Brief Description 

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.  

 A new management team was brought in just over a year ago: 

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:  

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. 

Strategy:  

(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: 

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. 

Guidance  

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: 

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 unsecureds 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 pari passu 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 

Summary: 

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.