Five Below: Rapid Expansion In Full Swing

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About: Five Below (FIVE)
by: David Krejca
Summary

Five Below is a rapidly expanding U.S. discount store.

The company has an outstanding new store economics and is just at the early beginning of its expansion.

Valuation suggests the company’s shares could provide a superior long run return potential.

Investment thesis

Five Below (FIVE) is a small U.S. rapidly expanding retailer with its presence established in 33 states. As the company’s expansion is still just at its very beginning and valuation of the company is attractive from a long run perspective, I believe the company’s shares are poised for a massive rally.

Corporate profile

Founded in 2002, Five Below is an American discount retailer currently operating in 33 states. The company’s product portfolio is primarily made of $5 U.S. dollar and below items which are targeted primarily on the pre-teen and teen population. Besides popular brands, the company is also capitalizing on various ‘craze trends’ items such as selfie sticks, yoga mats and camera drones. As of February, the company’s total store count has exceeded over 700 stores, with 67 new stores being opened during the second half of 2018. As of February, the company’s workforce had approximately 2700 full-time employees and 9400 part-time personnel who is trained to quickly identify relevant merchant trends and introduce them to the company’s business. The company is also just two years on its way of selling on the internet as it commenced selling merchandise as late as in August 2016.

Earnings surprise’s inflection point

Big picture shifts can be observed even on the company’s track record of earnings surprises. Over the last five years, only this year the company has managed to exceed analysts’ earnings expectations. This suggests the company’s business might have passed an inflection point after which a series of earnings surprises will be a new normal.

Source: F.A.S.T. Graphs

Accelerating expansion

As already mentioned in the paragraph above, this year the company has already managed to open over 67 stores which is more than a half of the current year’s store openings target. Last quarter, the company opened 34 new stores and this quarter, it plans to open approximately 50 new ones. This approximates an average annualized growth of almost 20 percent and the company’s expansion seems to be just at its very beginning. According to the company’s latest investor presentation, the company is roughly just at one-fourth of its way to an estimated target potential of 2500 stores across the United States.

Source: Five Below September 2018 investor presentation

Best in class new store metrics

The reason behind and one of the key drivers of the company’s rapid expansion is Five Below’s exceptional store economics. Based on the company’s stats, its average store 4-wall EBITDA accounts to $450K, whereas its average net store investment totals $300K. This implies a 150 percent average first-year ROI and a payback period of less than one year.

Source: Five Below September 2018 investor presentation

Toy opportunity ahead

An interesting point discussed during the second quarterly earnings call was also a so-called toy opportunity which, according to Five Below’s management, emerged largely due to the displacement of the company’s popular Toy ‘R’ Us and a fresh demand for new toys. This specific product demand is particularly heavily weighted to the fourth quarter as Christmas plays a strong seasonal note.

Solid financials and outstanding profitability

From the perspective of financial statements, Five Below has a solid debt-free balance sheet with an ample cash which provides sufficient liquidity for its operations. Looking at cash flow statements, the company can be clearly marked as a cash cow. Over the past several years, Five Below’s funds from operations have consistently grown and net operating cash flow to sales ratio has been steadily expanding. In terms of ROA, ROE, and ROI, the company belongs to the top of the industry, delivering two to three times higher returns than the industry averages.

Valuation

Plugging-in Five Below's financial statements' figures into my DCF template, the company appears to be currently slightly overvalued. Under perpetuity growth method with a terminal growth rate of 2 percent, constant 25 percent annual revenue growth over the next five years and 12 percent EBIT margin, fair value of the stock comes at US$74.9. Under the EBITDA multiple approach of a discounted cash flow model, the intrinsic value per share value of the company stands roughly at US$100.6 if we assume that the appropriate exit EV/EBITDA multiple in five years' time is around 15x.

Source: Author's own Excel model

Based on different valuation technique commonly-called as Peter Lynch earnings line, Five Below's shares look a lot more attractive. Using the Fast Graphs forecasting calculator with a default 30 percent adjusted operating earnings growth rate assumption, the company's intrinsic value by the end of December FY2024 is forecasted to reach US$262.7, which implies a total annualized rate of return upside potential of more than 19 percent.

Source: F.A.S.T. Graphs

Lastly, in the light of revenue variation of Five Below's popular earnings line for the projection of intrinsic per share values of the company, Five Below's shares appear to set to provide a positive rate of return. According to my model, assuming 25 percent annual revenue growth, zero percent annual equity dilution factor, a price-to-sales PS ratio of 4x, the company's per-share intrinsic value by the end of 2021 is forecasted to be roughly US$177. This suggests an average potential annualized rate of return of around 14 percent in the following years.

Source: Author's own Excel model

Key risks

  • The company may fail to successfully implement and execute its strategy on a timely basis or not at all, which could harm its growth and operating results.
  • Any failure or disruption in the company’s ability to select, obtain, distribute and market merchandise attractive to customers at prices that allow the company to profitably sell such merchandise could negatively impact the business.
  • Any failure to attract and retain qualified personnel could adversely affect the business.
  • Any disruption to the company’s distribution network could adversely impact sales, costs or the company’s ability to successfully roll out new stores.
  • Extreme weather conditions or natural disasters could negatively impact the company’s operations and financial results.
  • The company may become a subject of a litigation or negative publicity which may adversely affect its reputation and financial results.
  • The company operates in a competitive environment and therefore faces constant pressure on margins.
  • The seasonal nature of the business could negatively impact the company’s operating results.
  • The company’s profitability is vulnerable to inflation, cost increases, wage rate increases and energy prices.
  • General economics weakness might negatively impact the company’s financial results.
  • Changes in state or federal regulations could negatively impact the company’s operating results.

The bottom line

To sum up, Five Below is an outstanding company with an extraordinarily consistent growth. The company has strong unit economics which facilitates its expansion across the United States. As Five Below's management expressed in the latest investor presentation, it believes the company is just at the beginning of its business expansion. This lofty ambition backed by a solid ongoing development provide a healthy base for continued growth.

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Disclaimer: Please note that this article has an informative purpose, expresses its author's opinion, and does not constitute investment recommendation or advice. The author does not know individual investor's circumstances, portfolio constraints, etc. Readers are expected to do their own analysis prior to making any investment decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.