Is It Time to Bet on the Story at Five Below?

Source:  Five Below.

Investors in niche retailer Five Below (FIVE -2.01%) have been waiting for a breakout quarter to put some momentum behind the company's stock price, which has underperformed the major market averages over the past 12 months. Fortunately, they may have gotten it in March, as the company reported better-than-expected profitability and a slight increase in its all-important comparable-store sales. The results were enough to excite Mr. Market, propelling a subsequent double-digit gain for Five Below's stock price. So, is it time for investors to bet on the story with conviction?

What's the value?
Five Below competes in the ultra-value price segment of the retail industry, offering nearly everything in its stores at price points between $1 and $5. It generally focuses on the teen crowd, though all ages are apparently welcome, with an eclectic mix of products skewed toward the technology accessories, sports, and crafts categories. Five Below's ability to stay in touch with its core demographic's changing tastes has allowed it to generate a favorable multiyear growth trajectory in sales and profits, which has allowed it to internally fund a rapid store expansion over the past five years.

In its latest fiscal year, Five Below reported very solid numbers. Results were highlighted by a 27.8% top-line gain that was aided by the continuation of comparable-store sales growth as well as a more than 25% increase in its overall store network. The company's merchandise margin dipped slightly during the period, likely due to the effects from a highly promotional selling environment. But Five Below benefited from its larger size by creating efficiencies in its back-office operations, leading to a strong gain in its operating profitability. The net result for Five Below was improved operating cash flow that is funding the company's national expansion strategy, including plans for another large addition to its store base in 2014.

Baked in the cake
Certainly, Five Below's recent top-line growth has been admirable, given the difficulty that portions of the retail universe have had in generating similar growth profiles, a trend that has been especially prevalent among other teen-focused retailers. The trouble is that Five Below's stock price already reflects much of its relative outperformance, currently trading at a P/E multiple of more than 50. As such, investors have a choice of holding their noses and buying in, or, more wisely, looking for less expensive plays in the ultra-value price segment of the retail industry, like Dollar General (DG -0.89%).

The kingpin of the so-called dollar stores only sells a portion of its products for $1 anymore, roughly 25% at last count. But it continues to offer compelling values for its customers, as evidenced by a rising stream of people who find their way into its stores each year. Despite omnipresent competition from big-box retailers in most of its markets, Dollar General uses convenient locations and unbeatable low prices to win its fair share of customers' household spending. It's a strategy that has culminated in 24 straight years of comparable-store sales gains.

In FY 2013, Dollar General's recipe for success continued to be a winning formula. Results were highlighted by a 9.3% top-line gain that was a function of higher comparable-store sales and a modestly larger overall store base. While the company's merchandise margin fell compared to the prior year, partially due to a new focus on lower-margin food products, its operating margin remained above the 9.6% average of the past five years. More important, Dollar General's operations continued to generate strong operating cash flow, easily funding its growth plans while providing opportunities to return capital to shareholders.

Also in the value-priced camp is Dollar Tree Stores (DLTR -1.11%), a smaller competitor to Dollar General that remains true to its name by selling substantially all items in its stores for $1 or less. Like Dollar General, Dollar Tree has captured perennial increases in per-store sales by making its stores ultra-convenient for customers while also incorporating product lines into its business mix that lead to greater visit frequencies. Not surprisingly, the company's strategy produced similarly positive results in FY 2013, including rising comparable-store sales and higher operating cash flow, which is funding the continuation of its growth story in 2014.

The bottom line
Five Below is undoubtedly a solid growth story, as evidenced by a strong double-digit top-line gain in FY 2013. Unfortunately, everyone already knows it, which causes the company to sport a market valuation at nosebleed levels. As such, the rewards don't outweigh the downside risks, and investors should avoid this story until the euphoria subsides.