2023-06-06 11:16:24 ET
Summary
- Five Below's growth is primarily driven by an increase in store count rather than same-store sales growth.
- The company's aggressive expansion strategy may be risky during an economic slowdown, potentially impacting profitability.
- The current valuation is significantly higher than other retail companies, making it difficult to justify its price.
- I rate the company as a sell.
Investment Thesis
Five Below ( FIVE ) rallied over 7% on Friday after reporting its latest earnings and the company is now up over 60% from its 52-week low. The market is encouraged by the results but I am not buying into the optimism.
While the company demonstrated solid revenue growth, most of it came from the increase in store counts rather than same-store growth. The aggressive expansion in store count seems like a risky move as the economy continues to slow. The company will likely face increasing pressure moving forward as most of its products are discretionary with little differentiation. The current valuation is also very expensive and offers little to no margin of safety. Therefore I rate the company as a sell.
Underwhelming Q1 Earnings
Five Below announced its first-quarter earnings last week and the results are pretty underwhelming, especially the bottom line. The company reported revenue of $726.2 million, up 13.5% YoY (year over year) compared to $639.6 million. The growth is mostly driven by the increase in store count, which grew 11.6% YoY from 1,225 to 1,367. While store growth was solid, same-store sales growth was weak, indicating slowing demand. Comparable sales were only up by 2.7%, driven by a 3.9% increase in transactions, partially offset by a 1.2% decline in basket size. The gross profit increased 13.6% from $206.8 million to $234.8 million. The gross profit margin was flat YoY at 32.3%.
The bottom line was pretty weak due to the increase in spending amid new store openings. SG&A (selling, general and administrative) expenses as a percentage of revenue increased 80 basis points from 25.7% to 26.5%, largely driven by marketing initiatives and store-related expenses. The elevated spending resulted in the operating income being flat YoY at $42 million. The operating margin also declined 80 basis points from 6.6% to 5.8%. The diluted EPS was $0.67 compared to $0.59, as the company benefited from higher interest income.
Potential Headwinds
Five Below growth thesis relies heavily on new store openings rather than same-store sales. As mentioned above, store growth contributed 10.8 percentage points of revenue growth in the latest quarter, while comparable sales only grew 2.7%. According to the management team , the company plans to triple its store count from 1,200 to 3,500+ by 2030, with 200 stores being opened this year. This model performs well during economic expansion periods but it is quite risky to grow store count aggressively during an economic slowdown with a potential recession coming.
Joel Anderson, on new store openings
We now expect to reach a milestone of over 200 new stores this year, while building our pipeline for next year and beyond. In the first quarter, we opened 27 new stores across 19 states.
Due to slowing demand, new stores might not be able to hit their sales expectation and the payback period will lengthen meaningfully. This will weigh heavily on profitability as costs and expenses for new stores are often fixed yet sales growth stalls. The issue is already starting to emerge in the latest earnings as the operating margin declined from 6.6% to 5.8%.
Besides, the growth rates of existing stores will also be impacted by the slowing demand. Comparable sales growth is now down to just 2.7% and I expect further decline moving forward. The company mainly sells toys, tech, and party-related products, which are very discretionary. Their target demographic is also mostly teens, which usually have low spending power. This makes the company highly exposed to a slowdown as their spendings are usually the first to get cut down.
Unjustified Valuation
After the huge rally in the past year, Five Below's valuation is once again very elevated. The company is currently trading at a PE ratio of 38.3x, which is pretty much the highest among all retail companies. As shown in the chart below, it is much more expensive than other best-in-class retail companies including LVMH ( LVMUY ), Ulta Beauty ( ULTA ), and Tractor Supply ( TSCO ). The peer group has an average PE ratio of 23.2x, which represent a substantial discount of 39.4% compared to the company. These companies also have better fundamentals and resilience in my opinion (I have covered the three companies before so feel free to check out their respective article). Given the valuation gap, it is simply very hard to justify Five Below's current valuation.
Investors Takeaway
I believe the market is way too optimistic about the outlook of Five Below. Top-line growth is purely driven by store count increases while same-store sales growth remains compressed. I am also skeptical about the sustainability of aggressive store expansions during an economic slowdown, which may end up weighing on the bottom line instead. Valuation is also a huge issue here, as it is trading at a substantial premium compared to peers. If growth were to slow, we would likely see meaningful downside potential. I believe it is too risky to own the company right now and I rate it as a sell.
For further details see:
Five Below: Too Risky To Own After Earnings