This Specialty Retailer Might Be Growing Too Fast

This Specialty Retailer Might Be Growing Too Fast

"Hot Stuff. Cool Prices." That's Five Below's catchy slogan, likely to appeal to its teen and pre-teen target market. But the slogan doesn't seem to be the only appealing aspect of Five Below. With net sales jumping 33.1% year over year to $95.6 million in the first quarter, it would seem as though this stock has all the potential in the world. But things aren't always as they seem.

Substantial growth
From that 33.1% sales growth, you would likely assume that the company's strategy of selling everything in the store for $5 or less was working exceptionally well. In truth, it's a mixed bag.

While newer stores, not yet open 15 months, saw sales increase $20.8 million for the quarter, sales at existing stores only improved by a much less significant $3 million. The company opened 50 stores in 2012, but has 258 stores total, which means that the older stores carry a lot more weight. For many retailers, new stores tend to drive a lot of traffic at first, as consumers want to check them out. But over the long haul, only a percentage of those shoppers return.

This news isn't truly bad -- it's just not as exciting as the numbers indicate. First-quarter comps still improved by 4.2% year over year, with transactions rising 2.7%, and average dollar volume moving 1.5% higher. These are definitely positive trends, as is net income, which swung from a $2.7 million loss last year to a gain of $1.6 million this time around. This turnaround stemmed from the aforementioned improvements in number of transactions and average dollar volume, coupled with increased sales thanks to new store openings.

The point here is that while Five Below is performing well, it's important to keep in mind that a lot of the perceived success stems from its aggressive growth strategy. Five Below continues to open stores at a rapid rate. In fact, it plans on opening 60 stores this year. But what might really blow your mind is that Five Below wants its store base to grow at a rate of 20% annually over the next five years, and it ultimately plans on reaching a store count of 2,000. Remember, there are currently just 258 stores.

Five Below relies on hot teen and pre-teen trends, and almost everything it sells is discretionary. That poses a dual threat to the company. First, if its merchandise misses one of the current trends, which will likely happen at some point, its sales would be hurt significantly. Second, if consumer confidence weakens, customers will likely spend less on discretionary items.

Additionally, competition could increase at any time due to a relatively low barrier to entry. Five Below hasn't fortified its position in the market through a strong geographical presence and brand recognition. However, it's attempting to accomplish those goals. While they're not direct threats, dollar stores could still steal Five Below's market share

Safety in numbers and trends
In addition to real-world threats for Five Below, one of its key metrics might raise investors' concerns. Five Below is trading at 49 times forward earnings, which makes the stock expensive and sets expectations very high. If Five Below were to run into an unexpected problem in its supply chain, inventory, or anywhere else, then the stock could take a hard hit -- every long investor's worst fear.

While teens and pre-teens don't often plan to visit Dollar Tree and Dollar General with their friends, they do shop at these stores for similar items -- bracelets, plastic storage containers, markers, folders, notebooks, and more -- from time to time. And their parents might also shop at these locations for them.

These dollar stores are likely to be safer investments than Five Below because they sell consumer staples as well as discretionary items. And if the consumer weakens, dollar stores -- unlike other retailers -- have the potential to actually see increased traffic.

Dollar Tree and Dollar General are also trading at lower multiples than Five Below: 16 and 14 times forward earnings, respectively. Furthermore, it should be noted that the short positions on these stocks are low, at 1.40% and 2.40%, whereas the short position on Five Below is substantially higher at 14.20%, indicating a lack of broad investor confidence.

History sometimes repeats itself
Five Below founders David Schlessinger and Thomas Vellios started the educational toy store Zany Brainy in 1991. After a phenomenal start, the company filed for bankruptcy in 2001. Schlessinger blamed rapid growth in a sluggish retail environment. This is somewhat concerning, since his current company's situation is beginning to mirror that of its predecessor.

However, there's one big difference between Five Below and Zany Brainy thus far, which relates to being overaggressive. Zany Brainy's acquisition of 60 Noodle Kidoodle stores for $35 million in April 2000, just after the tech bubble peaked, played a significant role in its downfall.

Either Schlessinger and Vellios are on the path to making the same mistake twice due to their desire for rapid growth, or they have learned their lesson, and will effectively grow Five Below organically without making any risky or ill-timed acquisitions.

Five Below's growth potential is evident, but management seems to be a little too aggressive on its growth goals. Relying almost 100% on discretionary items is a high-risk strategy, and the stock is trading at 49 times forward earnings, which could set it up for a nasty fall. While Five Below still has upside potential, I think its downside risk is too high. You're likely to be much safer in Dollar Tree or Dollar General.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

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