Five Below

Moat: 2/5

Understandability: 1/5

Balance Sheet Health: 4/5

Five Below is a discount retailer targeting tweens and teens with a variety of trendy products priced at $5 and below, with select products offered at slightly higher prices.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Five Below’s business model is built on providing a treasure hunt experience for its target demographic, with products changing frequently and often aligning with current trends. The company operates a national chain of stores, focusing on providing a fun, engaging shopping experience for its customers.

  • Revenue Distribution:
    • Five Below’s revenue primarily comes from the sale of merchandise in its stores.
    • The company’s products are mainly discretionary items that appeal to tweens, teens, and their families.
    • Sales are largely driven by store traffic, promotions, and the company’s ability to effectively anticipate current trends.
    • Five Below also has an online presence, but physical stores are the major source of revenue.
  • Industry Trends:
    • The discount retail industry is highly competitive, with a focus on attracting consumers with low prices and trend-driven products.
    • There’s been a trend towards more experiential retail, where the shopping experience is as important as the products themselves.
    • The industry is influenced by macroeconomic trends, such as inflation, changes in disposable income, and consumer spending patterns.
    • Online sales have become a more important factor, pushing even brick-and-mortar retailers to improve their online capabilities.
    • Younger generations (Gen Z and Gen Alpha) are increasingly influencing the purchasing trends, so it is necessary to identify what those trends are and have products ready for them.
    • Supply chains and logistics have been extremely volatile lately, and companies need to adapt.
  • Margins:
    • Five Below’s margins are relatively low compared to luxury retailers because of their focus on low prices.
    • They often rely on high volume sales to generate decent profit.
    • They are able to increase profitability by increasing sales and decreasing expenses.
    • Their margins are heavily reliant on supply chain costs, as these tend to be their most volatile expense.
    • As of August 2023, the gross margin was 31.5%, which declined due to inventory increases, and transportation costs
  • Competitive Landscape:
    • The discount retail market is highly fragmented with many competitors, such as dollar stores, department store outlets, and online retailers.
    • Competition is also present by other retailers who sell similar products at slightly higher prices.
    • Five Below differentiates itself by targeting a specific demographic and consistently updating its product offerings.
    • It is becoming more challenging for stores to provide a unique product.
  • What Makes Five Below Different:
    • Five Below stands out because of its focus on a specific demographic (tweens and teens).
    • The company’s constantly changing product offerings create a unique treasure hunt-like shopping experience.
    • The low price point appeals to budget-conscious consumers, and makes it a natural destination for gifting.
    • Their merchandising model emphasizes trend-driven products, which means they have to be experts at finding the next big trend.
    • The company has its own direct-to-consumer model, and tries to stay ahead of competition by adding new features and improving efficiency.
    • They are continuing to aggressively expand to different locations.

Moat Analysis: Rating: 2/5 * Intangible Assets: Five Below’s brand has some pull but lacks the deep emotional connection that would give it a moat. Brand recognition can create value, but it can easily be replaced. * Switching Costs: The company has little to no switching cost for the consumer. Customers can switch with no barriers and no costs. There is no contractual element, or specific program that would make it costly for consumers to switch. * Network Effects: They have minimal network effect. Its value isn’t derived from having more customers, but rather, from its customer base. * Cost Advantage: Five Below leverages efficient distribution, and while its prices are lower than that of most traditional retail, those lower costs are relatively replicable, leading to the conclusion that this is not a strong source of cost advantage. * Overall: Five Below possesses some brand recognition, but the lack of strong structural competitive advantage creates a weak moat. They are extremely susceptible to competition, who could come and copy their practices. The lack of competitive advantage has led to pricing being the main driver, making the company very price sensitive to changes in the industry.

Legitimate Risks to the Moat and Business Resilience * Changing Trends: The preferences of their target demographic (tweens and teens) are constantly changing, making it very difficult for Five Below to stay on top of the current trends. * Economic Downturns: In times of economic recession, consumers are more likely to cut down on discretionary spending, which can harm companies like Five Below. * Supply Chain Issues: Supply chain disruptions can cause a sharp decline in revenue and margins, because of their large reliance on imported products. This would be disastrous for a budget conscious company, as they rely on low costs. * Pricing Competition: The extreme competition in the discount retail market leaves limited room for price hikes. Also, since many of their competitors are giant companies like Walmart, it would be difficult to compete with them on price. * Replicable Business Model: A major risk they face, is that the model is easily replicable. They have no exclusive process, or technology that their competition could not copy. This leaves them extremely vulnerable to competition. * Expansion Costs: Continued store expansion can be very costly and could hurt short-term profitability. * Management: The company’s success depends heavily on good operational management. Any mismanagement will have a direct impact on profits, as well as the company’s moat.

In-Depth Analysis of the Financials:

  • Current Financial Standing: According to the latest earnings report from Q2 2023, the company had cash and cash equivalents of $390 million, short term investments of $301 million, a total of ~$690 million in cash-like instruments. Total liabilities were $632 million, with a total long-term debt of $0. This indicates that their current ratio is favorable, and the company has more cash-like instruments than it has liabilities.
  • Revenues: The company’s revenue has grown from $2.7 billion in 2021, to $3.1 billion in 2022, to $3.5 billion in the trailing twelve months. This growth is primarily from expansion of the number of stores, and a small increase in per-store revenue. The revenue growth has also been consistent year over year. However, as you can see in the graph above, the company’s margins have been decreasing.
  • Profitability: Their net income has gone down since 2021. Net income was $228 million in 2021, $211 million in 2022, and $179 million in TTM. The decline is mostly due to a drop in gross margin. Selling, general, and administrative expenses has also increased, but at a slightly lower pace than their revenue.
  • Debt: The company has $0 long-term debt, meaning their financial health is excellent. This allows them a lot of flexibility, and a wide margin of safety when the economy takes a downturn.
  • Cash flow: The company’s cash flow statements show that they are consistently generating more cash from operations than they are spending in investments and financing, meaning they are a great cash generating business. This cash is being funneled back to operations for growth.

Understandability: Rating: 1/5 * Five Below’s business model is incredibly easy to understand. The core business operates as a retail chain selling cheap, trend-based products to tweens and teens. This is one of the most simplest business models possible, and is easy to grasp for most investors. Their target audience also makes the business very simple to understand. For these reasons, Five Below has a score of 1 on understandability.

Balance Sheet Health: Rating: 4/5 * Five Below’s has a high cash balance compared to their liabilities and has no debt, which indicates they are fiscally healthy and well positioned to weather any potential economic storm. Their liabilities are mostly in accounts payable, which is their suppliers. The company has no long-term liabilities, or large unmanageable assets on their books. However, as has been mentioned, some of their margins have declined, a sign of increasing cost pressures that the company may not be able to manage. Because of this, I am giving them a 4.

Recent Concerns/Controversies and Management Comments:

  • Declining margins: In the recent earnings call, they highlighted their revenue growth was offset by decreasing gross margin, mainly driven by increased transportation costs, and higher shrink rates (theft). Management is trying to implement price increases to combat the cost pressures, as well as improving supply chains.
  • Store expansion: They have a heavy focus on expanding their store count. However, they have expressed concern over the amount of expansion required to deliver good growth, which may indicate that they will start to face troubles with growth as well as costs that may come with excessive expansion.
  • Executive turnover: Some concern was raised by the recent change in CFO leadership, however they seem to have found a suitable replacement who had been with the company for some time.