Watch Out Below! By Chad Henage - September 19, 2012 | Tickers: DG, DLTR, FDO, FIVE | 0 Comments
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.
I can honestly say there is nothing like discovering a new store concept and then seeing the company go public. Small growth retailers are one of my favorite investments to track because they are so easy to understand. If their stores work in one area, they usually work in other areas as well. As long as comparable store sales are on the rise, and debt isn't excessive the stock is usually a good bet. One company that recently came to my attention, due to their store location right around the corner, is Five Below (NASDAQ: FIVE). Since the company just completed its IPO in July of this year, the recent earnings release was one of the first chances to look at the results from this fast-growing company. While the company's first earnings report is a little convoluted due to their IPO, everything looked okay until I calculated the company's current valuation.
Before we get to the valuation concerns that I have, let's compare Five Below and their type of store to several of their competitors. Since the company only operates 226 stores in 18 states there's a decent chance that some investors may not have actually stepped foot in a Five Below. One thing that I should point out is Five Below is a very different concept than many other dollar-denominated stores. The company describes itself as a retailer with all items priced at $5 or less that offers, “high-quality merchandise targeted at the teen and preteen customer.” This is a very different focus than competitors such as Dollar General (NYSE: DG), Family Dollar (NYSE: FDO), or Dollar Tree (NASDAQ: DLTR). Most dollar-denominated stores sell a mix of consumables, seasonal items, toys, and other goods. Just as an example, Dollar General gets about 74% of their total sales from consumables, and Dollar Tree has been expanding their frozen and refrigerated merchandise to bring in more frequent shoppers. While Five Below has a unique store concept, I fear sales results will be more inconsistent because they do not focus on the same categories that drive frequent visits. In addition, any retailer specifically targeting the teen and preteen marketplace, faces unique challenges keeping up with changing trends in this fickle demographic. That being said, the company's first earnings report showed some impressive numbers, but also a few red flags that investors should be aware of.
Five Below reported net sales up 40.11% and comparable store sales increased 8.6%. With 34.5% more new stores in place versus last year, you can see the company is expanding rapidly. The bad news for investors is, the company's previous complicated financial structure makes it difficult for the company to grow earnings per share at the same rate as more established competitors. When the company issued its shares from the IPO, the first priority was to retire the nearly $100 million in preferred shares outstanding. In order to accomplish this goal, Five Below entered into a $100 million loan agreement and used the proceeds to essentially buyout these preferred share holders. At the same time, the company owed about $100 million to an existing term loan. The proceeds from the IPO allowed the company to pay down $65 million of their existing loan balance, which left $35 million still on the balance sheet.
Long story short, there are multiple adjustments to the company's earnings per share that are needed. After all of the one-time items, the company's EPS was actually about $.14 versus a loss of $.10 last year. However, the company still carries a relatively significant long-term debt load, and the interest expense uses almost 28% of operating income. While this cost will go down on a relative basis if the company continues to grow, in the short term this creates a drag on earnings. This is the prime reason that with revenues up 40%, net income only increased 16.74%. When we dig further into the company's financial statements, the comparisons to their larger competition become even more difficult.
The size difference between Five Below and their competition cannot be understated. The company only operates 226 locations, versus their smallest competitor Dollar Tree which has well over 4,000 stores. However, for those that assume with size that capital expenditures go down, you only need to look at Family Dollar to disprove this theory. In the last few years, Family Dollar's capital expenditures have increased over 120%, while operating cash flow stayed relatively flat. For a company with over 7,000 stores, this appears to be an issue specific to Family Dollar, but is something for Five Below investors to be cautious of.
There are three different challenges that I noticed in Five Below's financials. First, the company's long-term debt uses a tremendous amount of the company's income. Second, even with the adjustments to net income related to the company's IPO, Five Below still would have been free cash flow negative by $4.68 million. A third issue is, the fact that the company's IPO caused their diluted share count to increase 18.61%. With significantly more shares, a large debt load, and the company running free cash flow negative, these are all items that will make true growth difficult. While all of these challenges might overcome with time, the valuation of the shares is something that I can't overlook.
I don't have any trouble saying on a relative basis Five Below looks far overvalued. In the dollar-denominated segment, even the fastest growing companies, Dollar General and Dollar Tree, trade for a forward P/E ratio very close to their 17% plus expected growth rates. Even Family Dollar, which is expected to grow at about 14% trades for roughly 17 times forward earnings estimates. Understanding that Five Below is expected to see significantly higher growth, still does not explain the forward P/E ratio of over 73. Even if investors are looking at 2013 full-year estimates, at current prices the shares trade at over 50 times next year's earnings as well.
Five Below is targeting a more challenging market with less consumables to drive repeat business. None of their competition trades at the type of premium to their growth rate that Five Below currently does. Considering that the company is free cash flow negative, has a significant interest expense, and is relatively small, could be reason enough to avoid the shares. However, when you add the fact that the shares appear significantly overvalued, all I can say is watch out below! |
