My top consumer goods growth stock to buy right now is discount retail chain Five Below (FIVE -1.12%). This company isn't curing cancer, splitting the atom, or landing humans on Mars -- it's simply a retail chain that specializes in toys, candy, and other novelty items for teens and preteens.
Nevertheless, this seemingly mundane business can be a spectacular long-term investment. Just ask anyone who bought shares of Five Below's initial public offering (IPO) in 2012. Their investment is up more than 10 times in value from the IPO price of $17 per share in less than 10 years -- returns many investors aspire to.
And the exact factors that made Five Below a winner since its IPO are still working to make Five Below a market-beating investment going forward. Here's why.
Image source: Five Below.
Profitable growth
When it comes to growth stocks, investors typically overlook net losses. And indeed, that's appropriate in certain situations. For example, it's reasonable for a software company to lose money early on, since it's expensive to build the product. However, profit margins increase with new customers because they're selling the same software product over and over again. Therefore, it makes sense to overlook losses for a young software company with a rapidly growing customer base.
By contrast, investors should not overlook losses with a retail business like Five Below, as profits are realized on individual sales. Fortunately, Five Below doesn't report any losses -- the company is solidly profitable. In 2020, it reported net income of $123 million (a 6.3% net profit margin), despite the challenges from the pandemic. And through the first three quarters of 2021, it's reported net income of $139 million (a 7.5% margin).
Keep in mind that Five Below has produced healthy profits even as it's expanded rapidly -- some retail companies promise profits "someday" with supply chain efficiencies. Not Five Below. The company is on pace to open 170 new locations this year (approaching 1,200 total), more than twice as many locations than the 522 it had at the end of 2016. And yet it's been profitable all along.
Underpinning this profitable expansion is Five Below's unit economics. New stores cost $300,000 on average but generate $450,000 in earnings before interest, taxes, depreciation, and amortization (EBITDA), meaning the payback period is less than one year on average. Those are stellar returns, and management is wise to aggressively open new locations as long as the return on investment is this good.
Possibly better profitability to come
Five Below is currently marching toward its long-term goal of owning more than 2,500 locations -- more than double what it has right now. Assuming the unit economics we just looked at hold up, this will be a business generating much higher profits in time. However, there's reason to believe its operations can gain more operating leverage with scale.
Five Below just opened a fulfillment center in Arizona in the third quarter of 2021 and only just fulfilled its first order from there in September. Another center is currently being built in Indiana. These locations are necessary to support 2,500 stores someday. But in the meantime, they're more of an expense than a savings.
However, as new stores are opened in proximity to new distribution centers, Five Below can start recognizing the efficiencies that come with these new facilities. According to management, with the Arizona and Indiana facilities, it will have the infrastructure to support 2,000 locations. This means it probably only needs one or two more distribution centers to get to 2,500 locations. And once those are built, higher profit margins will be possible.
Current valuation
Valuation isn't typically discussed with growth stocks, but I believe investors today are paying a price that's more than fair for Five Below stock.
FIVE PS Ratio data by YCharts
Since going public, Five Below stock has traded at cheaper and more expensive price-to-sales and price-to-earnings multiples. Its current valuation is neither expensive or cheap but rather within its normal range: fair.
However, paying a fair price for a quality company like Five Below feels like a rarity these days -- you typically pay up for quality in the stock market. Five Below has proven it's a quality company, and yet the valuation means the investment make sense today for those willing to hold for the next five years and more.
However, a closing word of caution: As a retail business, there could be lumpiness in Five Below's results. Expect occasional quarters of underperformance followed by a negative overreaction from Wall Street. The stock has dropped 20% or more many times in the past decade. But this kind of volatility isn't a risk for buy-and-hold investors -- as long as the company is expanding profitably, I expect it will be a market-beating investment over the long haul.
