Five Highlights From Five Below's 10-Q

What you need to know from Five Below's December 6th 10-Q

Jan 29, 2014 at 5:16PM

Quarterly reports can be a treasure trove of information for investors but their short-term nature and less detailed information than annual reports can make it hard to separate the treasure from the junk. On Dec. 2 Five Below (NASDAQ:FIVE) filed their third quarter 10-Q and here are the top five treasures.

Continued growth
For the quarter ending Nov. 2 the company saw net sales rise 27.9% and net income rise 130%. For the same quarter Dollar Tree Stores (NASDAQ:DLTR) reported a rise in net sales and a fall in net income of 19.3% but a rise of 32.4% when excluding the $60.8 million earned from the 2012 sale of the company's investment in Ollie's Holdings. While Dollar General (NYSE:DG) reported a 10.5% rise in net sales and a 14.3% rise in net income. Not only did Five Below outperform the competition but for the most part they also outperformed themselves from a year earlier. For the quarter ending Oct. 27, 2012 Five Below saw net sales rise 39.9% and net income rise 65.7%.

Such short-term information usually isn't all that relevant for long-term investors but the case of Five Below is an exception. As a young company Five Below is neither well established nor in possession of an adequate track record. Additionally, as a growth stock, much of the stock's performance is dependent upon growth that is superior to that of the competition. All factors combined make for an investment with a higher degree of risk and a higher need for more frequent monitoring.

Mixed margins results
While Five Below's operating margin increased from 0.84% to 1.51%, their gross margin fell from 31.1% to 30.9%. The company is still behind the respective gross and operating margins of Dollar Tree of 35% and 6.7%, as well as the respective gross and operating margins of Dollar General of 30.3% and 5.4%. As a smaller and still growing company it is to be expected that Five Below will have smaller margins but as the company scales it is expected to rise. 

Their growth in their operating margin allowed net income growth to outpace growth in net sales by such a great amount. A gross margin of 0.2% less may not appear very significant, but becomes more so when pieced together with past quarters. One year ago the company had reported a gross margin for the quarter of 31.1%, up from 29.7% a year prior. The company is too young to start drawing trends but this is definitely a segment to pay attention to in the future.

Discussing margins is irrelevant without reviewing the information behind the numbers. Cost of sales rose 28.3%, or in absolute terms, nearly $17 million. Much of the rise was caused by factors expected to rise with sales but the recent addition of a second distribution center resulted in $1.8 million in additional costs. This was responsible for the company's gross margin falling slightly, rather than continuing to rise. With net income for the quarter of only $1.7 million, this one expense clearly had a significant impact on the bottom line. The good news is that as the second distribution center becomes more utilized, its effect on the margins should decrease.

SG&A expenses rose 24.4%, mostly because of higher store opening and corporate related expenses. Five Below forecasts continued growth in the aforementioned categories as well as in compliance with the Sarbanes-Oxley Act. As long as the rate of growth continues to trail that of net sales there should be no problem.

Falling quick ratioBetween Feb. 2 and Nov.2 Five Below nearly doubled their inventory. In the process of doing so they spent 90.1% of their cash and dragged their quick ratio from 1 to 0.42. It is true that Five Below is in growth mode and a company does need to reinvest in order to continue generating a return on capital but allowing their quick ratio to fall below 1 adds an extra degree of risk that needs to be taken into consideration.

However, Dollar Tree and Dollar General have respective quick ratios of 0.33 as of Nov.2 and 0.18 as of Nov. 1, showing that Five Below is still well ahead of its peers. Assuming Five Below is able to sell just 36% of their inventory, their current ratio of 2 leaves them able to cover off all of their current liabilities with money left over. Comparatively, the respective current ratios for Dollar Tree and Dollar General are 1.94 and 1.66.

Store Count
In March of 2013 when Five Below filed their 10-K, the company reported that they planned to expand their then-current number of stores of 244 by 60 throughout fiscal 2013, up from 56 throughout fiscal 2012. Five Below met that goal with a quarter to spare. and as of Nov. 2, 2013 the company operated 304 stores.

Unless the company continues expansion throughout the remainder of the fiscal year their growth rate will come in at 24.6%, a decline from 29.2% for fiscal 2012, and 35.2% for fiscal 2011. Five Below believes they can one day reach 2,000 stores but the company is going to have to keep up a consistent rate of expansion if they wish to reach that target sooner than later.

The Foolish bottom line
Five Below had a more than satisfactory third quarter and going forward looks like a solid buy for investors comfortable with a degree of risk. I view the disruption in the company's gross margin to be a temporary disruption and view now as an opportunity to buy. In the future I would recommend paying close attention to the company's ability to maintain growth until they are able to develop an adequate record of profitability and a healthy balance sheet, as well as their ability to maintain a constant rate of store expansion.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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