Five Below: Proceed With Caution

| About: Five Below (FIVE)

Summary

Five Below is a value retailer that benefits from structural tailwinds and strong pace of store openings.

The company projects that growth continues at a rapid pace through 2020.

I see risks to the strong pace of growth and the valuation, making me very cautious on the prospects for the shares.

Five Below (FIVE) is a specialty retailer that sells a wide range of cheaper merchandise for teens and pre-teens. The company has reported very strong growth in terms of sales and earnings in recent years, but its stock has been trading in a $30-$50 range since its IPO in 2012.

The reason for the lagging performance is the very high valuation, as the shares still trade at 36 times trailing earnings. While the company projects growth to continue for years to come, I think shares are not very appealing at the moment due to the high valuation and potential risks to the growth story. As a result, I continue to approach the shares with caution, having a slightly bearish stance.

Solid Current Momentum

Dollar stores, and similar retailers that focus on great value have fared relatively well in recent years. This has even been the case as the economy has emerged from the great recession.

These tailwinds have aided Five Below in showing solid comparable growth results in recent years, as the company has been very aggressive in expanding the store base at the same time.

The company reported a 23.6% increase in its fourth-quarter sales, which advanced to $326.4 million. Store openings are responsible for the majority of growth, as comparable store sales growth came in at 3.6%, marking a slight acceleration from the full-year growth number of 3.4%.

The good news is that fourth-quarter operating earnings grew by 27.3% to $67.4 million. This means that operating margins improved by roughly half a percent to 20.6% of sales. The combination of margin expansion and sales growth obviously had a good impact on the bottom line.

The solid momentum is required as full-year earnings amounted to just $1.05 per share. With shares trading around the $38 mark, this results in a fairly expensive price-earnings ratio of 36 times earnings.

More Growth Is Required, Looking At The 2020 Plans

At the end of 2015, Five Below operated 437 stores, which seems like a lot, yet it only had a presence in 27 states. The company has outlined some goals for the next four years, such as an average of 20% sales growth through 2020.

Based on the 2015 full-year sales of $832 million, sales are seen at roughly $2 billion, if Five Below can deliver on its promises. The company guides for +20% growth in terms of earnings, as after-tax earnings now amount to nearly 7% of sales. If the company can deliver on after-tax margins of 8% by 2020, earnings could amount to $160 million five years down the road. If we assume that the outstanding share base remains constant between now and then, earnings could come in around $3 per share.

The company has a solid financial base to fund the planned growth as it holds roughly $100 million in cash and equivalents. Another pro for the business and its management is the strong track record in terms of growth in recent years.

As Five Below grows bigger, it is hard to maintain the percentage increase in revenues, as can be seen in the 2016 guidance. Sales are seen at $995 million to $1.005 billion, which at the midpoint suggests that full-year sales growth is seen at 20.2%, just above the 20% target. Part of the somewhat softer outlook is driven by the fact that comparable store sales growth is anticipated to slow down to roughly 3%.

However, some margin expansion is foreseen for the upcoming year. Earnings per share are projected to come in at $1.27 to $1.31 per share, a 23% increase as the midpoint of the range.

Worries About Growth and Competition

At the moment, Five Below is still benefiting from strong momentum, but I see two main concerns to the 2020 guidance. One of the major concerns is the fact that the company could start cannibalizing itself, as it faces a lot of pressure from the law of big numbers as well, making it hard to sustain its revenue growth.

The other worry is the impact of competition, and not just from dollar stores. With online shopping becoming more pronounced, and delivery costs being included into subscriptions like Amazon.com's (AMZN) Prime, consumers are likely to shop for smaller items as well. To put it bluntly, if I had to make a bet, I see greater chances for the scenario in which growth lags the 20% projection compared to the scenario in which it surprises to the upside.

Final Remarks

While investing is always a balancing act between risk and potential returns, these risks and the high current valuation explain my caution. If the company delivers on its 2020 targets, shares now trade at roughly 13 times 2020 earnings.

Yet, if Five Below can report an earnings per share number of $3 by 2020, while it maintains the solid pace of growth, I see no reason why shares should not trade at 20-25 times earnings that year. This translates into a $60-$75 price target; however, I don't see shares reaching that target before 2020. This leaves upside of 60%-100% from today's levels, which translates into capital gains of 10%-15% per annum, if everything goes according to plan.

If growth comes in at just 15% per year, earnings come in closer to $2 per share. With a 20 times market multiple, shares would only be worth $40 in that case, similar to where the stock trades today. That would imply that investors would not see any capital gains for five years to come, even as the company continues to grow at a solid pace.

The potential upside is not a compelling enough reason to buy the stock, so I'm bearish on this name.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in FIVE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.