Third, Five Below’s management will have to overcome the challenge of executing and managing exponential growth – it is much tougher to grow unit count 20% off a 300-store base than it is a 100-store base. Five Below Inc (NASDAQ:FIVE)’s management must now execute a new store expansion every few days, rather than every few weeks, and this could place tremendous pressure on IT systems, logistics, managerial talent, not to mention sourcing greater volumes of inventory over an ever-expanding store-base.
Finally, Five Below will have to find new locations with attractive economics. Like Denninghouse, Five Below Inc (NASDAQ:FIVE) is already showing signs of having difficulty in finding new attractive stores, given falling same-store-sales growth and plateauing margins. Below we show charts demonstrating how same-store sales growth has been declining over the past three years, and how margins have flattened at their current level.
|
Same Store Sales Growth (Quarterly) |
 |
|
EBITDA and EBIT Margins Flat Since 2011 |
| |
Specialty retailers have few lasting sustainable advantages. We believe that over the coming quarters, Five Below will face incredibly difficult competitive and operational challenges, and think that investors have fundamentally overestimated Five Below Inc (NASDAQ:FIVE)’s strategic position in the marketplace.
Recent Emerging Retailers That Have Disappointed Investors: Is FIVE next?
To further illustrate how investors often overestimate profits and growth rates in the specialty retail sector, we examined a screen of retail IPOs since 2010. Below we show a lengthy list of companies that have IPO’d over the past five years that featured rapid unit growth and / or lofty valuation multiples at the time of IPO. These once overhyped IPOs offer investors a valuable lesson: seemingly fast-growing concepts at inflated valuations can quickly lose momentum and fail to live up to expectations. Potbelly’s, Sprouts Farmers Market, Tilly’s and Francesca’s Holdings Corp (NASDAQ:FRAN)’s, all highlighted below, illustrate how that can happen.
|
Select Retail IPOs Since 2010 |
| |
Tilly’s is a good example of a specialized retailer that has drastically failed to live up to expectations. Tilly’s offers casual clothing, footwear and accessories, and, similar to Five Below Inc (NASDAQ:FIVE), its products are targeted for the teen and young adult demographic. Also similar to Five Below, Tilly’s had high growth expectations due to its significant “white space” opportunity to expand into other states. At IPO, Tilly’s operated 140 stores and was expected to expand that to ~500. When Tilly’s launched its IPO, both sell-side analysts and investors were overly optimistic. A quote from Stifel’s research analyst summarizes the bull case at the time.
The outlook for the company is favorable, in our opinion, given its business model of offering a fast-turning assortment of men’s and women’s apparel, shoes and accessories that is comprised of trend-right California inspired fashion brands. Tilly’s square footage expansion of +15% is likely for the foreseeable future, as it grows from a California-centric 145 location store into a national retail chain of over 500 stores. We anticipate comp store sales gains as new stores ramp-up with the potential for operating leverage. – Stifel Nicolaus, 5/29/2012
Unfortunately for Tilly’s investors, the company has since underperformed and the stock price has declined by over 50% since IPO. Same-store sales growth (SSSG), which seemed to be on an upward trajectory, has reversed. Valuations have come down significantly. After its IPO, Tilly’s was valued at EV/Sales and EV/EBITDA of 1.3x and 10x, respectively; in contrast, Tilly’s EV/Sales and EV/EBITDA multiples today are 0.4x and 3.6x.
Below is Tilly’s same-store sales growth over the past five years:
|
Tilly’s Same-Store Sales Growth Since FY 2010 |
| |
Potbelly’s, Sprouts Farmers Market and Francesca’s Holdings Corp (NASDAQ:FRAN)’s are also examples of other recent retail IPOs that have failed to live up to expectations. Both Potbelly’s and Sprouts were hot IPOs that saw their respective stock prices increase by 120% and 122%, respectively, on the day of IPO pricing. Since those highs however, the stocks have come crashing down in light of tempered expectations, and both Potbelly’s and Sprouts’ stock prices have declined by 49% and 24%, respectively. Valuation expectations have also been tempered. Potbelly’s and Sprouts were valued at 31x and 49x EBITDA following their IPOs, but those multiples have contracted to 13x and 27x.
|
Potbelly’s and Sprouts’ Declining Multiples |
| |
A Closer Look at Potbelly’s
Potbelly’s is yet another good example of a recent IPO that has seen its stock price dwindle amid tempered optimism. Potbelly’s successful IPO was fueled by investors hoping to witness another fast food chain growth darling similar to that of Buffalo Wild Wings (NASDAQ:BWLD) and Chipotle Mexican Grill, Inc. (NYSE:CMG). Similar to Five Below Inc (NASDAQ:FIVE), Potbelly’s is expected to have a fairly large geographic expansion opportunity with ~300 shops across 22 states. The optimism around Potbelly’s during its IPO sounds all too familiar – much of the hype was around how many thousand stores Potbelly’s could eventually grow to. Quotes from analysts at the time of IPO highlight some of the bullish views then.
It is at roughly 300 units today, out of a potential for several thousand, and new unit builds have historically generated 30-40% cash on cash returns. – Goldman Sachs 10/29/2013
Our saturation analysis suggests the potential for at least 1,000 locations, from about 295 domestic locations today, based on one-half of the penetration Potbelly has already achieved in its home market of Chicago. – William Blair 10/29/2013
We are initiating coverage on PBPB shares with an Overweight rating and $34 price target, which is 94x our FY14 earnings estimate. We believe this multiple is warranted given the scarcity value due to very few restaurant growth options from a public company perspective, a proven strategy to continue market share gains, and the pipeline value of future development. – Piper Jaffray 10/29/2013
Unfortunately for Potbelly’s IPO investors, the market has unmasked a weak SSSG trend that investors seemed to have ignored at IPO.
|
Potbelly’s Same-Store Sales Growth Since FY 2009 |
| |
The Container Store: Disappointing Growth Drags Down Share Price
Container Store Group Inc (NYSE:TCS) is a retailer of storage and organization products that went public in late 2013. At IPO, investors were enamored with this retailer with “hard to contain competitive advantages”, resulting in shares closing 96% above its IPO price. At IPO, TCS was similar to Five Below Inc (NASDAQ:FIVE) (and to Potbelly’s) as it was expected to have significant white space opportunity with a base of only 63 stores. Sell-side analysts, not surprisingly, had high expectations for this specialty retailer to expand rapidly.
Significant long-term growth opportunity with impressive sustainability and duration of growth. We see potential for 300-350 stores nationally, above management’s 300-store guidance (5x-6x the current store base). – Stifel 11/11/2013
Given its small size, just 63 stores and the potential for over 300 U.S. locations, we believe that positions TCS as one of the best growth names in our coverage. – Credit Suisse 11/26/2013
Since its IPO, TCS’ fundamentals have deteriorated and as a result, the share price has declined 39% from an all-time high of $47.07 in late 2013, and is down 20% since its IPO. SSSG, revenue growth and EBITDA margins have all since declined since the IPO.
|
The Container Store: Five-Year Historical Snapshot |
| |
TCS’ mediocre results have translated to an underperforming share price; in 2014 alone, TCS has declined 39%.
|
The Container Store: One-Year Share Price Performance |
| |
These examples all paint a similar picture: inflated expectations around overhyped retailers with seemingly unlimited geographic expansion potential often lead to disappointment. Time and time again, emerging retailer investors have ignored the fundamentals and have been burned on hard-to-attain promises. There are few retailers who are able to successfully achieve national scale rapidly enough to justify the types of overly optimistic valuation multiples that Five Below Inc (NASDAQ:FIVE) is trading at.
Conclusion
As we have illustrated in this article, the specialty retail sector is rife with historical examples of emerging concepts that have let down investors time and time again. We believe investors consistently forget about the natural “pop and drop” of the specialty retail sector. Specifically, the market often forgets that specialty retailers generally lack one of the most important factors that justify high valuation multiples: sustainable competitive advantages.
Five Below has limited competitive advantages. Five Below Inc (NASDAQ:FIVE) has no cost advantages relative to its larger competitors, nor does it have any merchandising advantages given its lack of proprietary products. While the idea of tailoring a discount retailer to a teenage demographic has allowed Five Below to make some inroads, it’s a concept that can easily be replicated by competitors. Accelerating competition within the discount retail sector, in terms of current dollar stores both expanding units and also introducing higher-priced products to compete with FIVE’s five-dollar threshold, as well as the expansion of Wal-Mart Stores, Inc. (NYSE:WMT)’s small-format stores, will present serious competitive threats to FIVE as it enters the intermediate stage of its growth trajectory. We wouldn’t be surprised if future concepts such as Five Under, Five’N’Less, Less Than Five, Five’s Too High, Thrive-Under-Five, Trinkets-For-Teens and other copycats also restrict FIVE’s long-term growth and undercut its margins.
