Conventional Dollar Stores Are a Better Bet Than This Company

Five Below (NASDAQ: FIVE  ) is essentially in the same category as Dollar General (NYSE: DG  )  and Family Dollar (NYSE: FDO  ) , because its stores focus on inexpensive fashion, toys, and gift items between $1 and $5. These types of items are usually in high demand by teens and tweens.

Investors who bought this stock at the time of its IPO in July last year are now sitting on gains of almost 65%, which is way above the performance of conventional dollar stores like Dollar General, Family Dollar, and Dollar Tree.

FIVE Chart

FIVE data by YCharts.

When cheap is good
Five Below's performance is not surprising when we consider the reports of weak consumer confidence and a dim job outlook seen last month. In addition, Thomson Reuters/University of Michigan's consumer sentiment index declined in September to a preliminary reading of 76.8 from August's final figure of 82.1.  These indicate that the upcoming holiday season could be a dampener. If we go by ShopperTrak's projections, we are in for the weakest holiday shopping season since 2009.

When consumer spending becomes slow, stores that carry discretionary items feel the heat as consumers look to stretch their dollars. Five Below is performing well because of the price point of the merchandise it sells, hence it is somewhat immune from a slowdown in spending.

The company posted better-than-expected second-quarter results with earnings of $0.11 per share. Total sales jumped 34.9% year over year and came in at $117.1 million.

An aggressive plan
Investors are encouraged by Five Below's aggressive store-opening plan. It plans to grow to 2,000 stores in the future, which is a very aggressive target considering that it currently operates 275 stores. During the previous quarter, the company opened 18 new outlets and saw its store count improve 22% from the prior-year period. Comparable-store sales, or comps, increased 6.6% on the back of strong demand across all segments.

Stretched valuation?
However, after a solid run since the IPO, Five Below is not cheap when compared to peers such as the dollar stores. Let us take a look at a few metrics. The trailing P/E ratio is pretty steep for Five Below compared to its peers; in fact, it's almost 4.5 times greater than its peers'.

FIVE PE Ratio TTM Chart

Even more remarkable are the forward P/E ratios. Five Below is trading close to 63 times its forward earnings, which is way more expensive than the dollar stores. Hence, it is evident that investors expect Five Below to deliver terrific earnings in the future. If the company falls on hard times, the downside could be steep.

Consumer behavior is unpredictable, and I have already discussed the woes of the "three A's" here as an example. There wasn't much wrong with the underlying businesses of the three apparel retailers mentioned in that article, but they still face difficulties due to the changing preferences of their target customers, who are mostly teens.

If Five Below faces similar difficulties, then it is definitely a risky bet at its current valuation. Hence, even though analysts are looking at annual earnings growth of a massive 33% for the next five years, there isn't much downside protection if Five Below falters due to a change in consumer preferences. Therefore, this stock is for those who have a higher appetite for risk.

FIVE Forward PE Ratio Chart

FIVE Forward P/E Ratio data by YCharts.

Safer bets
As seen above, the likes of Dollar General and Family Dollar are safer bets to benefit from sluggish consumer spending. These dollar stores trade at reasonable valuations, have provided steady share price appreciation so far, and have various growth initiatives in place.

For example, Dollar General, the nation's largest dollar store chain, has a network of more than 10,000 stores in 40 states. The company has already opened 375 new stores during the first half of 2013 and has plans to open a total of 650 new stores this year. Moreover, to further improve sales, Dollar General aims to remodel or relocate 550 stores.

The company's recent performance hasn't been bad, either. In the previous quarter, Dollar General reported 11.3% year-over-year growth in sales along with a 11.6% jump in earnings.  Its wide store coverage, aggressive store expansion, and valuation make it a safer pick than Five Below.

On the other hand, Family Dollar provides a decent dividend yield of 1.40%. It has raised its dividend for more than three decades now and the company is also looking to grow its sales further by adding products such as tobacco.

On the previous conference call, management stated that 60% of transactions that involve tobacco also have other items in the shopping basket. Such sales-driving initiatives, along with a wide network of 7,600 stores and a decent dividend, make Family Dollar a safer pick than Five Below.

Five Below has had a great run since it went public, but the stock is quite expensive at its current level. Hence, investors should consider cheaper options such as the dollar stores mentioned above because of their lower valuations and expansion plans.

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