Kerrisdale Commentary for Five Below Inc (FIVE) Part 2

As we described in our last article, Five Below Inc (NASDAQ:FIVE) trades at too high of a valuation for a discount retailer with mediocre same-store sales growth, average margins, and an insufficiently differentiated business model. The company’s current valuation of $2.0 billion is far too high for a retailer that generated only $76m of adjusted EBITDA over the last twelve months. We think it’s highly improbable that Five Below can meet the very lofty expectations that are built into the company’s sky-high 50x LTM P/E multiple.

The retail landscape is littered with the bodies of overhyped emerging concepts whose expansions failed to meet the market’s expectations, and who’ve seen dramatic multiple contractions as initial success ultimately succumbed to the brutally competitive nature of retail. For every Chipotle, there are dozens of Potbelly Corp (NASDAQ:PBPB)’s and Body Central Corp (NASDAQ:BODY), concepts that fell short of the generous expectations cast upon them during their initial years of rapid store expansion. In early years, emerging retailers can post promising financial metrics, driven by a large proportion of new stores as a percentage of their overall store base. Same-store sales growth can be rapid, as many stores are still in ramp-up mode and are handily lapping prior year revenue figures. Margins are steadily rising, boosted by increased SG&A leverage as fixed costs like corporate overhead are spread across a larger revenue base, as well as by increased profit per store as a large number of young stores mature. For FIVE, for instance, we saw 12% same store sales growth in 2009 and 16% in 2009, but that figure dropped to 4% last fiscal year and is projected to only be 4% in FYE 2014 (FY ending 1/31/2015). Five Below Inc (NASDAQ:FIVE)’s EBITDA margin expanded from 8% in FY 2009 to 14% in FY 2013, but now sits at levels higher than most other dollar stores.

As concepts mature, cracks begin to show in emerging retailers’ abilities to maintain healthy margins and same-store sales growth while simultaneously increasing unit growth by 20%+. Expanding a store base from 100 to 125 is far easier than expanding from 400 to 500. Obstacles that emerging retailers face as they enter the intermediate stages of their growth trajectories include:

  • Success in Specialty Retail Invites Competition – FIVE is Easy to Copy. Five Below Inc (NASDAQ:FIVE) does not have a patent on the concept of a dollar store catering to a teenage demographic, and copycats can pop up next door in each of Five Below’s strip malls to provide the same sorts of products and target the same customer demographics. This risk can be particularly pronounced for retailers that don’t sell proprietary products, because competitors can source cheap knickknacks from the same Chinese manufacturers as FIVE while arranging them in a colorful fashion in aisles labeled “NOW”. Five Below may have been the first mover to coin the NOW aisle heading, but the pre-teen of 2017 won’t differentiate much between the trinkets at Five Below and copycat competitors.
  • Trends Change – FIVE will Invariably Experience Merchandising Misses. As discussed in our prior article, we believe merchandising plays a greater role at Five Below than at other dollar stores. Five Below Inc (NASDAQ:FIVE) caters to teens and pre-teens, which is one of the most fickle demographics. Tastes change on a quarterly basis, and Five Below is prone to missing a merchandising trend periodically. Should stores focus on Candy Crush-themed water bottles this summer or Angry Birds? Below-the-knees swimming trunks, above-the-knees or mid-thigh? Because Five Below sells “trend” merchandise to a fickle market (teens and pre-teens), inventory that goes unsold is likely to be rendered obsolete, unlike the inventory at discount retailing peers which make more of their money selling non-perishable household consumables (such as batteries and toilet paper).
  • Compounding Growth Creates Execution Challenges – Five Below Has to Open a LOT of Stores. In its initial years, Five Below Inc (NASDAQ:FIVE) could focus its expansion plans on a smaller number of units per year. For instance, when Five Below had 100 stores, to grow units by 25% management only needed to focus on building out 25 new stores. At a 400 store count, 25% unit growth translates to 100 new stores. Negotiating a new lease, building out a store interior, hiring new store staff, arranging a new distribution route, and sourcing additional merchandise on an average of once every three and half calendar days becomes too daunting, and store growth decelerates.
  • As Specialty Retailers Grow, They Enter Less Attractive Markets – New Five Below Inc (NASDAQ:FIVE) Stores Will Likely be Less Profitable Than Original Stores. As specialty retailers expand, investors consistently overestimate the incremental profits from expansion. In the initial years of a specialty retailer’s growth trajectory, it expands into its most attractive markets first. It is during this period that investors tend to reward retailers with high valuation premiums, assuming future growth will be as profitable as past growth, generally extrapolating past revenue per store, sales per foot and margins well into the future. However, after a time, the best markets have been utilized and retailers are forced to enter 2nd and 3rd tier locations which are naturally less profitable.
  • Sales Per Square Foot Reach Peak Levels Across a Higher Proportion of the Store Base, Resulting in Stagnant or Declining Overall Growth Given that Unit Growth is Falling. In the intermediate phase of a retailer’s growth trajectory, a large proportion of the store base may be reaching peak sales per square foot levels, as growth begins to plateau in a store’s second, third or fourth year of operation. The combination of slowing unit growth and peak-level store metrics can result in growth rates that are too low to justify the emerging retailer’s sky-high valuation multiples. Retailers are not software companies that can massively scale a fixed cost base, and use technology to rapidly expand their customer bases. Rather, to justify 50x LTM P/E multiples, brick-and-mortar retailers must expand units at a torrid pace and do so with flawless execution. As we’ll see with Francesca’s Holdings Corp (NASDAQ:FRAN) later in this article, this goal is often too daunting.

In this article, we will explore from several different perspectives how difficult it is for a discount retailer to grow into a 3.4x LTM sales and 50x LTM P/E multiple. First, we’ll present two case studies. The first is Francesca’s Holdings Corp (NASDAQ:FRAN), a recent high-flyer that has seen its stock price decline approximately 45% since its 2011 IPO (inclusive of the first-day IPO “pop”) and its valuation multiples cut nearly by half after the company failed to match its historical same-store sales growth metrics. The second is Denninghouse, a Canadian dollar store retailer that experienced a rapid growth phase marked by high same-store sales growth, expanding margins and rapid unit growth only to ultimately go bankrupt in the mid-2000s. In addition to showing how once-promising financial metrics can dramatically reverse course for a retailer within a matter of years, the Denninghouse example also demonstrates how fragile the discount retailer business model really is.

Then we’ll review a long list of growth-oriented retailer IPOs over the past five years that have failed to meet market expectations, showing just how common it is for emerging retailers to see operating metrics fall back to earth as they enter the intermediate stages of their growth trajectories. As these metrics return to normalcy, so too do valuation multiples, and we routinely see 3x+ revenue multiples contract to 1x-2x, and P/E multiples fall from 50x to 15x-25x.

Case Study: Francesca’s

Francesca’s is an instructive example of a specialized retailer that witnessed a dramatic decline in overall sales growth, same-store sales growth (SSSG) and valuation in the years subsequent to its IPO. Francesca’s Holdings Corp (NASDAQ:FRAN)’s offers fashion apparel, jewelry and accessories for women between the ages of 18 and 35. FRAN went public in 2011 at an eye-popping EV/Sales and EV/EBITDA valuation of 8x and 31x, respectively (inclusive of the customary IPO “pop” after first-day trading).

FRAN: Stock Price Performance Since 2013

 FRAN share price history

At the time of its IPO, Francesca’s Holdings Corp (NASDAQ:FRAN)’s story had numerous parallels with how sell-side analysts currently describe Five Below Inc (NASDAQ:FIVE).

Sell-side Analysts on FRAN at IPO (2011)

Sell-side Analysts on FIVE (Current)

“We believe FRAN possesses one of the most compelling growth stories in softlines with only 249 boutiques and long-term potential of reaching ~900 stores nationwide. Moreover, the company’s boutique, “treasure-hunt” feel continues to drive comps with +6.6% projected for F11, after +15.2% in F10 and +9.8% in F09” – Wedbush, 8/25/2011“FRAN is a fast fashion women’s retailer positioned to capitalize on today’s value conscious consumer. Francesca’s currently operates 249 stores in 38 states within the U.S., and has the potential to reach 900 stores in the next 7-10 years. Square footage isgrowing at ~25% annually and we expect ongoing infrastructure investments and benefits of scale to yield 25-30% annual earnings growth in the long-term.” – Jefferies 8/31/2011“The shares are not inexpensive, but we believe they offer an entry into the early stages of a long and visible growth story. Plans call for 75 new stores annually for the next several years, fueling expected square footage growth upwards of 20% (36% in 2011) and bringing the store base to about 900 locations.” – RBC 8/31/2011 “Strong store economics are only half the story. Even more exciting is the long term square footage growth story. FIVE currently has 304 stores, and this concept warrants 2000+ stores nationwide.” – Janney Capital Markets 2/5/2014“While the shares are likely to respond well to this release, we think the stock still has a favorable long-term outlook. It has a significant growth opportunity and an unmatched offering, in our view. We project these factors should enable it to generate 25% plus earnings growth for an extended period of time.” – UBS 3/25/2014“Five Below is in an elite class of high growth retailers, with a differentiated value orientedconcept, exceptional and consistent new store economics, and a huge store growth opportunity that can continue at the current pace for 20+ years” – Wells Fargo 6/14/2014

While analysts were correct that Francesca’s Holdings Corp (NASDAQ:FRAN) would quickly expand its geographic footprint, FRAN’s same store sales growth declined significantly over that time. Interestingly, Five Below Inc (NASDAQ:FIVE)’s revenue growth and SSSG trend is strikingly similar.

FRAN vs. FIVE: Revenue Growth and Same-Store Sales Growth Decline

 FRAN revenue growth and SSSG decline  Five Below Revenue Growth

Similar to Five Below Inc (NASDAQ:FIVE), Francesca’s Holdings Corp (NASDAQ:FRAN) has witnessed a sharp SSSG growth deceleration since 2012. On the Q1’13 earnings call, FRAN’s management attributed the 2.0% SSSG to inclement weather, much like Five Below’s management did for the Q4 2013 slowdown.

This decrease was driven by lower than expected transaction volume as a reflection of the unseasonal — unseasonable weather conditions that persisted throughout the quarter. We’ve heard many retailers call out the negative impact of unseasonably cold weather on store traffic, and we were not immune to this trend. – Mark J. Vendetti, Francesca’s Holdings Corp (NASDAQ:FRAN) CFO on Q1’13 Earnings Call on 06/05/2013

Yet SSSG still hasn’t adequately recovered and has continued on its downward trajectory. Interestingly, SSSG for the following quarter was -1.0% (management previously guided towards a 1-2% increase); however, management could not blame the weather again for the decline. The same-store sales decline was purely attributable to a decline of transaction volume.

Comparable sales decreased 1%, including direct-to-consumer. This compares to a 21% increase in comparable sales in the same period last year, which has been restated to include direct-to-consumer sales. As Neill highlighted in his comments, this decrease was driven by a 4% decrease in comparable transaction volume, which we believe was representative of lower

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