- FIVE's current valuation of $2.0 billion is far too high for a retailer that generated only $76m of adjusted LTM EBITDA.
- Specialty retail is rife with historical examples of emerging concepts that have disappointed investors time and again. We discuss Francesca's, Denninghouse, Potbelly's and other brands whose valuations were overly optimistic.
- Many overhyped emerging retailers see dramatic multiple contractions as initial success ultimately succumbs to the brutally competitive nature of retail.
- Obstacles include copycat competitors, execution issues related to rapid expansion off of a larger store base, merchandising misses, price undercutting by lower cost incumbents, etc.
As we described in our last article, Five Below (NASDAQ:FIVE) trades at too high of a valuation for a discount retailer with mediocre same-store sales growth, average margins, and an insufficiently differentiated business model. The company's current valuation of $2.0 billion is far too high for a retailer that generated only $76m of adjusted EBITDA over the last twelve months. We think it's highly improbable that FIVE can meet the very lofty expectations that are built into the company's sky-high 50x LTM P/E multiple.
The retail landscape is littered with the bodies of overhyped emerging concepts whose expansions failed to meet the market's expectations, and who've seen dramatic multiple contractions as initial success ultimately succumbed to the brutally competitive nature of retail. For every Chipotle, there are dozens of Potbelly's (NASDAQ:PBPB) and Body Centrals (OTCQB:BODY), concepts that fell short of the generous expectations cast upon them during their initial years of rapid store expansion. In early years, emerging retailers can post promising financial metrics, driven by a large proportion of new stores as a percentage of their overall store base. Same-store sales growth can be rapid, as many stores are still in ramp-up mode and are handily lapping prior year revenue figures. Margins are steadily rising, boosted by increased SG&A leverage as fixed costs like corporate overhead are spread across a larger revenue base, as well as by increased profit per store as a large number of young stores mature. For FIVE, for instance, we saw 12% same store sales growth in 2009 and 16% in 2009, but that figure dropped to 4% last fiscal year and is projected to only be 4% in FYE 2014 (FY ending 1/31/2015). FIVE's EBITDA margin expanded from 8% in FY 2009 to 14% in FY 2013, but now sits at levels higher than most other dollar stores.
As concepts mature, cracks begin to show in emerging retailers' abilities to maintain healthy margins and same-store sales growth while simultaneously increasing unit growth by 20%+. Expanding a store base from 100 to 125 is far easier than expanding from 400 to 500. Obstacles that emerging retailers face as they enter the intermediate stages of their growth trajectories include:
- Success in Specialty Retail Invites Competition - FIVE is Easy to Copy. Five Below does not have a patent on the concept of a dollar store catering to a teenage demographic, and copycats can pop up next door in each of FIVE's strip malls to provide the same sorts of products and target the same customer demographics. This risk can be particularly pronounced for retailers that don't sell proprietary products, because competitors can source cheap knickknacks from the same Chinese manufacturers as FIVE while arranging them in a colorful fashion in aisles labeled "NOW". FIVE may have been the first mover to coin the NOW aisle heading, but the pre-teen of 2017 won't differentiate much between the trinkets at Five Below and copycat competitors.
- Trends Change - FIVE will Invariably Experience Merchandising Misses. As discussed in our prior article, we believe merchandising plays a greater role at Five Below than at other dollar stores. FIVE caters to teens and pre-teens, which is one of the most fickle demographics. Tastes change on a quarterly basis, and FIVE is prone to missing a merchandising trend periodically. Should stores focus on Candy Crush-themed water bottles this summer or Angry Birds? Below-the-knees swimming trunks, above-the-knees or mid-thigh? Because FIVE sells "trend" merchandise to a fickle market (teens and pre-teens), inventory that goes unsold is likely to be rendered obsolete, unlike the inventory at discount retailing peers which make more of their money selling non-perishable household consumables (such as batteries and toilet paper).
- Compounding Growth Creates Execution Challenges - FIVE Has to Open a LOT of Stores. In its initial years, FIVE could focus its expansion plans on a smaller number of units per year. For instance, when FIVE had 100 stores, to grow units by 25% management only needed to focus on building out 25 new stores. At a 400 store count, 25% unit growth translates to 100 new stores. Negotiating a new lease, building out a store interior, hiring new store staff, arranging a new distribution route, and sourcing additional merchandise on an average of once every three and half calendar days becomes too daunting, and store growth decelerates.
- As Specialty Retailers Grow, They Enter Less Attractive Markets - New FIVE Stores Will Likely be Less Profitable Than Original Stores. As specialty retailers expand, investors consistently overestimate the incremental profits from expansion. In the initial years of a specialty retailer's growth trajectory, it expands into its most attractive markets first. It is during this period that investors tend to reward retailers with high valuation premiums, assuming future growth will be as profitable as past growth, generally extrapolating past revenue per store, sales per foot and margins well into the future. However, after a time, the best markets have been utilized and retailers are forced to enter 2nd and 3rd tier locations which are naturally less profitable.
- Sales Per Square Foot Reach Peak Levels Across a Higher Proportion of the Store Base, Resulting in Stagnant or Declining Overall Growth Given that Unit Growth is Falling. In the intermediate phase of a retailer's growth trajectory, a large proportion of the store base may be reaching peak sales per square foot levels, as growth begins to plateau in a store's second, third or fourth year of operation. The combination of slowing unit growth and peak-level store metrics can result in growth rates that are too low to justify the emerging retailer's sky-high valuation multiples. Retailers are not software companies that can massively scale a fixed cost base, and use technology to rapidly expand their customer bases. Rather, to justify 50x LTM P/E multiples, brick-and-mortar retailers must expand units at a torrid pace and do so with flawless execution. As we'll see with FRAN later in this article, this goal is often too daunting.
In this article, we will explore from several different perspectives how difficult it is for a discount retailer to grow into a 3.4x LTM sales and 50x LTM P/E multiple. First, we'll present two case studies. The first is Francesca's (NASDAQ:FRAN), a recent high-flyer that has seen its stock price decline approximately 45% since its 2011 IPO (inclusive of the first-day IPO "pop") and its valuation multiples cut nearly by half after the company failed to match its historical same-store sales growth metrics. The second is Denninghouse, a Canadian dollar store retailer that experienced a rapid growth phase marked by high same-store sales growth, expanding margins and rapid unit growth only to ultimately go bankrupt in the mid-2000s. In addition to showing how once-promising financial metrics can dramatically reverse course for a retailer within a matter of years, the Denninghouse example also demonstrates how fragile the discount retailer business model really is.
Then we'll review a long list of growth-oriented retailer IPOs over the past five years that have failed to meet market expectations, showing just how common it is for emerging retailers to see operating metrics fall back to earth as they enter the intermediate stages of their growth trajectories. As these metrics return to normalcy, so too do valuation multiples, and we routinely see 3x+ revenue multiples contract to 1x-2x, and P/E multiples fall from 50x to 15x-25x.
Case Study: Francesca's
Francesca's is an instructive example of a specialized retailer that witnessed a dramatic decline in overall sales growth, same-store sales growth (SSSG) and valuation in the years subsequent to its IPO. Francesca's offers fashion apparel, jewelry and accessories for women between the ages of 18 and 35. FRAN went public in 2011 at an eye-popping EV/Sales and EV/EBITDA valuation of 8x and 31x, respectively (inclusive of the customary IPO "pop" after first-day trading).
FRAN: Stock Price Performance Since 2013
At the time of its IPO, FRAN's story had numerous parallels with how sell-side analysts currently describe FIVE.
Sell-side Analysts on FRAN at IPO (2011)
Sell-side Analysts on FIVE (Current)
"We believe FRAN possesses one of the most compelling growth stories in softlines with only 249 boutiques and long-term potential of reaching ~900 stores nationwide. Moreover, the company's boutique, "treasure-hunt" feel continues to drive comps with +6.6% projected for F11, after +15.2% in F10 and +9.8% in F09" - Wedbush, 8/25/2011
"FRAN is a fast fashion women's retailer positioned to capitalize on today's value conscious consumer. Francesca's currently operates 249 stores in 38 states within the U.S., and has the potential to reach 900 stores in the next 7-10 years. Square footage is growing at ~25% annually and we expect ongoing infrastructure investments and benefits of scale to yield 25-30% annual earnings growth in the long-term." - Jefferies 8/31/2011
"The shares are not inexpensive, but we believe they offer an entry into the early stages of a long and visible growth story. Plans call for 75 new stores annually for the next several years, fueling expected square footage growth upwards of 20% (36% in 2011) and bringing the store base to about 900 locations." - RBC 8/31/2011
"Strong store economics are only half the story. Even more exciting is the long term square footage growth story. FIVE currently has 304 stores, and this concept warrants 2000+ stores nationwide." - Janney Capital Markets 2/5/2014
"While the shares are likely to respond well to this release, we think the stock still has a favorable long-term outlook. It has a significant growth opportunity and an unmatched offering, in our view. We project these factors should enable it to generate 25% plus earnings growth for an extended period of time." - UBS 3/25/2014
"Five Below is in an elite class of high growth retailers, with a differentiated value oriented concept, exceptional and consistent new store economics, and a huge store growth opportunity that can continue at the current pace for 20+ years" - Wells Fargo 6/14/2014
While analysts were correct that FRAN would quickly expand its geographic footprint, FRAN's same store sales growth declined significantly over that time. Interestingly, FIVE's revenue growth and SSSG trend is strikingly similar.
FRAN vs. FIVE: Revenue Growth and Same-Store Sales Growth Decline
Similar to FIVE, FRAN has witnessed a sharp SSSG growth deceleration since 2012. On the Q1'13 earnings call, FRAN's management attributed the 2.0% SSSG to inclement weather, much like FIVE's management did for the Q4 2013 slowdown.
This decrease was driven by lower than expected transaction volume as a reflection of the unseasonal -- unseasonable weather conditions that persisted throughout the quarter. We've heard many retailers call out the negative impact of unseasonably cold weather on store traffic, and we were not immune to this trend. - Mark J. Vendetti, FRAN CFO on Q1'13 Earnings Call on 06/05/2013
Yet SSSG still hasn't adequately recovered and has continued on its downward trajectory. Interestingly, SSSG for the following quarter was -1.0% (management previously guided towards a 1-2% increase); however, management could not blame the weather again for the decline. The same-store sales decline was purely attributable to a decline of transaction volume.
Comparable sales decreased 1%, including direct-to-consumer. This compares to a 21% increase in comparable sales in the same period last year, which has been restated to include direct-to-consumer sales. As Neill highlighted in his comments, this decrease was driven by a 4% decrease in comparable transaction volume, which we believe was representative of lower consumer traffic overall. - Mark J. Vendetti, FRAN CFO on Q2'13 Earnings Call on 09/04/2013
FRAN: SSSG Trends Since 2010
Unfortunately for FRAN, the deteriorating operating performance has translated directly to a declining stock price and valuation. Since its IPO, after accounting for the customary pop that occurred on the day of the IPO, FRAN's stock price has since declined by 47%. Also, FRAN's EV/Revenue and EV/EBITDA multiples have tumbled to 1.8x and 7.5x, respectively, a far cry from the 8x EV / revenue and 31x EV / EBITDA valuation the day after its IPO.
FRAN: Valuation Decline Since IPO
On its latest earnings call, FRAN's management described the difficult retail environment as well as the challenges related to keeping ahead of trends for its targeted customer demographic.
Overall, the retail environment has been challenging since the beginning of the calendar year, with soft traffic trends and competitively aggressive promotions. The cumulative effect of these trends has limited the effectiveness of our merchandise clearance strategies, and has created bottlenecks in inventory flow for newness.
Our customer demographic trends respond best to well-edited assortments, newness, and lower price point items with a higher perceived value. Although motivated, she is not heavily interested in clearance. Even with our short lead times, we struggled to effectively clear during extended periods of slow traffic, and have limited space to maneuver from an inventory perspective. - Neill Davis, FRAN President and CEO on Q1'14 Earnings Call
This commentary highlights the difficulty of managing merchandise for a fickle demographic. While FIVE has been fairly successful with its concept thus far, the company is still in the early innings of a long and difficult road to national expansion. We believe that FIVE is prone to missing a merchandising trend periodically and that a severe miss has the potential to trigger a significant valuation correction, particularly if FIVE mismanages a holiday quarter.
Overall, we feel that FRAN's trends and history offer investors valuable lessons in what could go wrong with a fast-growing retailer. Like FIVE, FRAN also benefited from high SSSG, high revenue growth and sell-side analyst optimism during its early part of the growth phase. As FRAN is now in the intermediate stage of its expansion plan, it is having a challenging time managing a significantly larger store base. New competition, the challenge of managing exponential growth, combined with being forced to enter 2nd and 3rd tier markets, has led to the declining revenue and SSSG growth trend that have severely impacted FRAN's valuation. Interestingly, FRAN continues to rapidly expand store count (25% increase in FY 2013), but that has not masked other fundamental issues that we've outlined. We believe that FIVE's recent trends imply a similar trajectory and that it's only a matter of time before investors are less optimistic about FIVE's overhyped potential.
Case Study: Denninghouse
Next, we'll examine Denninghouse, a concept that operated in the same segment as FIVE: discount retail. Just like FIVE is now a darling among sellside analysts who cover dollar stores, Denninghouse was once Canada's hottest discount retail growth brand. Despite growing its store count and revenue nearly 1,000% over a 10-year period and achieving record financial results nearly every year, Denninghouse's competitive position was quickly ravaged by competition, resulting in the company's bankruptcy in 2004, only 2 years after it achieved its most profitable year in existence. The Denninghouse story offers instructive lessons for investors in easy-to-copy specialty retail formats.
Denninghouse: Stock Price Performance from 2001 - 2005
(Source: Denninghouse annual report)
Denninghouse was a Canadian discount specialty retailer that operated the "Buck or Two" stores - a line of small-format retail stores, averaging ~3,000 square feet, that sold a variety of seasonal and everyday items below a C$2.00 price point. Denninghouse started with a single store in 1987, and grew modestly until its management decided to pursue an aggressive franchising strategy in 1992.
(Source: Denninghouse public filings)
Over the next decade, Denninghouse's growth exploded. Within only six years, Denninghouse become the largest discount retailer in Canada, with over 200 stores across Canada and system-wide sales of nearly C$130 million. As Denninghouse grew, shareholders benefited from its attractive unit-level economics. Denninghouse operated with a very small store format - approximately 3,000 square feet - and thus it posted strong sales per square foot of ~C$240.00. Given the minimal costs to open a store, Denninghouse was able to attract hundreds of franchisees, more than doubling its unit count again between 1998 and 2002, peaking at 328 stores in 2002.
During its growth years, Denninghouse had many stark similarities with FIVE today:
- Denninghouse was a Canadian discount retailer that went through a rapid growth phase, going from only a handful of stores in 1987 to 328 stores by 2003 (given the Canadian market is approximately 1/10th the US market, that is equivalent to a penetration of about 3,200 stores in the US. To further put that in context, FDO, DG and DLTR currently have approximately 8,000, 11,000 and 5,000 stores in the United States, respectively)
- Denninghouse also focused largely on selling seasonal items and close-out merchandise, rather than consumables and household items which correspond to a more recurring revenue stream.
- Denninghouse also sold its products at a relatively higher gross margin than its competitors (Denninghouse gross margins were in the high-30%'s, versus low-20%'s for Wal-Mart).
- Denninghouse also had attractive unit-level economics, with a small-format store (~3,000 square feet) and sales per square foot in line with industry levels at the time (C$240/foot).
Despite putting up incredible growth and record profits year-after-year, Denninghouse blindsided investors with an incredibly rapid deterioration in profits. Denninghouse went from hitting record profits in calendar 2002 to being bankrupt by 2004! So how did Canada's leading national discount retailer go from setting record profits, to going bankrupt, in only 2 years?
(Source: Denninghouse public filings)
Seasoned investors could see troubling signs that the company's strategic position was under attack from competition many years before its eventual bankruptcy in 2004.
As Denninghouse grew its store base, it faced the same challenge every high-growth specialty retailer faces: finding attractive locations. Initially, Denninghouse capitalized on its most attractive markets with the best customer demographics and the least competition. However, as the company was faced with the challenge of maintaining its compounding growth, Denninghouse was forced to enter 2nd and 3rd tier markets. These markets were not as attractive as its initial stores, and thus did not have the same store-efficiency. As these stores matured, Denninghouse's growth in same store sales began to show a troubling and precipitous decline several years before its bankruptcy in 2004.
(Source: Denninghouse public filings)
Second, Denninghouse faced the inevitable risk that investors consistently ignore: new competition. Though Denninghouse had a unique specialty retail concept, the company had no sustainable competitive advantages. Its cost basis was not lower than that of its competitors' (including the rapidly growing Dollarama, which was later acquired by KKR). It sold products at a higher margin than did competitors like Wal-Mart and Costco, which left Denninghouse vulnerable to price undercutting by rivals. Its merchandising concept could be easily replicated and the company did not have a brand name or other type of loyalty that could retain foot traffic.
Like FIVE, Denninghouse merely provided a niche merchandise offering which was successful while it was a small, nimble retailer. But once Denninghouse became large enough and competitors took notice, Denninghouse's strategy was quickly copied and the company's sales and profits were decimated. When explaining how Denninghouse went from achieving its peak profitability in fiscal year 2003 to a record reversal only a year later, the MD&A explained:
The Company attributes these declines to increased competition as the number of stores operating within this retail sector continues to increase and other retail formats including supermarkets are testing or adding "dollar sections" within some of their stores. - Denninghouse MD&A, FY2004
FIVE will Not Go Bankrupt, but the Denninghouse Example Demonstrates Why It Shouldn't Be Trading at 50x P/E
Over the coming years, FIVE will face all of the challenges that Denninghouse faced during its torrid expansion, and eventual implosion, several years ago. However, given FIVE's current valuation at 50x PE, investors have given themselves little margin of safety for any operational missteps or competitive pressures.
Perhaps most significantly, FIVE is set to face a torrent of new competition from copy-cats. Like FIVE, Denninghouse was a leading discount retailer with phenomenal growth, great unit economics and a niche strategy. However, Denninghouse, like FIVE, had minimal sustainable competitive advantages. Once it became large enough that competitors took notice, Denninghouse and its shareholders were caught blindsided by the competitive attacks from copy-cat retailers and established incumbents. Denninghouse went from its most profitable year to bankruptcy in only 2 years! Investors could have seen troubling signs in Denninghouse's same-store-sales years before its eventual bankruptcy.
As we referenced extensively in our prior article, FIVE shareholders should be particularly concerned given that Wal-Mart's small-format stores, which are arguably the biggest competitive threat for the retailer, are expected to make significant inroads into the discount retailing market next year. Dollar General has already indicated a plan to attack FIVE's market aggressively. Despite these incredibly hostile competitive threats, investors appear to be valuing FIVE as if its growth was almost certain - we think this is a terrible risk/reward.
Second, FIVE must continue to call the trends amongst its fickle teenage clients correctly. Given that FIVE is a heavily seasonal retailer and generates almost all of its operating profit during the holiday (Q4) quarter, competitors like Dollar General and Wal-Mart can make very targeted attacks on the company through national, regional and online advertising campaigns in order to draw foot traffic and steal customers during the key holiday season. It will be very difficult for FIVE to differentiate itself going forward.
Third, FIVE's management will have to overcome the challenge of executing and managing exponential growth - it is much tougher to grow unit count 20% off a 300-store base than it is a 100-store base. FIVE's management must now execute a new store expansion every few days, rather than every few weeks, and this could place tremendous pressure on IT systems, logistics, managerial talent, not to mention sourcing greater volumes of inventory over an ever-expanding store-base.
Finally, FIVE will have to find new locations with attractive economics. Like Denninghouse, FIVE is already showing signs of having difficulty in finding new attractive stores, given falling same-store-sales growth and plateauing margins. Below we show charts demonstrating how same-store sales growth has been declining over the past three years, and how margins have flattened at their current level.
Same Store Sales Growth (Quarterly)
EBITDA and EBIT Margins Flat Since 2011
Specialty retailers have few lasting sustainable advantages. We believe that over the coming quarters, FIVE will face incredibly difficult competitive and operational challenges, and think that investors have fundamentally overestimated FIVE's strategic position in the marketplace.
Recent Emerging Retailers That Have Disappointed Investors: Is FIVE next?
To further illustrate how investors often overestimate profits and growth rates in the specialty retail sector, we examined a screen of retail IPOs since 2010. Below we show a lengthy list of companies that have IPO'd over the past five years that featured rapid unit growth and / or lofty valuation multiples at the time of IPO. These once overhyped IPOs offer investors a valuable lesson: seemingly fast-growing concepts at inflated valuations can quickly lose momentum and fail to live up to expectations. Potbelly's, Sprouts Farmers Market, Tilly's and Francesca's, all highlighted below, illustrate how that can happen.
Select Retail IPOs Since 2010
Tilly's is a good example of a specialized retailer that has drastically failed to live up to expectations. Tilly's offers casual clothing, footwear and accessories, and, similar to FIVE, its products are targeted for the teen and young adult demographic. Also similar to FIVE, Tilly's had high growth expectations due to its significant "white space" opportunity to expand into other states. At IPO, Tilly's operated 140 stores and was expected to expand that to ~500. When Tilly's launched its IPO, both sell-side analysts and investors were overly optimistic. A quote from Stifel's research analyst summarizes the bull case at the time.
The outlook for the company is favorable, in our opinion, given its business model of offering a fast-turning assortment of men's and women's apparel, shoes and accessories that is comprised of trend-right California inspired fashion brands. Tilly's square footage expansion of +15% is likely for the foreseeable future, as it grows from a California-centric 145 location store into a national retail chain of over 500 stores. We anticipate comp store sales gains as new stores ramp-up with the potential for operating leverage. - Stifel Nicolaus, 5/29/2012
Unfortunately for Tilly's investors, the company has since underperformed and the stock price has declined by over 50% since IPO. Same-store sales growth (SSSG), which seemed to be on an upward trajectory, has reversed. Valuations have come down significantly. After its IPO, Tilly's was valued at EV/Sales and EV/EBITDA of 1.3x and 10x, respectively; in contrast, Tilly's EV/Sales and EV/EBITDA multiples today are 0.4x and 3.6x.
Below is Tilly's same-store sales growth over the past five years:
Tilly's Same-Store Sales Growth Since FY 2010
Potbelly's, Sprouts Farmers Market and Francesca's are also examples of other recent retail IPOs that have failed to live up to expectations. Both Potbelly's and Sprouts were hot IPOs that saw their respective stock prices increase by 120% and 122%, respectively, on the day of IPO pricing. Since those highs however, the stocks have come crashing down in light of tempered expectations, and both Potbelly's and Sprouts' stock prices have declined by 49% and 24%, respectively. Valuation expectations have also been tempered. Potbelly's and Sprouts were valued at 31x and 49x EBITDA following their IPOs, but those multiples have contracted to 13x and 27x.
Potbelly's and Sprouts' Declining Multiples
A Closer Look at Potbelly's
Potbelly's is yet another good example of a recent IPO that has seen its stock price dwindle amid tempered optimism. Potbelly's successful IPO was fueled by investors hoping to witness another fast food chain growth darling similar to that of Buffalo Wild Wings (NASDAQ:BWLD) and Chipotle (NYSE:CMG). Similar to FIVE, Potbelly's is expected to have a fairly large geographic expansion opportunity with ~300 shops across 22 states. The optimism around Potbelly's during its IPO sounds all too familiar - much of the hype was around how many thousand stores Potbelly's could eventually grow to. Quotes from analysts at the time of IPO highlight some of the bullish views then.
It is at roughly 300 units today, out of a potential for several thousand, and new unit builds have historically generated 30-40% cash on cash returns. - Goldman Sachs 10/29/2013
Our saturation analysis suggests the potential for at least 1,000 locations, from about 295 domestic locations today, based on one-half of the penetration Potbelly has already achieved in its home market of Chicago. - William Blair 10/29/2013
We are initiating coverage on PBPB shares with an Overweight rating and $34 price target, which is 94x our FY14 earnings estimate. We believe this multiple is warranted given the scarcity value due to very few restaurant growth options from a public company perspective, a proven strategy to continue market share gains, and the pipeline value of future development. - Piper Jaffray 10/29/2013
Unfortunately for Potbelly's IPO investors, the market has unmasked a weak SSSG trend that investors seemed to have ignored at IPO.
Potbelly's Same-Store Sales Growth Since FY 2009
The Container Store: Disappointing Growth Drags Down Share Price
The Container Store (NYSE:TCS) is a retailer of storage and organization products that went public in late 2013. At IPO, investors were enamored with this retailer with "hard to contain competitive advantages", resulting in shares closing 96% above its IPO price. At IPO, TCS was similar to FIVE (and to Potbelly's) as it was expected to have significant white space opportunity with a base of only 63 stores. Sell-side analysts, not surprisingly, had high expectations for this specialty retailer to expand rapidly.
Significant long-term growth opportunity with impressive sustainability and duration of growth. We see potential for 300-350 stores nationally, above management's 300-store guidance (5x-6x the current store base). - Stifel 11/11/2013
Given its small size, just 63 stores and the potential for over 300 U.S. locations, we believe that positions TCS as one of the best growth names in our coverage. - Credit Suisse 11/26/2013
Since its IPO, TCS' fundamentals have deteriorated and as a result, the share price has declined 39% from an all-time high of $47.07 in late 2013, and is down 20% since its IPO. SSSG, revenue growth and EBITDA margins have all since declined since the IPO.
The Container Store: Five-Year Historical Snapshot
TCS' mediocre results have translated to an underperforming share price; in 2014 alone, TCS has declined 39%.
The Container Store: One-Year Share Price Performance
These examples all paint a similar picture: inflated expectations around overhyped retailers with seemingly unlimited geographic expansion potential often lead to disappointment. Time and time again, emerging retailer investors have ignored the fundamentals and have been burned on hard-to-attain promises. There are few retailers who are able to successfully achieve national scale rapidly enough to justify the types of overly optimistic valuation multiples that FIVE is trading at.
As we have illustrated in this article, the specialty retail sector is rife with historical examples of emerging concepts that have let down investors time and time again. We believe investors consistently forget about the natural "pop and drop" of the specialty retail sector. Specifically, the market often forgets that specialty retailers generally lack one of the most important factors that justify high valuation multiples: sustainable competitive advantages.
FIVE has limited competitive advantages. FIVE has no cost advantages relative to its larger competitors, nor does it have any merchandising advantages given its lack of proprietary products. While the idea of tailoring a discount retailer to a teenage demographic has allowed FIVE to make some inroads, it's a concept that can easily be replicated by competitors. Accelerating competition within the discount retail sector, in terms of current dollar stores both expanding units and also introducing higher-priced products to compete with FIVE's five-dollar threshold, as well as the expansion of Wal-Mart's small-format stores, will present serious competitive threats to FIVE as it enters the intermediate stage of its growth trajectory. We wouldn't be surprised if future concepts such as Five Under, Five'N'Less, Less Than Five, Five's Too High, Thrive-Under-Five, Trinkets-For-Teens and other copycats also restrict FIVE's long-term growth and undercut its margins.
Given the pressures ahead, we think that FIVE's 50x P/E and 3.4x EV / revenue multiples are wildly inflated. Analysts are pricing in continued rapid store expansion over the next 5+ years combined with healthy same-store sales growth and sector-leading margins. Even if FIVE executes flawlessly, it will have trouble growing into its $2bn valuation in a reasonable period of time. If, however, there are hiccups along the way, we think that the downside for shareholders could be substantial. Investors paying 50x LTM P/E, 26x LTM EV / EBITDA and 3.4x EV / LTM revenue for FIVE are likely to be as disappointed as those in Francesca's, Denninghouse, Tilly's, Potbelly's and the many other overhyped specialty retailers we have discussed in this article.
Disclosure: The author is short FIVE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Read our full disclaimer at kerrisdalecap.com/legal-disclaimer-3. This is not a recommendation to buy or sell securities. We may transact in securities of FIVE subsequent to publication. The author is also short TCS.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.