Five Below Is Looking Up Again

With margins and expenses holding up well, Five Below compares favorably to other established value clothing retail concepts, especially after the 25% sell-off.

Jan 11, 2014 at 7:30AM

Any hot growth stock that trades at lofty valuation multiples typically becomes more attractive after a cooling-down period. One such company is Five Below (NASDAQ:FIVE), whose stock doubled after a successful IPO. Following a quarter that disappointed most investors, the company's stock recently plunged around 25%; this provides a potentially ideal entry point for long-term investors. 

Five Below is a specialty value retailer that offers teen- and pre-teen-targeted merchandise. The company offers products priced at $5 and less, providing a general comparison to the dollar-store concepts. The retailer is growing exceptionally fast, with its 2013 store openings increasing 25% over the previous year. Five Below also recently opened an incredible 11 stores in the Dallas market on the same day in September, generating the largest single-day grand opening in company history.

Both of these situations question where the fast growth rates might impact margins and operation efficiency. In general, the third-quarter margins were very solid. Without any notable teen value retailers for comparison, a good point of view might be the dollar stores that offer a wide variety of products. Their longer-term track records and store bases should offer clues regarding Five Below's margins and operations. Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR) both have substantially larger store bases and operating histories, providing opportune margin comparisons to see if Five Below is staying on track.

Solid margins
With the breakneck pace of growth for Five Below stores, margins and comparable sales will be the first metrics that investors need to review each quarter. Sales cannibalization from too many stores will quickly turn comparable sales negative. Growing too fast will also impact operational efficiency, causing margins to weaken. Either one will crush a stock still trading at 45 times forward earnings estimates.

Currently, the margin story remains strong for Five Below, with gross margins sitting at the 31% level. Sales, general, and administrative expenses declined to a still rather high 26.8% as compared to 27.2% in the year-ago period. The fast growth rate doesn't appear to be impacting the retailer yet, with earnings expected to surge 40% this year. In addition, comparable sales surged 9%; this suggests that cannibalization of existing store sales is not an issue.

Next, we'll see if the numbers from Five Below stack up well against the established dollar-store concepts.

Dollar Tree impresses
Dollar Tree has impressive numbers that could be a long-term target for Five Below. For the third quarter, the company achieved gross margins of 35% and SG&A expenses equal to 24.2% of revenue. These impressive numbers helped operating income reach an impressive 10.8%, though this was down slightly from the 11.1% for the first three quarters of the year. Note that the operating margin is more than double the 4% posted by Five Below.

Dollar Tree operates nearly 5,000 stores in 48 states and five Canadian provinces. Even with a market cap of nearly $12 billion, the company's stock continues to trade at a forward price-to-earnings ratio of more than 17.

Dollar General in its shadow
Dollar General is the giant of the industry, with a nearly $20 billion market cap and an incredible 11,000 store base covering 40 states. Interestingly, the company isn't able to match the margins generated by its smaller rival Dollar Tree.

For the third quarter, Dollar General had gross margins of 30.3; this was down 61 basis points as compared to the third quarter of 2012. More important, SG&A expenses declined to only 21.4% of sales during the quarter, which compared very favorably to 21.8% during the prior-year period. The substantially larger store base and years of operations allows for Dollar General to better spread its costs among its stores. It is interesting that Five Below is able to achieve similar gross margins, however.

Dollar General is generating so much free cash flow that the company has already repurchased $1.3 billion worth of stock. It also has an additional $1.2 billion authorized.

Bottom line
In general, Five Below has relatively impressive margins for a young, fast-growing retailer. Naturally, the more established dollar-store retailers generated higher operating margins. Five Below's numbers highlight a growing retailer that should be able to double its operating margins in the long term. Investors will want to key in on these margin and expense numbers in future quarters to ensure that ultra-fast growth isn't hurting operations. Five Below wouldn't be the first retailer that ran into problems from growing too fast. The recent $14 decline in the stock price does provide an interesting opportunity for long-term investors.

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Fool contributor Mark Holder has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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