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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.