Sahm Adrangi: Five Below Inc (FIVE) by Kerrisdale Capital

Sahm Adrangi, Kerrisdale Capital’s commentary on Five Below Inc (NASDAQ:FIVE).

We believe that Five Below Inc (NASDAQ:FIVE) is highly overvalued. FIVE is a specialty value retailer that offers merchandise targeted to teens, pre-teens and their parents in a concept that we view as a glorified dollar / toy store. Its valuation multiples of 3x+ LTM revenue and 25x LTM EBITDA are far too high for a company with mediocre same-store sales growth operating in the brutally competitive discount segment of the retail industry. Same-store sales growth (SSSG) has declined dramatically over the past three years, with SSSG for Q4 2013 falling to an anemic 0.4% and overall forward year guidance projected to be a modest 4%. Additionally, we expect the company’s long-term margins to be pressured by the wave of competition flooding the discount retail sector, whether it be due to the 5% to 7% annual unit expansion of Dollar General, Dollar Tree or Family Dollar, or the 2,000+ Walmart Express small-format stores expected to open over the next five years; additionally, discount retailers rarely boast impressive profit margins due to their lack of brand name products. Finally, FIVE’s catalogue is biased towards trendy/fad items that are targeted for a fickle teenage demographic and its sales are disproportionately weighted towards the holiday season, factors which both translate to increased volatility in year-to-year results.

For all the aforementioned reasons, we think that the current $2.0 billion market cap being assigned to Five Below Inc (NASDAQ:FIVE), a company that generated only $80m of EBITDA and $40m of net income in fiscal 2013, faces substantial downside over the coming year. Indeed, it was no surprise that when the company released its Q1 earnings last week, and both beat analyst estimates and raised guidance, the stock ended the day down 4%. The market has seen a violent re-pricing for high-flying momentum stocks over the past few months, with former momo darlings like Splunk Inc (NASDAQ:SPLK), Castlight Health Inc (NYSE:CSLT) and FireEye Inc (NASDAQ:FEYE) down more than 50% from their peaks. Egregious valuations of recent IPOs that were inflated by thin floats and easy-to-beat sellside estimates have a seen a downward revision since mid-March. Many of these momentum names have beat estimates and raised guidance in the most recent quarter, but have still seen their stocks fall after earnings. Companies that have underperformed expectations have routinely witnessed their stocks plummet more than 20%.

We think Five Below Inc (NASDAQ:FIVE) has yet to fully participate in the much-deserved momo correction.

At current premium multiples, investors are assuming Five Below Inc (NASDAQ:FIVE) experiences no missteps in executing its high-growth strategy. A valuation of 25x LTM EBITDA implies substantial margin expansion, 10%+ SSS growth, and a maintenance of 20%+ unit growth for many years to come. However, we believe that FIVE’s 13% EBITDA margin is already at elevated levels; we note that its SSS growth has already fallen below 5%, let alone the 10%+ level that its nosebleed valuation implies; and we believe that 20%+ unit growth will be difficult to execute effectively as FIVE’s store base becomes larger and larger. Throughout this and future articles, we will elaborate on other fast-growing retailers that have expanded too quickly in order to justify lofty valuations, such as Francesca’s Holdings (FRAN), only to experience declining sales per square foot and negative same-store sales growth, which have in turn triggered valuation cuts of 50% or more.

To value Five Below Inc (NASDAQ:FIVE) , we discuss a comparable companies analysis that compares FIVE to other fast-growing emerging retailers, as well as dollar stores. FIVE’s stretched multiples stand out even when compared with other overhyped momo retailers. When matched with other dollar stores, FIVE’s valuation is clearly an outlier, and although investors may claim that FIVE is at a different stage in its lifecycle than perhaps a Dollar General, we question just how different FIVE’s business model really is from other discount retailers.

Additionally, we present a highly optimistic 10-year discounted cash flow analysis to supplement our comparable companies analysis. Our DCF yields a valuation for FIVE of approximately $23 / share, well below the current price of $35. Even in a scenario where FIVE triples its store count and quadruples revenue and EBITDA, shares would be 35% overvalued based on our analysis.

Five Below: Capitalization and Financial Snapshot

Five Below

Five Below: Gross Overvaluation Relative to Peers and other Retail Stocks

Five Below Inc (NASDAQ:FIVE)’s share price of $35/share implies a lofty valuation of 3.4x LTM revenue, 25x LTM EBITDA and 50x LTM P/E. On a forward basis, FIVE trades at 2.8x FY14E revenue, 20x FY14E EBITDA and 39x FY14E P/E. On almost any metric, FIVE looks expensive, especially when compared to other, arguably more successful, retailers. Lululemon Athletica inc. (NASDAQ:LULU) (TSE:LLL), which has a premium brand name, better margins, and higher SSSG, trades at a 34% and 43% discount to FIVE’s 2014E EV / EBITDA and P/E multiples, respectively. CONN’S, Inc. (NASDAQ:CONN), a specialty retailer focused on electronics and appliances, had SSSG of 27% in Q1’14, is expected to increase revenue by 27% in 2014, and has higher EBITDA margins than FIVE, yet it also trades at a significant discount relative to FIVE.

Below is a comparable companies analysis that compares FIVE to two comparables sets: (i) other dollar stores and (ii) other fast-growing retailers.

FIVE's share price of $35/share implies a lofty valuation of 3.4x LTM revenue, 25x LTM EBITDA and 50x LTM P/E. On a forward basis, FIVE trades at 2.8x FY14E revenue, 20x FY14E EBITDA and 39x FY14E P/E. On almost any metric, FIVE looks expensive, especially when compared to other, arguably more successful, retailers. Lululemon, which has a premium brand name, better margins, and higher SSSG, trades at a 34% and 43% discount to FIVE's 2014E EV / EBITDA and P/E multiples, respectively. Conn's Inc, a specialty retailer focused on electronics and appliances, had SSSG of 27% in Q1'14, is expected to increase revenue by 27% in 2014, and has higher EBITDA margins than FIVE, yet it also trades at a significant discount relative to FIVE.     Below is a comparable companies analysis that compares FIVE to two comparables sets: (i) other dollar stores and (ii) other fast-growing retailers.

When compared with other fast-growing retailers, Five Below Inc (NASDAQ:FIVE)’s steep valuation multiples stand out. For instance, Restoration Hardware (RH) is expected to grow 2014 revenue by 22%, and its 2013 same-store sales growth was a resounding 31%. The company is also benefiting from a showroom-oriented business model like WSM, whereby the company is rapidly increasing its online sales through online advertising and social media rather than expanding its units. Yet RH’s EV / EBITDA multiple is 30% lower than FIVE’s.

When compared to other dollar store operators, Five Below Inc (NASDAQ:FIVE)’s revenue multiple is three times higher than the average of the comparable set, and its forward 2014E EV / EBITDA and P / E multiples are more than twice as high. We expect FIVE’s growth and margin metrics to moderate faster than sellside analysts think. Maintaining 14% EBITDA margins and elevated same store sales growth as a discount retailer will become much harder when the company operates 500+ stores as compared with its current 323-store base, especially when the company is increasing unit growth at a 25%+ annual clip. We think it’s probable that execution issues, such as poor site selection, disadvantageous leases, and off-trend merchandising, will hamper FIVE’s growth and margins in the near- to intermediate-term.

Over time, we believe the valuation gap between FIVE and its peers will narrow, as investors will realize that FIVE’s premium valuation is unwarranted.

Five Below: Declining Same Store Sales Growth Suggests 20+% Revenue Growth Unsustainable

At first glance, Five Below Inc (NASDAQ:FIVE)’s FY 2009 – 2013 revenue CAGR of 44% certainly seems impressive. However, most of this growth was driven by new store openings. From FY 2009 – 2013, FIVE opened 222 net new stores (CAGR of 31%) and expects to open 62 more in FY 2014. Over the same period, same store sales growth (SSSG) declined from a high of 15.6% in FY 2010 to 4.0% in FY 2013. For FY 2014, management projects that same store sales growth will be flat at 4.0%, implying no improvement from FY 2013.

FIve Below SSS

Notably, Five Below Inc (NASDAQ:FIVE)’s SSSG in the fourth quarter has been on a declining trend since FY 2011. The fourth quarter is the most important quarter of the year for many retailers due to the holiday season. This is especially true for FIVE as the fourth quarter represented 42%, 41% and 40% of total sales for the fiscal years 2011, 2012 and 2013, respectively.

Five  below QSSS

The deceleration of SSSG is a common trend in the dollar store industry. SSSG for Dollar General Corp. (NYSE:DG), Dollar Tree, Inc. (NASDAQ:DLTR) and Family Dollar Stores, Inc. (NYSE:FDO) has declined significantly since FY 2009. Extrapolating from this trend would suggest that long-term growth rates for this industry would be in the low single-digits. While FIVE continues to grow revenues by 20-30% (31% y-o-y growth in Q1’14), the growth has been fuelled via adding new stores, which requires upfront capital, rather than same store sales growth.

The deceleration of SSSG is a common trend in the dollar store industry. SSSG for Dollar General, Dollar Tree and Family Dollar has declined significantly since FY 2009. Extrapolating from this trend would suggest that long-term growth rates for this industry would be in the low single-digits. While FIVE continues to grow revenues by 20-30% (31% y-o-y growth in Q1’14), the growth has been fuelled via adding new stores, which requires upfront capital, rather than same store sales growth.

 

Margins at Elevated Levels and May Contract Long-Term

Investors in Five Below Inc (NASDAQ:FIVE) are bullish on the company’s growth prospects, highlighting FIVE’s profitability and operating metrics. Retail however is a commoditized and cutthroat industry, and while FIVE may have carved out a unique niche as a teen and pre-teen focused dollar store operator, we question its ability to command sector-leading margins as it expands its store base.

Five Below Inc (NASDAQ:FIVE) has minimal sustainable competitive advantages. Despite operating in a commoditized industry, it is not a low-cost competitor, like a Wal-Mart or Costco. It does not have strategic real estate locations, unlike many of the dollar stores, which had first-mover advantages in picking up prime dense-population locations. It does not have unique product sourcing capability. Nor does the firm have a brand name or long-standing customer relationships and customer data (one of the few things keeping customers coming to retailers such as JC Penny and Sears). Its unique strategy of focusing on teenagers and their parents differentiates the retailer, but we don’t think this will be enough to allow FIVE to maintain sector-leading margins over the long-term.

Below is a comparison of Five Below Inc (NASDAQ:FIVE)’s margins to competitors:

As we can see, Five Below Inc (NASDAQ:FIVE) currently boasts a higher margin than both Dollar General and Family Dollar, by over 250 basis points as compared to Dollar General and at nearly double the EBITDA margin of Family Dollar. We don’t think this is sustainable.

What Five Below Inc (NASDAQ:FIVE) offers is simply a product assortment and a price point. And these are things that any retailer can quite easily replicate. Competitor commentary indicates that traditional discount retailers are already adding products at the $1.00 to $5.00 price point. For example, Dollar Tree has been rapidly expanding its Deal$ store format, which sells products higher than its traditional $1.00 price format. It should be noted that Dollar Tree’s Deal$ format is already quite sizable at ~220 locations, compared to ~300 for FIVE.

“Another key component of our growth strategy is the expansion of Deal$, Dollar Tree Canada, and Dollar Tree Direct. Our Deal$ format extends our ability to serve more customers with more categories and increases our unit growth potential. Deal$ stores deliver low prices on everyday essentials, party goods, seasonal and home product. By lifting the restriction of the $1 price point at Deal$, we’re able to serve more customers with more products at value prices every day. We ended the quarter with a total of 217 Deal$ stores and growing.” – Bob Sasser, Dollar Tree CEO, Q1 2014 Transcript

Perhaps even more troubling is the recent decision by Dollar General to add more products at a higher price point in order to capture additional consumer wallet share. Dollar General is currently the largest discount convenience retailer in the United States, with over 11,000 locations. While Dollar Tree decided to create an entirely

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