2023-03-23 09:00:00 ET
Summary
- Five Below, Inc. reported an in-line quarter, with margin expansion for the first time in a while.
- The company ended the year with 1,340 stores.
- Management will ramp up investments in 2023 to take advantage of the weak environment around retail.
- There has been some reshuffling in the management team. We go over the changes.
- Guidance appeared weak, but context is necessary.
Introduction
Five Below, Inc. ( FIVE ) reported Q4 earnings on Wednesday after the market close. Judging by the company’s valuation, expectations were high coming into earnings. The company’s stock has performed very well over the last months through significant multiple expansion:
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After an outstanding Q3 , Five Below reported in-line earnings in Q4. There was nothing extraordinary in the release, but nothing worrying, either. The company continues to execute, but the market had such high expectations that the stock dropped after the release despite a very strong day in the stock market:
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Weakness in the stock might last for a while, but we can't know for sure. The market is always unpredictable. I didn't have this kind of multiple expansion on my bingo card either.
The Numbers
a. The Headline Numbers
The company slightly beat analysts’ top line estimates and met those of the bottom line. Revenue came in at $1.1 billion, up 13% year-over-year. EPS came in at $3.07, a 23% year-over-year increase:
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There were really few surprises to what the market expected and what the company delivered. This said, management again proved conservative with its own guidance , as it beat the high end of its revenue guidance and met the high end of its bottom line guidance.
Five Below posted sales of $3.08 billion for the year, an 8% year-over-year increase. EPS came in at $4.69, a 5% decrease. Management guided for the following back in March 30th, 2022:
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Net sales are expected to be in the range of $3.16 billion to $3.26 billion based on opening approximately 160 new stores and assuming an approximate flat to 3% increase in comparable sales.
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Diluted income per common share is expected to be in the range of $5.19 to $5.70 on approximately 56.2 million diluted weighted average shares outstanding.
The company missed on pretty much everything, but few expected rampant inflation and a deteriorating macro backdrop at the time. The fact that the company came close on revenue portrays the strength of the operating model even in tough times.
The top line and its drivers: comparable sales and store growth
Five Below has two main drivers of its top line: comparable sales and new store openings. Comparable sales refer to the increase or decrease in sales from stores already open in the comparable period. So, for example, comparable sales for Q4 2022 will be a calculation using only the changes in sales from those stores that were already open during Q4 2021. New store openings are self-explanatory.
This quarter the outperformance was driven by comparable sales, as the company opened precisely the same number of stores it guided to last quarter.
Comparable sales: driven by volume
Comparable sales returned to the growth path in Q4, which is impressive considering they faced tough comps from a year ago. Comparable sales increased 1.9% year over year , ahead of management’s midpoint guidance of 0%.
Comparable sales have been highly volatile during and after the pandemic period, but Q4 comparable sales have held very well as the company enjoyed the pull forward created by government stimulus during the pandemic:
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Comparable sales also have two underlying growth drivers: average ticket and the number of transactions . Average ticket is related to how much money customers spend per transaction, whereas the number of transactions is what it says: the number of transactions the company’s customers make.
Five Below saw a 2.8% increase in transactions, partially offset by a 0.9% decrease in average ticket. The decrease in average ticket was probably caused by increased promotions and the consumer suffering from the impact of inflation (emphasis added):
And then on the other end of it, we really pushed the $1 item holiday and that was successful as well.
Source: Joel Anderson, Five Below’s CEO, during the Q4 2022 earnings call .
However, we think that the key metric here is the number of transactions . This is what we wrote several quarters ago when comparable sales were decreasing (emphasis added):
When it comes to Five Below, we prefer a comparable sales decrease driven by ticket than by transactions. The rationale is that the company is more in control of average ticket (due to initiatives such as Five Beyond) than traffic. Seeing the number of transactions decrease might mean that traffic is plummeting, which would be worse for Five Below than its customers temporarily spending less. If the customer is in the store, management has more flexibility to lead them to spend more.
We still think this stands true today and we still think that traffic is much more important to measure the effectiveness of the company’s stores than average ticket. The rationale is that the latter is more impacted by external factors out of the company’s control.
For example, the Five Beyond concept should allow the company to increase average ticket. For yet another quarter, Five Beyond customers continued to spend around twice those that did not purchase any Five Beyond products . Management noted that customers are taking higher prices well (emphasis added):
We're really not seeing any sensitivity higher to lower priced items. It's been pretty balanced. We continue to be pleased with the Five Beyond rollout. And that penetration continues to increase and there really hasn't been any pushback.
Source: Joel Anderson, Five Below’s CEO, during the Q4 2022 earnings call .
Five Beyond is the company's store-within-a-store concept through which it sells items that are priced above $5. Almost 20% of the company’s fleet is now converted to this format, so when the macro and promotions normalize, we should see an even more significant impact on average ticket. What’s interesting is that conversions are also having a positive impact on volume:
As we continue on these conversions, we're immediately seeing a lift in sales and it's primarily through transactions.
Source: Joel Anderson, Five Below’s CEO, during the Q4 2022 earnings call .
The company’s average volume today lies at 2.4 million units, with expectations to reach around 3 million in the future. This means that comparable sales growth in the future will come both from higher prices as well as a significant uptick in volume.
New store openings come out in line, but their timing matters too
Five Below opened 48 stores during the quarter, in line with management’s expectations. The store count is now 1,340 , and if we do some basic math, we can see that Five Below did not close a single store this quarter , as usual:
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The company opened 150 stores in 2022 , a slight decrease compared to 2021 when the company opened 170 stores. However, management said that conditions to open stores faster are improving and they expect to open a record 200 stores in 2023. The timing of the store openings will be different than in 2022, which impacts sales. We’ll discuss this later in guidance.
The company remodeled 200 stores to the Beyond model this year and expects to remodel a record 400 stores in 2023 . Assuming that the company currently has 20% of its stores in the Beyond model (around 268 stores) and plans to open an additional 200 stores under this prototype and convert an additional 400, it should end the year with more than 50% of stores under the Beyond model.
Digging into profitability
Five Below showed margin expansion this quarter after several quarters of margin contraction due to significant deleveraging.
Operating income grew 20% year-over-year to $225.8 million, and net income grew 22% to $171.3 million. Gross margin also expanded:
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Gross margin and operating income increased mainly due to the cost management strategies that management put in place to fight inflation in 2022. The additional growth in net income came primarily from a lower tax rate this quarter.
The 2020-2022 period was strange for most companies. First, we had a pandemic met by an unprecedented fiscal and monetary stimulus. This stimulus and a crippled supply chain ended up creating rampant inflation. For this reason, it’s difficult to draw conclusions from this period, and we prefer to see where we are today compared to 2019 :
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This quarter’s margins came in pretty close to those of 2019 despite all the things that have impacted profitability throughout the pandemic period. It seems like management’s cost reduction efforts bear fruit, and we expect margins to expand when cost inflation comes down (which will inevitably happen).
Zooming out and looking at the full fiscal year, we can see that margins contracted . This is normal considering there was a margin contraction in the year’s first three quarters. Margins throughout the year suffered the impact of deleveraging due to a 2% drop in comparable sales. Costs to run stores are mostly fixed (employees, merchandise, energy…), so when comparable sales decrease, so do margins.
The inverse is also true, though. Some quarters ago, management argued that we should see leverage (so margin upside) with a 3% positive comparable sales , but they took this “estimate” down this quarter (emphasis added):
I think the bigger part of that is as we move forward, our expectations are that we should see greater leverage as we've moved forward into out years, and potentially at a 3% or lower comp as we start to leverage on those investments we've made over the years, like distribution and corporate overhead in areas like that. So, I do think we have the ability to lever at a lower than a 3% comp, or slightly lower than a 3% comp.
Source: Ken Bull, Five Below CFO, during the Q4 2022 earnings call .
In plain English, this means that if Five Below’s comparable sales grow at 3% or slightly lower than this number, we should see continued margin expansion. This was not the case in 2022, so we saw margin contraction.
Solid cash flow and balance sheet
Operating cash flow decreased by 4% this year but remained relatively resilient considering the drop in net income (-6% Y/Y).
Despite the drop in margins and overall profitability of the business, management maintained a good deal of capital expenditures, although these decreased by 13%. This decrease made Free Cash Flow increase by 58% year-over-year to $62 million:
Note, though, that this increase in Free Cash Flow will probably be temporary because management guided for $325 million in capex for 2023, a 29% year-over-year increase. The company will open a record 200 stores, remodel 400 to the Beyond model and spend a bit of the capex on the expansions of two distribution centers. The company is currently in “expansion mode,” so we are not worried about Free Cash Flow today. We’d rather see management spend it in new stores from which the company earns an excellent return.
This cash generation capacity further strengthened the company’s financial position this year. The company started the year with $342.1 million in cash and ended it with $399.2 million, with no debt in either period.
Note though, that store locations are leased. Even though operating leases don’t count as “official debt,” we should count them as such because they constitute an obligation for the company. Due to additional store openings, operating lease liabilities (those that must be serviced in under one year) increased 22% to $199 million. Operating lease assets (i.e., the total liability of the leases) increased 15% to $1.3 billion. When taking these into account, Five Below is in a net debt position:
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The good thing about leases is that they give management much more flexibility than debt does. Debt is a somewhat fixed expense, whereas operating leases are variable and allow the company to downsize quickly if needed. Of course, there are also disadvantages of not owning the locations, like being subject to rent raises.
All in all, Five Below is a cash-generating and cash-rich business, which will come in handy with high interest rates (emphasis added):
With our strong cash balance and healthy free cash flow generation combined with higher year-over-year interest rates, we are assuming a significant increase in interest income this year .
Source: Ken Bull, Five Below CFO, during the Q4 2022 earnings call .
Qualitative highlights
Inventories back to normal, just as management announced last quarter
Inventories have been a hot topic in the retail industry for some time now. Some people argued that a fast rise in inventory levels across many retail companies showed a weakening consumer. Five Below also saw its inventory increase relatively fast throughout most of 2022, but according to management, this was a conscious decision to prepare for the holiday season:
We strategically accelerated inventory receipts to ensure a great in-stock position for the holiday season.
Source: Joel Anderson, Five Below’s CEO, during the Q3 2022 earnings call .
Management also noted that after the holiday season inventory growth rates would normalize:
We continue to expect the growth in average year-over-year inventory per store to moderate significantly by the end of the fourth quarter.
Source: Ken Bull, Five Below’s CFO, during the Q3 2022 earnings call .
Once again, management demonstrates it can be trusted . Inventory increased 16% year-over-year but only 3% on a per-store basis.
It’s great to partner with a management team that knows its business, can look ahead and be right. For example, when Five Below started the year weakly, the stock dropped like a rock to $113. Back then, management said they expected the consumer to unfreeze and that the situation would improve throughout the year. That’s precisely what happened, and Five Below reported an outstanding Q3, significantly beating all expectations.
New positions in the management team - COO and CIO
Five Below announced two changes to the executive team. First, Ken Bull, the current CFO, will now operate as COO (Chief Operating Officer) and will be focused on the company’s triple-double vision. Five Below announced its triple-double vision in 2022, through which it plans to triple the number of stores through 2030 and double its sales and earnings through 2025. The company is already actively searching for a new CFO.
Joel Anderson also announced that Amit Jhunjhunwala, the CIO, will now report directly to him. Data and technology are becoming increasingly important for Five Below, and this change reflects just that.
Guidance - Impacted by timing and wide ranges
Due to the uncertain economic environment, management provided wide ranges for its guidance numbers. At first glance, guidance doesn’t look exceptional, but we must consider all the context.
Quarterly guidance
Management expects sales between $723 to $735 million in Q1, which translates to 14% growth at the midpoint . Sales growth will be driven by 25 store openings and a 2.5% to 4% increase in comparable sales.
Net income is expected to be between $33 and $37 million, a 7% growth year over year at the midpoint.
So, a couple of things here. First, Q1 sales are impacted by fewer store openings than in 2022 . In the comparable quarter, management opened 35 stores, so opening fewer stores obviously affects the growth rate.
Then, as you can see, there will be net income margin contraction. This is strange considering comparable sales will grow at or above the threshold for leverage which we discussed earlier. Management argued that the reason for the margin contraction was that marketing expenses are going to ramp up this quarter.
Yearly guidance
Management expects net sales between $3.49 to $3.59 billion, 15% growth at the midpoint . Net income should come in around $295 to $323 million, or an 18% increase year-over-year at the midpoint.
Context is needed here too. First, the company’s fiscal year 2023 will have an additional week , adding around $40 million in sales and $0.08 in EPS. Without this additional week, growth would be slightly lower.
We must also consider that store openings will be more back-ended this year, opening a larger number of stores in the second half. This obviously has a negative impact on growth, although management expects to return to opening 50% of stores in each half of the year in the coming years.
Thirdly, the increase in net income will most likely come from the interest income we discussed before thanks to the company’s rich cash position. Management only expects slight leverage in operating income in 2023 . This operating income will come from lower freight costs which will be offset by the unlapping of several cost mitigation strategies, which were one time.
We don’t see anything in the guidance that makes us worried about the thesis and we believe management continues to execute well.
Conclusion
Five Below, Inc. reported an okay quarter. There was nothing extraordinary but nothing worrying, either. The company is back on the growth path and will invest aggressively in 2023, laser-focused on its triple-double vision.
Expectations were high coming into earnings and the stock is not cheap, but we will hold all of our shares.
In the meantime, keep growing!
For further details see:
Five Below's Q4 2022: Is The Thesis Busted?