Dollar General Corporation (NYSE:DG), to which we will also refer as “DG” throughout the article, reported what appeared to be bad Q2 earnings a couple of weeks ago. We say they “appear to be bad earnings” because we have not looked at the company in detail to have an opinion on its fundamentals. However, the stock price seems to indicate that investors are not happy with the company’s performance this year:
If we zoom out and look at the company’s relative performance against the S&P 500 (SP500) over longer time periods, we can see that we reach a similar conclusion: Dollar General has underperformed the index over the past 5 and 10-year periods. Of course, much of this longer-term underperformance has been caused by the recent drop, with the company significantly outpacing the index coming into 2023:
This, in my opinion, shows why investing can be very tough. An investor could’ve held Dollar General for 9 years, significantly outperforming the index. This same investor would’ve seen their outperformance wiped out in under 6 months. The stock market can indeed be brutal.
Without making any judgment on the company’s future performance, this situation demonstrates that investing is not only a game of buying but also one of selling. But if one does their research correctly and thoroughly, it has the potential to become a game more tilted to the buying than the selling. Don’t forget, though, that even the greatest investors of all time have hit rates below 70%, meaning they also have quite a bit of losers. Luckily for investors, stock investing is asymmetric: the potential gain is infinite, whereas the downside is capped at 100% (unless one uses leverage). This ultimately means that a hit rate of 50% can yield exceptional returns.
Anyways, back to the subject of this article… This lousy performance by the U.S.’s largest publicly traded dollar store (even after the substantial drop) begs the question:
Are dollar stores a good business, or are they reaching terminal decline?
While we will not aim to answer this question in this article, we do want to write about why Five Below, Inc. (NASDAQ:FIVE), one of our positions, should not be bundled with other dollar stores.
Investors typically give the “Dollar Store” etiquette to every retailer that sells value goods. Well-known companies in this bundle are Dollar General, Dollar Tree (DLTR), Five Below, and maybe Dollarama, although that one is more focused on Canada. Bundling them together makes it seem as if these companies are peers, but the reality is that they are not. Of course, some are more comparable than others, but ultimately, the only thing all of these have in common is low prices and a value proposition of convenience.
We consider Dollar General, Dollar Tree, and Dollarama somewhat comparable, but we don’t think Five Below is a peer. Differences might appear subtle over the surface, but nuances are important not only to remain cautious when cross-reading earnings calls but also because it makes the exposure to risks vary significantly, among other things.
The article aims to explain what we think makes Five Below different from Dollar General, so, hopefully, you understand why they can’t be bundled together. Without further ado, let’s get on with it!
Difference #1: The maturity stage
Five Below is earlier in its growth story than Dollar General. The former was founded in 2002 in Philadelphia, whereas the latter was founded 63 years earlier (in 1939) in Kentucky. These widely diverging life spans have led to different maturity stages. Dollar General’s maturity gap with Dollar Tree is obviously much thinner, as the latter was founded in 1986.
DG currently operates more than 19,000 stores in the U.S., whereas Five Below owns around 1,400. DG operates 13x as many stores as Five Below. A pretty significant gap.
This store gap is also evident in new store growth rates. DG’s growth rate in new store builds has remained somewhat stable around the 5-6% mark for much of the past decade, which is pretty impressive considering the scale. But Five Below’s store growth is significantly higher at this point:
Five Below continues to grow its store base at double-digit rates, with an expected acceleration in the second half of 2023 and 2024. New store builds have been somewhat lower due to the subdued availability of real estate and the pandemic. Management expects to open more than 3,500 stores by 2030, yielding a 13% CAGR from today’s numbers. Of course, growth will not be linear here, as management expects around an 18% CAGR in store openings through 2025, which should moderate thereafter.
It’s important to consider that this number is management’s view on the company’s store potential, but it’s unlikely to constitute an upper lifetime limit. Five Below’s store potential has been revised upwards a couple of times. For example, on the most recent investor day, management took it to 3,500 stores from the prior expectation of 2,000+ stores; that’s a 75% increase in store potential. I think it’s fair to assume that it can be revised upwards in the future again, especially since Five Below continues to grow its store base fast in densely-populated markets.
The gap between Dollar General’s and Five Below’s store base is large, and although I don’t anticipate it to close entirely due to differing value propositions, I do believe it portrays the opportunity Five Below has ahead. Also, consider that Five Below’s average store is around 8,500 sq feet, whereas Dollar General’s is around 7,400. This means the gap in square footage is not as wide as in the number of stores.
The gap in number of stores not only has implications for growth but also for the predictability of this growth. Opening new stores is a very repeatable model if stores enjoy good economics. On the other hand, same-store sales can be a tad more challenging to project forward due to their reliance on innovation.
Five Below does expect same-store sales to play an important role in its midterm guidance, but store openings will lead the way here:
Cannibalization is a fair pushback to store densification. Five Below is also expected to do well in this regard, and it should arguably be a bigger problem for Dollar General considering its maturity stage. Philadelphia is Five Below’s most densified market to date, and management expects to double the company’s store base there without significantly impacting store performance. The graph below shows how store performance is pretty consistent across regions regardless of the densification stage:
Comparing Five Below and Dollar General doesn’t make much sense solely based on the fact that both companies are at widely differing growth stages. Dollar General is a much more mature company than Five Below, and the company’s new store growth in the coming years might negatively weigh on same-store sales, at least to a greater extent than for Five Below.
Of course, the difference in maturity stages is somewhat captured in the valuation differential:
Plotting this out made us realize that the P/E ratios of both companies converged a year ago, something surprising considering what we have just discussed in this section. Of course, the P/E ratio can be influenced by many things (for example, a company might be over-under earning), so taking it at face value might not be the best idea.
Difference #2: The customer base
Probably the most relevant difference between both companies (as it leads to different economics) is the customer base. Five Below targets teens and tweens, whereas Dollar General primarily targets low-income individuals who rely on the company’s low prices to get to the next paycheck. There’s no direct mention of the income level in Five Below’s target customer definition.
Almost half of Five Below’s customers are in the sub $50,000 household income level, but customers are pretty diversified across income levels. This is the first indicator that Five Below’s value proposition goes beyond low prices:
What’s important to understand here is that while Five Below also follows a model of convenience and low prices (just like Dollar General or other dollar stores), it’s much more anchored to the in-store experience because that’s what their target customer demands. Dollar General’s target customer does not go to the company’s stores for the in-store experience but for its convenience and low prices. The difference might appear subtle, but it’s not.
Dollar General has tried going into Five Below’s “fun” territory through pOpshelf. This concept aimed to transform the experience into a treasure hunt, just like the one Five Below tries to offer its customers:
pOpshelf was first discussed in 2021, but its performance/KPIs have not been disclosed since then as far as we know and management announced in Q1 they would slow down the rollout of this store format:
Included in these plans, we have made the decision to moderate our rollout of pOpshelf in 2023, as we now plan to open approximately 90 stores compared to our original expectation of approximately 150 openings. We believe this is a proven reduction based on the current environment.
Source: Jeffrey Owen, Dollar General’s CEO, during the Q1 2023 Earnings Call (emphasis added).
Having to slow down the rollout due to macroeconomic headwinds probably indicates the concept is not resonating with DG’s customers who want low prices and maybe not so much a fun experience. Note that Five Below’s model has remained pretty resilient all throughout macroeconomic turbulence.
We can see why Dollar General would find problems going into Five Below’s area of expertise, though. While Five Below’s stores, assortment, and brand proposition have historically targeted teen and tween customers, Dollar General’s has not. Switching customer bases or catering to new customer bases is easier said than done. We don’t think Five Below’s value proposition would appeal to the typical Dollar General customer.
Ultimately, what this customer difference allows Five Below to do is focus less on prices and more on the experience, extracting the value along the way. When one’s value proposition is low prices, it’s much more difficult to weather the impact of inflation, for example. Five Below’s gross margin has been consistently higher than that of Dollar General despite not being run for efficiency in its current state:
Here we want to bring a quote by our friend Shree Viswanathan, the founder and sole employee of SVN Capital. He explained in my interview with him how he views margins in the context of business performance. Shree also mentioned that he would not apply this to every scenario, but we think it definitely applies here (emphasis added).
You know, as an aside, one interesting viewpoint is if you take the income statement of any business, when you go from top of the income statement to the bottom, you’ll come across gross margin, which is your sales minus the cost of goods. So high gross margin will tell you about the quality of the business itself most of the time. Always take all these things with some kind of a caveat at the end. But a high gross margin will tell you about the quality of the business.
Difference #3: Resilience?
Another potential difference between both is the business’ resilience through tough times. Dollar General has a significantly larger mix of consumables, whereas Five Below is only represented in this category through its Candy world (every store is organized across 8 worlds):
The higher weight of consumables might make Dollar General more resilient through tough times and, most importantly, less subject to shifts in customer preferences, which can be brutal in the retail industry. Five Below seems to be doing well in this regard, though. Comparable sales are currently in an uptrend, primarily led by traffic:
We have, however, read in several expert calls (Five Below was not publicly traded during the Global Financial Crisis of 2008) that Five Below managed to grow comparable sales through the Global Financial Crisis. This would make quite a bit of sense, considering that kids are not the first place where parents cut expenses and that Five Below provides a cheap and fun experience for kids. During tough times, one might not have money to take their kids to Disney, but a trip to a Five Below store can do the trick (of course, the experiences are not directly comparable). Five Below’s management argues that despite selling discretionary items, the experience makes Five Below resilient during tough times.
Difference #4: Returns
Of course, the fact that these companies are not comparable can also be seen in the returns they generate for shareholders. Dollar General has historically produced attractive returns on capital, coming in at an average of 17.6% over the past decade:
The company has historically juiced these returns for shareholders using debt, averaging a return on equity of around 28% over the last decade. Five Below doesn’t carry debt, so its ROE is not “juiced up.” However, Five Below enjoys significantly better returns on capital than Dollar General, aided by its differentiated value proposition.
The company has averaged ROIC of 26% over the last decade, 900 basis points above that of Dollar General:
Where does this difference come from? Well, the starting point is probably the returns on new store builds. According to a research paper by Credit Suisse, Five Below enjoys 4-wall ROICs above 100%, the best in the business. Those of Dollar General revolve around 50% (still very respectable):
Note that a +100% 4-wall ROI means that Five Below has a payback period for new stores of lower than one year. This also explains the no-debt; the company does not need it to fund its operations.
We should also highlight the significant gap between Five Below’s 4-wall and company-wide ROIs. Dollar General has a 3,274 basis points differential, while Five Below’s is 14,300 basis points. The substantial difference probably comes from Five Below not being optimized for efficiency but for growth, which penalizes company-wide ROI due to higher-than-usual operating costs. For example, the company’s current distribution network can service around 2,000 stores, but the company is 600 away from this target. With operating leverage kicking in in the coming years, we should see margins expand and the gap between 4-wall and company-wide ROI close substantially.
Are these high returns a sign of a moat? Well, at first glance it would seem so, as these returns have not been competed away for more than two decades. It’s fair to believe that other dollar stores might have never needed to enter Five Below’s niche due to their core business doing well. Has Five Below suffered significant moat attacks during its lifetime? Tough to answer, but as the company gains scale, it’s fair to assume moat attacks have a lower probability of bearing fruit.
More than a moaty business, we could say Five Below is an extremely well-run business with a differentiated value proposition. As the business grows we might start to call this a moat due to scale advantages that impact both distribution and more importantly, brand awareness.
It’s also obvious that we can’t compare Five Below’s returns today with those of Dollar General for a very simple reason which we have already discussed in this article: they are in different maturity stages. With Dollar General’s densification one could argue that it’s tougher to generate superior returns than Five Below, which is much earlier into its expansion plans. Simply put, there’s white space ahead for Five Below while Dollar General is now competing with itself in many geographies.
The argument makes sense, but if we look back, it seems that Dollar General has never reached the returns that Five Below enjoys today, irrespective of maturity stage:
In our opinion, the differing returns are already a pretty good indicator of differentiation. Dollar General seems to be reaching a more mature state and is not alone in its business. Five Below is early into its growth trajectory and has carved out a niche where no competitor has been able to compete away its returns.
Difference #5: Risk exposure
Bundling an industry under the same label can translate into misconceptions regarding risk exposure. At first, all dollar (or “Value”) stores were considered insulated against the e-commerce risk. The rationale was that low price points rendered e-commerce non-economical due to shipping costs. Simply put, it would make little sense to buy a product for $3 and incur the same amount in shipping costs.
This common narrative, however, might be changing now. Players such as Temu and Shein (both Chinese; Temu is Pinduoduo’s international brand) might be starting to alter the landscape in the US, and it seems that customers might be starting to get comfortable with buying cheap products online. According to an analyst, Temu and Shein are considerably cheaper than Amazon in comparable products:
This analyst also claims that Temu and Shein will continue to eat into Amazon’s market share and also of dollar stores who never saw e-commerce as a threat. Will this risk materialize and how? We honestly don’t have the answer to these questions, and even if we did, it’s not the subject of this article. However, we are confident that Five Below’s exposure to this risk is significantly lower than other dollar stores that have exclusively focused their value proposition on low prices.
At Five Below, the in-store experience (treasure hunt) carries the most value for the customer. Of course, it’s also a value proposition of convenience and low prices, but the store setup and the merchandise are clearly geared to make the experience worthwhile for its target customers. When the in-store experience is the most important thing, the risk of disruption from e-commerce diminishes materially. Note that Five Below has offered multichannel capabilities for some time now but these have never grown to a sizeable portion of the business. In fact, the last time management talked about e-commerce was more than 2 years ago.
Of course, there will definitely be some e-commerce volume, especially among customers who value convenience more than the in-store experience. Still, in our opinion, the risk is more limited than for companies where convenience is the central aspect of the value proposition.
Note also what we commented before: Dollar General might be less exposed to recessionary impacts than Five Below due to its higher mix of consumables. This, however, seems like a short-term risk in nature (the economy eventually turns around) more than a terminal one like e-commerce might prove to be. This higher exposure to the economy’s swings might also be why Five Below has an immaculate financial position while Dollar General does not.
We hope this article helped you understand why we should be careful in bundling companies in the same industry without additional context. It will sometimes be the case that two companies can be bundled under the same label, but there will always be differences between individual companies that make generalizations useless. Dollar General and Five Below might operate in the same value category, but they are different as night and day.
In the meantime, keep growing!