Don't Get Too High on Five Below

Many investors are buying stock in Five Below . On the surface, this is a tremendous growth story with a unique concept that's working without any significant hitches. But if you dig a little deeper, then there are reasons to exercise some caution.

Bullish view
Five Below sells trend-right merchandise to teens and preteens for $5 or less, hence the name Five Below. The company breaks down its merchandise into several different categories, including style, room, sports, media, crafts, party, candy, and seasonal.

Overall, the relatively new retailer (12 years in existence) has delivered rapid net store growth. After just 12 years in existence, it already has 323 stores across 20 states. And its long-term game plan is to have a whopping 2,000 locations. More on this soon since it plays a key role in the story.

Also in regard to rapid growth, first-quarter sales skyrocketed 32% to $126 million on a year-over-year basis. Comps (sales at stores open at least 15 months in this case) also increased 6.2%, representing 32 consecutive quarters of comps growth. This was also stronger than the 4.2% comps improvement in the year-ago quarter. Furthermore, Five Below's margins have most recently benefited from revenue outpacing selling, general, and administrative expenses:

FIVE Revenue (TTM) Chart

Five Below revenue (trailing-12 months) data by YCharts

Looking ahead to the second quarter, Five Below expects comps growth of 3%-4% and for fiscal-year comps to grow at a 4% clip. In order to aid this and future growth, Five Below plans on investing in its infrastructure, systems, and talent.

If you were only to read this story up until this point, then you would likely be tempted to rush to your preferred online trading platform and place an order. However, stories aren't meant to be read only halfway through...

Bearish view
Five Below aims for 2,000 locations over the long haul. That's quite ambitious. You only want to see this kind of ambition if the upper management team had succeeded with a similar venture in the past. In this case, it's quite the opposite, and it appears as though they might be making the same mistake twice. 

Five Below Co-Founders Thomas Vellios and David Schlessinger once ran Zany Brainy together -- a store that sold toys and games. They aimed for rapid growth by acquiring Noodle Kidoodle and paying $9 million for an Internet investment. Shortly thereafter the Zany Brainy found itself in Chapter 11 bankruptcy.

Ironically, Vellios blamed the bankruptcy on rapid growth. In the meantime, Five Below just opened eight stores in Houston with the goal of 100 stores throughout the state of Texas alone. It added 19 stores throughout the U.S. in the first quarter, and once again, the company is aiming for 2,000 stores over the long haul. 

There are several potential problems with rapid growth for a small retailer. One, it can simply outgrow its infrastructure. The average Five Below store has 4,000 items in stock. What happens if the company misses on merchandise? In other words, what happens when it attempts to sell merchandise that teens and preteens don't find cool? What happens if there's a supply chain issue or another unexpected problem? Some might say these risks are part and parcel of owning stock, but at 64 times trailing earnings at what point is this rick not fully priced in? Also consider that teen retailers are often seen as hot until they're not. It's a generational problem.

On top of all of that, there's a low barrier to entry. Wal-Mart Stores currently sells like products, but Wal-Mart isn't trendy to teens and preteens, and not nearly as focused. However, Wal-Mart noticed how well the dollar stores were doing, so it launched its own small-box stores to regain lost market share. With so many larger, better capitalized competitors, it's not out of the question for Five Below to face a stiffer-than-expected headwind when realizing this growth potential.

The Foolish bottom line
Vellios and Schlessinger have more flexible merchandise with Five Below than they had with Zany Brainy, and that can go a long way. This is just one reason this story isn't meant to be bearish. It's clear that Five Below is on the rise.

On the other hand, Five Below may be following a similar past mistake of overzealous growth by this management team. Additionally, success would only lead to increased competition. We no longer live in a world where scores of new retailers can pop up, grow, and succeed over the long haul without being crushed or acquired. At least that latter possibility would be appealing to investors.

The most likely scenario is that Five Below continues to grow at a rapid rate for the next few years before having to deal with larger and more powerful competitors. Since Foolish investing is more focused on long-term investing, you might want to consider a better opportunity.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends Five Below. 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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