Ninety Nine Cents Only NDN
August 07, 2006 - 2:42am EST by
gumpster335
2006 2007
Price: 10.81 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 577 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

My VIC recommendation of deep-discounter Ninety Nine Cents Only in December 2004 (at $16.08) was very early -- but the thesis for a turnaround remains intact and appears possibly in sight (after 18 months of pain). I am re-recommending the stock at $10.81, where the stock has substantially lower downside risk (in addition to the lower stock price, the company appears closer to resolving its issues and has further strengthened its already solid balance sheet).
 
Ninety Nine Cents Only is a family-controlled (the Gold family and other insiders own 33% of the stock) retailer that sells all items for $0.99 (in Texas, 99 cents or less). About half of the merchandise sold is close-outs, with the remainder available for reorder and offered to provide selection consistency.  After excellent growth and profitability from its initial public offering in 1996 to 2002, the company has suffered. Part of this turmoil is due to challenging conditions for low-end retailers, but much more is attributable to horrible execution by 99 Cents Only Management.
 
At the current price, I see virtually no downside risk (if results deteriorate further, management should take the company private or sell out at a price that should be higher than the current price). If management finally starts delivering on a turnaround, the stock could easily double within two to three years with opportunities for a higher price if the company recaptures its growth characteristics and investor base.
 

Quick Background

David and Sherry Gold founded the company and grew its base of loyal California customers by offering phenomenal values, available due to buying acumen and a frugal corporate culture. Success with rapid growth, combined with the availability of an attractively priced distribution center, emboldened the company to jump geography and plan an invasion of Texas in 2003.
 
The Texas expansion has thus far been a complete disaster -- the company opened stores that were too large, poorly situation (too many in upper-middle class neighborhoods instead of low and lower-middle class neighborhoods), didn't have strong local management, and were poorly merchandised. In addition, the company faced many new competitors in Texas (land constraints help restrict California competition) and couldn't rely on its traditional word-of-mouth advertising given its lack of name recognition in the new market.
 
As the company began to run into problems with Texas, its core California operations began to flounder due to poor systems and infrastructure, distribution center overcapacity, huge jumps in California workers compensation expense, and thinly stretched management.
 
To top off everything, founder David Gold ran into medical issues and resigned as CEO, handing the reins over to son-in-law Eric Schiffer, who has been with the company since 1991. Son Jeff Gold, who had been with the company since 1984, assumed the President and COO role.
 
You can review my December 27, 2004 VIC recommendation for more detailed information on the company and industry, as well as legacy problems. 

Why the stock hasn't worked since my initial VIC recommendation

Financial controls and reporting has been in disarray
The company announced the delay of its 2004 10-K due to a need to restate results from a couple of accounting pronouncements and misapplications. Shortly thereafter, a recently appointed CFO left to pursue other opportunities. With the help of an interim CFO, the 10-K for 2004 was finally filed on August 9th, 2005, audited by Deloitte and Touche, which replaced PwC. The restatement turned out to be a non-event from a financial perspective, as prior net income was increased mostly due to the company depreciating buildings and equipment too quickly. But the company did fail Sarbanes-Oxley testing due to weak internal controls throughout the system.
 
Weak financial controls and getting filings up-to-date remain a problem. The company didn't file quarterly reports for 2005 as it worked on the accounting restatement and auditing of 2004 results. In November 2005, the company announced that BDO Seideman would be auditor for fiscal 2005 as well as the appointment of a new permanent CFO, Rob Kautz. Kautz has started to right the ship - after missing a couple of promised dates, the company filed quarterly reports through December 31, 2005 on June 1, 2006.
 
The company changed its fiscal year to March 31st and has yet to file its 2006 annual report. In mid-June, the company stated they would file the 10-K by July 31st. On that date, they stated the report would be delayed further, but should be filed (along with the June 30, 2006 10-Q) by August 9th or within the 5-day extension for the 10-Q.
 

Texas sales were worse than expected

When writing the December 2004 NDN recommendation, I estimated that average sales per Texas store open the entire year would be about $3mm, but it turned out they were worse -- $2.2mm. Sales per square foot were $101, well below the non-Texas average of $293. In addition, I hypothesized that Texas comp sales would show meaningful increases as store awareness increased and operations improved from their low base. That turned out not to be the case, as poor execution had limited good word-of-mouth and repeat purchases and the opening of a significant number of closely-located new stores hindered comps. In calendar 2005, average store sales on a much larger store base were flat at $2.2mm, while average sales per square foot increased to $108.

Sales outside Texas continued to deteriorate

The weak supply chain and warehouse oversupply issues, combined with distracted management (they were focusing on all the other problems) caused weak performance in non-Texas stores as well.  For calendar 2005, average sales per non-Texas store fell to $4.7mm from $4.8mm, while non-Texas average sales per salable sq. foot fell to $283 from $293. Total sales also were lower than expected because management smartly reduced 2005 new store growth to 5% from a planned 11% rate. They are picking up unit expansion to 10% this year.
 

Profitability remains awful

With weak sales, sloppy execution, distracted management, and high consulting costs, earnings in calendar 2005 plunged below those of the prior year - down to $13.2mm, 1.3% of sales and $0.19/share on a reported basis. In addition to some one-time charges, margins deteriorated due to high spoilage/shrinkage and a continued mix shift to include more lower-margin grocery items.
 

Sector has remained out of favor

My original thesis was that the dollar sector overall was due for a rebound. In fact, almost all of the companies in the sector have traded down since my initial recommendation. Dollar Tree (NDN's most-similar competitor, which focuses on single-price retailing) is flat, helped by a 9% jump last week on solid comps. The other players -- Family Dollar, Dollar General, and Fred's -- are down 20%-31%, while Ninety Nine Cents Only lags the pack with a -33% return. Sector-level problems include a challenging macro environment for low-end consumers as well as margin pressure from mix shifts to lower-margin consumables.
 

Why Ninety Nine Cents Only outlook appears to improving

 
Financial reporting should soon be up-to-date
The company's recent history or missing filing deadlines doesn't bode well for the fiscal 2006 10-K and Q1:07 10-Q to be filed by its revised August 16th target. That being said, the fact that they management reduced the target filing date to two and a half weeks out rather than one month out is encouraging (repeated delays in deadlines for filing the fiscal 2006 quarterlies were accompanied by new target dates one month out). Even if the company misses the August 16th date, it sounds like the company is making progress and should bring filings up-to-date and meet normal deadlines in the next quarter or two.
 
The company will obviously continue to have material deficiencies in internal controls from a Sarbanes-Oxley perspective, but the company is making progress on that front. Getting filings in on times seems to be the most important thing to me.
 
Significantly enhanced management
As mentioned early, Ninety Nine Cents Only brought in Rob Kautz as CFO in November. Kautz was formerly CFO and CEO of Wolfgang Puck Casual Dining and Wolfgang Puck Worldwide, as well as CFO and President of Koo Koo Roo. Other experience includes strategic planning consulting for PwC and financial positions at a couple of other firms. In the nine months he's been in the role, he appears to have done a good job beginning to improve the company's financial controls. (One caveat: someone should remind him the value of underpromising and overdelivering in terms of providing expected filing dates).
 
Mike Zelkind, the EVP for Supply Chain and Merchandising hired in October 2004, remains with the company and appears to be beginning to straighten out some of the supply issues (calendar Q1 warehouse fulfillment was at an all-time high, per the last conference call).
 
The company has hired at least five additional VPs in the past several months covering areas such as real estate, IT, Finance/Controller, Distribution, and HR. The company also promoted people into Vice President roles for purchasing, merchandise planning, and strategy.
 
Undoubtedly, it will take time for all these new people to climb the learning curve and maximize their impact with the company. But these hires signal that the executive team is serious about beefing up its depth so that NDN has the infrastructure necessary for long-term growth and success.
 

Signs of NDN sales improvement (both in and out of Texas)

In the first calendar quarter of 2006 (FQ4:06), Ninety Nine Cents Only reported comps of 1.8%, with Texas stores up 8.5% and non-Texas stores up 1.3%. A grand reopening that began at the end of March helped the Texas comp, but these results are nonetheless good news. Making the numbers even better is the fact that a late Easter pulled these numbers down a little.
 
For the second calendar quarter of 2006 (FQ1:07), comps were up 3.6%. The company hasn't yet broken out Texas and non-Texas comps for this period, but Texas appears stronger than the non-TX stores. Overall results were helped by the Easter shift and Texas continued to benefit from the grand reopening activities. The company should shed more light on sales results when final quarterly results are announced and the 10-Q is filed.
 

Some components in place for profitability improvement

Management has stated they expect profitability to improve in fiscal 2007 from the awful 2006 results, but have not quantified this total. The good news is that this means the company should be able to overcome the impact of options expensing and the cost of its beefed-up management team.
 
Helping to offset these increased offerings could be restraint in workers compensation expense. After two years of dramatically increased costs, it appears that this expense may be stabilizing if not waning. While fiscal 2006 numbers won't be available until the 10-K is filed, during the first nine months of the fiscal year, workers comp expense was down $12mm from inflated levels. In addition, the amount expensed appears to remain high as the balance sheet accrued liability increased another $6mm during the same period.
 
Once the restatements are complete, NDN should also have reduced financial and consulting fees -- during the first 9 months of fiscal 2006, this expense increased $4.4mm from the prior year.
 
Finally, management has indicated they expect margin pressures from mix shifts to begin abating. With a full complement of groceries already offered, they don't believe the mix shift will continue hurting margins. In fact, they hope renewed merchandising initiatives will help improve mix margins. Margins would also be helped if improved inventory systems help reduce shrink from the current 3.6%, which is higher than normal.

Industry malaise may be ending

After years of being out of favor during a strong economy, the deep discounters may be set up for an improvement in results, particularly if the economy continues slowing down. While the slowdown hurts the sector's core low-end customer (who's already been suffering for the past several years), it benefits from middle-class customers trading down. While one month or doesn't make a trend, July comps were encouraging for the sector: Dollar Tree reported that Q2 comps were up 4.2%, Family Dollar July same-store sales were up 7.5%, Dollar General July comps were up 4.6%, and Fred's July comps were up 4.5%.

A pretty good business

Many people will argue that this is no longer a good business because of recent pathetic returns and intense competition. That being said, I'm somewhat impressed that a business suffering from the panoply of problems and expenses NDN has brought upon it is still profitable and generating significantly more cash than net income. For calendar 2005, the company had net earnings of $13.2mm and generated operating cash flow of $57.9mm. After $38mm in CAPX, which includes $10mm for the purchase of warehouse in California, the company had nearly $20mm in FCF in an awful year.
 
The great historical financial returns have enabled the company to build a balance sheet with $170mm cash (about $2.40/share) and no debt.  As of 8/31/05, the company also owned 35 stores (many owned for a while in California) and its main warehouses and distribution facilities.
 

Valuation

In my initial report, I assumed NDN could again achieve at least a 6.5% margin, which is well below its historical norm. Taking into account the industry malaise, poor company execution, and the structural challenges to Texas margins until (if) appropriate scale is reached, I'm lowering this figure to 5% for my base-case normalized earnings. With trailing twelve months sales of just over $1 billion and about 70mm shares, that equates to normalized earnings about $0.75/shares and a 14x multiple. Netting out cash of $2.40/share brings the stock down to about 11x normalized earnings.
 
With a profitable business and a great balance sheet, NDN has bright prospects if execution is improved. Assuming it takes three years to achieve normalized margins and sales grow 12% annually (fairly conservative since the company plans 10% unit expansion this year and 15% next year), the company would be earning over $1.00 and would likely have a multiple of 15x-20x.  Of course, more rapid sales growth or net margins of 6% or more (which should be achievable in a very-good case scenario) would result in substantially more upside.
 
If not successful in a reasonable period of time, management would likely partner with a private equity firm to take NDN private. At price/sales ratio of 0.73x (0.56x net of cash) and a very solid $7.17/share book value, the downside price appears quite limited.

Catalyst

· Bringing SEC filings up-to-date (potentially within 2 weeks, but very likely in next two quarters)
· Improved profitability from continuation of same-store sales improvement (early signs already apparent that comps are improving)
· Higher industry valuation as subsector returns to favor after long period of disfavor (early signs this is beginning)
· Improved profitability from improved efficiency, as well as controlling workers comp and other limited-time expenses (likely to start in late fiscal '07, fiscal '08)
· Earnings growth from acceleration of store expansion (expansion in traditional markets can help, but biggest benefit would be if Texas expansion can be profitability executed to leverage excess distribution capacity and gain economies of scale in that market - not likely to happen until fiscal 2008 at the earliest)
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