99 Cents Only is a company that has been in turnaround mode for more than three years. Gumpster335’s write-ups from 2004 and 2006 provide a great deal of background information on the company. If you are new to NDN, I strongly suggest you review those write-ups first, as this one will assume some knowledge of the company. This write-up will focus on recent developments, and how the company’s current situation presents the investor with a very favorable risk/return profile.

On a macroeconomic level, I believe investors are selling out of retailers like NDN which cater to lower-income consumers based on a broad thesis that they will be spending less money in coming months. While I do not believe a short-term dropoff in sales, if it materializes, will impair NDN’s value, the spectre of such a decline has almost certainly affected the company’s stock price. I believe this presents opportunity for the long-term investor.

Additionally, after the close of trading today (November 8), the company reported net earnings that fell short of analysts’ expectations by $0.06 per share. I believe this could create still more weakness in the share price and represent an even better buying opportunity in the coming couple of days.

The core of this idea is my belief that management will begin to show significant progress in fixing the company’s remaining problems across the coming year. At the same time, I believe the company’s solid balance sheet and shareholder-oriented management provide excellent downside protection.

NDN has a very strong balance sheet, with no debt and significant assets. Normally, the company holds a significant net cash position. During the most recent quarter, the company ramped up inventory for Halloween and Christmas sales, but I do not consider that an issue, as the company’s 7 inventory turns per year show they have a strong cash conversion capability.

Net cash computation:

Cash and short-term investments $96.6M

· + Long-term investments 21.3M

· + Income taxes receivable 10.3M

· - All Liabilities (128.6M)

· = Net Cash (0.4M)

Additional current asset:

· Inventory $168.6M

The company also has very significant real estate assets, including two distribution centers and owned stores left over from their early days in Los Angeles.

Real estate assets:

* City of Commerce distribution center. Tesco announced they are spending up to $250M this year on their expansion into Southern CA, a significant amount of which is their new distribution center in Riverside, CA. NDN’s facility is somewhat larger and in a much more attractive location. I believe a conservative valuation of that facility is 150M.

· * The distribution center in Katy, TX is conservatively worth in the $75M range (around $100/sq ft).

· * The company owns 41 stores and 4 potential store sites. The valuation of these is somewhat mysterious, but the number on the balance sheet is certainly vastly understated. Assuming a typical size of 15k square feet and a value of $250/sq foot, the valuation is $154M. I believe this is conservative.

Balance sheet bottom line:

· Net Cash ($0.4M)

· + Inventory $168.6M

· + LA Dist Center $150M

· + Katy Dist Center $75M

· + Owned stores $154M

· = Total $547.2M

·
Total per share $7.81

I believe this book value computation is conservative and provides a reasonable worst-case valuation estimate for a long-term investor.

NDN is a partly family-owned company. This is a positive insofar as management’s interests are aligned with the shareholders. However, there is some question as to how hard management would fight to prevent a takeover should the stock price continue to languish.

The family owns about 33% of the company’s voting shares. So it is possible, though unlikely, for a takeover attempt to succeed. More likely, the family will fight to continue in their efforts to turn the company around. I believe this “value trap” scenario represents the biggest risk to an investor.

The company has experienced a litany of problems in the past three years including a troubled expansion plan, workers comp issues, Sarbanes Oxley compliance problems and management departures. During this period, management has kept gross margins relatively steady in the 37-39% range (note that NDN’s COGS do not include transportation and warehousing costs, which helps explain why the gross margin numbers are higher than comparable companies’).

At the same time, operating margins have deteriorated from 14% down to basically zero, a consequence of rising SG&A due to poor execution. I will look at each execution issue separately, but I believe the critical piece of the company’s turnaround remains to be completed. This last, trickiest, piece involves integrating their information systems and store management procedures to complete the transition from a regional player with all its stores in a 50-mile radius to a company with a national footprint.

The company’s 2003 expansion into Texas experienced serious problems as a consequence of poor site selection. Sales per square foot started out at $100 as compared with high $300s numbers in the core Los Angeles region.

More recently, sales in Texas have improved due to management opening smaller stores in much better locations. Recently opened stores in San Antonio and Dallas are performing in a manner much closer to Los Angeles stores. This is important information, because it demonstrates that the company’s Texas expansion can succeed. Previously, there was significant concern that Texas was just not a good location for the single-price concept.

The company’s distribution center in Katy, Texas also remains far too large for the company’s base of stores in the region. This issue is slowly but meaningfully improving as the company grows its Texas store base. Similarly, the company still has to truck many goods from Los Angeles to Texas because the smaller store base there does not provide them the purchasing power to negotiate deals locally.

While I am normally suspicious of companies which aim to “grow” their way out of execution problems, NDN’s demonstrated improvement in Texas site selection gives me confidence that they will see material margin improvement in that region in the coming year.

The company was delinquent on its filings for a long period of time, a consequence of going through multiple CFOs and multiple auditors. This situation was a consequence of management’s (probably misplaced) drive to try and save money on auditing costs, and some level of inexperience dealing with more complex accounting issues. The amounts spent per year on Sarbanes Oxley were $15M in 2005 and 2006, and the company is still making some additional one-time payments through the most recent quarter. I believe this issue has been completely resolved, with the added benefit that management has become more sophisticated in their understanding of these issues.

Management has been very forthright about the fact that they did a poor job of anticipating the increased costs involved in growing from a regional to a national business. A whole variety of incremental costs due to expansion have assailed the company since 2003, increasing SG&A as a percentage of sales by more than 600 basis points. Key issues include transportation costs, higher employee turnover, logistical issues such as shipping the wrong products to the wrong places, and problems implementing their new HighJump warehouse management system.

In the past three years, the company’s problems here have looked like a giant game of whack-a-mole. Every time they figure out one element, a new one jumps up to cause problems. I believe it is likely management is finally on the right track for the following reasons:

· * Management has shifted responsibility for store operations to Jeff Gold, who grew up working in the stores and I believe is much more detail oriented than the CEO Eric Schiffer.

· * The company has recently enacted a new employee bonus system focused on operating profitability instead of same-store-sales growth.

· * Management recently brought on several key managers, including Steve Horowitz and Mike Gerety, who have significant experience running far-flung retail operations. While this does not guarantee success, I believe it does mean that the right people are in place to make it work if possible.

· * Management is moving to control in-store costs by more closely tying a given store’s employee costs to that store’s revenue contribution.

As with any turnaround, there’s no way to get 100% certainty about the success of management’s efforts. I believe that NDN has reached the inflection point on the SG&A cost issue.

When NDN operated only in the Los Angeles basin, they regularly put up operating profit margins in the 14% range while growing their store base by 10-15% annually. Recently, management has returned to growing the store base at that higher rate. I believe this will serve a dual purpose, both increasing revenue more rapidly and helping the company to grow into some of the increased costs associated with its geographical expansion.

NDN’s currently targets lower income consumers, with a particular emphasis on Hispanics. Fortunately, the growth of that demographic and the company’s incomplete penetration in fertile growth areas (for example, San Diego, northern California, Las Vegas) mean that NDN is nowhere near buildout. The company’s strong revenue growth rate in recent years bears this out.

I believe that NDN can achieve a sustained operating profitability level in the 8-9% range, a rate regularly attained by such competitors as Dollar Tree. DLTR is not a perfect comparable for NDN, as it sells no produce (which has a lower margin), for example, while NDN’s stores are far more productive in terms of revenue per square foot. But I believe it is instructive in that DLTR represents a nationwide single-price store with a built-out distribution framework and store footprint. The way NDN will achieve this level of profitability is by nailing down the SG&A issues surrounding their geographic growth.

NDN should generate $1.2B of revenue in fiscal 2008, which implies an operating earning power in the $100M range if you accept the 8-9% assumption. This translates to $60M of net earning power, for a P/E multiple in the 11-12 range.

Given the company’s asset base and revenue growth rate, I believe the market would assign a significantly higher multiple should the company attain this level of profitability.

There is no question that NDN has a ways to go in its turnaround effort. I believe this company presents an investor with opportunity through asymmetric returns. Should the turnaround continue to drag out, I do not believe shareholders stand to experience a significant impairment of capital. The company’s strong asset base and profitable Los Angeles operation offer a margin of safety. If, however, the turnaround begins to bear fruit across the next year, I believe shareholders will see significant returns, as investors assign higher multiples to the company’s earning power.