Stitch Fix - Earnings Call - Q1 2020

Transcript

Operator (participant)

Good day, and welcome to the Stitch Fix First Quarter 2020 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to David Pearce. Please go ahead.

David Pearce (VP of Strategic Finance, Investor Relations, and Capital Markets)

Thank you for joining us on the call today to discuss the results for our first quarter of fiscal 2020. Joining me on today's call are Katrina Lake, Founder and CEO of Stitch Fix; Mike Smith, President and COO; and Paul Yee, our CFO. We have posted complete Q1 financial results in our shareholder letter on the IR section of our website, investors.stitchfix.com. A link to the webcast of today's conference call can also be found on our site. We would like to remind everyone that we will be making forward-looking statements on this call, which involve risks and uncertainties. Actual results could differ materially from those contemplated by our forward-looking statements. Reported results should not be considered as an indication of future performance. Please review our filings with the SEC for a discussion of the factors that could cause the results to differ.

Also, note that the forward-looking statements on this call are based on information available to us as of today's date. We disclaim any obligation to update any forward-looking statements except as required by law. During this call, we will discuss certain non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are provided in the shareholder letter on our IR website. These non-GAAP measures are not intended to be a substitute for our GAAP result. Finally, this call in its entirety is being webcast on our IR website, and a replay of this call will be available on the website shortly. Now, I'd like to turn the call over to Katrina.

Katrina Lake (Founder and CEO)

Thanks, David, and thanks for joining us. After the market closed today, we issued our quarterly shareholder letter with more details on our results and strategy, which I encourage you to read. I'm excited to share our first quarter results and provide more detail on some of the key initiatives that demonstrate our ability to extend our personalization capabilities in new ways. We continue to gain confidence that these initiatives open the door to greater client engagement near-term and expand our market opportunity in the long term. We also have leadership updates to share on today's call. I'll discuss those in more detail later in the call and can address any questions at the end. In Q1 2020, we generated net revenue of $445 million, exceeding guidance and reflecting 21% year-over-year growth.

We delivered a net loss of $0.2 million and +$5.1 million in adjusted EBITDA, which also exceeded our guidance. Adjusted EBITDA excluding SBC was $17.3 million. During the quarter, we grew our active client count to 3.4 million, an increase of 486,000 clients and 17% year-over-year. In addition, we grew net revenue per active client by 10% year-over-year, our sixth consecutive quarter of growth and a reflection of our strengthening ability to help clients find what they love. Today, I'd like to dive deeper into a few of the new initiatives that we briefly discussed last quarter, and I'll also share updates on the early progress and investments we're making. To date, most of our business and client experiences have been oriented around supporting five-item Fixes through stylish curated experiences.

This model has required us to build a strong set of recommendation capabilities made possible by the wealth of data we've collected across these transactions. This powerful personalization capability we've built to support this business can extend far beyond Fixes, and we're looking forward to both the challenge and the opportunity to offer new ways for clients to engage with our service. With the introduction of our Direct Buy capability, which allows clients to choose and purchase items outside of a Fix directly on our app or website, we've begun taking steps on what will be a multi-year process of evolving our offering so that our personalization service can be accessed in more flexible ways. We strongly believe Direct Buy will ultimately be incremental to our business from both a wallet share and addressable market perspective, and as a result, we've actively prioritized continued rollout and improvements to this capability.

Now, I'd like to discuss several of the developments we've driven across our first two Direct Buy features, Shop Your Looks and Shop New Colors. Unlike most e-commerce offerings, which choose to show every available product to every visitor, Shop Your Looks is hyper-curated and algorithmically personalized to every client. While we have tens of thousands of items available in our assortment that we could show clients, our personalization capabilities are strong enough that we can reduce this paradox of choice and show clients only a small subset of our inventory. For example, today, we present clients with an average of 30-40 shoppable items at a time. This radical e-commerce experience is working, and we're encouraged by early signs that Shop Your Looks is both complementary and additive to the Fix experience.

Fixes have been an amazing way to lay the foundation for categories that have traditionally been more difficult to shop online, such as denim, blazers, and everyday wardrobe staples where fabrication and fit can be challenging to pinpoint. With Shop Your Looks, we offer the same categories but in a way that allows clients to play a more active role in the purchase experience. By enabling clients to select items for themselves in a highly personalized set of options, we're able to meet more needs, drive better engagement, and capture additional wallet share. One example of our ability to do this is through non-apparel items such as shoes, handbags, and accessories, which we believe are often instant gratification purchases tied to more immediate want or need.

These items have historically comprised less than 10% of Fix revenue but over 20% of revenue in the quarter from Shop Your Looks, showing this new feature's potential to capture wallet share that we weren't previously able to access. We also expect Shop Your Looks to strengthen our inventory management capabilities. The feature draws on our existing inventory and thus allows us to be more productive with the assortment we already have on hand. Its recommendations are refreshed multiple times daily based on live inventory availability, creating constant newness and excitement for clients when they log into our website or mobile app. We've also seen low return rates through Shop Your Looks contributing to the offering's healthy unit economics. While Shop Your Looks has strong early results, it's still in beta, and we've been gradually rolling out features.

By the end of Q1, we had it rolled out to 1/3 of our U.S. Women's active clients and were moving rapidly to put engineering talent and resources against this initiative to keep up with its momentum. In the near term, we've optimized certain features. We've already changed the site navigation to include a shop section in our website and app, and we have plans to improve the product through features such as cart and feedback functionality. In Q1, more than 1/3 of clients who purchased through Shop Your Looks engaged with us multiple times, and approximately 60% of clients who purchased through the offering bought two items or more. Given these encouraging results, we plan to offer Shop Your Looks to all U.S. Women's clients, both active and inactive, and begin testing the offering with U.S. Men's clients by the end of FY 2020.

Before I hand it over to Mike, I'd like to discuss Shop New Colors, another feature in our Direct Buy offering. Shop New Colors was made available to all adult U.S. clients in June, enabling them to buy previously purchased items in new colors, prints, and sizes. Before we introduced this feature, we heard from clients who wanted to buy more of the items they love and discovered through us, and that they would go directly to vendors or other retailers to purchase additional items in more colors. Now, we're able to capitalize on these supplemental purchases of items that were inspired by Stitch Fix. With Shop New Colors, we're better able to engage these clients and also serve more of their needs.

To date, the top-selling items across our Men's and Women's categories in this offering have been exclusive brands, highlighting our ability to successfully pinpoint both fit and style. Based on the success we've seen, we plan to introduce Shop New Colors to our Kids clients by the end of FY 2020, giving parents an opportunity to not only stock up on more of the items their Kids love but also find previously purchased items in new sizes as Kids grow. We're excited by the potential that remains to engage more of our existing clients through this offering. The momentum we've built thus far across both Shop Your Looks and Shop New Colors gives us confidence in our ability to accelerate revenue growth through the end of the fiscal year. Strong results from these offerings demonstrate how successful we can be when we expand our personalization capabilities in new and incremental ways.

Direct Buy is anchored on the personalization engine we built that has enabled us to sell nearly $5 billion in apparel and accessories over the last five years. We look forward to using this advantage and extending our capability to better serve existing clients and reach new ones over time. As we extend our offering to new form factors, the efficiencies we're driving through inventory management will play a key role in enabling us to better serve our clients. With that, I'll turn it over to Mike to discuss how our inventory optimization algorithm continues to strengthen client and business outcomes and to provide an update on our Kids offering.

Mike Smith (President and COO)

Thanks, Katrina, and hello to everyone joining us on today's call. In Q1, we celebrated the one-year anniversary of our Kids offering. Over the last year, we've taken key learnings from the rollout to enhance our assortment and deliver better client outcomes, and we're excited about the progress we've made. Success rates in Kids have improved every quarter since Q2 2019, and in Q1 2020, success rates, average order values, and client satisfaction reached their highest levels yet. Underpinning this product-market fit has been a combination of both our exclusive brands and market brands. With our exclusive brands, we focused on creating unique, high-quality apparel rooted in our rich client data around fit, design, and price. Brands like Rumi + Ryder and Bailey Lane have been particularly successful, with higher success rates and satisfaction scores relative to market brands.

Activewear, in particular, has performed well and driven success rates and average order values. We've seen our exclusive activewear product, in addition to key market brands such as Under Armour and Adidas, resonate with boys and girls. While Kids is still a young category, we're excited about the progress we've made over the past year and look forward to scaling this offering over time. I'd also like to provide an update on a key initiative we introduced in Q2 last year. One of our key strengths is our ability to use data science to match inventory to each of our clients' unique preferences. As we expand our capabilities beyond our traditional Fix form factor to include Direct Buy, we're focused on improving the algorithms that drive these inventory decisions to enhance client experience.

In Q2 2019, we launched an inventory optimization algorithm to begin allocating inventory more effectively across our U.S. Women's clients. The algorithm considers the preference of a broader universe of clients in our styling queue rather than one client at a time, as it determines what inventory should be made available to stylists as they style each client. Over the last few quarters, we've refined the algorithm to improve our assortment and be more effective in reserving inventory for clients in our styling queue. Through this algorithm, we aim to deliver stronger outcomes for each client while considering preferences for clients still waiting to be styled. For example, if we reserve too much inventory for clients later in the queue, we may sacrifice outcomes for clients being styled in the near term.

On the other hand, if we don't reserve enough inventory, near-term client outcomes may benefit at the expense of those later in the queue. At the end of Q1 2020, our inventory optimization algorithm contributed to an increase in average items purchased for Fix, benefiting gross margins. In addition, we've seen higher client satisfaction levels where the algorithm was applied and received feedback from clients that their Fixes were more personalized. The updated algorithm also shortened average styling time, further enhancing our unit economics. Over time, we believe this algorithm will allow us to more effectively serve our growing client base while also driving efficiencies across inventory management, styling, and operation. Now, I'll turn the call over to Paul to discuss our financial performance and outlook.

Paul Yee (CFO)

Thank you, Mike. We're pleased with our first quarter results and remain confident in our full-year outlook. First, I'll share a color from the quarter. Our Q1 net revenue of $445 million represented 21% growth year-over-year, exceeding our guidance. We saw healthy growth in both Women's and Men's and continue to build out our Kids and U.K. categories as well as our new Direct Buy initiatives. Active clients grew to 3.4 million, or 16.6% year-over-year. Net revenue per active client grew 9.5% year-over-year, representing our sixth consecutive quarter of growth. Excluding the impact of the extra week in Q4 2019, net revenue per active client grew by 7.9% compared to Q1 2019. Note that net revenue in the calculation is based on the last four fiscal quarters and benefits from the extra week in Q4 2019, while active clients is measured over 52 weeks.

Q1 gross margin was 45.3%, 20 basis points higher than Q1 of last year. This was driven by improvements in merchandise costs and operational efficiencies, partially offset by an increase in inventory reserves. Advertising was 11.4% of net revenue, with brand spend representing approximately $4 million in the quarter, or about 1% of net revenue. Other SG&A, excluding advertising, was 33.8% of net revenue in the quarter, reflecting investments in payroll and stock-based compensation to attract and retain top talent, as well as expansion of our fulfillment centers and offices. Note that we drove higher-than-expected leverage in our variable costs in Q1, resulting from greater efficiencies in our warehouse and styling operations. Q1 Adjusted EBITDA was $5.1 million, or 1.2% of net revenue, exceeding our guidance driven by revenue upside, higher gross margin, variable labor efficiencies, and expense timing.

Adjusted EBITDA, excluding SBC, was $17.3 million, or 3.9% of net revenue, also exceeding guidance. Our Q1 net loss was $0.2 million, and diluted loss per share was $0. In Q1, we also delivered free cash flow of $20 million, and ended the quarter with zero debt and $388 million in cash, cash equivalents, and highly rated securities. Given our quick inventory turns, low capital spend as a percent of net revenue, and the non-cash nature of our SBC investments, we expect to continue to drive positive free cash flow this fiscal year. Our healthy cash flows have enabled us to self-fund our growth in Men's, Kids, and the U.K. We expect our longer-term adjusted EBITDA expansion will translate to even stronger cash flows to capitalize on our growth strategies. Before I give guidance, I want to share thoughts on leverage.

As we make key investments this year to support future growth, we know it's important to demonstrate efficiencies over time. It's notable that our business, excluding the U.K. and technology talent investments, is already scaling. At the gross profit line, we've expanded gross margin every year since 2015. Despite our ongoing mix shift into newer categories like Men's, Kids, and the U.K., we continue to see opportunity to drive that higher. As we look ahead, much of our Adjusted EBITDA margin expansion will be achieved through leverage of SG&A, excluding advertising. This line item currently represents 34% of net revenue, with the two key components, variable labor and fixed costs, evenly weighted in terms of opportunity. Through efficiency initiatives, we've driven reductions in variable labor as a percent of net revenue in each of the last three years. I already noted these gains in Q1 2020.

As we continue to invest capital and engineering capabilities to drive greater efficiencies in our warehouses and styling teams, we plan to leverage this line for the full year 2020 and beyond. The second piece, fixed costs, includes fixed payroll and SBC. It's important to note that as we add data scientists, product experts, and engineers, we are adding key capabilities. These enable us to better leverage our rich Style Shuffle platform, improve our client targeting capabilities, and develop smarter algorithms that benefit our buying, styling, and warehouse teams. These key investments lay the groundwork to support a $10 billion business as much as a $2 billion one, allowing us to scale over time. Now to our outlook. For Q2 2020, we expect net revenue in the range of $447 million-$455 million, representing growth of 21%-23% year-over-year.

This range reflects growth rates similar to the guidance we've historically set for Q2. As we've done in past Q2s, we plan to pull back on marketing as we tend to see lower marketing efficiencies during the holiday season. Our guidance reflects year-over-year active client growth that is approximately in line with the 17% we delivered in Q1 2020, as well as continued growth in revenue per client. We expect Q2 adjusted EBITDA in the range of $10 million-$15 million. This includes an SBC estimate of $18 million, resulting in adjusted EBITDA, excluding SBC, of $28 million-$33 million. For fiscal 2020, we continue to expect net revenue in the range of $1.90 billion-$1.93 billion, representing growth of 20.5%-22.5% year-over-year. Adjusting for the impact of the 53rd week in FY 2019, our guidance range reflects growth of 23%-25% year-over-year on a 52-week comparable basis.

In light of our adjusted EBITDA strength in Q1, we are also raising our adjusted EBITDA guidance to reflect a range of $18 million-$32 million, which results in an adjusted EBITDA, excluding SBC, range of $93 million-$107 million. As Katrina mentioned earlier, we are confident that our Direct Buy momentum, paired with our elevated marketing investments in second half 2020, will allow us to reach these full-year targets. With that, I'll now hand it back to Katrina.

Katrina Lake (Founder and CEO)

Thanks, Paul. As you may have seen in our release today, we are announcing a few leadership updates. First, I'm very excited that Elizabeth Spaulding will be joining us as President. Most recently, Elizabeth was a partner at Bain & Company, where she was Global Head and Founder of the Digital Practice and served on its Board of Directors. Elizabeth will help lead us into our next chapter of growth and will be central in helping shape our longer-term strategy. She will lead the expansion of our customer experience beyond our core Fix offering, and we are so excited to welcome her to the team. Second, I want to share that our CFO, Paul Yee, is stepping down. Thank you, Paul. The team and I are so grateful for all you've done for Stitch Fix.

We're proud of the many goals and milestones we've achieved with your leadership and are full of gratitude for you and excitement for your future.

Paul Yee (CFO)

Thanks so much, Katrina. With this being my last earnings call with Stitch Fix, I want to take a moment to thank the entire Stitch Fix family and the investor community for an incredible journey these past few years. I am proud of the team's accomplishments and remain excited about the future of this company and its growth plan.

Katrina Lake (Founder and CEO)

Paul's departure is effective January 3rd, 2020, and Mike Smith will step in as interim CFO as we search for a replacement. Last but not least, I'm pleased to announce the addition of two very experienced senior merchandising leaders to our management team. Loretta Choy leads our Women's category and joined us from Old Navy, and John Stratford leads our Men's category and joined us from Gap. We believe these updates position the company well to continue delivering on our strategic objectives today and set us up for continued innovation and differentiation in the years to come. With that, I'll turn it over to the operator.

Operator (participant)

If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star one to ask a question, and we'll pause for just a moment to allow everyone an opportunity to signal for questions. And we'll go first to Doug Anmuth with JPMorgan.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thanks for taking the questions. Just wanted to ask about Direct Buys and, I guess, Shop Your Looks in particular. So it looks like you're about 1/3 rolled out here to women in the U.S. Curious, just given the positive early results that you're seeing, if there's a way that you can speed that up sooner than kind of end of fiscal year 2020. And then are you already starting to see that help drive new customers overall into Stitch Fix? And then how should we think about the contribution to driving accelerating growth through the rest of fiscal 2020, I guess, combined with Shop Your Looks and then also Shop New Colors? Thanks.

Katrina Lake (Founder and CEO)

Great. Thanks for the question, Doug. Yeah, we've been really excited about the momentum and the engagement we've seen with Shop Your Looks. I think that being said, we still know there's a lot of opportunity in the product. And so I think while I love that we have leaned into things that we've seen working, we also are admittedly launching products before they are kind of as good as we know that they can be. And so with this launch, we're really trying to both capitalize on as many early learnings as we possibly can while, at the same time, being able to kind of triage the rollout in a way that we can learn from what we have learned from the rollout so far and incorporate those learnings into the way that we evolve the product.

And so to be clear, we plan to roll it out to all of women by the end of the year. And so you can imagine that there'll be a ramp through that. But I think that strategy is right for us as we try to be quick and innovative, but also really holding ourselves to a high bar in terms of the quality of the product that we put out there. In terms of new clients, it's actually currently not oriented towards helping new clients. This is really about increasing revenue per client. It's about filling out more of his or her share of wallet. But as we look into the future, that's absolutely an opportunity that we look forward to sharing more on as we have updates there. And maybe, Paul, you quickly speak to just kind of guidance on it.

Paul Yee (CFO)

Yeah. Hi, Doug. Our full-year revenue guidance does reflect the rollout over the course of the second half of Shop Your Looks in Women's, as well as launching by the end of the year an equivalent feature in Men's. As you can tell, our implied acceleration of growth in the second half is driven by both Direct Buy as well as a variety of other initiatives on the product and marketing side. We also are looking to invest in more performance marketing in the second half versus the first half. So all of those are embedded in our full-year guidance that I just gave.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thank you both.

Paul Yee (CFO)

Thank you, Doug.

Operator (participant)

We'll go next to Ross Sandler with Barclays.

Doug Anmuth (Managing Director and Internet Analyst)

Thanks, guys. Question about the recent proxy filing. I know that probably never comes up on these types of conference calls. But you guys changed your management compensation to reflect client growth in 2020. Last year, I think there was like a 20% bonus that reflected revenue per client growth. And yet, Paul just said that client growth will be around that 17% range that you're seeing right now. So I guess that would imply with the guidance that client growth will start to accelerate as we move through 2020. So I guess can we confirm that? And then the second question is, if growth is picking up, can you parse out, is that a reflection of Direct Buy driving an uplift in the many paused clients or clients that haven't bought in the last 12 months?

Or is that new client growth coming in or some combination of the two? And then how much of that is core Women's versus non-Women areas in 2020? Thanks a lot.

Paul Yee (CFO)

Let me talk about your question around the proxy filing. So as our board worked with management on the metrics for 2020, you did note that we added client count as one of the operating metrics. And as you step back, we have many drivers of growth, both revenue per active client and client count notably. And so for this year, we're focusing on client count. The growth rate we saw in Q1 at 17% is healthy and consistent with what we're looking for in Q2. And so rest assured, we have a variety of initiatives to ensure we drive client count over the course of the year. And more notably, that's healthy in nature. So I haven't given specific guidance for the full year in client count, but given the disclosure and the proxy filing, you can note that it's an important part of our focus for this year.

And then secondly, your question around sort of the Direct Buy uplift in the second half. On the highest level, it's going to be with existing clients. Driving revenue per client, we drove that up 10% in Q1. Certainly, we see it as an opportunity to re-engage lapsed clients as we have a good understanding of your profile and we have an opportunity to engage them in new ways. And over the longer term, probably less so in the second half, being able to acquire new clients through this feature. That's part of the reason why we're investing in technology talent and product talent to make that a viable feature. But that will be beyond fiscal 2020 as a key driver.

Operator (participant)

And we'll go next to Mark Mahaney with RBC Capital Markets.

Doug Anmuth (Managing Director and Internet Analyst)

Thanks. Two questions, please. One, could you provide a little more color on the traction you're seeing in the U.K. market? And then secondly, Shop Your Looks, you gave out one data point on it and you talked about it qualitatively. What about the impact it's having on churn? Are you finding that for those third of your women customer base that you're seeing lower churn rates, greater retention as a cohort, as a group because of Shop Your Looks? Thank you.

Paul Yee (CFO)

Yeah, Mark, I'll take the U.K. question. We launched the U.K. in May and still early days. And future calls will probably give a deeper, more robust update on the U.K. I think the learnings that we've seen so far is that the client experience matters in all of our business, but it matters a lot over there, specifically on transportation, kind of what they expect in terms of how they return product. And that has been where we've been spending our time enhancing kind of our product offering in the U.K. But we're excited about what we're seeing in Men's in particular. The product acceptance in Men's has been very healthy. So early days and probably updates in future quarters in the U.K.

Katrina Lake (Founder and CEO)

And then, Mark, and just to answer your question on Shop Your Looks, the data points, I would say that in general, when you see clients engaging more with the service, when you see them buying more with the service, that in general correlates with higher retention. And so while we haven't shared any number specifically to that, I think what a lot of our excitement around this is that we're seeing that this is a kind of additional tool that we have to really be able to drive that love for the brand, drive engagement, and serve our clients really well. And we'll continue to share more as we have more to share.

Doug Anmuth (Managing Director and Internet Analyst)

Okay. Thank you.

Operator (participant)

We'll go next to Heath Terry with Goldman Sachs.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thanks. I was hoping you could help us break down the components of gross margin this quarter. I know we got a little bit of expansion. Can you give us a sense of how much of that was or the different pieces of that that may have come from product cost versus the efficiencies that you talked about in the letter related to the algorithm, improvements that you made? Anything else that you would call out? And then as we look sort of further down the income statement, any specific sort of areas that we should be looking to as we go through the year ahead for specific areas of margin improvement, just given the guidance for better EBITDA leverage over the course of the year?

Paul Yee (CFO)

Hi, Heath. This is Paul. So specifically to Q1's gross margin, we're really pleased with the fact that we leveraged by 20 points.

Part of the upside we saw in EBITDA versus the guidance was higher gross margins. And as you step back, there are two drivers of our gross margin at the highest levels. First is investments. We're investing in the U.K. As a result, we invest in more inventory and the margins are lower, as well as the fact that their buys are smaller. And starting in the second half of last year, rolling into this first half, we're also investing in inventory. That's a conscious effort for us to broaden our available inventory to better be able to personalize our offerings to each of our clients. So that impacted our inventory reserves. And so those reflected investment year over year in gross margins. But we were able to offset all of that this quarter with continued improvement in our operating efficiencies.

The fact that we are able to understand our clients even better through things like Style Shuffle and being able to engage them in ways to help our buyers buy the right inventory and matching those products with our clients, the inventory algorithms that Mike talked about is certainly another example of that. That reduces clearance and allows us to better reduce the amount of inventory at the end of the supply chain. We also had a lower shrink in damages. So those are operating focus areas for our warehouse teams. All of that combined helped us offset the investment we saw in Q1, and therefore our gross margins expanded year over year. As you look forward to the rest of the year in terms of gross margins, those two dynamics will continue to play out. We expect the gross margins for 2020 to be roughly flat versus 2019.

But rest assured, we're continuing to find and seek ways to drive those efficiencies. I think you were talking about gross margins. Were you also talking about EBITDA margin in your second question, Heath?

Doug Anmuth (Managing Director and Internet Analyst)

Yeah. The second part of that was just as we look out further into the year, anything kind of further down the income statement that you would point us to where we should be looking for specific efficiencies?

Paul Yee (CFO)

Absolutely, so that same dynamic we're seeing in gross margins with investments and efficiencies also play out in other SG&A. I talked about the two opportunities to leverage over time. In the near term, we're continuing to focus on efficiencies in our warehouses and our styling teams, and we saw that in Q1. We actually leveraged by 90 basis points in that area, which is the result of our capital investments in automation and better tools in our warehouses and then better algorithms to guide our stylists so that they also be more efficient. That continues for the rest of the year, and that's helping offset in part the investments in SBC and fixed payroll to build the capabilities to help us expand Direct Buy into continuing to improve our offering, so that same dynamic is also reflected in my full-year EBITDA guidance.

Certainly, that's sort of our overarching goal of self-funding our growth over time.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thanks, Paul.

Paul Yee (CFO)

Thanks, Heath.

Operator (participant)

We'll go next to Ralph Schackart with William Blair.

Doug Anmuth (Managing Director and Internet Analyst)

Hi, good afternoon. Yet another strong quarter of sales growth of clients. I think in the shareholder letter, you called out Women's having a positive contribution to that. Just curious if you could maybe provide some color on some other factors like Style Shuffle, increased inventory, the optimization algorithm. Might any of that also have had a positive impact? And if so, is any one factor having a more pronounced impact, or is it sort of evenly split? Thanks.

Paul Yee (CFO)

Sure. This is Paul. And it is hard to parse out, but ultimately, because of our client centricity, ultimately, by being able to understand them well through games such as Style Shuffle, by being able to provide them better inventory through our investments there and through our algorithms to match them to our clients, that ultimately drives retention and engagement over time. And Direct Buy is another tool that we're investing in 2020. And so all of those help improve client count, layering on top of the fact that we're continuing to invest in performance marketing as well as to build out our capabilities in brand. We actually had a small investment in Q1 with brand. So all of those combined are helping us not only attract the right clients, but retain them over time.

That's part of the sort of area that we have focused on for the rest of the year in terms of driving revenue, which is client count for our base business, as well as being able to expand our TAM through U.K. and then also Kids.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Maybe just to follow up on the initial brand investment, just curious how it's going relative to expectations and how are consumers responding to it? Any extra color you could share on that?

Katrina Lake (Founder and CEO)

Yeah, sure. We've been happy with what we've been seeing on the brand side, I think, especially as we think about things like Shop Your Looks and Shop New Colors and just having a more diverse set of ways to engage with Stitch Fix. It's ever more important that people experience the brand in a consistent way and have an emotional connection to the brand, and so our brand spend is not something that we expect to materialize in active clients within a given quarter. It's really meant to impact things like people's understanding of Stitch Fix and people's kind of emotional attachment to Stitch Fix.

We definitely are pleased with what we see so far, but we also feel like we still have a lot of work to do and we still have a lot of opportunity to make sure that people understand Stitch Fix in the right way to be able to kind of grow and expand our offering in as aggressive a way that we believe we can. I think so far, we're happy with what we see, but we also see there's still a lot of opportunity.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thanks, Katrina. Thanks, Paul.

Operator (participant)

We'll go next to Edward Yruma with KeyBanc Capital Markets.

Doug Anmuth (Managing Director and Internet Analyst)

Hey, good evening, guys. Thanks for taking the questions. I guess first, on Direct Buy, I wonder if you could maybe boil down the unit economics. I'm sure there are lots of positives and negatives, maybe higher shipping costs, but lower labor costs since you don't use a stylist. If you could help us understand kind of what the margin implications of Direct Buy are longer term. And then second, you talk a lot about extending personalization. I guess kind of other areas that you think you can extend into in the medium term or other capabilities that we should expect to see roll out? Thank you.

Paul Yee (CFO)

Hi, I'll take the first question. So right now, you kind of called out the client costs with our current offering through Direct Buy. And we're pleased that the unit economics of our current offering are fairly similar to our base Fix business, as you called out. We do have lower labor costs associated normally with styling, but we don't have an optimized shipping platform today. We currently offer only one item per shipment because we don't have a cart feature. So over time, absolutely, we've seen opportunity to improve our gross margins. It's worthy to note that we're leveraging and pulling from existing inventory for Direct Buy. So another efficiency that ultimately drives gross margin is the fact that we can share the inventory and be able to have a very live refresh for our clients through Shop Your Looks.

I would say longer term, we see opportunities not only to improve our gross margins as we grow that business, but also through cost of acquisition. One of the investments we're making this year is to see Direct Buy as a way to acquire new clients to showcase our personalization capabilities for people who may not know Stitch Fix. So over time, we've seen opportunities certainly to improve our market efficiencies, our users with a new way to share with new clients what Stitch Fix is all about.

Katrina Lake (Founder and CEO)

Just on your second question around expanding personalization, I mean, this is probably one of our favorite topics around here. I mean, I really believe that the market opportunity of a more personalized, never mind apparel, but more personalized buying experience everywhere is like all of it. If you could have a more personalized experience in stores, if you could have a more personalized digital experience where you're only seeing relevant products for you, that really is the promised land of what retail should be able to do in the future. I really believe that our capabilities are very far ahead in those worlds. That being said, even today, there's just so much low-hanging fruit in the categories that we're already in today.

And the data point that we shared around Direct Buy and Fixes and how they're engaging with each other and how we see, historically, we've always kind of believed that we underindex in categories such as handbags and accessories. And what we see is that Direct Buy actually overindexed relative to our Fix business, which to us says that this is going to be a better way to serve that kind of incremental wallet share. And so the kind of categories that we're in represent $400 billion of opportunity. And so while we think personalization can extend to many other ones, I think right now we're really focused on the kind of opportunity in front of us, which is really how do we capture more of that client's wallet and how do we make sure that we can have a relevant and kind of client-right offering for more people.

Doug Anmuth (Managing Director and Internet Analyst)

Great. Thanks so much, guys.

Operator (participant)

We'll go next to Erinn Murphy with Piper Jaffray.

Erinn Murphy (Equity Research Analyst)

Great. Thanks. Good afternoon. And Paul, all the best going forward. I guess the first question, Katrina, if we could just talk a little bit more about, I think in your prepared remarks, you said Shop Your Looks will be with active and inactive customers by the end of the year. How do you plan to let the inactive customers know about this feature? I guess what's required from the marketing front? And then for active customers, is that just an email notification that goes out, or are there other ways that you're working to kind of notify the customer that this option is available for them?

Katrina Lake (Founder and CEO)

Yeah, that's a great question, Erinn. I think this is exactly part of the earlier question around how do we think about triaging the launch. This type of question is exactly part of what we want to make sure that we are optimizing. Being able to kind of roll this feature out gradually allows us to be able to learn how do we make sure to make people aware of the offering in the right way. Yes, email is definitely a big vehicle that we have, but we also are able to use notifications within an app. We also are able to use a bunch of other marketing channels. We can use partnerships. We can use influencers. There are so many ways that we can engage with and remind active clients, but also inactive clients of the offering.

And I think what we are really fine-tuning is what are all of the different sets of strategies and how do we make sure that we're using the right sets of strategies for the right groups of people so that people are kind of getting introduced or reintroduced to this in a really personalized way. So it's a great question, Erinn, and one that we're definitely working very hard on.

Erinn Murphy (Equity Research Analyst)

Okay. Got it. And then just on the cart function or functionality, any insights on when that will be added? It just seems like a big opportunity given that if I want to speak to two items today, two separate checkout processes, is it just because you're sourcing from so many DCs, or what's the hang-up on adding that functionality?

Katrina Lake (Founder and CEO)

It's really just more around, this is a feature that we rushed to get out the door because people seem to really love it, and so we built it without kind of the full-fledged suite of what you might expect, and so we're actively working on it. It'll certainly be in the product by the end of the year, but it's definitely, I think, in the category of low-hanging fruit in terms of opportunity.

Erinn Murphy (Equity Research Analyst)

Okay. Got it. And then Paul, this may be one question for you. Just on tariffs, can you just remind us what's embedded in your guidance for tariffs thus far? Thank you.

Paul Yee (CFO)

Thank you, Erinn. So our continued expectations around the impact of tariffs is very immaterial. And the full-year guidance I've given does reflect the tariffs that went into effect in September and also what would potentially be in effect with List 4B items in December. That second list is pretty small. So nonetheless, because we have really great relationships with our vendors, we've been working with them very carefully. And so all the assumptions with our sort of second-half buys reflect the tariffs still intact and our actions in place to offset them. And that's reflected in my full-year guidance, but that number is immaterial.

Erinn Murphy (Equity Research Analyst)

All right. Thank you so much and all the best for the holidays. Thanks.

Paul Yee (CFO)

Thanks, Erinn.

Operator (participant)

We'll go next to Youssef Squali with SunTrust.

Youssef Squali (Managing Director)

Great. Thank you very much. A couple of questions here as well. How are we thinking about the, excuse me, the reacceleration in revenue in the second half to get to that 23%-25% for the year? Just trying to think through the main drivers and kind of the confidence you have to get there. And then second, on the state income tax, can you maybe just shed a little more light on maybe how many states do you collect state income tax today and how potentially significant a headwind could that be to future growth throughout the year as you guys are forced to kind of start collecting it systematically? Thanks.

Paul Yee (CFO)

Hi, Youssef. This is Paul. So we collect in all states where there is an income tax, a state tax, excuse me, a sales tax, and so there's no impact with the recent legislation. In terms of the acceleration implied in the second half with our full-year guidance, I would say there's three main areas. One is the continued rollout of our Direct Buy functionality as we optimize that feature and have that more accessible for our client base. Two, our marketing spend. I've guided for the full year that we expect marketing to be roughly 10% for the year. If you keep in mind that the second quarter is typically one we don't spend on marketing, we pull that back. You'll note that our spend on marketing in the second half will be higher than 10%. So we know we'll be investing there to drive revenue.

And finally, the U.K. and Kids, while still very early, they're building quarter-over-quarter, and they continue to be an important growth driver for us. So those are just three major examples among the other many smaller initiatives we have in flight to drive revenue growth, client satisfaction, and overall revenue per client.

Youssef Squali (Managing Director)

All right. That's super helpful. And then one last, if I may. On the Shop Your Looks, any plans to launch a dropship capability this year?

Katrina Lake (Founder and CEO)

That's a great question. It's definitely something we've talked about, not something that we have any news to share on.

Youssef Squali (Managing Director)

Great. Thanks, and Paul, all the best to you.

Paul Yee (CFO)

Thanks, Youssef.

Operator (participant)

And we have Ike Boruchow next with Wells Fargo.

Thanks, guys. This is Matt on for Ike. Good to see positive early results on the Direct Buy initiatives, just building on Erinn's question a little bit more. Can you discuss how your advertising for the Direct Buy will impact overall spend and potential increased costs for the inactive members? And then just some color on other KPIs. Can you give any updates around the cannibalization impact that you saw in the quarter relative to your comments prior?

Katrina Lake (Founder and CEO)

Yeah, so in terms of advertising spend, I don't know the word or place where we have a perspective on that yet. I think in the longer run, we believe that being able to have lighter-weight ways for people to engage with Stitch Fix and experience the personalization of Stitch Fix could open up incremental channels for us, could open up kind of incremental clients, and so we believe that I think having this fuller set of features in a way that people can engage with outside of Fixes might have marketing efficiency over the long run, but to be really clear, this fiscal year, we are not planning to have any of the Direct Buy capability that would be accessible and open to people who are not getting Fixes, and so that's more of a longer-term thesis than a shorter-term thesis.

In terms of cannibalization, I think that's part of what we really are trying to learn. Stitch Fix is a model where people engage with us over very long periods of time. And so to be able to have the feature now rolled out to 30% of people at the end of this last quarter allows us to be able to have kind of the ability to look to see how those clients engage with us longitudinally over a longer period of time so that we'll be able to have more concrete answers to this. But the thesis in launching this is that, yes, there is a small amount of cannibalization, but it really is incremental. And so the handbag example is a good example of if we weren't selling that many handbags through Fixes, we actually are finding we're able to sell more through Direct Buy.

Selling less in Fixes wasn't that our clients weren't buying a lot of handbags. It's that we were not offering handbags in the right way that she wanted to shop. What we know is that these clients who are engaging with us in Direct Buy, they're spending more, they're more engaged. Overall to the business, it is incremental. As we have a greater sense around what that looks like at a more granular level, we'll be happy to share.

Okay. That's very helpful. Thanks. Best of luck, Paul.

Paul Yee (CFO)

Thank you.

Operator (participant)

We'll go next to Dana Telsey with Telsey Advisory Group.

Dana Telsey (CEO and Chief Research Officer)

Good afternoon, everyone, and congratulations on the quarter. As you think about, and Katrina, you mentioned the handbags, which now on Shop Your Looks are over 20% of revenue in the first quarter. What is that doing to margins? And are you seeing more of it on branded or exclusive? And is there an opportunity that way? Thank you.

Katrina Lake (Founder and CEO)

Yeah, that's a great question. On the margin side, Paul spoke to it. I think right now we're seeing Direct Buy margins are pretty comparable to what we see in our Fix business. And in terms of branded versus our exclusive brands, I mean, we're seeing both perform. And buying new colors, for example, we see that exclusive brands do really, really well. And so in that case, we're selling more woven shirts that are Stitch Fix branded. We're selling some of our cardigans on the Women's side that are Stitch Fix branded. And so those are doing extraordinarily well. So I don't think that the handbag thing is a negligible impact to margins. And right now, we feel really confident around the margin structure and the Direct Buy model.

Dana Telsey (CEO and Chief Research Officer)

Thank you.

Operator (participant)

We'll go next to Mark Altschwager with Baird.

Mark Altschwager (Senior Research Analyst)

Good afternoon. Thanks for taking my question. I'm curious how the inventory optimization strategy is interplaying with the strategy to accelerate the Shop Your Looks. I guess bigger picture, it seems like you're introducing a fairly significant new variable into the algorithm here. And I'm just wondering if it will perhaps require a bigger inventory investment in the near term in order to ensure overall guest satisfaction.

Katrina Lake (Founder and CEO)

Yeah. I mean, right now, actually, it doesn't. Our algorithms kind of have a sense of what is available in our inventory at any given time. And the inventory optimization is really able to optimize not just for this exact moment, but over the longer term. And the way that Shop Your Looks and Shop New Colors engages with that is that actually it's based on real-time inventory. And so we're not buying inventory to support those businesses. It's really capitalizing on inventory that we already have in our four walls and making that inventory actually more productive. And so over time, are there more creative ways for us to inventory the Direct Buy models? Yes, there probably are. But today, it's really kind of a benefit to our model and that it's actually making our inventory more productive.

Mark Altschwager (Senior Research Analyst)

Very helpful. Thank you. And maybe just a quick follow-up for Paul on free cash flow. A little bit lower year over year. I think in Q1, I think that was primarily the inventory investment. Maybe just update us on how you're thinking about inventory growth and free cash flow overall for the year?

Paul Yee (CFO)

Sure, Mark. This is Paul. So we continue to have a very strong free cash flow engine. We turn inventory quickly. We manage our expenses well. And that is not changing going forward. We've been able to self-fund all of our growth initiatives the past few years because of our healthy growth and free cash flow. Specific to inventory, year over year, we are investing in inventory. We ended the quarter with 39%. And that was exactly in line with plan. As you may recall, in the second half of last year, we saw an opportunity to better serve our existing clients and our new clients better. And so we broadened our offerings and deepened some buys as well to be able to serve them well.

Over the course of the second half, we expect that growth rate to normalize more in line with revenue by the end of 2020 fiscal. And so I would step back and say our continued ability to match clients with inventory through our better understanding of them through our algorithms and great styling teams, that continues to be our secret weapon to be able to turn inventory well and to pile that back into the business and drive even future revenue streams. So overall, free cash flow of $20 million for Q1, I think that's something that we stand behind with pride. And those drivers continue for many years to come.

Mark Altschwager (Senior Research Analyst)

Thanks for the call. Best of luck.

Paul Yee (CFO)

Thank you.

Operator (participant)

We'll go next to Rick Patel with Needham & Company.

Rick Patel (Principal and Senior Equity Research Analyst)

Thank you. Good afternoon, everyone. Can you help us with the outlook for AOV as we think about Q2 and the rest of the year? You entered the first quarter with headwinds from summer product, but curious how we should think about the opportunity in the coming quarters, especially as you ramp up with Direct Buy.

Paul Yee (CFO)

Hi, Rick. This is Paul. So yes, we did have some seasonality impacts in Q1 as we had clients loving our summer product throughout the first half of that quarter. And so that trend has obviously gone away as we are squarely now in the winter season. As we think about AOV, we see continued opportunities to drive that through keep rate. Our ability to be able to give clients product that they want and be able to use the feedback loop to better serve them is certainly a driver of AOV.

As I step back, I would say our revenue per client focus, the fact that we've grown that six consecutive quarters now, year over year, is a reflection of the fact to be able to engage them over time and make sure that they do buy more with us and make sure we can meet their needs well. Those are underlying the drivers of our AOV, but ultimately we're optimizing for client outcomes such as revenue per client. Those drivers continue for the rest of the year.

Rick Patel (Principal and Senior Equity Research Analyst)

Got it. And Paul, you mentioned that expense timing was a factor for better than expected EBITDA in the first quarter. Any color on what that was and which quarter those expenses might move into?

Paul Yee (CFO)

Yeah. So the biggest drivers that we gave it upside were gross profit and variable labor. A smaller portion of that was sort of expense timing. And we're not managing those kinds of expenses from quarter to quarter. Think of professional fees and some other fees that might sort of just come in another quarter. But there's nothing I would say to highlight as material. And if it were notable, I'd call it out, but it's just other quarters. But nothing I would call it as material. And as you can see, we raised the full-year EBITDA reflecting sort of the flow through some of the upside that we saw in Q1 for the full year.

Rick Patel (Principal and Senior Equity Research Analyst)

Thanks very much.

Paul Yee (CFO)

Thanks, Rick.

Operator (participant)

At this time, I would like to hand the call back over to Katrina for any additional or closing remarks.

Katrina Lake (Founder and CEO)

Great. Thank you all for joining us today. Have a wonderful holiday season.

Operator (participant)

That does conclude today's conference. We thank you for your participation.