Five Below Hits Q1 Targets, but Tariffs Cloud Outlook

It was never so much whether Five Below (NASDAQ: FIVE) would execute well in the first quarter but rather how worsening trade tensions would determine its immediate future.

As expected, the teen and tween retailer did exceptionally well in the quarter, and though its stock retreated in early-morning trading, the decline is not nearly as bad as it could have been. Tariffs will take a toll, to be sure, but in maintaining its full-year guidance, Five Below is indicating it will be able to mitigate the worst aspects of any increases.

Still firing on all cylinders

Five Below turned in another rather stellar quarter, with sales surging 23% to $365 million, right in the middle of its guidance of $361 million to $366 million, and comparable-store sales rose 3.1%, toward the low end of its 3% to 4% guidance but slightly below last year's 3.2% rise.

Net profits were also up almost 18% to $25.7 million, or $0.46 per share, well ahead of management's forecast and Wall Street's outlook of $0.35 per share, as well as last year's $0.39. However, the result includes an $0.11-per-share benefit from share-based accounting, which if factored in would have put it at last year's $0.35 per share, as the first quarter of 2018 had a $0.04-per-share benefit.

But the first quarter may have been the easy part. The new tariffs didn't go into effect until after the quarter had ended, and Five Below had previously been able to fully mitigate the increases in tariffs that accompanies the early rounds of import duties by buying a lot of merchandise early and pulling it into the 2018 fiscal year.

Now some 15% of Five Below's merchandise is subject to the new tariffs that jumped to 25% on the so-called List 3 tariffs, and beyond sourcing merchandise from countries other than China, negotiating with vendors, and changing up its product mix, the retailer is resorting to raising prices, and not by an inconsequential amount.

The ugly underside to tariff hikes

President and CEO Joel Anderson said prices on items normally sold for $1 would quadruple to $4, while those priced at $5, which account for 40% of its inventory, would also rise. Although Anderson said most of Five Below's product line would remain below the $5 threshold, it's clear there was no easy workaround to the higher rates.

Perhaps worse, there's the possibility that tariffs on List 4 products, which cover thousands of new items worth some $300 billion, will also be raised. And it's not only the direct costs that Five Below would bear from the increased tariffs; most retailers are raising prices in response to the trade battles, and that could have an impact on consumer spending for discretionary items like those it sells.

Five Below isn't changing its full-year outlook -- it is calling for sales to rise 20% to 21% to a range of $1.86 billion to $1.89 billion, comps to rise 3%, and earnings to be between $3.11 and $3.18 per share. This suggests the company thinks its actions will sufficiently cover the increases.

The company has said before that an increase in List 3 tariffs could hurt gross margins, so it is essentially saying it will be able to navigate those waters. And for the most part, it should.

Outlook has some caveats

While Five Below's products are discretionary, they still represent a very discounted price point, particularly for its target demographic, and it was already experimenting with prices as high as $10, albeit in only a few dozen stores. Still, it might be able to offset some of the setback of charging higher prices by also increasing the quality of the goods it's selling. That was the reason for the 10 Below concept, and the company might be able to extend it further, depending on the impetus of the tariff hikes.

Right now, though, Five Below is focusing on mitigating the impact of the List 3 tariffs, so quality issues will have to wait. It also means its guidance doesn't take into account potential List 4 tariff hikes, which could dramatically alter its outlook if they go up.

Certainly it could have been a much worse outcome for Five Below, and while it still could be, the discount retailer looks as though it is adequately putting out the fires as they arise.

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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.