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.
· 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)