Description

Preface
A fairly high quality sector – one that has typically enjoyed returns on capital of 15%-25% -- currently out of favor is retail’s dollar store segment. With sluggigh same-store sales and margin pressures, almost all of these stocks have been dropped down to levels that are worthy of further investigation. From a big picture perspective, this sales weakness is being attributed to high energy prices and a not-so-great job market for low-end consumers, while margin pressures are resulting from weak comps, higher costs, and an increasing portion of grocery sales (typically lower margin than non-grocery). These trends can generally be seen at broad-based dollar stores like Dollar General and Family Dollar and single-price-point Dollar Tree and 99 Cents Only, as well as the Wal*Mart gorilla.

I contemplated writing up Dollar Tree, as I like the name, believe it has great financial characteristics, and figure it closely fits a traditional value idea on the site (great returns on equity and assets, solid cash flow, strong management, and a reasonable valuation). As this site is designed for us to discuss our best ideas, not the easiest to write, I moved to another stock. Despite selling for 36x calendar ‘04 earnings estimates and 29x ’05 projections, I think 99 Cents Only will likely be the better of two good investments over the next few years.

Before discounting this idea out of hand because of those ridiculous-sounding numbers, let me point out a couple of factors: NDN is suffering from a slew of company miscues on top of general industry sluggishness, which are elaborated on below. Despite these many challenges, the company is still profitable, although at a depressed level: net margins are expected to be about 3.2% in ’04 and 3.5% in ’05, yet between 1996-2002 the company achieved net margins of 7.5%-8.3%.

While it’s hard to discern exactly when some of the company’s challenges will be solved, the multiple on normalized earnings isn’t too atrocious – about 16x. And that number is probably conservative, as it is based upon net margins of 6.5% (well below the company’s historical norms, but in line with competitor Dollar Tree’s average over the past decade) and sales of $1.1B (about a 10% increase over ’04 projections, below square footage growth planned for next year). That multiple also doesn’t really take into account the company’s balance sheet with over $2 per share cash as of September 30th (normally the low cash-point of the year due to seasonal inventory build) or owned distribution centers and 30 owned stores.

While 16x normalized earnings isn’t a bargain for a no- or slow-growth business that requires external capital, 99 Cents Only could post internal earnings growth of 15%-20% off its normalized earnings base once it addresses its infrastructure needs (and in fact did that from 1996-2002).

Overview
99 Cents Only Stores is a leading deep-discount retailer of primarily name-brand and consumable general merchandise. Everything sold in the store is typically 99 cents (except in Texas, where prices are 99 cents or less). The Company's stores offers an assortment of regularly available consumer goods as well as first-quality, close-out merchandise. A good portion of merchandise is grocery, which helps to increase customer traffic (although typically carries lower gross margins). A significant portion of the company’s sales – 40%-45% -- are closeouts and special buys available due to the company’s strong buying group and supplier network. The remaining 55%-60% is merchandise that is regularly available for reorder.

As of Sept 30, 2004, the company operated 217 retail stores with 155 in California, 33 in Texas, 18 in Arizona and 11 in Nevada and an average store size of about 22,000 sq. ft.

With its strong merchandising, nicely maintained stores, and “treasure hunt” atmosphere, the company has been successful at attracting a broader array of customers (read: more higher-end) than many competitors. In fact, one of the company’s most successful stores, with sales reportedly around $10MM, is in Beverly Hills, CA.

Strong Historical Track Record
NDN has historically been a phenomenal operator, with sales per salable square foot for stores open an entire year of well over $300, although results on this metric have deteriorated as the company began opening larger stores – this figure dropped from $332 in 1999 to $308 in 2003. Despite lower sales per square foot, average store sales increased to $4.9MM last year (vs. $4.5MM in ’00) due to a larger store size. (These figures will fall in ’04 as the less successful new stores in Texas are included in the calculation and sluggish comps pull down figures (comps were down 0.6% for the first nine months of ’04).

The company had also experienced financial success, with earnings growing at an annualized rate of 18% between 1999 and 2002. (The 1996-2002 annualized earnings growth rate was slightly higher, at 22%). This growth was fueled by both unit expansion and the benefit of solid comparable store sales. During this period the company successfully expanded its geographic territory outside of its original Southern California base into Arizona and Nevada. The company also maintained positive comps of 6.1% in 1999, 2.0% in 2000, 5.9% in 2001, and 3.6% in 2002.

A decision to opportunistically expand into Texas at the beginning of 2003 (the company acquired a distribution facility with an all-in cost of about $70MM from Albertson’s for $23MM) coincided with several other issues that began a downward spiral that has hindered the company’s performance since then. Although comps were a positive 4.5% in 2003, earnings per share declined to 0.78 from 0.83. This downward spiral has accelerated this year, with earnings estimated to fall to about 0.44/share on margin pressure and weak sales. Gross margins have fallen as the company has increased its portion of lower-margin grocery sales and faced some pricing competition, while operating costs have ballooned for numerous reasons elaborated upon below. Comps for the first nine months of 2004 were down 0.6%, although they were up a nominal 0.5% in the third quarter.

Great Balance Sheet and Typically good Cash Flow
The company’s 9/30/04 balance sheet includes cash and equivalents of about $102MM and $54MM of long term marketable securities, a total of about $2.20/share. (This is typically the lowest cash balance of the year with the inventory build for q4). The company doesn’t have any debt, but it does have a $24MM current reserve for workers comp expenditures.

As of 12/31/03, the company owned its main office, warehouse, and distribution center, as well as a 66K frozen and deli facility, in City of Commerce California; its 780K sq foot Houston distribution facility, and 30 stores.

Cash flow has typically been well in excess of earnings and CAPX. This was not true in 2003, due to a CAPX surge related to the acquisition of the Houston DC, a frozen and deli DC in California, and accelerated store openings to ramp-up Texas. CAPX is down substantially this year and should moderate as the company slows expansion – although it will likely buy another DC in the next couple of years.

($MM) 2001 2002 2003 9 mos 2004
Net Income 48.4 59.0 56.5 16.6
Cash from Ops (ex option benefit): 61.0 67.2 68.5 36.2
CAPX 46.9 41.6 98.6 43.5

Thin, family-oriented management team overwhelmed by issues
99 Cents Only has run itself as a lean, family-oriented organization and hasn’t sufficiently invested in its infrastructure. Dave Gold has been the company’s CEO; Eric Schiffer, Mr. Gold’s son-in-law is President; Mr. Gold’s sons Howard and Jeff are SVP- Distribution and SVP of Real Estate and IT, respectively. Medical problems sidetracked founder and CEO Dave Gold earlier this year, further weakened a thin management team (he’ll be formally stepping down as CEO January 1st, 2005). Below is a brief summary of some of the issues impacting the company:

• Terrible Results from Texas expansion. With the acquisition of the Texas distribution facility, 99 Cents Only management decided to aggressively target the Texas marketplace to leverage its fixed costs. Unfortunately, performance from these stores has been well below company average (store sales are likely averaging somewhere around $3MM vs. the $4.9MM company average in 2003). Weak sales have been caused by myriad reasons:
o Competition in Texas is more intense than in the company’s core markets (more availability of land, lots more Wal*Marts, and stronger competitors that have learned to compete with Wal*Mart);
o The company was not known in the marketplace
o It appears the company rushed its real estate decisions and made some poorer choices
o Management didn’t sufficiently customize merchandising for the Texas consumer

• California Distribution Center operating above capacity. With the company’s rapid growth, its California Distribution Center exceeded its capacity, with the resulting inefficiency causing higher levels of shrink and out-of-stocks at stores.

• Intensified competition in California post-the grocers strike. The entire grocery-related retail environment became more competitive this year as grocers tried to regain market share lost during the strike and competitors tried to maintain what was gained.

• Out-of-stocks from higher commodity prices. Increases in milk and eggs made it difficult to get product in the store at the 99 cent price point to the detriment of sales and traffic.

• Soaring workers compensation expenses. 99 Cents Only has been facing huge increases in workers comp, including reserve increases. The increases appear caused by poor internal systems to track losses, weak procedures in some areas, and potentially some abuse of the system (many other California retailers have been facing challenges, but 99 Cents Only problems appear more significant than others).

• Challenging macroeconomic environment. Most retailers serving lower-end customers have been suffering from a weaker sales results, including behemoth Wal*Mart. These poor results are generally attributed to low levels of disposable income due to a still-sluggish job market and higher energy prices.

• Restatement of third quarter results. NDN delayed filing its Q for the third quarter and restated its balance sheet from that announced in is press release. The company didn’t elaborate on the issues, but the changes included reducing inventory by $1.69MM, increasing net property by $10.724MM, and increasing other assets by $1.092MM; accounts payable was also increased by $10.126MM. (Apparently, the company didn’t incorporate PP&E expenditures that had yet to be paid and shifted some items from inventory to other assets and PP&E, but I haven’t been able to confirm the details.)

In dollar terms, these issues have hit the company on both the gross margin and operating expense lines. For the first nine months of this year, retail gross margin was 38.9% versus 41.1% for 2003. Operating expenses for the first nine months of 2004 were 34.5% of sales, versus 29.5% in the same period of 2003. This deterioration was caused by: litigation loss provision (85 basis points), workers comp (73 bps); depreciation (72 bps); labor and benefit costs (71 bps); rent (64 basis points), other legal and professional costs, including Sarbanes-Oxley compliance work (46 bps), and transportation costs (44 bps). The remaining 45 basis points is primarily due to decreased leverage on labor and other costs from comparably lower sales in the Texas stores. (Note that 2003 operating costs were already inflated by roughly 250 bps because of workers compensation expenses and costs related to the Texas expansion)

Company taking steps to address problems
To address the company’s issues, the company is taking numerous steps

• Slowing down unit growth. 99 Cents delayed opening a few stores this year and plans to open at least 25 stores in 2005, which at the low end would represent 11% unit expansion. This growth rate is lower than the 31 units (16% growth rate) of ’04, the 38 stores (25%) of ’03 and 28 stores (22%) of ’02. Slower growth should give management more time to focus on its infrastructure and the basics

• Beefing up the executive suite. As previously mentioned, founder and CEO Dave Gold will be passing the baton to Eric Schiffer on January 1st, 2005 and Jeff Gold will become President and COO. More important than these changes, the company is hiring outsiders to beef up the management ranks: Mike Zelkind, a former VP of Inventory Management and Supply Chain at ConAgra has been named EVP of Supply Chain and Merchandising. James Ritter, a retail veteran who most recently was CFO of Bristol Farms, has also joined the company as CFO. (Previous CFO Andy Farina will stay on board as Treasurer; Howard Gold, who previously oversaw distribution will be EVP of Special Projects). A deeper and less executive suite should be able to better address company challenges.

• Enhancing the infrastructure. The company has rented 200K sq feet of additional warehouse capacity in California, which should help alleviate overcapacity in its main DC. The company is looking build a new facility to more permanently address the issue, but is in the midst of a legal dispute regarding an option on the land. NDN will also be slowly implementing an improved management control system at its existing California warehouse. While such a switch can be perilous, this transition will hopefully be eased by its deliberate pace and company experience with the new software in its Texas distribution center. This technological upgrade is an important step in enhancing the company’s supply chain infrastructure.

• Trying to figure out Texas. The company has hired a new buyer and merchandiser with Texas experience to better serve that market. In addition, the company has instituted a 99 cents or less policy in Texas, which provides more flexibility to merchandise and address competition. While management is taking these steps, it is also slowing unit growth in this market. My interpretation is that they are trying to figure out if they can make the Texas market for 99 Cents Only. If these new efforts don’t work, they could decide to pull out at some point in the next couple of years.

Attractive Valuation
As mentioned in the introduction, all of the dollar stores valuations have been beaten down in the marketplace because of recent mediocre performance. Due to its depressed margins, I’m comparing these companies based on price to sales and then looking at margins. (Note that DLTR is the most comparable competitor, as it is also a single-price concept; FDO and DG are multi-price point retailers and have somewhat different dynamics). While 99 Cents Only remains slightly more expensive than everyone else on a price/sales basis at 1.21x, it is still attractively priced relative to industry norms (average of 1.51x for its three competitors over the past nine years) and its own history (2.7x since IPO nine years ago). In addition, the company has substantially larger growth prospects than its peers assuming it can get its infrastructure in place and maintain the success of its stores. (Even if Texas doesn’t end up being successful, the company could at least double its store base on the West Coast.)

From my perspective, 99 Cents Only’s company-specific problems occurring in the midst of an industry downturn presents an excellent opportunity to invest in an above-average concept at a well-below average price. The company has started to take necessary steps to improve execution with a slowdown in growth and significant focus on enhancing its infrastructure. While it may take time for these steps to improve results, the company has a strong balance sheet that should enable it to endure this turmoil.

In a bad-case scenario where the company continues to struggle with its infrastructure, its Texas stores need to be shuddered, and the dollar store industry continues to suffer from competitive inroads, someone would likely try to buy the company and improve performance (note that with 32% insider ownership, management would need to be willing to sell for this to happen). Given the control of real estate in relatively difficult-to-enter California, and a generally better concept, I suspect a takeout price should be higher than the most recent substantial acquisition, DollarTree’s June 2003 purchase of privately-held Greenbacks for $100MM or 0.8x trailing sales. Unlike NDN, Greenbacks didn’t own its distribution centers or any stores, so I consider a sustainable downside of about 0.9x sales, or $12 on current sales.

Assuming overall industry conditions improve a bit, but the company continues to struggle with execution and becomes just an average company in the industry (i.e. higher infrastructure costs and lower gross margins pull sustainable net margins down to the 6.%-7% range), I think the stock could trade up to the sector average over the past nine years (ex-NDN) of about 1.5x sales, which translates into a current price of about $20 (that would be about 20x normalized earnings).

Of course, in a best-case scenario where management is able to turn around Texas, correct infrastructure deficiencies on the West Coast, and regain sales and profitability there, the stock could easily achieve the historical average valuation of competitor Dollar Tree and hit at 2x sales, which would translate into a price of about $26.50.

All of the potential price outcomes listed above are driven by sales, so continued company growth (which is planned) would move them higher if the company can execute. (In 2005, a year of “slow” growth, unit expansion will still be 11%).

Current Price Sales
NDN 1.21
DLTR 1.07
FDO 0.94
DG 0.90

Historical Price/Sales Ranges (1996-2004)
NDN 0.95-4.59 Avg 2.70
DLTR 0.87-3.81 Avg 1.99
FDO 0.39-1.68 Avg 1.21
DG 0.55-2.76 Avg 1.34

Current Net Margins
NDN 3.8
DLTR 5.8
FDO 4.7
DG 4.4

Historical Net Margins (1996-2004)
NDN 3.8-9.6 (Avg. 8.3%; 7.5% or higher from 1996-2002)
DLTR 5.0-8.0 Avg. 6.5%
FDO 3.5-5.6 Avg. 5.2%
DG 3.7-5.5 Avg. 4.6%

Primary Risks
• Company can’t turn around Texas market, decides to linger at mediocre profitability or exit
• Distribution issues aren’t resolved/deteriorate further
• Company’s merchandising edge wanes with loss of Dave Gold as CEO
• Inability to manage workers comp expenditures
• Problems with installation of new software in California distribution center or building of new California distribution (likely in next couple of years)
• Current industry woes are a structural shift rather than difficulty for target customer; intensified competition reduces sustainable margins
• Internal controls not improved quickly enough to meet company needs
• Inability to successfully expand into new geographic territory on the West Coast and elsewhere

Catalyst

• Improved profitability as company slows growth and successfully addresses problems
• New executive appointees enable management team to more effectively meet company challenges.
• Improved comparable store sales as company addresses distribution issues (new temporary facility, new EVP of distribution)
• Improved profitability and comps from Texas stores (with weak initial results, comps could notably impact company if it fixes problems). Company includes stores open more than 15-months in comp base, so these stores are just starting to enter comp base (the first stores opened in June ’03). Texas now accounts for about 15% of store base, but virtually none of these were in comp base through Q3:04).
• Rebound in low-end consumer helps improve comps and profitability
• 12-24 months out: departure from Texas if company can’t turn around operations there; while this hopefully won’t happen, the company should be able to continue successfully growing in West Coast markets for at least five years.