Five Below Inc (FIVE) Strong Sell: Kerrisdale Capital

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separate brand (“Deal$”) for its stores that carry a wider assortment of goods, Dollar General’s decision to allow > $1.00 price products into its existing stores could represent a significant threat to FIVE’s locations, many of which are adjacent to Dollar General’s existing stores.

Five Below

Source: Bloomberg

If the increased competitiveness of dollar stores is not dangerous enough, the US convenience store industry has also seen a very significant expansion in terms of both units and square footage and is now creating considerable competition in terms of consumables.

Five Below

However, these competitive threats are likely dwarfed by the potential threat from Wal-Mart Neighborhood Market and Wal-Mart Express.

Investors are Going to be Blindsided by a Looming Threat… Wal-Mart Neighborhood Market

Five Below Inc (NASDAQ:FIVE)’s success has largely been a function of identifying a unique inventory assortment and making it available in a small, convenient and local store format. Investors have largely assumed that FIVE has a unique market position since many of its inventory products are not widely available at the other local discount retailers (such as formats owned by FDO, DG, DLTR) because FIVE’s discount competitors were largely focused on selling consumables rather than variety, house ware and seasonal goods.

That is about to change with the broad introduction of Wal-Mart Stores, Inc. (NYSE:WMT)’s new small-format concepts: Wal-Mart Neighborhood Market and Wal-Mart Express (collectively referred to as “Wal-Mart Small Format” or “WSF” in this report).

WSF’s are particularly worrisome competitive threats for the discount retail industry for four key reasons:

  1. Wal-Mart sell products for a far lower profit than competitors; this will decimate margins in the industry
  2. Wal-Mart will likely take share; it has greater brand recognition, foot traffic, and turnover
  3. WSFs will offer a wider assortment of products and services given their larger footprint
  4. WSFs are not only a retail format, but a shipment node for the lower cost Wal-Mart supercenter stores

For the past several years, Wal-Mart has been experimenting with smaller-format concepts as well as online delivery business models. It has been trying to understand which store size, product assortment and price points will allow them to profitably enter the local discount retailing space, and how these local stores can be used to augment and enhance their online strategy.

Finally, after several years of testing and adaptation, the company has finally settled on a business model it is happy with, and Wal-Mart has indicated that 2014 is the start of an aggressive expansion of its WSF stores, with the planned opening of at least 250 of these stores in the coming year, with hundreds more to follow in coming years.

Five Below

Source: Wal-Mart investor day presentation, March 2014

“We’ll add 270 to 300 new small units this year. That includes 160 to 180 Neighborhood Markets, 110 to 120 Express formats. This will allow us to gain more of a convenient shopping trip for our customers in what they want… There are something like, I think, 11,000 new small stores that have been put out in the U.S. in the last 3 years that we think have impacted that… We think it’ll be a very powerful vehicle for the customer experience with this convenience and be able to combine that digital and that physical for that customer.” –Source: Charles Holley, CFO, March 2014

While the typical Wal-Mart supercenter is nearly 200,000 square feet, the Wal-Mart Neighborhood Market and Wal-Mart Express stores are approximately 40,000 and 12,000 square feet in size, respectively, a significantly larger format than the typical discount store size of between 5,000 and 10,000 square feet. These stores will have a large enough footprint such that, in addition to offering grocery, pharmacy, and other key recurring-revenue consumable products (which is the bread & butter of most discount retailers), the WSFs will also have sufficient space to offer housewares, party, sporting goods and other seasonal selective merchandise which will be in direct competition with Five Below Inc (NASDAQ:FIVE).

The mere footprint expansion does not capture the full scale of the competitive threat.

Investors may look at Wal-Mart’s modest unit count and assume that it is only modestly nudging the total industry’s unit growth over the coming couple of years. However, when one looks at the projected increase in competition from a revenue standpoint, one can see that the WSF stores’ total revenue expansion is a far more serious threat. Simply put, FIVE is competing in a commoditized industry where nearly every competitor plans to aggressively grow unit count and even more aggressively grow revenue, yet analysts expect margins and profitability to remain constant despite the world’s most sophisticated and aggressive retailer entering the market?

Wal-Mart is Going to Quickly Become a Very Major Competitor in the Discount Retail Industry
Five Below Five Below


This doesn’t seem to make sense, particularly when one looks at Wal-Mart’s far lower margins, and store-level turnover metrics.

Wal-Mart Sells Products at a Far Lower Price… … by Utilizing its Real Estate More Efficiently…
Wal-Mart pricing is disruptive for the entire discount retail industryFive Below Wal-Mart will use its brand recognition, superior slate of services, and larger format to grab shareFive Below


The primary concern is that Wal-Mart, simply put, is an incredibly aggressive competitor that is willing to earn less on each sale than its competitors. They make up for this lower profit by turning their inventory faster, and utilizing their real estate more efficiently through better sales per square foot.

The entry of Wal-Mart is not just a threat for Five Below Inc (NASDAQ:FIVE), but for the entire discount retail market in general. The copious profits, impressive 10%+ EBITDA margins, and fantastic returns on equity that the industry has enjoyed for the past decade are likely to deteriorate when Wal-Mart begins to disrupt the industry.

Five Below’s Retailing Model is Inherently More Risky than Other Discount Retailers Due to Dependency on Holiday Season

Many research analysts compare Five Below Inc (NASDAQ:FIVE) to other discount retailers such as DG, FDO and DLTR. However, there are fundamental differences in FIVE’s business model which make these comparisons quite risky and misleading.

While other discount store retailers focus heavily on providing consumable merchandise, such as grocery and household consumables, FIVE is more heavily weighted towards leisure items and house ware. Discount retailers often focus on minimizing costs, improving efficiencies and sourcing the lowest-cost everyday household items; in contrast, FIVE’s merchandising team must continue to accurately predict customer tastes and trends, much like a fashion or furniture retailer. Thus, FIVE’s merchandising mix is significantly riskier than that of a consumables retailer such as Dollar General.

DG Sales are Largely Recurring Consumables… … Whereas FIVE Sales are “Trend”
FY 2014 Revenue: $17.5BFive Below FY 2014 Revenue: $0.5BFive Below


Another important data point is Five Below Inc (NASDAQ:FIVE)’s heavy dependence on the holiday season for sales. This important distinction is not as evident when one looks at annual figures; however, when looking at quarterly financial results, it is quite evident that FIVE is disproportionately reliant on the holiday season. In fact, the company is barely profitable for the other three quarters of the year.

FIVE EBIT Margins Appear Normal on an Annualized Level…

Five Below


While DG, FDO and DLTR generate a relatively steady, recurring engagement with their customers through selling convenient consumable merchandise, FIVE is far more dependent on selling “trend” inventory for holiday gifting season. Though this strategy can yield outsized margins when successful, the risks to investors from even one poor Christmas season can be significant. Particularly cold weather, as in 2013, or poor holiday merchandising in a given year can adversely impact FIVE far more than its peers.

… but Quarterly Results Show that FIVE is Really a Holiday Retailer

Five Below


Thus, due to Five Below Inc (NASDAQ:FIVE)’s heavier reliance on non-recurring items and holiday sales, its revenue and profits are less predictable than its discount retailing peers. Seasonal weather or poor execution during the holiday season can have a particularly pronounced impact on FIVE’s profitability. FIVE’s dependence on predicting customer demand for seasonal items makes them more akin to a lower-multiple fashion retailer such as a GPS (which trades at 14x forward P/E) rather than a recurring-revenue, low-cost consumable merchandise company such as a Costco (23x forward P/E) or DG (18x forward P/E)

Low Inventory Turnover a Cause for Concern

When comparing Five Below Inc (NASDAQ:FIVE)’s inventory turnover metrics, cost basis (SG&A as % of revenue) and overall retail efficiency (sales

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