EUR 850.00 For Business Accounts Only

Morningstar | Solid Execution Lifts Our Outlook, but We No Longer See an Economic Moat at Five Below; Shares Rich

Amid intense competition in a sector with virtually no switching costs, we now contend that Five Below does not enjoy a sustainable competitive edge (versus our prior narrow-moat rating). However, we believe its strong execution and differentiated concept merit raising our sales and profitability forecasts and cutting our uncertainty rating to medium from high. We also see its consistent returns as indicative of a strong management team, resulting in an upgraded stewardship rating (to Exemplary from Standard). Now calling for 16% top-line growth against 13% operating margins, on average, over the next 10 years (versus our earlier 14% and 12% respective marks), we are lifting our valuation to $89 per share from $76.

Five Below has leveraged a differentiated concept and prudent expansion to generate returns despite a crowded competitive landscape. We believe it has ample room to expand profitably toward its 2,500-store count target, which we expect it to approach by the end of our decadelong explicit forecast. We contend that the store experience and constantly refreshed assortment, focused on preteens and teenagers with all items priced at or below $5, translate well across a wide range of households, as shown by the average customer's household income of around $80,000, with over a quarter of sales made to those earning more than $100,000.

However, we suspect that the firm's growth and consistent profitability (averaging 25% top-line expansion and a 12% operating margin over the last five fiscal years) reflect management's strength rather than a sustainable competitive edge. Competition is fierce, and Five Below competes against a wide variety of retailers and other destinations for disposable income (including entertainment options) targeted at the mercurial tastes of young Americans. Still, we expect the firm's growth and strong execution to persist, leaving results fairly consistent in the near-to-medium term (leading to our moderated uncertainty rating).

We continue to believe Five Below's competitive standing is holding steady, hence our stable moat trend rating. Although competition is intensifying, we believe emerging cost leverage as the chain grows and accumulating brand awareness from customers and vendors alike should help offset the effects of the challenging retail environment. As a result, we expect relatively steady operating margins and returns on invested capital over the course of our 10-year explicit forecast, each averaging in the low to midteens.