Stocks that carry a trailing P/E of greater than 40 aren’t featured in our newsletter, mostly because they are simply too expensive, suggests Doug Gerlach, editor of Investor Advisory Service.
However, compelling long-term growth prospects, coupled with an immediate boost in earnings due to corporate tax reform, has led us to recommend Five Below, Inc. (FIVE) as a stock worthy of study.
Five Below is a value retailer marketing merchandise priced $5 or less to teens and tweens, particularly Generation Z (ages 8 to 14). Because of this age focus, the company also ends up selling to Generation Z’s parents, which include Millennials and early Generation X (ages 22 to 44).
The average customer household income is $80,000 with a surprising 27% having income over $100,000. The beauty of Five Below’s merchandise strategy is that teens and tweens have disposable income because their basic needs are met by their parents and goods $5 or less are easily affordable.
To keep customers interested in visiting the stores, the company follows trends and fads by constantly turning over its product lines. Five Below calls this Trend Right “WOW” Products.
Each store sells merchandise in eight “Worlds”: Sports, Tech, Create, Party, Candy, Room, Style, and Now. In 2017, the sales breakdown was 50% from leisure products, 32% fashion and home, and the balance party and snack goods.
Store economics are compelling. Stores average about 8,000 square feet and yearly sales of about $2 million. For a net investment of about $300,000, the first year EBITDA (Earnings Before Interest Depreciation and Amortization, a measure of cash flow) of a new store is $450,000, a 150% return on investment.
We rarely see this kind of rapid payback on invested capital. Five Below was incorporated in January 2002 and has been a public company since 2012. Even so, the company is relatively early in its growth phase. As of February 3, 2018, it operated 625 stores across 32 states.
The firm estimates an area with as little as 100,000 people can support a store and believes it can grow its base to 2,500. We note that most existing stores are concentrated in the East, Southeast, and Midwest, with hardly any in the Western U.S. California only has 15 stores today.
Five Below expects to open 125 new stores in 2018, about 20% growth. The firm’s financial metrics and balance sheet are strong. In 2017, Five Below generated $100 million in free cash flow and ended the year with about $245 million in cash and no debt.
Analysts expect Five Below can grow its EPS 23% per year. While this seems aggressive, EPS will receive a substantial boost in 2018 due to corporate tax reform that will reduce the firm’s tax rate from 37.5% to 24.5%. After the 31% increase in EPS for 2018, the estimated annual EPS growth rate for the remaining four-year period drops to 21%.
Five years of this blended annual earnings growth of 23% would imply EPS of $5.18 in 2022 and, when coupled with an average high P/E of 35, shares could reach $181.
For the low price estimate, we use the average low P/E of 23.5 and 2017 EPS of $1.84 to generate a low price of 43. The upside/downside ratio is 3.3 to 1 and compounded annual return potential is 19%.
