FBR Fund Advisers, Inc. on Behalf of the FBR Focus Fund Sends Letter to Board of Directors of 99 Cents Only Stores

/ Source: GlobeNewswire

ARLINGTON, Va., April 12, 2011 (GLOBE NEWSWIRE) -- 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, 9Arlington, VA 22209

April 8, 2011
Board of Directors
99 Cents Only Stores
4000 Union Pacific Avenue
City of Commerce, CA 90023


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:

– 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.

– 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.

– 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.

– 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.


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 .  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