It hasn't been a smooth ride for the retail sector (XRT) - Get Report so far this year. Exposed the most to the trade dispute between the U.S. and China, alongside technology device makers, almost all major retailers have seen their equity's market value plummet recently.
Things got worse when the trade war escalated in first few days of August. Share price weakness came on top of unfavorable secular trends that have been forming for several years, including Amazon's (AMZN) - Get Report increasing dominance of the fast-growing digital channel and the much-debated "death of the mall" phenomenon.
While some retailers have been struggling to weather the headwinds, others appear to be on much better footing. Caught in the crossfire and hurt by the market's risk-off attitude, their shares now seem to be priced at much more enticing levels, certainly in relation to the superior fundamentals of these higher-quality companies.
An Unlikely Brick-and-Mortar Growth Story
Pushing against the wave of brick-and-mortar store closures across the country, the Philadelphia-based chain is one of the few that are undergoing an aggressive footprint expansion phase. Five Below plans on extending its presence to 36 states by the end of 2019, maintaining its store count growth pace of 20% per year.
The company seems to have found a niche of younger Gen Z, Millennial and Gen X shoppers who value "trend-right" products (think fidget spinners last year as a simple example) that other successful discount retailers like Dollar General (DG) - Get Report and Dollar Tree (DLTR) - Get Report seem unable to serve properly. Five Below's consistent low-to-mid single digit comps over the past several quarters reflect the company's competitive advantage.
Easing concerns over the impact of increased tariffs, the executive team has taken steps to protect the retailer's margins, and the initiatives seem to be working. First, and despite the store's name, Five Below has been slowly expanding its product portfolio to include items priced at up to $10 -- the so-called "Ten Below" concept.
With the added flexibility, the management team has been hiking prices of certain items from $5 to as high as $5.75 in order to combat the higher import taxes. Other tools in the toolbox to achieve the same goal include vendor negotiations, process efficiencies and supply chain adjustments to diversify country of origin.
Second, gains of scale resulting from Five Below's footprint expansion have been supporting the bottom line. Despite sizable investments in infrastructure that are likely to taper over time, including the cost of adding a new distribution center in the Southeast region, gross margin remained largely flat in the most recent quarter.
Same Great Company, Better Stock Price
One of the main overhangs for value investors is that Five Below's stock has traditionally traded at a high EPS multiple of as much as 48x in September 2018 and then again in April of this year. The valuation premium is understandable, considering the company's aggressive growth profile and cash-rich, debt-free balance sheet.
In panic mode, however, the market has unearthed a gem. Five Below now trades at roughly $110/share, nearly 30% off its recent 52-week peak and representing a much more digestible 33.5x current-year earnings multiple. Adjusted for long-term EPS growth expectations, Five Below is substantially cheaper than both Dollar General and Dollar Tree, at a PEG of only 1.4x.
Although risks will continue to exist in the retail space, at the very least that of subdued market sentiment, Five Below looks like a high quality, fast-growing company whose stock seems too cheap to ignore.
The author has no positions in any stocks mentioned in this article.