1 Warning to Consider Before You Buy This Growth Stock

With the market rallying nicely during the past couple of years, investors undoubtedly have every reason to be bullish. But there are certain businesses that continue to disappoint their shareholders.

This growth stock is 56% off its peak price back in August 2021. You might be inclined to buy the shares in the expectation that things can take a turn for the better. However, it's critical you don't ignore this one warning.

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Rapid expansion

Discount retailer Five Below (NASDAQ: FIVE) has had rapidly growing revenue by aggressively opening new stores. Its top line came in at $736 million in the latest fiscal quarter (Q3 2024, ended Nov. 2). That was a 95% jump from the same period five years ago. This has been driven by an almost doubling of its store count.

Management says the unit economics are strong. A new Five Below location requires an upfront investment of $500,000. But on average, it will generate $2.2 million in annual revenue and $500,000 in yearly earnings before interest, taxes, depreciation, and amortization (EBITDA). Viewed from this perspective, it makes sense why the leadership team wants to keep growing.

What's more, Five Below is expanding without stressing its finances. As of Nov. 2, the company had zero long-term debt on the balance sheet. This probably is a surprise because you'd think a business investing aggressively to build out new stores would take on more debt.

Major red flag

Top-line revenue growth is robust. But the key warning investors need to pay attention to is weak same-store-sales (SSS) trends. A retailer's top priority is to increase SSS consistently because this indicates healthy foot traffic and pricing over time from existing locations. Five Below posted a whopping 30.3% SSS gain in fiscal 2021, followed by a 2% decrease and a 2.8% increase, respectively, in fiscal 2022 and fiscal 2023.

But things have taken a turn for the worse. Through the first nine months of fiscal 2024, same-store-sales fell 2.6% versus the same period last year. To be fair, they were up 0.6% in Q3, but that's nothing to write home about.

Throughout calendar 2024, inflation has drifted lower. In theory, this should have eased the pressure on consumers and their spending behavior. However, because Five Below sells merchandise mainly lower than the $5 mark, it should be somewhat insulated from inflationary headwinds because providing consistent value is its main selling point.

Clearly, the financial headwinds tell a different story. In Q2 2024, there were signs of weakness among lower-income consumers.

On a bright note, executives did say traffic trends across the entire retail sector improved toward the second half of 2024. And for Five Below specifically, management believes the business is doing a good job focusing more intently on having a fresh product assortment that drives customer excitement, which is absolutely paramount.

Looking ahead, investors need to pay close attention to the trajectory of SSS. It would be nice to see this figure get back to low to mid-single percentage digit increases. It doesn't help that leadership forecasts a 4% SSS drop in Q4 (at the midpoint). Apparently, things will get worse before they get better.

Cheap for a reason

Five Below shares have gotten crushed since their 2021 peak. During that same time, the S&P 500 is up 30%. The investment community is souring on the business, and for good reason.

As a result, the valuation is depressed. The stock sells for a price-to-earnings ratio of 20.6. During the past 10 years, the multiple has averaged 41.7. Some might find this discount hard to ignore.

The shares might be trading at a historically cheap valuation. But investors should avoid buying this growth stock right now. Five Below needs to prove that SSS can get back to sustainably healthy growth before investors even consider adding the stock to their portfolios.

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Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool recommends Five Below. The Motley Fool has a disclosure policy.