Five Below: The Differentiation Problem

Five Below may be today's growth story, but is there room for the newcomer in the face of Goliath-sized competitors?

May 12, 2014 at 11:12AM

Five Below (NASDAQ:FIVE) has made for a great growth story in recent years but still remains a minor player in the dollar-store industry. Its 304 stores pale in comparison to industry leaders like Dollar General (NYSE:DG), which operates 11,215 stores, Family Dollar (NYSE:FDO), which operates over 8,100, and Dollar Tree (NASDAQ:DLTR), which operates 4,992. Five Below may be able to ride the growth of the dollar store industry, but is there enough room for the newcomer if the industry's growth halts or worse, contracts?

Nothing proprietary
Five Below may have a few defense mechanisms to ward off competition but at the end of the day it's a business that would be relatively easy to replicate. Unlike a pharmaceutical or tech company that develops research-intensive products which can be copyrighted, or a company like Coca-Cola with a brand known in households across the globe, Five Below is a young brand with a business model even mom and pop entrepreneurs can copy.

While this does pose a challenge for Five Below, it in no way spells its imminent doom. Unlike their producer counterparts which can copyright the products they derive their revenue from, retailers, no matter how large or unique, cannot copyright their business model. Therefore, since neither Five Below nor its competitors can ever eliminate this risk, it must be treated as a risk when investing in the entire retail sector and not one that is unique to Five Below. Yet even if all retailers face this risk, some face it more than others and this is where the aforementioned defense mechanisms come into play.

A nice niche
While the wording may differ slightly, the business models of the big three are essentially the same: to provide a general assortment of value-priced goods. Instead of this, Five Below focuses on selling an assortment of goods to teens and pre-teens for five dollars or less. Even though there may be some overlap in the products offered between the big three and Five Below, they are selling their products with different strategies and focuses in mind.

One could take this as a new company in a crowded market trying to stand out from the herd with a gimmicky twist, but looking deeper into the four companies' 10-K's it would appear that the big three don't view Five Below as a noteworthy threat, and that Five Below doesn't even view the big three as its primary competitors. Dollar General explicitly calls out Family Dollar, Dollar Tree, Fred's, and the 99 Cent Store as direct competitors before going on to list indirect competitors such as Wal-Mart and Kroger. The closest the company gets to listing Five Below is through listing "various local, independent operators." The same holds true for Family Dollar, while Dollar Tree avoids explicitly naming any competitors. Five Below states that the company "competes with a broad range of retailers including discount, mass merchandise, grocery, drug, convenience, and other variety stores with both physical locations and online stores." This sort of phrasing creates the impression that Five Below views the big three as no greater a threat than companies like Wal-Mart or Rite Aid.

Regional concentration
Five Below
Part of Five Below's growth strategy is to focus on saturating markets with clusters of stores before moving on to new ones. In the face of goliath-sized competition this is definitely a smart move. The power of a strong regional brand is not to be underestimated. New businesses form where the demand is, and by saturating select markets while leaving others unserved Five Below has created a situation where would-be competitors are far more likely to open shop in a state without a Five Below than to go head-to-head.

While regional concentration may help Five Below avoid head-to-head competition, it does come with downsides. Five Below is a growing company not content with remaining a regional power. In fact, the company sees a potential for 2,000 locations. Its current 304 stores leaves room for growth in the regions the company currently operates in, but to reach 2,000 Five Below is going to have to go nationwide. If the company is unable to do so fast enough, they run the risk of another regional power developing and limiting the company's growth potential.

Sometimes size does matter
Five Below's unique niche may be keeping it off of the big three's radar for the time being, but ultimately they or others will try to replicate Five Below's success. Even if Five Below were to suddenly open its 2,000th store, it would still be less than half the size of Dollar Tree. Even so, there is a huge difference between 2,000 stores or even 1,000 stores and only 304, especially when Five Below and the big three aren't technically direct competitors. Five Below sees annual square footage growth of about 20% as a reasonable expectation in the near-term. If such expectations indeed pan out, I see two likely outcomes. The first is that after the eventual arrival of direct competitors Five Below will still be able to claim the title of market leader and thus secure its survival. The second is Five Below is able to seize a large enough share of the 2,000 store potential before the entry of direct competitors that it would make more sense for companies like Dollar General or Family Dollar to buy them out rather than building their own competing brand. While investors should go beyond analyzing a company's competitive position when conducting their due diligence, I do believe that Five Below's competitive position contributes to a long-term buy thesis with a degree of risk which should gradually decrease as time goes on.

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Brodie McLeod has no position in any stocks mentioned. The Motley Fool recommends Five Below. 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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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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