99 Cents Only: Ripe for Sale or Private Equity Transaction

| About: 99 Cents (NDN)

Recent option activity spikes in shares of deep discount retailer 99 Cents Only Stores (NYSE:NDN) caught our attention recently, suggesting to us that the 24 year-old company may be close to a sale or private equity/LBO transaction.

While 99 Cent would be a perfect fit for rival Family Dollar (NYSE:FDO), which has already expressed strong interest in the California market, where NDN operates most of its 237 stores, we believe that the better exit strategy for NDN is the private equity route. Below are some of the key takeaways from a report we’re currently putting together.

Description: 99 Cents Only Stores is a deep-discount retailer of primarily name brand, consumable general merchandise. Its stores offer an assortment of consumer goods and a variety of merchandise. It sells name-brand and private-label food and beverages, health and beauty aids, household goods, toys, and similar products.

The company operates around 237 retail stores, located in California, Nevada, Texas and Arizona. The company also sells merchandise through its Bargain Wholesale division at prices below normal wholesale levels to local, regional and national discount, drug and grocery stores and independent retailers, distributors and exporters. The Gold family owns roughly 33 % of the company.

Positive/Negative Considerations:
We believe NDN’s geographical concentration (major presence in California) and clean balance sheet ($128MM in cash, minimal debt, and substantial real estate assets) make the stock an attractive acquisition target for one of its larger competitors, like Family Dollar or Dollar General (NYSE:DG).

Family Dollar recently expressed strong interest in the California market, where NDN operates a large portion of its 237 stores. An acquisition of NDN by FDO would enable the latter to quickly capture 99 Cent Only’s customer base and forgo costly store build-out, as well as exploit NDN’s ability to break even on its new stores just one year after their opening.

A sale of the company would instantly cash out long term holders of NDN shares, who’ve unfortunately taken a massive beating during the last three years (see Figure 1). The more likely scenario, we think, is a management-led buyout.

On August 2nd, NDN announced that it was adding Jennifer Dunbar to its Board of Directors. This is significant because Dunbar is a former partner of Leonard Green & Partners, a private equity firm with $3.7B in capital under management. Interestingly enough, Leonard Green has a history of going after cash flow positive businesses with robust growth prospects.

Because we believe NDN is unlikely to retain its historical 5Y average 22% sales growth, the time for NDN to go private couldn’t be better. We believe the current stock price reflects an overly-optimistic belief that NDN will recoup is past successes and quickly mitigate its growing pains. There is little doubt that NDN’s single-price-point and inexpensive basic item concept holds considerable brand promise, but unfortunately, it’s a value proposition that can be easily replicated, tormented, and ultimately squandered.

Without a moat/competitive advantage or management expertise to protect the firm’s profit sanctuaries, NDN is not a stock we’d invest in without reassurance of a management buyout [MBO] on the horizon.

Risks: Lack of visibility concerning NDN’s 2005 financials present, we believe, substantial risk to investors. Last month, NDN told investors its 10K for fiscal 05 would miss its filing deadline. In addition, execution risk (last month, NDN brought on 3 new Board members), eroding macroeconomic conditions, higher gasoline prices (up 30% y/y), SG&A de-leveraging, and formidable competitive threats (e.g, SuperValu’s Sav-A-Lot chain) may re-price shares to the downside.

NDN’s concentration in California leaves the firm susceptible to economic trends specific to that area. In 2004, NDN’s CFO resigned after he found the firm’s laxity surrounding Sarbanes-Oxley [SOX] procedures unacceptable. Lastly, NDN’s premium valuation (P/E 36x, PEG 2.9x) puts shares at risk
of multiple contraction.

Valuation: Taking into account NDN’s strong cash position ($128MM as of Q306, approximately 12% of the firm’s market cap) and acquisition potential, we rate shares a speculative buy. We believe NDN’s merchandising expertise and ability to fund store expansion without taking on more debt makes the firm an attractive acquisition candidate, but harboring a pessimistic view on NDN’s increasing SG&A/sales ratio, we revise our estimates downward and arrive at our $9.50 price target. The rosier side of our price target scenario sees shares climbing to the $13-$14 range in the event that NDN pursues a management-driven buyout.

Summary: Core competencies are rare wherever the ease of imitation is pervasive. We believe NDN’s 68% stock price erosion and staggering 1000bps drop in ROE (from FY01 to FY04) demonstrate the difficulties of operating a discount retailer in a fiercely competitive atmosphere. As it stands, NDN is an underperformer (below industry average inventory turns) suffering from margin pressure and weak internal controls (i.e, obsolete payroll controls and shrink issues).

If NDN’s management wants to create shareholder value and demonstrate to investors that it’s attuned to their needs, NDN should enlist the help of private equity, take itself private, and run the firm strictly for cash. The market opportunities that NDN can target are many (In 2005, 63% of American households shopped at discount retailers, an increase of 800bps from 2004 numbers), but we think
it’s be better off pursuing them as a private concern.

Our price/sales based price target of $13 suggests a 20% upside move for shares if and when NDN announces a go-private transaction. Without the MBO catalyst to lift shares, however, NDN may fall under $10 before Christmas.

NDN 3-yr chart:

The author, Daniel A. Jacome, is an MBA/CFA candidate at the Kelley School of Business @ Indiana University, where he is majoring in Finance. At the time of publication, he did not hold a position in any of the stocks mentioned.