On April 8, 2011, the portfolio managers of the FBR Focus Fund (the
"Fund") a mutual fund advised by FBR Fund Advisers, Inc. submitted
a letter on behalf of the Fund to the Board of Directors of 99
Cents Only Stores (NYSE:NDN), a City of Commerce-based extreme
value retailer. The Fund is the beneficial owner of approximately
5.4% of 99 Cents Only Stores' common stock, and is currently the
largest unaffiliated investor in the Company. The letter was
included in a Schedule 13D filed by FBR Fund Advisers, Inc. and
certain of its affiliates.
Full text of the letter can be found below.
FBR Fund Advisers,
Inc. 1001 Nineteenth Street North, 9th
Floor Arlington, VA
22209
April 8, 2011 Board of Directors 99 Cents Only Stores 4000 Union
Pacific Avenue City of Commerce, CA 90023
Gentlemen:
FBR Fund Advisers, Inc. ("Fund Advisers") is the investment
adviser for the FBR Focus Fund, a public mutual fund owning more
than 3.8 million shares of 99 Cents Only Stores, Inc. ("NDN" or the
"Company"), or approximately 5.4% of the Company's outstanding
common stock. Fund Advisers is a subsidiary of FBR Capital Markets
Corporation ("Capital Markets"). On March 11, 2011, Fund
Advisers and Capital Markets, together with their affiliate FBR
Asset Management Holdings, jointly filed a Schedule 13D with
respect to NDN. The shares of common stock of NDN
discussed herein are held exclusively by mutual fund clients of
Fund Advisers and are not held by Capital Markets. This
letter is being submitted to the Board of Directors of NDN by the
portfolio managers of the FBR Focus Fund on behalf of the
shareholders of the Fund.
We are an independent investor with no ties to NDN's management
or the NDN Board of Directors, and as such we are interested only
in maximizing the value of our fund shareholders'
investment. Our ownership position makes us the largest
unaffiliated investor in the Company. Further, we are a
long-term investor in NDN, as we have held shares in the Company
since 2004.
We are writing to state our opposition to the proposed
management buyout at $19.09 per share presented to the Company by
the Schiffer / Gold Family in conjunction with Leonard Green &
Partners, L.P. (the "MBO Proposal"). We are not opposed
to a sale of NDN; rather, we are writing to express our concern
about the transaction process and to ensure that the Special
Committee's process achieves full value for the Company's
shareholders in connection with any sale. The reason for
our opposition to the MBO Proposal is simple: as evidenced below,
we believe the Company's value to be substantially in excess of
$19.09 per share.
The initial press release from the Company announcing receipt of
the MBO Proposal indicated a plan to create a Special Committee of
independent directors to consider how to respond to the MBO
Proposal. Because we have not seen any subsequent
releases announcing the creation of a Special Committee or
disclosing any procedures in response to the MBO Proposal, we
believe that this process is still in its initial
stages. To state what should be obvious, the Special
Committee should be comprised entirely of directors who are fully
independent of the Schiffer / Gold Family and Leonard Green &
Partners. We believe that, in accordance with best
governance practices, the test for "independence" in these
circumstances is quite broad and contextual, and directors who have
a close personal relationship to any members of the Schiffer / Gold
Family and/or persons affiliated with Leonard Green & Partners
should not serve on the Special Committee. All members
of the Special Committee should be independent in fact and
appearance, and not just technically "independent".
Equally as important as the composition of the Special Committee
is the scope of its authority. In this regard we believe
it is critical that the Special Committee have the authority to
explore all potential transactions, and not be limited to simply
negotiating the terms of the MBO Proposal. We think it
important that the Special Committee be specifically authorized to
contact other potential strategic and financial bidders prior to
entering into any agreement so that the value of the Company in any
sale can be maximized. In our experience we believe that
so-called "go-shop" clauses permitting the solicitation of offers
after a deal is signed are no substitute for a robust auction
process prior to entering into any agreement. To the
contrary, we believe that in light of the MBO Proposal the Special
Committee should explore the full range of available strategic
alternatives, including soliciting indications of interest from
possible strategic acquirers and other private equity firms, or
even a leveraged recapitalization, prior to entering into any
agreement. In addition, we believe the Special Committee
should have the authority to reject the MBO Proposal if it does not
deem it in the best interest of stockholders. Only
through these efforts can the Special Committee achieve the highest
value reasonably available for the Company's stockholders.
Another important step in the process is retaining expert,
independent advisers to assist the Special Committee in its
deliberations, including helping the Special Committee formulate a
robust sales process. Given the size of this transaction
we believe that the Special Committee should have no problem
retaining top tier, independent advisers experienced in
transactions of this size and complexity. While we do
not presume to recommend any particular investment bank or law
firm, we do expect that the Special Committee will ensure that the
firms selected have no prior relationship with either Leonard Green
& Partners or the Schiffer / Gold
Family. Independent advisers are critical to a good
process, and the best governance practices require advisers who do
not have relationships with anyone in the proposed MBO
group. Further, we expect that as part of any engagement
all the advisers to the Special Committee should agree that they
will not participate in, or support, any particular bid or
offer.
Once the Special Committee is established with the appropriate
charter and advisers, its first task should be to look at the
Company's intrinsic value on a stand-alone basis. We
have conducted considerable analyses on this issue, and of course
we consider assessing the long-term value of a company our business
expertise. Our analysis, which is based purely on public
information, shows value considerably in excess of the $19.09,
which is the reason for our strong opposition to the MBO
Proposal. Our analysis is based upon a number of
factors, including the following:
1. Significant Potential For Margin Expansion –
NDN consistently earned 13% to 15% operating margins from the time
it went public in 1996 until management mistakes led to a margin
collapse in the mid-2000s. Over the last several years NDN
management has implemented the first half of what they call their
"Profit Improvement Plan". Under this Plan, operating margins
have improved from (0.5%) in fiscal 2008, to 1.0% in fiscal 2009,
to 6.9% in fiscal 2010, and to 8.2% in the most recent twelve month
reporting period. Implementation of the second half of the
Profit Improvement Plan is now underway. Unfortunately
management (including the Schiffer / Gold Family) has not disclosed
to outside shareholders their margin projections for the next
several years, but they have discussed their excitement about the
potential impact of pending store labor, distribution, information
systems, and product sourcing initiatives. We note that NDN
has materially higher sales per square foot and store network
density than any of its publicly traded dollar store peers. In
the past this translated into best in class operating margins, and
with current and pending operating initiatives, it could reasonably
be expected to produce best in class results again.
2. Untapped Real Estate Value – As of the
Company's most recent 10-Q filing, it owned $257 million of land,
buildings, and building improvements at historical cost, gross of
depreciation. This balance includes approximately 62 owned
retail stores (NDN stores avg. about 21,300 sq. ft.), an 880,000
sq. ft. distribution / office building near Los Angeles in City of
Commerce, CA, a 741,000 sq. ft. distribution / office building near
Houston in Katy, TX, and various satellite warehouses around metro
L.A.
Presumably the Schiffer / Gold Family has a good understanding
of the value of this real estate, but outside shareholders do not
have the benefit of recent market value appraisals. Our
observation is that most of these assets were purchased
opportunistically – and many were acquired more than a decade ago –
which suggests that there has been significant appreciation over
historical cost.
Not only does this real estate appear to be significantly more
valuable than reported on the balance sheet, but it could be more
efficiently financed with low cost mortgage debt and/or key assets
sold or restructured to produce cash for shareholders. 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. In this regard, we share the
following observations about some key assets:
a. The Katy, Texas distribution complex was purchased from
Albertson's in 2003 for $23 million. Management has estimated
that Albertson's spent about $80 million on the facility. This
is a 741,000 sq ft property put in service in 1996 with a full
racking and conveyer system, 220,000 sq ft of refrigerated /
freezer capacity, and convenient access to Houston. When
purchased, the facility was expected to service about 175 NDN
stores. Today it is servicing 34 NDN stores, or just 20% of
its intended capacity. Several attempts have been made to
sublet the excess space, with an undisclosed result. This
facility is grossly underutilized by NDN stores and is ripe for
outright sale with NDN leasing more appropriate space
elsewhere.
b. The City of Commerce distribution center was purchased in
2000 for $10.5 million using an option to purchase secured in
1993. This is an 880,000 sq ft building in the center of metro
L.A. with direct access to a rail spur. Loopnet shows large
footprint metro L.A. warehouse space sold / listed for sale for $60
to $80 per foot implying a $53 to $70 million potential value for
NDN's property. Management comments on earnings calls have
alluded to rationalizing distribution in metro L.A., but management
has not articulated details of their plan for outside
shareholders. According to a March 22, 2011, L.A. Times
article, NDN has signed a new lease on a nearby 622,216 sq. ft.
distribution facility, so the rationalization appears
underway. Any sale of the main Commerce facility, or other
owned warehouse assets in metro L.A., would enable significant
capital withdrawal from the business.
c. NDN has a warehouse in Eagan, Minnesota, 924 miles away from
NDN's nearest retail store in Dallas, Texas. This warehouse
was acquired March 28, 2000, for $7.0 million. It appears to
have a book value of $7.3 million today. This property is
"held for sale", and management anticipates a sale price in excess
of the book value.
3. Untapped Pricing Power – NDN has implemented
two important pricing actions. First, in October of 2007 the
Company moved to flexible pricing so that products could be sold in
increments other than $0.99 (i.e. $0.89, $0.79,
$0.69...). This enabled select price increases by offering,
for example, one unit for $0.59 rather than two units for
$0.99. And second, in September of 2008, the Company changed
its standard unit pricing to $0.9999 from $0.9900. These
pricing actions have provided a significant profit boost with
virtually no discernable negative impact on customer demand.
The Company has disclosed that it is now exploring two
additional important price actions: selling certain staple items
for more than $0.9999 (i.e. gallons of milk, eggs), and selling
certain commodity items by weight rather than unit (i.e. rice for
$0.99 per pound, tomatoes for $0.79 per pound). While
these actions will impact a limited number of items, these items
have among the highest sales velocity in the store. And
the Company should have additional pricing actions it can take
beyond these two pending initiatives.
Price increases can be very powerful, yielding an almost 100%
flow through to pretax profits. To illustrate, our
analysis indicates that the pricing change to $0.9999 from $0.9900
(about a 1% price increase) may have created $13 million in pretax
profits on NDN's $1.3 billion of sales. At a valuation
multiple of 8.5x EV to EBITDA, this created about $110 million of
shareholder value, or $1.55 per NDN share.
Our observation – after making dozens of NDN store visits and
speaking with customers – is that NDN customers like the novelty of
the $0.99 price point, but the Company has achieved sustained
success not because of the price point, but rather because it
delivers excellent value to the customer. Note that NDN
has sales per salable sq. ft. of $289, more than 30% higher than
the next closest public dollar store competitors (Dollar General at
$201, and Dollarama at $221 [converted to U.S. Dollars at 0.96
CAD/USD exchange rate]). We believe that this materially
higher sales per sq. ft. and customers' ready acceptance of NDN's
recent pricing actions indicate that NDN has further pricing power
that can be prudently tapped to create significant shareholder
value while still delivering excellent value to the customer.
4. Growth Inflection – NDN is a regional
operator today with stores in California, Arizona, Nevada, and
Texas. The Company has infill opportunities in these four
states and almost open-ended potential for geographic expansion
beyond. Management has shared its view that the store concept
is portable to other high density population areas, and that the
current operating systems and process improvements are laying the
foundation for store growth and expansion. We concur with
management's view on this issue. After years of internal
focus, the company now appears to be at an inflection point: store
unit growth was 3% in fiscal 2011, and Company guidance is for 6%
store unit growth in fiscal 2012. Management has indicated
that store growth will remain restrained through the end of fiscal
2012, so we can reasonably conclude that store growth will
accelerate further in 2013. The Company once sustained a high
store growth rate and received a high valuation multiple to
match. With a modest valuation multiple today, and store
growth accelerating, the shareholders of NDN have the potential for
the return of a premium valuation, and the significant shareholder
value creation that would come with it.
Family Dollar Precedent
Family Dollar received a buyout proposal from Trian Group on
February 15, 2011, at a proposed price of $55 to $60 per share,
valuing the business at that time at an EV to EBITDA multiple of
8.5 to 9.3 times Wall Street analysts' consensus EBITDA estimates
for the next year. The Family Dollar Board reviewed the
buyout proposal, and unanimously rejected it, concluding that it
"substantially undervalues the company".
If Family Dollar's 8.5x to 9.3x valuation metric is applied to
NDN, it implies a buyout price of approximately $21.75 to $23.50
per NDN share. We believe that such a proposal also
"substantially undervalues" NDN, yet note that it is also
significantly above the $19.09 MBO Proposal. While we
recognize that each business is unique, there are substantial
similarities between NDN and Family Dollar (and many reasons, some
cited above, why NDN should receive a higher valuation multiple),
and certainly the Family Dollar Board's rejection of Trian's
proposal is an important valuation comparable. As a
result, we believe that the Special Committee could not justify
accepting an offer below this $21.75 to $23.50 price range, and has
the opportunity, assuming it runs an appropriate process, to
achieve a price significantly above this range.
We appreciate the opportunity to share our analyses with the
Board, and are available to the Board or the Special Committee to
discuss these issues in more detail.
Respectfully,
The FBR Focus Fund Portfolio Managers:
Brian Macauley, CFA
David Rainey, CFA
Ira Rothberg, CFA
Cc: David J. Berger, Wilson Sonsini Goodrich & Rosati
Additional Information
Investors are reminded to consider the investment objectives,
risks, charges, and expenses of the FBR Funds carefully before
investing. For a prospectus with this and other information
about the FBR Funds, please call 888.200.4710 or visit
www.fbrfunds.com. The prospectus should be read carefully
before investing.
The FBR Funds are distributed by FBR Investment Services, Inc.,
member FINRA/SIPC.
CONTACT: Media:
Tucker Hewes
212.207.9451
tucker@hewescomm.com
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