Five Below’s Winning Strategy (NASDAQ:FIVE)

Introduction

Five Below (NASDAQ:FIVE) reported excellent earnings last week despite all the worries some investors had. These worries allowed long-term investors to continue adding to their positions. I started adding to my Five Below position again in September after more than one year since my last additions. I felt the company was at attractive levels at $167, but it went down to around $150, price points that I took advantage of, just like the company, as you’ll see later in this article.

My additions were not very aggressive because I already had a significant position. The opportunity was short-lived, with the stock already over $200 after reporting strong Q3 earnings:

So, what’s the lesson here? Even high-quality companies go on sale occasionally, but we’ll only be able to seize the opportunity if we have done the homework beforehand. Stocks typically go on sale for one of two reasons during a bull market:

1. Investors believe in the LT opportunity but think the next 12 months will be rough. Few are willing to hold these companies during rough times.

2. Investors believe the long-term growth prospects of the company have been permanently impaired.

Five Below’s opportunity came from a bit of both. As for #1, many were worried about current growth and its implications for the triple-double guidance. As for #2, many were worried about the impact of Temu and a weak consumer.

We believed both were overdone, which is why we continued adding to our position.

Without further ado, let’s look at the results in a bit more detail.

The numbers

The headline numbers

Five Below reported excellent headline numbers, beating both the top and bottom line estimates:

The company’s forward commentary for its most important quarter (Q4 due to the holiday season) was also great, but we’ll leave that for later.

Sales growth accelerated this quarter. Sales grew 14.2% year over year to $736.4 million. This is consistent with an accelerated pace of store openings, something management has been saying for months that would happen (more on this later). There was also a highlight in comparable sales, driven by the most crucial metric again: traffic.

Earnings per share actually dropped year over year from $0.29 to $0.26, primarily driven by shrink (something which we discussed with subscribers last quarter). This is what we said:

Growth might not look impressive here. However, as I discussed last quarter, store openings would be back-ended, meaning plenty of growth should be pushed forward to next year. This and the expected leverage on operating margin should position Five Below for a very strong FY 2024 on the bottom line.

We think this is perfectly applicable this quarter too, and we are starting to see some of those benefits flowing through to the company’s growth rate, which is accelerating:

The top line and its drivers: comparable sales and store growth

Five Below has two main drivers of its top line: comparable sales and new store openings. Comparable sales refer to the increase or decrease in sales from stores already open in the comparable period. So, for example, comparable sales for Q3 2023 will be a calculation using only the changes in sales from those stores that were already open during Q3 2022. New store openings are self-explanatory.

Over the past few quarters, the highlight was in comparable sales, with muted store openings. However, the highlight this quarter was in both growth drivers.

Comparable sales: continued strength

Comparable sales grew 2.5% year over year (similar to last quarter). Comparable sales growth was extremely volatile during the pandemic (for obvious reasons), but this volatility is already behind us:

Comparable sales also have two underlying growth drivers: average tickets and the number of transactions. Average ticket is related to how much money customers spend per transaction, whereas the number of transactions is just that: the number of transactions the company’s customers make.

The most important driver of these two is undoubtedly the number of transactions because they serve as a proxy for traffic. Once a customer is in a store, it is much easier to increase the ticket. However, customers not going into stores is a warning sign for any retailer.

Five Below continued to demonstrate the relevance of its stores, growing comparable transactions by 3.1%. This was the fourth consecutive quarter of comparable sales growth:

Management has been remodeling stores to the Beyond model for some time, creating an uplift in comparable sales. They claimed that some of these stores are also comping positive in the second year:

It is a small sample size, and – but all signals of that first wave of groups that popped into the year two and Q3 is that they’re comping positive. And so we obviously need to get to Q4 here, we’ll have another big chunk of stores entering year two, plus we’ll have a second quarter of those or in year two.

But as it stands right now, we are not seeing anything that would indicate that they would give back any of the gains they got in year one of the conversion and seem to be more in line with what the chain is comping.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

This, and the fact that older stores are also comping positively, means that Five Below’s brand is strong and more relevant than ever. In one of our prior articles, we mentioned that a well-functioning brand is essential to build the company’s long-term competitive advantage, and management thinks similarly:

We believe we have established Five Below as the go-to brand for value and fun, though a big opportunity remains to increase brand awareness.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

Tickets decreased by 0.6% year over year, but we don’t think we need to worry too much about this. Five Beyond should be a tailwind for this metric over the long term, with management seeing potentially higher prices than $25 in the distant future:

And so we haven’t earned the right or have the need to go above $25. There are so many great items they’ve got in that $6 to $25 range, and that’s where the focus is. But I do have expectations that, that penetration will continue to increase as the customers really responding positively to this new format of Five Below in the front, Five Beyond in the back, and keeping that separation. And now we’ve got to keep growing both just like John Heinbockel was asking about Five Below and you’re asking about Five Beyond, I think both of those are upsides for many years to come.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

New store openings: just like management announced

The other growth driver for the company, or what can be considered inorganic, is store openings. Management opened a record 74 new stores in the quarter to end with 1,481 stores:

For yet another quarter, the company did not close one single store. More importantly, management has complied with what it has been saying for the last few quarters: store openings accelerated significantly. There’s also optimism as to what 2024 and beyond (no pun intended) can bring:

Our real estate teams have built a strong pipeline of new stores for 2024 and have also started working on 2025 stores.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

Just to get a sense of the accelerated pace of store openings here…Five Below opened 7 more stores in Q3 than in the prior two quarters combined (67). Management has guided for 200 store openings in 2023, so we should expect somewhere close to 60 store openings in Q4. Note that this accelerated pace of store openings is one of the reasons why we were cautious in extrapolating the current growth rate forward and its implications for management’s triple-double vision.

The best news is that management still sees similar performance in new stores:

On new store performance, Matt, Q3 was in line with Q1 and 2, which were in the mid-80s to low 90. And Q4 at the midpoint, you’ll find is pretty consistent with that as well coming in close to the mid-80% range for new store productivity.

Source: Kristy Chipman, Five Below’s CFO, during the Q3 2023 earnings call

This means there’s still no significant cannibalization, which bodes well for Five Below’s long-term growth runway. Conversions continued but at a slower pace because management was now focused on store openings. Five Below already has around 50% of its comparable store base converted to the Beyond model.

Digging into profitability

Despite seeing an EPS year-over-year decrease, Five Below beat the market’s expectations on profitability. This was possible because the year-over-year EPS decrease was well anticipated by management. As discussed last quarter by management:

We expect an operating margin of 1.4% to 2.1% in the third quarter of 2023. The approximate 150 basis points of deleverage at the midpoint is primarily due to the anticipated shrink headwind.

Source: Kristy Chipman, Five Below’s CFO, during the Q2 2023 earnings call

However, management came above this guidance and posted an operating margin of 2.2% thanks to SG&A leverage:

As a percentage of sales, SG&A for the third quarter of 2023 decreased approximately 90 basis points to 28.1% versus last year’s third quarter, driven primarily by the timing of marketing spend and leverage on certain store-related expenses.

Source: Kristy Chipman, Five Below’s CFO, during the Q3 2023 earnings call

There was also an update on shrink: management is working on it and will give investors more updates after Q4:

As it relates to shrink, we are working on many initiatives throughout the organization to help mitigate the anticipated increase we have forecasted, and we will update you on the progress of these efforts at year-end.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

The anticipated shrink was not the only reason for the EPS evolution; there was a headwind and a tailwind. As a headwind, there were taxes:

Our effective tax rate for the third quarter of 2023 was 25.4% compared to 24.6% in the third quarter of 2022.

The tailwind was buybacks. Management repurchased $80 million worth of stock during the quarter, adding $0.03 to EPS. The best news is that management made these repurchases at what we believe are very attractive prices. The average price paid was $158:

Management is already up 27% on this purchase. We are starting to like the following chart, which shows management tends to repurchase stock when it’s out of favor. Notice how buybacks tend to go up when the stock goes down. This is how the return of capital to shareholders should be done:

There was another tailwind to earnings thanks to the company’s solid financial position: a significant increase in interest income. Interest income increased 611% to $3.4 million, or 21% of the company’s total operating income.

Solid cash flow and balance sheet

We’ve already discussed the balance sheet in some way in the section above, but we’ll bring it here summarized. Five Below held $163 million in cash and no debt as of the end of the quarter. This is a solid financial position and one of the reasons we believe Five Below is so attractive as an investment: it has a self-financing flywheel thanks to its short payback period. In short, existing stores finance the opening of new stores without incurring debt.

If we look at cash flows, we can see two things:

1. The company has generated much more cash YTD in 2023 than it did in 2022.

2. The company’s cash flows were negative in Q3 (this quarter)

The reason for both is related to inventories. In 2022, inventory was a significant headwind for Five Below but less of a headwind this fiscal year. Similarly, the company tends to report negative cash flow in Q3 as it prepares the inventory for the holiday season. Q3 tends to be a negative cash flow quarter, followed by the strongest cash flow quarter of all, which is Q4. This volatility is not worrying:

Five Below continues to work on inventory optimization to improve cash conversion going forward, and it seems to be working:

The fourth pillar, inventory optimization, is another area where we have made meaningful progress in order to drive sales and maximize profits. As I mentioned before, this is a pillar Ken is leading as COO. Our teams are focused on improving inventory productivity by leveraging more sophisticated processes, technology, and analytics.

We are developing methods that will improve our ability to predict demand further optimize inventory levels and track the movement of product through the supply chain.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

The good news for investors is that Five Below continues to reinvest aggressively at great rates of return. The company spent $232 million in Capex (store openings and remodels) in the first 9 months, up 34% year over year. Free Cash Flow for the first 9 months has been significantly negative:

There’s nothing worrying in this for two reasons:

1. Operating cash flow is volatile, whereas Capex is not. This means we should see these numbers improve significantly in Q4.

2. We shouldn’t really care about FCF generation right now as the company is in an investment phase. What we should care about is FCF looking forward.

Qualitative highlights

Thoughts on the competitive landscape and a good management trait

With all the Temu noise, management was asked about the competitive landscape. For starters, management mentioned that they are not seeing an impact from Temu but that they continue to monitor it:

But we’ll continue to watch them and see where they go. But as you can see in the consistency of our results, it really hasn’t had an impact for us yet.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

We have already mentioned several times why we don’t see eCommerce as a risk for Five Below. The key lies in the in-store experience, which is the company’s main value proposition and which is completely absent in eCommerce.

Management exhibited a key trait in the answer to this question:

That’s something we’ve done since the day we started this business. And you marry that value message up in a Five Below with a great experience. And we’re not always perfect, we’ve got some stores that struggle. But overall, we deliver a really great experience for our value customer.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

Any business has problems regardless of how good it looks on the surface, so we prefer to give our money to a management team that can openly admit their mistakes and struggles. Investing is an area where honesty is a rare commodity and should be valued.

Guidance – Good news

Guidance showed great news due to the numbers and the commentary. As for the numbers, management decided to revise the low end of its yearly guidance upward, meaning that they have now increased the midpoint:

It does seem that management is being a bit conservative here. They are seeing very positive trends early into Q4, but of course, they still have to go through the most important weeks, so they don’t want to read too much into the early trend:

While the biggest holiday weeks are still ahead of us, we are really pleased with the start to our fourth quarter.

Source: Joel Anderson, Five Below’s CEO, during the Q3 2023 earnings call

Last quarter we shared with subscribers that we believed the company was cheap if we assumed management would get close to the triple-double guidance. Of course, the company is now significantly higher than it was back then, but we still believe it’s not as expensive as many people think.

Conclusion

All in all, Five Below reported excellent earnings last week, driven this time by comparable sales and an accelerated pace of store openings. We believe the runway ahead is still long.

In the meantime, keep growing!