So… what’s going in in the Real Money Portfolio this week, as we close up shop and get ready for a bit of time with family and friends? I do have one buy to share with you today, I decided to pick up some shares of the stock that I wrote to you about a week ago, Five Below (FIVE).
Why? Well, what helped to tip the balance is that Five Below (FIVE) will be a very big beneficiary of the lower tax rate, all else being equal… they pay about 36% in income taxes at the corporate level, so if we assume that they will pay roughly 21% in the future that’s a substantial boost. Right now, if the tax cut were retroactive to 2017 (it isn’t, of course, this is just an exercise), their net income would be about 23% higher.
If we use a slightly smaller number, say 20%, and apply that to future estimates (the average estimate almost certainly does not account for the new tax rate yet, since it was just passed and analysts are not typically aggressive with such things), then the 2019 earnings (they’re in FY 2018 right now) could go from $2.06 to $2.47. That means the forward PE goes from 32 to 27.
So yes, it still trades at a premium prices… but I’ll bite at that level, particularly because the stock was fairly appealing even before, and this tax cut isn’t likely to otherwise pressure the growth numbers… in fact, it could also be that the tax cut is positive for top-line sales, not just the bottom line profitability. If withholding is slightly lower for most middle class taxpayers starting in January, there could be more disposable income, which tends to leak down to the teenagers who frequent Five Below.
And really, other than Amazon my portfolio is quite lacking in retail or real consumer-driven companies, so it will probably be good to have some further exposure to that sector — even if I’m not willing to risk a lot on most of the struggling retailers right now… FIVE seems, with its fun stores and low prices, to be effectively immune from the Amazon flu that ails so many retailers, though that, of course, is no guarantee that they’re immunized forever.
It still could fall apart on an operational level too, of course, the next quarter (ending in January) is by far the most important one for FIVE, as it is for pretty much all retailers (close to 40% of revenue comes in the Nov-Jan quarter, and their profit margin tends to be about 12-13% at this time of year — versus 2-4% the rest of the year), so the late February earnings report will be watched very closely, as will any commentary from the company about holiday sales.
It could also be that some of that run from $55 to $65 was because investors were “baking in” the likely tax cuts — they had a strong “beat and raise” quarter right after Thanksgiving, at about the same time that most stocks and sectors started surging, so I think that operational performance was the primary reason for the jump… but I could be wrong. I think it will take a while for the tax cut to be fully priced-in to the expectations for a lot of stocks… and that could really add to the growth story for stocks that have fundamental growth that looks really strong and can lever that up with a really substantial increase in earnings per share from the corporate tax cut.
I don’t know what will happen with stocks that are just getting a one-time shot of earnings growth from tax cuts, or from repatriating overseas cash, sometimes one-time improvements that make a stock look like it’s growing earnings are adored by the market, sometimes they’re ignored as non-repeating windfalls… but since growth is projected to be very high for FIVE anyway, with a huge buildout in new stores that are apparently doing very well, I think it’s likely that the tax cuts will just be a bit more leverage for growth that was already coming… and I expect investors will reward that pretty handsomely as long as the economy overall is doing OK — as it should, at least in the first flush of tax cuts.
I expect we’ll see a substantial rise in inflation next year as a result of this additional spending and the projection of additional borrowing by the government, and that could bring faster interest rate rises that serve to put the brakes on a little bit, but you never really know for sure what will happen — particularly in this environment, where interest rates remain so much lower in most of the larger economies than there are here in the US.
So I’ve put on a small equity position and another levered bet that FIVE will also see some significant analyst estimate increases by next month that drive the shares higher — I did that through some January in-the-money call options, which are fairly inexpensive because the stock has run so much and there isn’t a formal “catalyst” before the expiration (the next earnings report won’t come out until late March), but I think estimate increases will come before then, largely because of taxes, and that will push the shares higher.
I’m comfortable with the equity investment, even at these high prices, and I think FIVE will likely do very well next year… but the options bet is far riskier, given that we’ve only a few weeks to expiration, and I could easily lose 100% on that position (that’s more of an “indulge my inner bettor” move than it is an actual investment).
There’s certainly risk in the stock, as well, and not just because it’s priced at a premium to the market or just because Amazon is, per investor consensus, destroying mall retailers. Five Below is largely a seasonal and fad-driven retailer, and that has brought plenty of ups and downs… those holding since the IPO five years ago would have done well thanks to this year’s surge, but there were also plenty of opportunities to lose money along the way, and it could easily be that one of the upcoming quarters looks relatively weaker year over year because of something fad-related (if, for example, nothing takes the place of this year’s “fidget spinner” craze that really ballooned earnings for a few months in 2017). Part of what has really worked for FIVE as a business model is pulling in people for fads, and keeping them for more “regular” stuff… so they think that those fidget spinner buyers from last Summer will come back and buy Star Wars gear this winter, or candy, or cell phone cases for their new phones, or whatever. The concept is very similar to a dollar store, in that everything is super cheap ($5 or less), but unlike Dollar Tree (DLTR) or Dollar General (DG) they don’t feature so much of the “boring” stuff like food and shampoo, it’s much more of a toy store for teens.
Despite the low prices, they earn pretty high gross margins — in the 35% range, a bit better than the 30% the big dollar store chains generally earn (gross margin is just the revenue minus the cost of goods). Add in the cost of operations, and the margin edge remains — their operating margin is about 11.4