FBCM Fbr Capital Markets Corp. (MM)

A mutual fund run by FBR Capital Markets Corp. (FBCM) on Friday pressed its case that the value of 99 Cents Only Stores (NDN) is "considerably in excess" of the $19.09-per-share buyout offer made last month by retail investor Leonard Green & Partners LP and the dollar-store chain's founding family.

In a letter to the 99 Cents Only board of directors, dated Friday and disclosed in a Monday filing with the Securities and Exchange Commission, the co-managers of the FBR Focus fund cited the company's opportunity for margin expansion, untapped real estate value, untapped pricing power and its potential to expand the chain, both in the four states it currently serves and beyond.

Further, the portfolio managers said 99 Cents Only would be valued at $21.75 to $23.50 a share using the valuation multiple of a transaction proposed in February by which billionaire Nelson Peltz's Trian Fund Management offered to buy larger competitor Family Dollar Stores Inc. (FDO). FBR noted that Family Dollar's board unanimously rejected the bid, of $55 to $60 a Family Dollar share, or what FBR said is 8.5 to 9.3 times enterprise value to Wall Street analysts' consensus adjusted forward earnings estimates, for "substantially" undervaluing Family Dollar.

Before the company's ill-fated expansion attempts several years ago, most notably in Texas, 99 Cents Only enjoyed 13% to 15% operating margins, FBR said, and its margins are only now starting to recover, going from slightly negative in fiscal 2008 to 8.2% during the most recently reported 12 months. The California-based company also has "materially higher sales per square foot and store network density than any of its publicly traded dollar store peers," FBR added.

FBR said 99 Cents Only's real estate is also worth more than the $257 million reported on its books in its most recent quarterly filing, a number that includes accumulated depreciation. "The company, to date, has not pulled the levers to harvest this cash, but the shareholders should be fairly compensated if the opportunity is transferred to a new owner," the fund managers wrote.

Following two price increases in recent years, including moving to sell items in increments other than 99 cents and a 1% increase to make prices 99.99 cents rather than just 99 cents, FBR said there is room for further pricing power. The fund managers said there is room even beyond two initiatives 99 Cents Only is exploring, which includes selling certain staples like milk and eggs for more than 99 cents and selling certain commodities like rice and produce by weight rather than unit.

Lastly, FBR said there is room to add new stores in its existing markets of California, Arizona, Nevada and Texas, plus the company has "almost open-ended potential for geographic expansion beyond." The managers argued 99 Cents Only is at a "growth inflection," with store unit growth of 3% in fiscal 2011 and company guidance for 6% expansion in fiscal 2012, which FBR said means there is an opportunity for accelerating growth in future years. "The company once sustained a high store growth rate and received a high valuation multiple to match."

An FBR representative said the fund managers weren't promptly available for an interview, and a 99 Cents Only spokeswoman didn't return a phone call seeking comment.

The FBR Focus fund, which went from a passive investor to an activist following the offer to buy the company, owns about 3.8 million 99 Cents Only shares that it bought for an average of roughly $10.06 apiece. The fund is highly concentrated, with only 17 stocks as of the end of last year, and its 99 Cents Only stake represented more than 7.8% of the $773.4 million portfolio, according to fund tracker Morningstar. Its annualized return over the past 10 years is nearly 15%, putting it in the top 1% of 399 mid-cap growth funds over the same time, Morningstar said, and $10,000 placed in the fund a decade ago would be $39,631 today.

-By Maxwell Murphy, Dow Jones Newswires; 212-416-2171; maxwell.murphy@dowjones.com

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