Five Below's (FIVE) discount model is firmly under the microscope as increasing tariffs look to take a toll on margins.
Shares of the discount retailer have dropped off sharply after the open, eroding pre-market positivity driven by an earnings beat and guidance raise, driven largely by a retail sector threatened by external macro impacts.
The still uncertain situation was noted as extremely fluid at the moment by CEO Joel Anderson.
"As a value-driven retailer we are concerned about higher tariffs as they will be impactful to our business and lead to higher prices," he acknowledged. "We expect to mitigate the jump to 25% and are working on a number of options to do so including vendor negotiations, price increases on our $1 to $4 items, process efficiencies and overtime moving production to other countries."
He noted that 15% of receipts in 2019 for the company are due to be impacted by the additional $250 billion in products due to be taxed on China, which could be worsened by further impositions on goods from Mexico or India, for example.
"This dire situation has been so fluid," Anderson added.
As Jim Cramer noted in his morning column, "nothing is worse than fluid."
Still, the company remains confident it can contend with the always evolving macro environment, noting a combination of vendor negotiations, price increases, and efficiency increasing efforts that will need to be utilized in the near term.
Of course, as a discount retailer, margins remain thin and an increase on prices threatens to soften demand for the deals they offer.
"Increasing prices beyond the $5 price point is a decision we do not take lightly. We have put a lot of thought behind this decision and we'll proceed with pace and diligence," Anderson said of the decision. "We will be testing higher pricing on select products in a group of stores before rolling out increases to the entire chain."
He added that the company will look to keep price increases minimal so as not to deter customers and maintain its commitment to "providing extreme value" to consumers.
Overall, analysts on Wall Street have lauded the price increases as a wise decision that shouldn't sting demand to too large a degree.
"Sales/margin guidance was unchanged even though underlying tariff assumptions moved to 25% from 10%, as Five expects to mitigate the impact," RBC Capital Markets analyst Scott Ciccarelli noted. "Valuation isn't 'inexpensive,' but we remain buyers given the company's store growth potential and extremely strong unit economics, awarding it true scarcity value in today's market."
Ciccarelli increased his price target from $134 to $139 on his belief that further share growth remains ahead despite the headwind.
Additionally, while the company's $5 price point target is indeed low, it offers far more flexibility than peers like Dollar General (DG) and Dollar Tree (DLTR) that aim to set targets at just $1. Rather intuitively, a price increase from $5 to $5.25 or $5.50 (a 5%-10% increase) is far less impactful to demand dynamics than a 25% increase to prices from a dollar store competitor.
"We believe the beauty of the Five Below model is that it should provide pricing flexibility, where customers may not overly scrutinize price increases," Ciccarelli commented. "While Five could face some elasticity challenges, we think the company generally has the ability to modestly raise prices in this situation."
With largely laudable mitigation strategies in place, it would appear that as the stock's decline Thursday morning is a result of Five Below being a good house that finds itself in a bad neighborhood, i.e. the overall retail sector.