Will This Teen Retailer Become the Next Victim of Wal-Mart's Small Store Push?

Source: Five Below

At an investor conference in March 2014, Wal-Mart (NYSE: WMT  ) disclosed plans to roll out more of its small stores in the near future. It expects to increase its Neighborhood Market store count from 346 in fiscal 2014 to over 500 in fiscal 2015; Wal-Mart Express stores will potentially grow from 20 locations to over 120 over the same period.

While dollar store operators are expected to bear the brunt of Wal-Mart's small store format expansion, an unexpected victim could be Five Below (NASDAQ: FIVE  ) , a teen-focused specialty value retailer that offers convenience and low absolute prices. Given Wal-Mart's traditional strengths in wide product assortment and 'every day low prices', can Five Below compete successfully on the basis of either product differentiation or cost effectiveness?

Source: Five Below

Product differentiation strategy
Five Below differentiates itself from its peers by leveraging major brands & licensed products and creating an unique shopping experience.

Five Below's brands and licensed merchandise include Star Wars, Transformers, and Hello Kitty, among others. While this is undoubtedly a crowd puller, these licensing agreements aren't exclusive in nature. This means that nothing stops competitors like Wal-Mart from selling similar products if they become hot sellers at Five Below.

Five Below also adopts shopper-friendly elements such as a consistent floor layout with easy-to-navigate sightlines and novel merchandise displays (e.g. placing items in wheelbarrows and barrels) in its stores to engage its customers. Again, competitors can easily duplicate these features in their own stores as well.

Sustainable differentiation strategies are rare in the retail industry, as there aren't any barriers to imitation. Five Below is no exception.

Low cost strategy
For the past five years from fiscal 2010 to 2014, Five Below has maintained its gross margin within a narrow range of between 32%-35%. Over the same period, its operating margin has increased from 5.5% in 2010 to 10% in 2014. This suggests that Five Below has managed its cost structure well. There are two key reasons for Five Below's consistently high margins (and low costs).

Firstly, Five Below has adopted a store-clustering strategy with most of its stores concentrated on the eastern side of the country. Over the years, it has expanded strategically, filling up individual markets with a sufficient number of its stores before expanding to adjacent states. In 2013, Five Below targeted the Austin and Dallas markets; it expanded into Tennessee and Houston this year.

More telling was the fact that Five Below opened eight new stores in Houston on a single day in June, which ties in closely with its store clustering strategy. By opening multiple stores in a concentrated geographical region, Five Below can spread its fixed advertising and distribution costs over a larger revenue base in a short time.

Secondly, Five Below carefully 'edits' its product assortment to ensure that it only stocks 'trend-right' merchandise. As a result, it boasts a relatively low number of SKUs at approximately 4,000, which helps keep its inventory holding costs low. 

Five Below's relatively low cost structure enables it to price its items below $5, which makes its products affordable for its customer base. It's estimated that more than 60% of Five Below's customers have annual incomes below $75,000. However, it's unlikely that Five Below will be able to match Wal-Mart's low costs and low pricing.

With revenue close to 900 times that of Five Below, Wal-Mart's purchasing power with suppliers is unrivaled by any competitor including Five Below. Moreover, both dollar-store operators and retailers like Five Below have traditionally relied on product unbundling to sell individual items (in smaller quantities) at low absolute prices. On an apples-to-apples comparison (same quantity of identical items), Wal-Mart has the ability to price its products much lower.

The results speak for themselves. Wal-Mart's gross margin of 25% is almost 1,000 basis points lower than that of Five Below; its inventory turnover ratio is close to double that of Five Below. This suggests that Wal-Mart has always been willing to price its products aggressively in exchange for significantly higher volumes.

Foolish final thoughts
In my opinion, Five Below is a well-run retailer that leverages both product differentiation and low-cost strategies to carve out a profitable niche for itself. Unfortunately, like other retailers, it's equally defenseless against a tough competitor like Wal-Mart wading into its turf, especially with respect to Wal-Mart's huge cost advantage.

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Read/Post Comments (5) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 06, 2014, at 10:09 AM, ElmerBling wrote:

    Who actually writes these articles? You can write an article on Wal-Mart and practically any retailer out there. Five Below is aimed at teenagers and pre-teens. Wal-Mart isn't aimed at that age. Or, actually, they are aimed at every age. This is just lazy writing....or just a filler.

  • Report this Comment On July 06, 2014, at 10:16 AM, ElmerBling wrote:

    Who actually writes these articles? You can write an article on Wal-Mart and practically any retailer out there. Five Below is aimed at teenagers and pre-teens. Wal-Mart isn't aimed at that age. Or, actually, they are aimed at every age. This is just lazy writing....or just a filler.

  • Report this Comment On July 06, 2014, at 1:50 PM, alexa3458 wrote:

    While they may target a younger crowd their prices can't be beat for phone covers, tablet and phone accessories. For summer items and exercise items. I found the BEST water infuser bottle there! And if you're a sunglass junkie well....You have to know your pricing as they are higher on a lot of the same items you can find at Dollar Tree for yes, $1.00 Personally I try to avoid Wal-Mart when at all possible. They've destroyed more than they've created and their greed to dominate at any cost is just something I can't stomach.

  • Report this Comment On July 07, 2014, at 9:20 AM, JamesCage wrote:

    Interesting article. Innovation and new strategies will help retail's manage their products and ensure they stay competitive by improving their shipping and delivery systems to meet the changing and ever growing consumer demand. I came across a whitepaper about this very topic that readers will also find very useful @ Count, manage and move: Warehouse inventory control strategies

  • Report this Comment On July 07, 2014, at 10:15 AM, jimman300 wrote:

    I wonder if this author as even been in a Wal-mart Neighborhood market store or a Wal-Mart Express???? Their Market concept is Grocery only, not a competitor of FIVE below. And their Express concept is just like a normal walmart, only smaller because it’s designed to go into small towns or urban areas. It's like a Walgreens or Dollar General with a heavy focus on grocery. Since FIVE below goes into suburban strip centers there is NO OVERLAP with an Express Store. I would wager you a guess that there is a super walmart within 5 miles of EVERY currently open Five Below RIGHT NOW so there is NO additional competition from them that doesn't already exist. Apparently this author doesn’t do his homework.

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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8/31/2015 3:59 PM
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