Is Five Below Worthy of This Post-Earnings Rally?

Five Below may have traded higher after it reported earnings, but two things within the report might make you think twice about chasing these gains.

Apr 1, 2014 at 1:45PM

Five Below (NASDAQ:FIVE) traded with double-digit gains after it reported earnings on Tuesday March 25, 2014. However, what caused those gains was a combination of low expectations and a somewhat beaten down stock.  Thus, relative to the other dollar stores like Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR), did it deserve these gains, and will it continue to trade higher?

Five Below soars after earnings
In a retail environment with tight prices and thin wallets, dollar stores and value retailers have performed well and shown above-average growth.

Five Below is a smaller company within this space that operates 304 stores in 19 states. With fourth-quarter revenue of $212 million, it saw growth of 22.1%. With that said, Five Below's revenue and profit both exceeded expectations, and the company gave no further warnings on traffic or pricing pressure. As a result, its shares reacted in a favorable manner and they currently show a 13% gain.

2 key problems worth noting
While Five Below's earnings look OK on the surface, investors should take two key metrics into consideration. First, Five Below's comparable-store sales grew just 0.3% year-over-year and the company's year-end store count at 304 increased 25% over the prior-year total.

So, what makes these two metrics so important? Well, obviously the company's year-over-year revenue growth in the fourth quarter came in below its store expansion. In retail, companies grow either by expanding their store counts or through expanding comparable-store sales, which means more customers at existing stores. Five Below has clearly not driven more traffic into its existing stores and it has been growing by adding new stores. The fact that revenue growth came in below the rate of expansion could signal weak performance at new stores, a bad sign for investors.

For example, Dollar Tree operates 4,992 stores and in the fourth quarter it opened 51 stores and closed 12 stores, but those additions alone won't drive significant top-line growth. Hence, Dollar Tree's 6% revenue growth in 2013 did partially come from expansion, but it also came from a 2.4% increase in comparable-store sales, which is a ratio needed for long-term survival in retail.

Dollar General also competes with Five Below and it is even larger than Dollar Tree with 11,132 stores. It grew its total sales by 9.2% and increased its same-store sales by 3.3% last year. Now, the company's guiding for first-quarter same-store sales growth of 2%-3% in the first quarter, slightly less than Five Below's 3%-4% growth guidance, yet Dollar General saw a stock price loss of 5% when it announced its guidance.

Essentially, Five Below is only growing because  it's small enough to expand, and over the long-term this is not a winning formula. Also, a lack of existing store growth could affect the company's ability to grow its margins over the long-term. Overall, this signals that Five Below's strong post-earnings reaction resulted more from the headline numbers than the data inside its quarterly report.

Final Thoughts
At 37 times next year's estimated earnings, Five Below is quite pricey and perhaps too expensive given the fact that year-over-year store expansion becomes more difficult as a company's store count grows larger. Dollar General and Dollar Tree both trade at 14 times next year's earnings, which is a much more favorable ratio going forward. Considering Five Below's expensive stock price in combination with the two noted concerns, it is rather difficult to say that the stock deserved its post-earnings reaction. 

With that said, if you're looking for safety in these uncertain times, Dollar General and Dollar Tree are both good picks. Also, because Five Below has an over-inflated valuation relative to its growth, either Dollar General or Dollar Tree will likely outperform Five Below as well over the long-term.

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Brian Nichols 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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