Scaling, $5 At A Time

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Recently, I was thinking about valuing a company traded outside India and it came to me as a very interesting proposition when someone suggested that I value Five Below. FIVE (NASDAQ) is a chain of discount stores in the US that sells all its products for $5 or below. And does it well.

Five Below (NASDAQ Ticker: FIVE) is a chain of discount stores in the US, incorporated first in 2002. It has a differentiated business model of offering a variety of trendy products, all below $5, to teens and pre-teens. Their products lines are diverse, ranging from apparel to superhero figurines. Although the company is direct competition with a number of other discount stores and mass retailers, their pricing and target customers offer them a competitive advantage. In fact, a research conducted recently by KeyBanc suggests that Five Below customers “find value that is not replicated at Amazon, as items we have surveyed are 50%+ less expensive on average at Five Below for similar products.”

The company’s “Growth Strategy” also sounds promising, pegging a medium term target of 2500 stores (Compared to the existing 625 stores) and improving margins through operational scale.

It is noteworthy here that Five Below is currently working with a ‘Lease and Operate’ model for their outlets (i.e None of their current outlets are owned by them). Of course, with Brick & Mortar retailing also comes the possibility of franchising, which they have not yet considered and online retailing, which they have just begun. Regardless, Five Below is an unique Cost Leader in an age old industry, operating in a niche customer segmentation. This offers them abundant possibilities to scale up efficiently. Considering the fairly straightforward business model, the key business risk for Five Below would be the inability to maintain their current margins going forward. A brief look at the history of dollar dime stores or online retailers will suggest that sooner or later, the margins will go.

So, it did not come as a surprise to me that Discount Stores have been growing at a steady pace of 15-17% from 2008-2019 and have encroached a sizable amount of market share from the big boys.

The Numbers

And may I take this moment to admire just how fantastic the Financial Reporting system is in the United States. I spent almost no time looking for information in two places. Everything I required was found with simple searches and every explanation provided for. There were no complaints from my side, unlike my previous post.

If you’d like to look at how I calculated the Beta and Volatility for Five Below (And the CAGR of the S&P 500 for the past 5 years), feel free to download the linked file (Downloads can be made from ‘File -> Download As’):

The Capital Conversions

We will have to make some careful observations here. Many people who have used my DCF valuation model or seen my posts before, ask me why I bother going through the pain of converting R&D, Debt, Operating Lease and Equity Options to represent them fairly. While it’s true that for many companies, the impact of these numbers on the value are negligible, cases like this prove to be a great explanation for why I do what I do.

Operating Lease

As already mentioned, Five Below does not own any outlets. It rents or rather leases stores in all the current 625 locations. Therefore, it’s only understandable that the PV of these future lease payments totals to around $366 Million, which is close to 72% of the company’s Shareholder’s Equity. I’m not saying this is a bad thing, it’s as a good as an operational model as any. However, for the sake of our valuation, I am converting these leases into Debt.

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All we’re essentially doing is taking the operating lease payments (Which is off-the-books) and bringing it into the books of the company, therefore creating a ‘Source of Funds’ or ‘Liabilities’. Accounting 101 tells us that every Source of Funds must be supported by an equal amount of ‘Uses of Funds’ or ‘Assets’. In this case, of course, we know that Five Below has been leasing Retail Outlets, which will serve as proxy property.

In simple terms, the following will be the overall impact of this re-classification:

The capitalization of lease will reduce the existing lease expenditure of the company (Since we capitalized a part of it). Since we bought the Retail Stores into the books, this will increase the value of Depreciation as well. On the other side, bringing in a new Asset into the books will cause Capital Turnover to drop drastically (Meaning, the company isn’t as nimble as you would have thought it is at a cursory glance). Finally, converting leases into Debt will bring down the Enterprise Value or put simply, this Debt will be removed from the final value of the company.

Equity Options

Five Below has several ESOPs outstanding and most of them at the extremely low price of $27.95. However, it isn’t the company’s fault that the stock zoomed almost 3x in a single year. When these Options were issued, the stock was trading at $35-40 levels, which sounds like a fair enough deal. But as it stands today, these Options are valued at a staggering $55 Million — almost 11% of the company’s Book Value of Equity. Once again, this value will be removed from the final valuation of Five Below.

The Assumptions

This is my favorite part of any valuation exercise, because I get to play God.

The numbers displayed here will play a key role in determining the intrinsic value of Five Below. I justify them as such:

1. High Growth Period: Five Below is a mid-sized Brick & Mortar retailer. A look at how much retailers have contributed to growth in the US and for how long, will tells us that the industry in general has a long Competitive Advantage Period. Also, according to the crux of my argument, Five Below operates in the niche segment, fulfilling needs that neither Amazon nor the dollar and dime store can fulfill. This provides them with a psuedo-Competitive Advantage. Hence, I’ve used a 20-year High Growth Period (The longest option in my model, anyway).

2. Sales Growth: A quick look at Five Below’s past numbers will tell us that they’ve had a staggering growth of around 35-40% just a few years back to 25-30% levels last year. The company’s short-term Return on Equity average is around 26% and they haven’t paid out any dividends. So, their Self Sustainable Growth Rate, the rate at which they can grow by using only internal accruals, is around 26% too. I’ve used exactly that.. starting with 25.04% for the initial years and eventually slowing down to half of the long-term Risk-free Rate (1.57%).

If that line of reasoning seems weak to you, try this. Five Below has had Revenues of $832, $1000 and $1278 (In Millions) in the past 3 years. In the same time, their Revenue-per-store increased from $1.90 to $1.92 to $2.04 (In Millions) respectively. I’m simply going to extend these Revenues using my Sales Growth assumptions and the Revenue-per-store in line with the trend (A 7% YoY increase). This is what happens:

First, this graph shows that in about 8-10 years from now, Five Below will have opened 2500+ stores, which is in line with their ‘Growth Strategy’. Considering the very long term, this essentially tells us that if things go according to my plan, Five Below will have opened around a ballpark of 11,000 stores in the 38th year of their operation. Is this figure reasonable? Well, let’s take a look at the closest competitor to Five Below, Dollar Tree: 

Dollar Tree was incorporated in 1986. So, in the 32nd year of their operation, Dollar Tree has opened around 15,000 stores, which pales in comparison to my assumption. So, this provides me with enough conviction that my growth assumptions aren’t ill-founded.

3. Operating Margins: Let’s face it. Retailing isn’t treasure island. A quick look at the history of any dime and dollar store or even the largest discount retailers (Such as Walmart) will tell you that these high margin levels are not sustainable. I’ve reduced it in line with this expectation, even when the management seems very sure that they can squeeze out more margins from the business (Refer to the ‘Growth Strategy’ above). In an interview with the CNBC, the company’s CEO mentioned that they source materials from different countries (He mentioned the Honduras, China and India) for different products. That might speak something about the company’s high bargaining power, but if I’m going to err, I’d much rather err on the side of caution. In the Terminal Period, the margins (6.53%) reflect the state of the differentiated retailing industry in the US.

4. Tax Rate: The Corporate Tax rate slowly converges towards the Margin Corporate Tax Rate in the US (30%) and then jumps to the Average Tax Rate in the world (25%) for the Terminal Period.

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5. Capital Turnover: Five Below has an amazing new store economics–so much so that it breaks even in just 7 months. So once the company departs from its crazy expansionary mode, it will find the Economies of Scale helping its productivity. The industry average capital turnover is also 2.57, somewhat higher than the company’s current capital turnover of 1.85. So, I will slightly improve this figure and move it towards the industry average during the High Growth Period.

6. Reinvestment Rate: Retailers usually have very high reinvestment rates. No surprises here.

7. Return on Capital: Return on Capital converges towards the long-term Cost of Capital (i.e. The company finds it more and more difficult to deliver what the market demands).

8. Depreciation: Depreciation remains fairly stable and converges towards the industry average.

9. Cost of Capital: The Free Cash Flows produced from these assumptions will be discounted at the Bottom-up Beta-based CAPM Cost of Capital (9.13%).

P.S. If you have doubts about why I’ve started with higher Margins, higher Depreciation and lower Capital Turnover than the short term averages from the books of the company (Which I what I usually do), remember our earlier conversation about Capital Conversions. The data related to industry averages have been obtained from Prof. Aswath Damodaran’s ‘Useful Data Sets’.

The Diagnostics

No red flags here. Let’s proceed.

The Cash Flows

Based on all the above assumptions, this is how Five Below’s Cash Flows will evolve:

Putting this down in a bite-sized graph will make it look like this:

The Value

This brings us to the moment we’ve all been waiting for–the intrinsic value of Five Below.

Providing for a 5% Probability of Failure and a 10% Margin of Safety, I believe Five Below is fairly valued at $140. This signifies a 8% undervaluation, which isn’t much. However, this revelation provides a logical explanation for the below:

Five Below’s stock nearly tripled in a 2018. Now you know why. However, personally, I would sincerely advise against a FOMO thought process here, since we already saw that the value we ended up with provides very little Margin of Safety.


The Monte Carlo Simulation

A good practice to check an assumption is to test its limits. I will randomize most of my assumptions between a +/- 15% nominal spread. However, since a lot hinges on the Operating Margins of Five Below, I will define the lower limit of margin assumptions as the industry average (6.53%) instead. Essentially, while all other assumptions get randomized within a range of +/-15%, margins will be randomized between 6.53%-15.08%, 6.53%-12.80%, 6.53%-10.88% and 6.53%-8.71% respectively throughout the High Growth Period. Here are the initial results of the simulation:

This can be better represented as a Normal Curve of Values:

If you are not privy to statistical analysis, this is how you should interpret this data instead:

Our current value is matched with a 50% Probability of Undervaluation. Is that enough? Only you can answer that question for yourself. Personally, I would demand a 90-95% Probability, which would put my expected purchase price at $100-110. Tell me, what’s yours?

The Model

Did you not like the way I fashioned my assumptions? Do you think I missed out on something that would drastically alter the value of Five Below? You can always download the model for yourself and play around with the assumptions (And by ‘play’, I mean ‘justify with real life facts’):

Downloads can be made from ‘File -> Download As’.

If you indeed value the company differently, do let me know in the comments below. Crowd-sourcing a valuation is way more fun!

As a matter of personal philosophy, I never give out direct recommendations on any stock. However, if you are having a difficult time deciding whether or not to purchase Five Below, I will leave you with an age old wisdom from an investing genius:

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.”

Warren Buffet.

So, according to your knowledge of the Discount Retailing space in the US, where do you think Five Below is travelling? Over a 6-inch crevice or the Grand Canyon?

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Dinesh Sairam

Dinesh Sairam

Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME
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