Five Below: Is This Discounter Growing Too Fast?

Just how many discount stores can the United States support? One has to ask that question after taking a look at Five Below (NASDAQ: FIVE), a fast-growing chain of dollar stores based in Philadelphia.

The small box operator’s gimmick is that it sells everything for less than $5, a variation on the old dime store model of everything priced at 5¢ or 10¢. Five Below also rips off the strategy of another very successful discounter, Dollar Tree Stores (NASDAQ: DLTR), which only has one price in many of its stores: $1.

Is It Family Dollar All Over Again?

The potential problem with Five Below is the speed at which it is growing. Five Below has only been in business since 2002 yet now operates around 400 stores in 25 states. That, of course, is very reminiscent of another high-flying, bottom-feeding discounter, Family Dollar, which crashed and burned last year. Family Dollar, which had been a Wall Street darling, was forced to sell itself to Dollar Tree just to survive.

Five Below’s revenue has grown fast as well, rising from $601.19 million in July 2014 to $737.65 million in July 2015. The problem here is that the increase in revenues may not cover the costs of expansion, something that happened at Family Dollar, which was forced to go from opening stores at a breakneck pace to closing hundreds of locations almost overnight.

One reason why Family Dollar did that was that it hit the limits of discounting. One can only make so much money selling at such low prices even at high volumes. There are also limits to the volumes a discounter can sell, as Walmart Stores Inc. (NYSE: WMT) recently discovered, in today’s hyper-competitive retail marketplace.

Are There Too Many Discount Stores?

Another is that there simply might be too many discount stores in America today. Here are some numbers for major discount chains that seem to prove this thesis:

• 12,198 Dollar General stores (NYSE: DG)

 

• 13,600 Family Dollar and Dollar Tree stores in the United States and Canada

 

• 3,445 Walmart Supercenters

 

• 652 Sam’s Clubs

 

• 656 Walmart Neighborhood Markets

 

• 2,625 Kroger (NYSE: KR) supermarkets and supercenters

 

• 1,799 Target (NYSE TGT) stores

 

• 474 Costco Wholesale (NASDAQ: COST) club stores

When added up, that comes to 25,798 stores, which sounds like too many for a country the size of the U.S. This growth should concern us for two reasons. First real wages and incomes for average Americans are dropping. The Bureau of Labor Statistics found that real wages fell for 85% of Americans between 2007 and 2015. That means Americans have less money to spend which is good and bad news for discount stores.

Discounters might have more potential customers, but those customers will have less money to spend. This can help bottom-feeding operations like Five Below, which cater to the less affluent.

An even more worrying trend is the growth of online retailers, which means a lower volume of business for brick and mortar stores. Revenue figures indicate that sales at some online retailers are increasing dramatically even as they are stagnant at brick-and-mortar chains like Walmart.

Amazon.com (NASDAQ: AMZN) added nearly $5 billion in revenue between June and September of 2015. Its revenue exceeded $100 billion for the first time in the third quarter of 2015. This indicates that the amount of business for brick-and-mortar stores seems to be falling as online retail grows, yet we are building more brick-and-mortar discount stores.

One danger that online retailers such as Amazon.com present to Five Below is that they take away higher-income customers that spend more. Middle- and upper-class shoppers with higher incomes and credit cards are more likely to shop online even for items like groceries and household supplies. That reduces the number of potential customers and, worse, leaves the discount chains to fight over customers with limited amounts of money.

The Trends Are Not Good for Five Below

Actually, the trends are not that great for Five Below. In addition to the growth of Amazon.com, Five Below faces growing incursions into the small box discount arena by both Walmart and Kroger. Kroger is not operating small boxes like Walmart is, but it is undercutting dollar stores on many prices.

Walmart’s Neighborhood Markets, which offer such amenities as fuel, pharmacies, and full grocery stores, are an even greater threat to small box retailers. Neighborhood Markets are often located in the same urban and suburban areas historically served by dollar stores.

Five Below is going to have a difficult time dealing with such direct challenges because its resources are limited. On July 31, 2015, Five Below reported the following financial numbers:

• A TTM revenue of $737.65 million
• A net income of $47.96 million
• A free cash flow of $7.875 million
• Cash and short-term investments of $60.92 million
• $75.06 million in cash from operations
• A market cap of $1.87 billion
• An enterprise value of $1.760 billion

It looks as if Five Below simply lacks the cash to compete in a radically changing discount marketplace. One obvious danger here is that a sudden drop in revenue could bring the expansion to a screeching halt.

A troubling scenario for Five Below would be that aggressive competitors such as Walmart, Dollar General or Kroger would simply start undercutting its prices. Something to remember is that Five Below only has discounting to reply upon. Kroger and Walmart have other sources of revenue to tap, such as grocery and fuel sales.

Kroger in particular seems to be using specific products as loss leaders in an effort to undercut dollar stores. Where I live in Colorado, Kroger subsidiary City Market regularly sells coffee for $5 a can and canned tomatoes for 50¢—prices that Family Dollar, the only dollar store operator in our area, cannot seem to match.

One just has to wonder how dollar store chains can survive in such an environment. With their low margins, all Kroger or Walmart would have to do to send a dollar store chain into the death spiral would be to take between 5% and 10% of its business—something that would not be that hard. Both Walmart and Kroger have a strong incentive to do this given their recent low levels of revenue growth.

Investors should stay away from dollar stores in general and Five Below in particular because this sector is too volatile. My prediction is that we are about to see major carnage in dollar stores and the disappearance of even more brands in this sector. The market is simply too saturated for chains like Five Below to survive.

Disclosure: the author of this piece is long on Kroger.