Slime, Squishy and Mermaids: What's Driving Five Below's Blowout Quarter

There are a lot of things Five Below Inc. (FIVE) got right in its second quarter.

The Philadelphia-based retailer that caters to children, pre-teens, teens and their parents got product-market fit figured out, they focus on discounts, they're on an aggressive geographic expansion spree and they're thinking like a startup.

This is what led to $347.7 million in net sales, a 23% jump from a previous quarter, and a 2.7% increase in same-store sales in the same quarter. Net income soared 49.1% to $25.1 million.

The shares jumped 12.5% in pre-market trading as of 8:57 a.m. in New York.

J.P. Morgan (JPM) , which raised its price guidance to $150 from $116, called the discount retailer "industry best in class" in a research note on Thursday, noting the company's 2018 new store fleet is "trending to a historical peak with 2Q adjusted productivity exceeding 100% and stores opening at a 150% ROI with less than a one year payback."

The company, which became public in 2012, offers a range of seasonal and trend-driven products across retail categories: from sporting goods and fashion and video game accessories to room decor and jewelry.

The company also raised its fiscal year earnings per share guidance to $2.51-2.57 from $2.42-2.48. They also expect the sales momentum to last.

"For the full year 2018, we are raising our sales guidance, which we expect to be in the range of $1.528 billion to $1.540 billion, an increase of 21 to 22%," Kenneth Bull, Five Below's chief financial officer, told investors on a call on Thursday.

Tween Power

What does Five Below get right? They know their customers and their business model is dependent on staying relevant.

"We've previously talked about three broad types of trends in our business. First, crazes like Spinners, second, brands and licenses like Frozen and Star Wars, and third, constitutes a very core of Five Below, relevancy," Chief Executive Office Joel Anderson said on a call. "While we will not have a craze or license trend in every quarter, we will almost always have relevancy trends such as slime, squishy, spa and mermaid which continued in the second quarter this year."

They also offer a range of retail categories that matter to their consumers.

The company management noted that their performance in the second quarter was driven by Tech, Handy, Create, Style and Room categories.

Create is Five Below's crafts and art supplies division, which offers a range of products from play-do to coloring books. This is a niche space that is not dominated by e-commerce giants like Amazon.com, Inc. (AMZN) and where retailers like Etsy Inc (ETSY) have been able to make successful inroads.

As the name suggests, Five Below specializes in discounted merchandise that does not break the bank and kids and parents can afford to update their phone accessories regularly and stay "on trend."

The company's gross profit rose 23.6% to $121.8 million from the same period a year before. Five Below's gross margin rose 20 basis points to 35%, "driven primarily by occupancy cost leverage on the higher sales" according to the CFO.

The management aims to build scale and target high-teens in its ambitious store rollout.

"In the first half of 2018, we opened a total of 67 new stores representing just over half of our planned 125 store openings for 2018," said CEO Joel Anderson on a call on Thursday.

"In Q3, we are planning on opening approximately 50 stores. This would be a record for us and we have already opened 17 of them. Two weeks ago, we opened our 700th store in Glendale, California, which was also our 25th California store."

The company is planning to spend about $130 million in gross expenditures on expansion.

Analysts note the uncertainty and underlying risk behind Five Below's aggressive geographic growth.

"With only 625 stores today and a target of 4x its current base, there is the risk that management is overestimating the availability of appropriate real estate or underestimating the competitive backdrop," said Matthew Boss, analyst at J.P. Morgan, in a research note.

Thinking Like a Startup

Five Below is thinking like an agile startup, looking to bring in fresh blood, and recognizing the need to adjust quickly to new trends and staying on top of their customers' changing tastes.

The company announced Rob Feuerman as the new CIO. Feuerman is also a founder of two startups. One of the startups is Kid Chow, an online school lunch company in the Bay Area making organic meals to K-8 schools.

"As we expand our footprint across the country, we continue to focus on having the right people, systems, and infrastructure in place to support our growth while keeping execution at a high and consistent level," Anderson said.

 So far, they've been doing just that.