7 Reasons Five Below Sets the Gold Standard for Retail

John Ballard, The Motley Fool

Selling items priced below $5 to teenagers doesn't seem like the recipe for an explosive growth story, but Five Below (NASDAQ: FIVE) has made that strategy a very profitable one. Last year, the company earned $150 million in profit after selling $1.56 billion worth of various items such as basketballs, candy, phone cases, remote control cars, yoga mats, and more. 

Five Below opened its first store in 2002 in Pennsylvania and now has 750 locations in 33 states. The store chain is going national with plans to open another 145 to 150 stores this year and expand to three new states. The stock has already tripled over the last two years, but with half the country to expand into, Five Below is a long way off from reaching its full potential.

Here are several reasons why Five Below is succeeding in the challenging brick-and-mortar retail world, and why it should remain a great growth stock for investors.

A girl and a boy filling candy into a bag in a store aisle.

IMAGE SOURCE: GETTY IMAGES.

1. A CEO who knows retail

Five Below CEO Joel Anderson is the former head of Walmart's online business. He's applying his experience from running Walmart.com to Five Below.

Walmart mastered the art of sourcing merchandise cheap and selling it cheap. This invaluable experience makes Anderson the perfect fit to run Five Below, given that the store's basic concept is built around selling everything for less than $5, including tech gadgets like bluetooth speakers. 

2. Profitable store expansion

At the most basic level, a successful retail operation is all about running profitable stores. Five Below is expanding fast, which can sometimes get retailers into trouble as they expand too aggressively. However, Five Below tripled the store base over the last six years, while net income has increased by 650%. 

Management plans to open as many as 2,500 stores, which has investors fired up about the stock with a forward price-to-earnings ratio of 45 times. 

But here's why investors are really excited ...

3. Incredibly profitable stores

It costs $300,000 to open a Five Below store, and each new location generates about $450,000 in operating income within the first year. New stores have a cash payback period of just seven months! 

Anderson previously said during an episode of Mad Money on CNBC, "I've been in retail a long time, and this is the best new store economics I've ever seen."

4. Balanced, broad success

Additionally, Five Below is enjoying balanced success across the country with average annual revenue per store of around $2 million. This means Five Below is a store chain that can likely succeed anywhere in the country, whether it's the Midwest or Manhattan. 

5. Relentless cost cutting

So how does Five Below sell something like a bluetooth speaker for less than $5?

The company strips all costs out of the supply chain to sell as close to the source price as possible. They go as far as deflating basketballs so there's less weight and packaging during shipment. 

Over time, what this allows Five Below to do is not only sell a fancy gadget at a cheap price but also expand product lines. For example, Five Below couldn't sell that bluetooth speaker five years ago for less than $5, but the company is now generating over $1.5 billion in revenue -- that increased scale means it can better negotiate with suppliers and acquire inventory at volumes that drive the cost per unit down.

6. Store densification

Marketing plays a big role in Five Below's success, too.

The company's expansion strategy involves opening a distribution center in a new area of the country. Then, it opens stores in clusters close to that distribution center, which keeps shipping costs down. 

Once stores are open, the company uses a variety of marketing channels, including print ads, TV ads, and social media, to drive traffic. About half of new customers come to a store after hearing about it, while the other half of traffic comes after visiting another store in the same location. In other words, about half of Five Below's customers walk into a store without being pulled in by marketing. 

What this means is that as Five Below scales into a nationwide brand, there may be some upside to the profit margin if the company is able to scale back on marketing expense as the brand becomes a household name.

7. A powerful combo of cheap and fun

Five Below is known for being a fun place to shop for several reasons. First, the stores are easy to navigate with bright lighting and shelving that allows customers to see all the way across a store. 

There's also a treasure-hunt aspect to shopping at a store. Management constantly monitors what teenagers are into and keeps inventory fresh based on the latest trends. For example, Wall Streeters thought Five Below was finished when the fidget-spinner fad was over in 2017. However, Five Below kept posting big numbers in 2018, because the company's merchandising strategy is designed to follow whatever is selling every year. This makes Five Below less susceptible to the shopping patterns of fickle teenagers.

Teenagers keep coming back to Five Below, because the store encourages them to come back. Five Below is a toy store for those too old for a toy store. Cheap items encourage impulse buys, and the store almost invites shoppers in by persuading them to think, "What can I buy for $5?"

With a roster of retail veterans overseeing a widening footprint of profitable stores, this growth story has some serious legs.

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John Ballard has no position in any of the stocks mentioned. The Motley Fool recommends Five Below. The Motley Fool has a disclosure policy.