that someone can make the argument with a straight face is meaningful.
For instance, on Twitter last month we highlighted a thread telling the backstory of the battle between Blockbuster and Netflix, which Blockbuster undeniably could have won.
In terms of competitive positioning and reach, Uber probably has been as successful as bulls believed it would be. UBER stock is down 24% from its 2019 IPO price anyway.
Very good article and clear thinking in my view.