5 Things That Five Below Investors Should Look For in Q4

Specialty chain Five Below (NASDAQ: FIVE) has been one of the few stars in retailing that has surpassed expectations and avoided the downdraft that has sent even stalwart businesses careening lower.

The retailer to teens and tweens is expected to report fourth-quarter 2018 earnings on March 27, and though there have been no indications that Five Below should turn in anything other than another solid report, here are five things investors should look for.

1. Impact from the Toys R Us bankruptcy

A lot of retailers seemed to do a remarkable job of reeling in customers set adrift by the demise of Toys R Us, with NPD Group reporting that toy sales fell only 2% last year. Considering the toy retailer had a 15% market share and billions in sales even at the end, the rest of the market seems to have picked up much of the slack.

How much went to Five Below is what we'd like to know. It had reset its stores to capture that opportunity, creating a "mega toy island" and investing in more marketing to increase interest. Five Below noted that 50% of its stores were covered by its new promotional campaign compared with 40% before, so it will be instructional to see how well consumers responded to the effort.

2. Operating margins

While virtually every line item on Five Below's financial statements has been steadily rising, one area that has fallen has been operating margin, which was down 80 basis points last quarter and 50 basis points in the second. Management expects to see it decline by 100 basis points this quarter.

However, the decline is coming because Five Below is using the tax benefits it derived from tax reform to invest in the business. It is telling that when management first warned that operating margin would drop in the coming quarters, it had expected declines of 100 basis points or more. But because store performance has been so far ahead of expectations, it has been able to offset much of the contraction expected.

Those investments include the new campaign Five Below undertook on social media and in mailers, which it maintains is an important marketing tool.

3. Store unit growth

Five Below's business model is such that it will be able to support significant expansion beyond the 750 stores it operates today. Because of its very low pricing model, opening stores within a few miles of one another doesn't hurt the existing stores' sales.

Moreover, Five Below is finding its new stores are able to pay back the investment in them in less than a year's time, a very rare occurrence in the retail industry, and they're far outperforming even internal expectations. Management expects to continue opening new stores at its current torrid pace for the next few years.

Because new stores account for some 80% of Five Below's sales growth, it fully expects to continue to enjoy better than 20% growth each quarter during this phase.

4. A new loyalty program

What might help Five Below exceed even those heightened expectations is the development of a new loyalty program. Details were light when management brought it up last quarter because the company was focused on the holidays, but CEO Joel Anderson promised more details this quarter, as it should have launched in January. A search of the website, though, doesn't show anything obviously related to such a program, so we'll need to hear what management has to say.

5. Next, it's 10 Below

Five Below will be testing a new store concept called 10 Below that expands the world of possibilities for what it sells. Still very affordable, it ought to allow management to increase the brands, quality, and selection in its stores. Activist investors have suggested that Dollar Tree, which sells everything for a dollar or less, try doing the same thing, through raising prices to just $2 or less.

A separate higher-priced chain could lift profits for Five Below even more, but because this is still a work in progress, management might not be ready to share details just yet.

The bottom line

Five Below is internet-resistant (but not internet-proof). The immediate gratification it provides to teens and tweens -- who don't have many outlets available to spend money on a whim, almost without constraint -- gives it a unique position in the marketplace.

Its fourth-quarter earnings report will give investors a sense of just how well this specialty retail concept is doing on expanding its base.

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