Five Below: Does Growth Support Its Valuation?

Five Below: Does Growth Support Its Valuation?

Five Below had high expectations prior to its IPO, but decelerating growth has caused some to question the company's upside. Therefore, with it priced like Michael Kors and nowhere near becoming the next Dollar Tree , should investors buy?

A deceleration of growth
Five Below became a public company in 2012, with growth of 40% and a business strategy that was reminiscent of Dollar Tree.

Dollar Tree sells everything for $1, and has surprisingly managed to produce operating margins of 12.5%. In fact, Dollar Tree might just be the most efficient retailer in the market. The company has grown to more than 4,200 stores with $7.85 billion in annual sales, and even to this day maintains growth of 9%.

On the other hand we have Five Below, a retailer that sells everything below $5. As an investor, the idea sounds brilliant. Given Dollar Tree's profitable success, investors had really gotten behind the future of Five Below.

Since the company's IPO, however, growth has decelerated from a 40% rate to a 28% rate. With just $110 million in sales during its last quarter, Five Below is still a relatively small retailer.

By comparison, Dollar Tree had $110 million in quarterly sales back in 1996. The difference was that in its third-quarter report, Dollar Tree was growing at nearly 65% year over year, significantly faster than Five Below.

It was easier to predict that Dollar Tree would continue to explode. With Five Below already seeing such a rapid deceleration of growth, though, investors must consider that anticipated billions in future revenue might not become reality.

More bad news
Since December, shares of Five Below have fallen 25%. Much of this has been a result of speculation followed by disappointing holiday numbers.

Five Below announced that during the nine-week holiday season, its sales increased 25.4%. This showed a further deceleration from the third quarter. The most disappointing statistic is that comparable-store sales are estimated to fall 0.5% to 1.5%, meaning that fewer consumers are coming in the doors of existing stores.

This means that all of Five Below's growth was achieved via store expansion. With traffic declining, margin pressure becomes a real threat.

Is it cheap?
Given Five Below's problems and its recent stock decline, some investors might wonder if it's now presenting value. Although it may never grow to become the next Dollar Tree, Five Below might still be a good investment. The problem with this logic is that valuation must then become a factor, and Five Below is still priced for significant growth.

For example, luxury retailer Michael Kors has soared 230% since its 2011 IPO. It is not what most investors would call a cheap stock, however. In the last 12 months, though, Michael Kors grew 39% year over year for a total revenue of $2.6 billion. Therefore, Michael Kors is significantly larger than Five Below and is growing much faster.

With that said, Five Below and Michael Kors are by no means an equal, nor operate the same business model. However, in this case, we are only looking at growth within retail, and the valuation that is awarded to different levels of growth. Hence, Five Below trades at a whopping 43.5 times next year's earnings. This puts it at a near 100% premium to the faster-growing and larger Michael Kors, which trades at 23 times forward earnings.

Final thoughts
At some point, Five Below might in fact become a value investment. At the moment, though, its valuation and decelerating growth suggests that it could see significant downside pressure before that day occurs.

You might wonder what price would present value. While there is no absolute answer, one might state that Five Below is not presenting value until it trades at a multiple that better reflects its fundamental performance and outlook. Five Below should not be more expensive than Michael Kors, and should perhaps trade closer to Dollar Tree at 17 times forward earnings.

In regards to Dollar Tree and Michael Kors, both are priced attractively with impressive growth. Given the comparison to Five Below, investors might find more upside in either of these two companies instead of Five Below.

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Fool contributor Brian Nichols owns Dollar Tree. The Motley Fool recommends Michael Kors Holdings. 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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