|Shares Out. (in M):||0||P/E||0||0|
|Market Cap (in $M):||0||P/FCF||0||0|
|Net Debt (in $M):||902||EBIT||0||0|
Security: 11% $250MM SENIOR NOTES DUE 12/15/2019
Current Price: 58c / 19% CY / 33% YTW
Enterprise Value: $797 million (market value through the bonds; assumes private equity is worth zero)
The bonds of 99 Cents Only Stores, LLC (99C) has traded down to distressed levels over the past 18 months due to significant missteps by the former management team. Following a complete management change in September 2015, the new CEO embarked on a comprehensive restructuring plan that is now beginning to bear fruit. Fiscal Q2-2017 (quarter ended July 29, 2016) showed significant improvements in same-store sales, gross margins and liquidity. As such, I am bullish on the company’s prospects and recommend the 11% Senior Notes ’19 at 58c (19% CY, 33% YTW) as a long investment.
99C is an extreme value discount retailer, or “dollar store”, with a focus on selling everyday consumable products and other household and seasonal items. Founded in 1965 in Commerce, CA, the company now has 394 stores and ~17,000 (non-unionized) employees located in California, Texas, Arizona and Nevada. As the company’s name implies, most of the items are sold for 99.99 cents or less. Until FY 2016 (January fiscal year-end) 99C had reported same-store sales growth in 9 of the last 10 years and Adj. EBITDA margins consistently in the 8-10% vicinity. In FY2016, the company generated $2bn in revenue and $39.5MM in Adj. EBITDA (down from $144MM in the prior year). The company’s business model has generally proved resilient during difficult periods, even generating positive “4 wall” cash flow at nearly all of its stores in FY2016. The company owns 69 of its 394 stores and 2 of its 5 warehouses/distribution centers. 99C was acquired in January 2012 by Ares and CPPIB for $1.56bn (~$650MM equity contribution) or ~10x FY2012 Adj. EBITDA.
|99 CENTS ONLY STORES, LLC|
|As of 7/29/16 ($million)||$ Avail.||$ Face Out.||LIBOR/Flr||Interest||Maturity||Price||CY||YTW||S&P/Moody's||Book Lvg.||Mkt Lvg.||Book Lvg.||Mkt Lvg.||Book Lvg.||Mkt Lvg.||Book Lvg.||Mkt Lvg.||Book Lvg.||Mkt Lvg.|
|(FY14 Adj. EBITDA)||(FY15 Adj. EBITDA)||(FY16 Adj. EBITDA)||(LTM Adj. EBITDA)||(Steady-state EBITDA)|
|99 Cents Only Stores, LLC||$ 155||$ 144||$ 40||$ 26||$ 120|
|1st Lien Term Loan(1)||597||1.00%||3.50%||Jan-19||78.0||4.5%||15.5%|
|OpCo Secured Debt||654||523||4.2x||3.4x||4.6x||3.6x||16.6x||13.2x||25.1x||20.0x||5.5x||4.4x|
|Unsecured Senior Notes(2)||250||11.00%||Dec-19||58.0||19.0%||33.9%||CCC-/Caa3|
|Cash / Equivalents||2|
|Total Net Debt||902||797|
|Ares/CPPIB private equity buyout (Jan-2012)||653|
|(1) As of July 29, 2016, funds affiliated with Ares and Canadian Pension Plan Investment Board (CPPIB) held $131.2MM of the 1st Lien Term Loan facility.|
|(2) As of July 29, 2016, funds affiliated with Ares and CPPIB have collectively acquired $102.1MM of the Senior Notes in open market transactions.|
Why does the opportunity exist?
The simple answer is mismanagement and a temporary hit (in my view) to operating performance. Between mid-FY2014 and Q3-FY2016, the former management team embarked on a series of poorly executed strategies that ultimately led to a self-inflicted wounds in key drivers of business value - same-store sales, gross margins and Adj. EBITDA:
Accelerated Store Growth – after the buyout, the management team ramped up new store growth, with +8.5% (27 new stores) in FY2014 and +11.7% (40 new stores, most in company’s history) in FY2015. This compares to 3-5% annual new store growth prior to the buyout.
Impact: cannibalization: same-store sales declined from 3.7% in FY2014 to a low of -3.9% in Q3-FY2016.
“Go Taller” – involved retrofitting existing stores with longer and taller shelves designed to expand merchandise space and capture more seasonal traffic.
Impact: excess inventory and inventory shrinkage: the program resulted in significant inventory build (+50% from $206MM at FY2014 to $302MM at Q1-FY2016) and increased misplaced and damaged products as items were moved from shelves to the floor to accommodate the remodeling. The company implemented an inventory clearance initiative, aggressively marking down inventory to ensure sell through. Gross margin declined ~525bps from 32% in FY2014 to 26.8% in Q3-FY2016.
Decremental margins – owing to the fixed nature of SG&A expenses (which has in fact moved higher recently as a % of revenue due to the minimum wage increase introduced in CA in January 2016), the negative operating leverage from the hit to same-store sales and gross margins has been severe.
Impact: 99C has now reported eight consecutive quarters of declining Adj. EBITDA and Adj. EBITDA margins have dropped from 8.4% in FY2014 to 1.0% in Q3-FY2016. Margins are still hovering in the 1% range as of the most recent quarter.
It looks like the company has a lot of problems, so why is it interesting? Why are the bonds mispriced?
A new management team was brought in just over a year ago:
- Geoffrey Covert – joined in September 2015 as the CEO; he was previously as Kroger since 1996 most recently as a senior executive of the retail division
- Felicia Thornton – joined in November 2015 as the CFO; she was most recently President of Demoulas Super Market
- Jack Sinclair – joined in July 2015 as Head of Merchandising; he was previously at as a Senior VP of Food.
In Q3-FY2016, the new team embarked on a comprehensive turnaround strategy focused on the following 3 key areas designed to improve growth, cut operating costs particularly those relating to excess inventory and increase gross margins. Early signs have been encouraging and the business is already seeing improvement:
1. Restore same-store sales growth:
Strategy: Slow new store openings and improve the customer experience - the new team has significantly reduced the rate of store growth (from 40 new stores in FY2015 to 5 in FY2017) in an effort to stabilize the business and restore organic growth. In Q3-FY2016, the new CEO rolled out a new strategy in certain test markets which involved upgrading store facilities, tweaking delivery schedules to ensure higher in-stock levels of the top re-orderable products, and employee training programs to improve customer service.
Results: early results have been very positive – since Covert started as CEO, same-store sales have increased 500bps, from -3.9% in Q3-FY2016 to +1.1% in Q2-FY2017 (the most recent quarter). In the test markets, which underperformed the overall chain prior to the refresh, reported same-store sales growth of +1.8%, 70bps higher than the overall chain. Notably, both average ticket and number of transactions increased in the test markets during Q2. 99C is currently looking to expand these initiatives to the rest of the enterprise.
2. Improve inventory management:
The previous management purchased too much seasonal product in their aggressive push to generate higher traffic during the holiday season. As a result, sales growth relative to inventory growth completed inverted from 8.9% vs 0.3% in FY2014 and 10.2% vs 2.3% in FY2015 to 4.7% vs 43.5% in FY2015. These elevated inventory levels, coupled with poor decision making and general mismanagement, also led to a spike in inventory shrinkage which was a significant contributor to the gross margin decline. Of the ~510bps decline in gross margins in FY2016 alone, excess inventory reduction and inventory shrink contributed ~200bps (~40%) of the decrease.
(i) Cut excess inventory – in an effort to reduce absolute inventory levels the company implemented inventory clearance initiatives including aggressive seasonal merchandise promotions. While cash levels increased, gross margin was negatively impacted. Inventory has now declined by over $100MM (from +$300MM in Q1-FY2016 to $176MM in Q2-FY2017) to a more manageable level.
The inventory reduction has also resulted in rationalizing the company’s warehouse and distribution center footprint. During Q2-FY2017, the company opportunistically monetized one of its owned and non-strategic warehouse facilities in Southern CA for $29MM.
(ii) Reducing shrink – according to management, reducing shrink and managing scrap typically takes some time to resolve, and maybe longer to show up in the company’s financial results. The company has introduced 2 pilot programs aimed at the addressing the issue:
Manual SKU-level data processing designed to ensure that all standard operating procedures are followed at the store level and measure all product in-flows and out-flows – based on the initial results at 3 stores, the company has rolled out the program to 3 additional stores to validate the positive results from the 1st 3 stores.
Store Inventory Model (SIM) - the company implemented a SIM in 6 stores that will provide perpetual automated SKU data on shrink. Based on early learnings, the company expects to roll out SIM to the rest of its stores by the end of Q1-FY2018. The company has also created an in-house loss prevention team to monitor and reduce theft.
Additionally, the company is proactively addressing other operating costs such as its distribution and transportation expenses which contributed ~50bps of the gross margin decline. In Q1-FY2017, 99C completed its transition to the use of one national carrier for its outside carrier needs during Q1-2017 and expects transportation costs to 'normalize' over time. The company had previously relied upon 50 local and regional partners for its transportation needs. Management expects the change to result in significant cost savings and improved delivery times to stores.
Improve gross margins – in large part due to the aforementioned strategic steps to reduce inventory-related expenses, in Q2-FY2017, the company experienced a 60bps decrease in shrinkage which ultimately led to the first gross margin y/y increase in 10 quarters.
Management's seems very confident that it can deliver on it's restructuring initiatives. At end of FY2016, the company offered the following guidance which it reiterated in both Q1-FY2017 and Q2-FY2017:
Positive same-store sales for FY2017
Substantial year-over-year increase in Adj. EBITDA, particularly in the second half of FY2017, and a substantial decrease in net loss over the same period
Capex in $35-40MM (new/existing stores: $20-25MM, IT/supply chain: $15MM)
Expect to open 5 new stores in FY2017 (down from 6-8 initial guidance)
Management's efforts received an early vote of confidence from the equity sponsors which acquired $102MM of the 11% Senior Notes in Q3-FY2016 in open market transactions. Ares and CPPIB also own $131MM of the 1st Lien Term Loan.
Credit protection for the and liquidity:
Credit protection: the bond indenture has a 2:1 Fixed Charge Coverage Ratio (FCCR) for debt incurrence. With LTM Adj. EBITDA at $26MM and cash interest at $58MM, the company is clearly in violation of the incurrence test and not permitted to raise debt. Practically, at ~34% YTW on the bonds, 99C is shut out of the unsecured bond market.
Liquidity: The company has improved its liquidity profile over the last 5 quarters given its strategic steps to reduce inventory and sell a non-core asset. As such, its cash draw under the ABL Facility is now $21MM compared to $107MM in Q2-FY2016. The company can draw another $76MM based on availability under the ABL facility and the carveout language for the credit facility in the bond indenture.
Sources and uses: with annual cash expenses of about $40MM of capex and $60MM interest, the company needs to generate +$100MM in Adj. EBITDA to get to cash flow breakeven. On a revenue base of $2bn, the company would have to generate an Adj. EBITDA margin of ~5% margin (from +1% currently) – significantly below the 7.5-10% range prior to FY2016. While $100MM is attainable in my view (my base case is $120MM), the company doesn't have much time (+2 years) as the capital structure essentially matures in CY2019.
Real Estate: the company could certainly monetize some or all of its 69 owned stores, which are located in densely populated areas, and its 2 warehouse facilities for liquidity purposes. I have assumed proceeds of ~$250-300MM under this scenario which would obviously increase rent expense by ~20-25% (from $97.5MM currently) and reduce Adj. EBITDA but give the company additional runway.
Valuation / Recovery:
At 58c (19% CY / 34% YTW), the market clearly expects 99C to face a restructuring scenario in the next few years and views the bonds are permanently impaired. Given the positive momentum of same-store sales and gross margin, I think the risk/reward is attractive as bondholders get paid (handsomely) to wait for the fruits of the company's restructuring initiatives to materialize.
Below I have outlined a few simplistic recovery scenarios:
Scenario 1: Base case
|LTM EBITDA||$ 120||$ 120||$ 120|
|Secured Bank Debt||654||654||654|
|Additional ABL Draw||76||76||76|
|11% Senior Notes '19||250||250||250|
Scenario 2: Assumes sale of real estate
|LTM EBITDA||$ 100||$ 100||$ 100|
|Plus: Sale of 69 Stores||175||200||225|
|Plus: Sale of Warehouses||25||50||75|
|Secured Bank Debt||654||654||654|
|Additional ABL Draw||76||76||76|
|11% Senior Notes '19||250||250||250|
Scenario 3: Reorg equity analysis - "Consensus" vs Base
|Revenue||$ 2,099||$ 2,099|
|11% Nts - "reorg equity"||145||145||(58c)|
It is important to appreciate that prior to the former management's missteps, Adj. EBITDA was comfortably in the $140-160MM range, and on a lower revenue base. As such, contrary to the consensus view, I don't believe the company's value proposition and cash flow generation capacity have been permanently impaired. While there is always execution risk with any restructuring, early signs are promising and the company has several options to extend its runway.