Five Below 22% Up

In this episode of the Market Foolery podcast, host Chris Hill and Motley Fool contributor Jason Moser hit on some of the market’s biggest stories. Discount retailer Five Below‘s (NASDAQ: FIVE) 22% jump is probably an overreaction, but long-term investors still might want to check this company out.

On the other side of the overreaction coin, video-processing chipmaker Ambarella (NASDAQ: AMBA) dropped a whopping 13% on its quarterly report, but the company’s long-term outlook is a bit less rosy. The mysterious JPHathAzon healthcare company has reportedly decided on a CEO, but further details haven’t yet been released. And Warren Buffett and Jamie Dimon are weighing in on quarterly expectations culture. Click play and find out more.

A full transcript follows the video.

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This video was recorded on June 7, 2018.

Chris Hill: It’s Thursday, June 7th. Welcome to Market Foolery! I’m Chris Hill. Joining me in studio, Jason Moser. Happy Thursday!

Jason Moser: Hey now!

Hill: Are you ready for the weekend?

Moser: I am. I’m always ready for the weekend.

Hill: You know what? You had a pretty nice weekend last weekend.

Moser: [laughs] Listen, I’m still kind of on weekend time. Yeah, I was down in Georgia last weekend. Unfortunately, I had to miss FoolFest. That was not intentional. The plans were made far in advance. I just didn’t realize the two would mash up. I was sorry to miss that. But any time I get a chance to go play golf with my dad, I like to take it. We were down in Georgia on Sea Island, where I had never been before. It was pretty. It was pretty hot, too.

Hill: Nice. We have retail earnings, we have chip earnings. We have a very interesting letter from Warren Buffett and Jamie Dimon, and we’re going to get to all those. Let’s start, though, with consumer goods. [sighs] You can hear the resignation in my voice. J.M. Smucker (NYSE: SJM), fourth quarter profits and revenue came in lower than expected. Their guidance for the new fiscal year was weak. The stock is down about 5%. This whole industry is in the doghouse right now. Consumer goods is just the worst right now.

Moser: [laughs] It’s not good. I basically put companies like this in the same category as actual grocery stores. I mean, Smucker is responsible for a lot of the stuff that you find in the grocery store, right? So, I’d put them in the same category, in regard to whether you’d want to invest in them or not.

I personally have no interest in investing in them. There are a number of reasons why. One is, it’s not a business where there’s a lot of pricing power, really at all. I think, maybe a time ago, there was, when there perhaps was some brand loyalty. I don’t think there is as much brand loyalty today. There are a lot of alternatives coming on the market, particularly with naturals and organics.

What you’ve seen with companies like Smucker is, they start facing these challenges growing their top line. In order to do that, they try to, maybe, make some acquisitions here and there. But ultimately, that doesn’t really pan out. Acquisition is always a risky strategy. Then, it becomes more and more difficult for them to bring that down to the bottom line. And that’s what we’re seeing, really. Adjusted operating income for the quarter was up just 3%, and you can see the stretch of top line challenges they’ve had over the past five, six years.

Hill: And we’ve seen this with other consumer staples companies. The one thing that makes me wonder about Smucker is, they have coffee, and they have pet food. We’ve talked before about how the pet food industry, the pet care industry, these are generally rewarding investments. If the only thing Smucker was relying on to drive their sales was just the basic peanut butter and jelly I find in the grocery store, or vegetable oil, and all that sort of thing, I would understand this. The fact that they have pet food, and had to integrate that acquisition, the fact that they have coffee and they’re not really making that work, that makes me wonder if there’s also some operational difficulties within the company, beyond just the fact that this is a tough industry to invest in right now. This shouldn’t be happening across the board.

Moser: You wouldn’t think. In the coffee segment, they own some brands. They license a lot of stuff, too. They license the Dunkin’ Donuts K-Cups or pods or whatever. When it comes to pet food, I think Milk-Bone is one that they either own or license. But, regardless, I think when you look at coffee, that’s an extremely challenging market just because we know the big players in that space. If I’m going to invest in coffee, I’m just going to buy stock in Starbucks and/ or Dunkin’ Donuts and just call it a day. I don’t think Folgers is a very compelling name in this space anymore, and that has historically been Smucker’s strong brand. So, they have a lot of brands that we’re familiar with, but they’re becoming a bit antiquated and a bit, I guess, irrelevant.

Hill: And one other thing in the coffee space — this is not a public company — JAB Holding, which has methodically snapped up a bunch of coffee companies. Caribou Coffee, Peet’s Coffee, as well. And JAB is a big player in this industry, as well.

Moser: It is. Maybe “irrelevant” was a strong word for me to use, but I guess, when you just go back to that idea that there are so many substitutes out there … and even go to the private brand market there. Look at what Amazon, for example, is doing with that Whole Foods acquisition and the investments it’s making in the 365 private brand. I think they see a big opportunity there in developing this really quality, reputable private label brand, that, I mean, it doesn’t make you think “private label brand” from the very start. I think Whole Foods did a good job early on in developing that.

When you look at Smucker, I mean, you’re right, there are some operational problems there. They’ve talked about, for 2019, they had an investor conference back in February and they were talking about some elevated capital expenditures coming this year as they’re going to try to right the ship and whittle down the business to its core operating successes and unload the dead weight. When you look at that, and then you look at the fact that, if you take this past fiscal year’s normalized earnings, this stock is trading at around 15X those normalized earnings.

Which, in an environment where the tide is lifting all boats, I look at a business like that and, it sounds kind of cheap, but really, when you consider the challenges it has out in front of it, I would much rather pay up considerably more for a company like McCormick, for example, where I think there is more brand loyalty, I think there is more pricing power. Then, on top of that, McCormick, they’re a dividend aristocrat. You’re going to have the reliability there with the business, whereas Smucker’s, they’re dealing with some challenges. I think that’s reflected in the stock price. Again, I don’t know those challenges are so easily addressed. Again, it goes back to that core assumption that it’s such a difficult market, I just don’t know that I’m all that interested in it in the first place.

Hill: Let’s move on to retail. Five Below, their first quarter profits and revenue looked good. You tell me how good this actually was, because shares of Five Below are up 22% this morning.

Moser: That’s a good day.

Hill: [laughs] That’s a really good day. There was some guidance along with that, as well. But, is this warranted?

Moser: I think probably. I look at this, there are a few things that we can count on in life. There’s death, taxes, Facebook selling its users out to unload data in the name of profits.

Hill: [laughs] Hey now!

Moser: It’s seemingly an endless and insatiable appetite for just crap. Let’s be clear, that really is what Five Below is.

Hill: It’s inexpensive, though.

Moser: It is! And that’s just it!

Hill: That’s the best kind!

Moser: That goes to the strength that I’m going to touch on in a minute. For me, personally, I’m not really a clutter kind of guy. There are some things I’m sentimental about, but really, I try to keep the clutter to a minimum. I’m not into the stuff that Five Below is selling. Therefore, from an investment perspective, it’s not really what I would be interested in.

But, I say that, I do see why this is actually working out as a decent investment. If you look at the five-year chart, it actually is working out. I think a lot of it is what you keyed in on there, it’s cheap. I think they’ve done a very good job of basically identifying that and saying, “Listen, very specifically, this is what we do.” And a lot of times, you probably don’t even go in there knowing specifically what you want, you’re just on a treasure hunt or whatever. I took my girls there probably a month ago, and I walked around the store and I thought, “This isn’t the kind of thing that interests me, but I can see why it would interest younger folks.”

Hill: You get the appeal.

Moser: Yeah, I get the appeal. From that perspective, listen, one of the things I thought was really interesting to look at was from an inventory perspective. Because the stuff they’re selling is so cheap, there’s a limited inventory risk there. In other words, they’re not going to be subject, probably, to writing off a bunch of inventory, because it’s kind of worthless already. And I say that sort of tongue and cheek, but it really kind of is. The inventory that they have just doesn’t cost a lot.

If you look historically, Five Below, their inventory is around 30% of assets on their balance sheet. Whereas, if you look at something like Bed Bath & Beyond — another store that sells a lot of crap — that’s more like 40% of assets. And then, if you look at how that translates down to the gross margin line for a company like Five Below, their gross margin is closer to 60%, whereas something like Bed Bath & Beyond, they’re in the upper 30s.

So, I don’t think Five Below has any pricing power in this industry, but they don’t need it, because they’ve clearly laid out of the proposition there to begin with. So, then the question is, you just have to ask yourself, how far can this go? How much can they grow? And I’m just not sure.

Hill: Right now, Five Below has about 650 stores. They say they can get to 2,500.

Moser: That’s a lot. In my experience, when we see companies making those forecasts, they’re almost always too ambitious. I basically approach those forecasts and try to take about 70% of them.

Hill: I was just going to say, we’ve talked before about restaurant chains that have ambitions to grow. I think, in the past, we’ve tended to look at them in that way. “They have X right now, they think they can get to 4X or 5X. Even if they get to 2X or 3X, that’s still pretty decent growth beyond where they are right now.” And when I heard that this morning, I just thought, “Wow, 2,500 seems high. But, even if they get to 1,500, that’s roughly 2.5X from where they are right now.”

Moser: I tend to think it’s a safe rule of thumb for investors, whenever you look at these companies where they’re talking about how much they think they can grow that footprint, don’t take that at face value. Scrutinize that a little bit. Think about it from the perspective, we are kind of in an e-commerce world now. Are they really selling a revolutionary product? Or are they just selling a neat experience? In a country that’s very consumer-driven, it works. I think maybe … 2,500, you said?

Hill: Yeah.

Moser: I think that’s probably a lot.

Hill: I didn’t say it, they said it.

Moser: [laughs] They said it, yeah. I think, I’d probably cut that in half, in all honesty, and value the stock based on that.

Hill: Let’s move on to Ambarella, which is the video processing chip company. First quarter results were … wow, not good. And the stock has bounced back, but it’s had a rough 24 hours. You tell me. In the same way that, when we were talking about Five Below, and my question was basically, “This was a good quarter, but was this 22% good?” That’s sort of my question for Ambarella. Is this ‘stock dropping 13% in one fell swoop’ bad, or is this maybe a slight over-reaction?

Moser: I don’t think there was really anything unexpected from their earnings release. That’s why you probably see a bit more of a muted reaction on the stock. It’s not seeing a Five Below type of move one way or another. But there aren’t a lot of surprises here. It’s very tough to get worked up for this one, because we know a lot more now than we knew before.

For a time, a couple of years ago, we carried a small starter position in Ambarella in Million Dollar Portfolio. That was a fixed-money portfolio, so we approached it from, we’d start a small position and then determine if it’s really one that we want to add to and build over time, or, is the company just not really meeting its full potential, and then we would just cut it loose. And we ended up cutting Ambarella loose shortly after we bought it.

There were just a lot of trends in the numbers that caused our concern, and we’re still seeing that today. Top line is challenged. If you can’t grow sales in an environment like this, which is a very tech-driven environment, and you’re a chip provider, which is basically what Ambarella is, a chip provider in the video space, they’re falling under that squeeze where they can’t get the same pricing. So, consequently, you’ve seen margins taking a beating.

It reminds me a lot of what we saw with InvenSense a number of years back. I’m sure a lot of people out there are familiar with InvenSense. Similar story, ultimately was acquired by TDK. Shareholders ended up losing in that deal. It seems like Ambarella is working out this very same way.

I would not recommend buying it. I think, if you look at their research and development alone, in 2014 it was 30% of revenue, today it’s over 40%. That’s in the face of declining revenue. So, they’re spending more and making less, and that’s never good.

Hill: A couple of things with Warren Buffett and Jamie Dimon in the news today. One, along with Jeff Bezos, they mentioned that they’ve decided on who their CEO is going to be for the new healthcare company. I think they said something like, “We’re still tying up a few loose ends.” So, I guess that announcement is coming soon.

Moser: How many people do you think immediately just said Howard Schultz?

Hill: Howard Schultz?!

Moser: [laughs] Just, given what we know with Schultz stepping down, how many people —

Hill: To run a healthcare company?!

Moser: I’m just saying!

Hill: I think Howard Schultz has made it pretty clear that he’s not looking to run another company. I think he’s looking to maybe move to 1600 Pennsylvania Avenue.

Moser: I’m not saying I agree with it, I just wonder how many people immediately defaulted to that because of the timing of the situation.

Hill: Oh, I immediately defaulted to Kristine Harjes —

Moser: A worthy choice.

Hill: — who hosts the Healthcare episodes of Industry Focus. I saw her this morning. She was playing her cards pretty close to the vest.

Moser: I am of a strong opinion that a woman should fill this role, because I think that a woman in this position would have the wherewithal, the long-term focus, the equanimity to be able to approach this without getting too worked up one way or the other, being able to see the forest for the trees. I do hope a woman fills that role.

Hill: Well, given what we know about, certainly Buffett and Bezos, and I would add Jamie Dimon in that, as well, what we know about the three of them and how they feel about long-term thinking, presumably whoever they pick is going to have that quality.

And long-term thinking goes to the other reason that Buffett and Dimon are in the news today, and it is this op-ed piece they wrote in the Wall Street Journal entitled “Short-Termism is Harming the Economy.” That’s the headline. Really, the headline should be “We Don’t Think Companies Should Give Earnings Guidance Anymore.” Do you agree with that?

Moser: Yeah, I do. In short, I do. I think one of the weirdest things to come to grips with for investors who are new to investing is to see this expectations game being played. You wonder why it’s being done. How in the world can companies be so accurate to predict their earnings down to a penny? And furthermore, what’s the disparity between what Wall Street expects versus what the company is telling you they expect? Because there’s always the battle there, as well.

So, I agree. I think it’s one of the things that confounds most new investors, and some old. They’ll see companies release earnings, and it seems like a great quarter and great guidance, and then the stock tanks. And you’re thinking, “What just happened? I don’t get it.” For me, I like that they were saying it was just the earnings forecast, not the transparency —

Hill: Earnings per share.

Moser: Right, exactly. They’re still all for transparency. Hey, tell us how the business is doing. File your SEC filings, your 10-Ks, whatever. But, on a quarter-by-quarter basis, yeah, I think it’s more or less unnecessary, and it certainly isn’t in line with the way we invest here, which is obviously more business-focused.

Hill: And if you think about Dimon and Buffett, obviously, Berkshire Hathaway, they file their quarterly paperwork with the SEC, and that’s it. They don’t do conference calls. JPMorgan, I’m pretty sure it does calls. I don’t know if Dimon himself is on them, although I think he is.

Moser: He does. Sometimes he gets pretty hot under the collar.

Hill: Yeah, I was going to say, I seem to recall some entertaining —

Moser: Had to whip out the edit button maybe once or twice. [laughs]

Hill: Yeah. So, in their own business practices, they diverge on that. But, I think they’re clearly in lockstep in terms of, public company CEOs are under varying degrees of pressure, and one of those pressures is earnings guidance. And if they remove that from their playbook and just say, “We’re still going to do the quarterly calls, we’re still going to do all this other stuff, we’re just not going to do earnings guidance,” then, presumably, not only would it stabilize what’s happening with their stock, but also — and this is one of the things they get to in the letter — it would remove pressure to make short-term moves. I mean, come on, we know that there are plenty of CEOs, and who can blame them, really, for saying, “Well, instead of taking this amount of money and putting it toward this long-term investment which we think is going to benefit our company and our shareholders over the next ten years, if we dial that investment back and pour it over here, that’s going to juice our earnings for the next quarter, and we need that.”

Moser: Yeah, or, “We’re going to buy back a little bit more stock just to tack on a few pennies per share, and that’ll appease Wall Street.” And, I mean, to be clear, I think, in a perfect world, this works. If companies stopped issuing that guidance, I don’t think that necessarily implies that Wall Street would stop making their projections. So, there’s still going to be a problem there. And Wall Street, that’s how that game works there, that’s what they do. But, from a company perspective, I think it frees them up to make better long-term-focused decisions. I would certainly be on board with that.

Hill: By the way, who was it? Was it Ford or GM who came out earlier this year, I think it was GM, and said, “We’re done issuing monthly sales figures. We’re not doing that anymore.”

Moser: It sounds like it would have been a GM thing, if I recall correctly, but I’d have to make sure of that. I like that, I’m OK with it! I mean, we complain about quarterly. Now, you want to go to monthly. I mean, start telling me what’s happening daily. Let’s have a conference call every morning at 6 o’clock. Right? At some point, you just have to let the business be the business, knowing that, in most cases, you feel like you’ve invested in good leadership teams that are running a good business with a good future. And if you do that, no, it doesn’t work every time, but if you approach it from that perspective, it works more times than not. And the longer you stretch out your timeline, there’s plenty of data out there to show you that, basically, the risk of you losing money is zero, if you take the longer timeline. That’s what we do, and it seems to be working out.

Hill: Thanks for being here!

Moser: Thank you for having me!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. That’s going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I’m Chris Hill. Thanks for listening! We’ll see you on Monday!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Chris Hill owns shares of Amazon and Starbucks. Jason Moser owns shares of Starbucks. The Motley Fool owns shares of and recommends Amazon, Ambarella, Berkshire Hathaway (B shares), Facebook, and Starbucks. The Motley Fool recommends Five Below, Ford, and McCormick. The Motley Fool has a disclosure policy.

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