June 10 (Bloomberg) -- Five Below Inc. founders David Schlessinger and Thomas Vellios have so far learned to avoid the pitfalls that undid their last business -- the bankrupt Zany Brainy toy company. Still, the real test lies ahead.
The duo are expanding the chain that sells teens discounted items from tie-dyed T-shirts to bedazzled iPhone cases at a breakneck pace, with a 72 percent increase in its store base helping more than double sales in the past two years.
Zany Brainy, which sold children’s toys and games, took off on a similar trajectory before flaming out when an acquisition and losses on an Internet investment hurt it just as the U.S. was heading into the 2001 recession. Now, Five Below’s shares have more than doubled since their July initial offering on prospects that the retailer’s growth is just beginning, while analysts say its rich price-to-earnings multiple -- the highest among its peers -- leaves the company little room for error.
“They can’t have supply chain issues, and they can’t have inventory issues at this kind of multiple -- and all those things are really worrisome when you’re growing this fast because you outgrow your infrastructure,” Jan Kniffen, chief executive officer of J. Rogers Kniffen Worldwide Enterprises, a retail consulting and equity-research firm in New York, said in a telephone interview. “It’s a $2 billion company that trades like Amazon.”
Shares of Philadelphia-based Five Below closed June 7 at about 49 times its estimated earnings for the next 12 months, higher than any other retailer in the Russell 2000 Index other than Office Depot Inc., which is in the midst of a merger, according to data compiled by Bloomberg. Amazon.com Inc. closed at about 70 times estimated earnings on that basis.
Five Below rose 2.5 percent to $37.13 at the close in New York today.
Schlessinger, Five Below’s chairman, founded Zany Brainy in 1991, and Vellios joined the company in 1995 before becoming CEO in September 2000. The company went public in June 1999, purchased rival Noodle Kidoodle a little more than a year later and lost about $9 million on an Internet retail investment.
In May 2001, Zany Brainy filed for Chapter 11 bankruptcy, listing $131 million of debt and $201 million of assets. It was acquired in September of that year by Right Start Inc., which bought FAO Schwarz and changed its name to FAO Inc. Zany Brainy was shuttered in 2003, when FAO filed for bankruptcy.
Vellios in a May 2001 press release blamed the company’s bankruptcy on its “rapid growth,” which included opening 27 new Zany Brainy stores and acquiring the 60 Noodle Kidoodle shops. He also cited declining sales in the absence of a “hot” product in a slow retail environment.
After Zany Brainy’s collapse, Schlessinger and Vellios founded Cheap Holdings Inc. in January 2002 and later changed the name to Five Below, a nod to its prices of $5 or less, with its first store in Philadelphia.
The company, led by Schlessinger as chairman and Vellios again as CEO, expanded throughout the eastern U.S. and is now branching into the Midwest and the South. Five Below added 52 stores last year to bring its total to 244 as of Feb. 2, up from 142 two years ago, and plans to open 60 more this year. The store base will expand at least 20 percent annually for the next five years, Vellios said on a conference call in September. Five Below said in a March filing that it could grow to more than 2,000 stores “over time.”
The executives declined to comment through Denise DiMeglio, a Five Below spokeswoman who works for Gregory FCA Communications.
Five Below stores are usually small, located in strip malls and opened in clusters in the same region at once, helping generate attention. The locations each stock more than 4,000 items, according to company filings.
Five Below has no direct competition for its concept, Kniffen said. While Wal-Mart Stores Inc., Target Corp., major dollar retailers and Claire’s Stores Inc. all carry some of the same products, Five Below is the only one with its particular assortment of items in one place.
The strategy so far is working. Sales rose to $418.8 million in the year ended Feb. 2, more than double the $197.2 million from two years earlier. Net income last year rose 25 percent from a year earlier to $20 million. Through Friday, the shares had advanced 13 percent, compared with a 15 percent rise for the Standard & Poor’s 500 Index. The retailer is scheduled to report first-quarter earnings June 12.
The company’s total debt was 73 percent of its $47.3 million in trailing 12-month earnings before interest, taxes, depreciation and amortization, less than half the 1.8 times average for consumer discretionary companies in the Standard & Poor’s 500 Index.
Analysts, however, are cautious. Of the 14 analysts that cover Five Below, 36 percent recommend buying it. That gives the company a consensus analyst rating of 3.57, on a scale in which five is a unanimous buy and one is a unanimous sell. The average for the Russell 2000 is 3.76.
Five Below risks competition from major retailers as well as the potential for an imitator, Matt Nemer, a San Francisco-based analyst with Wells Fargo & Co., said in a phone interview. While Five Below’s rapid expansion may help it deter potential competitors, slowing its store growth to 15 percent from 20 percent would allow it to focus more on selecting the right locations and hiring qualified staff, said Nemer, who rates the shares hold.
Another potential weakness is that Five Below doesn’t carry consumer staples. That leaves it vulnerable to the rapidly changing tastes of its teen and preteen customers, said Patrick McKeever, managing director for MKM Partners LLC in Stamford, Connecticut.
“They really have to properly identify what’s popular and what’s going to be popular with teens -- if they make some bad merchandising decision that could hurt the business,” McKeever said in a telephone interview. He has the equivalent of a hold rating on the stock and cites its high valuation as one reason he doesn’t recommend buying the shares.
Still, those risks aren’t as great as the ones that undid Zany Brainy, Wells Fargo’s Nemer said. Five Below has a simpler model to execute than Zany Brainy with small stores, flexible merchandise and few regionalized products, Nemer said.
“It was a great learning experience,” he said, “but it’s a very different concept.”
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