FBCM Fbr Capital Markets Corp. (MM)

On May 23, 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 Special Committee of 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

May 23, 2011

Special Committee of the Board of Directors

99 Cents Only Stores

4000 Union Pacific Avenue

City of Commerce, CA 90023

Gentlemen:

We write this letter to follow-up our April 8, 2011 letter to the Company's Board of Directors, and our recent discussions and correspondence with the Special Committee's advisers.

Our previous letter detailed three sources of value at 99 Cents Only Stores, Inc. ("NDN" or the "Company") that form part of our basis for concluding that the Company is worth significantly more than the $19.09 per share buyout price proposed by the Schiffer/Gold Family in conjunction with Leonard Green & Partners. Indeed, for the reasons articulated in that letter, we believe that the Special Committee could not justify accepting an offer below a $21.75 to $23.50 price range, and could potentially achieve a price significantly above this range if it conducts the appropriate sales process. Recent events only serve to reinforce this view. We highlight that the Company's April 14 sales release disclosed that March quarter same store sales improved sequentially from the December quarter, even with a significant negative calendar shift due to the timing of Easter. Further, since the March 11 disclosure of the buyout proposal, more than 52 million Company shares have traded, all in excess of $19.09 per share and many in excess of $20 per share. During this same time period, the stock prices of comparable public dollar stores have appreciated significantly (Dollarama +12%, DollarTree +19%, Dollar General +20%, and Family Dollar +6%).

But beyond the general favorable environment for deep value retailers and the appreciation seen in their shares, we believe the Company continues to make important strides in two areas: 1) controlling and eliminating distribution/transportation costs, and 2) reducing store level labor costs while increasing sales per square foot. Though the Company appears to be in the 6th or 7th inning of its distribution/ transportation cost reduction programs, we believe it is just in the early innings of its store level efforts. Looking at the financial results since the four-year Profit Improvement Plan was announced in February 2008, the Company's operating margin has expanded at over twice the rate management predicted (3.8% FY2011 Plan vs. 8.5% FY2011 est.). The major initiatives that drove the operating margin expansion should continue to mature and produce incremental benefits. These include early pricing and merchandising changes, and ongoing improvements to racking, perpetual inventory systems and dynamic truck routing at the distribution centers.

Beyond these early initiatives, we continue to expect another 50 basis points of operating margin expansion from distribution/transportation fine tuning, warehouse consolidation and more mechanized picking. Based on our analysis of store level expenses at other dollar stores, we anticipate another 200 to 400 basis points of margin expansion from store level initiatives as the Company's efforts to implement modern and robust point-of-sale systems, automated product reordering systems and dynamic labor scheduling bear fruit. In fact, the implementation of more modern and robust systems should allow the Company to narrow the dramatic sales per square foot dispersion across its store base resulting in important store level margin improvement. We believe that these many Profit Improvement Plan initiatives have the potential to move the Company's operating margin comfortably into the low double digits over the next couple of years. Although management has not publicly provided a new operating margin target, we would not be surprised if profitability again dramatically exceeds consensus expectations as modern systems and processes are rolled out across the store base.

In any management buyout proposal, there are inherent conflicts of interest. Managers' personal interests are pitted against their fiduciary duties to shareholders. Not only do insiders possess an informational advantage relative to outside shareholders, but they may also possess leverage in negotiations because of their role in the business. For these reasons, a management buyout should be held to an even higher standard than a sale to an unaffiliated buyer.

In the case of the Company, we want to revisit some recent history. Since 2007, we and other shareholders have publicly and repeatedly asked management to explain its plans for the Company's large and growing cash balance. While at first refusing to provide an explanation, the Schiffer/Gold Family later insisted that the cash was required to fund real estate and inventory purchases to grow the business. This management position was exceptionally costly to unaffiliated shareholders as it prevented the Company from executing a material share repurchase at significantly lower prices. Now, management appears to have changed its position and will use the cash stockpile, along with debt financing, to facilitate the purchase of the company from unaffiliated shareholders. In light of this incongruous behavior, we believe that it is especially important that the Committee be sensitive to shareholders' concerns and conduct a process that adheres to the highest standards in both appearance and fact. 

We want to note that we have generally been pleased that the Special Committee's advisors have made themselves available to listen to some of our comments and concerns. We are sensitive to the Committee's need to manage an auction process and engage in confidential negotiations with various bidders. At the same time, we are concerned that there are constraints on the Committee that may prevent the maximization of value in this process.

We highlight a recent media report citing the perceptions of potential bidders that they must secure the Schiffer/Gold Family's support (owing to their large stock ownership position and management role) to compete effectively in a bid to buy the Company. This perception can only serve to chill the auction process, to the benefit of the Schiffer/Gold Family's interests, and at the expense of non-insider shareholders. This causes us considerable concern. Clearly, the Committee should seek from the Schiffer/Gold Family a public and binding commitment to support the highest and best bid – regardless of the bidder – that can be secured through this process. In the continued absence of this commitment, the Committee should offer other bidders contractual terms and structural protections to help limit the Schiffer/Gold Family's advantaged position. 

It is also important for the Committee to make clear to the market and all potential bidders that it has sufficient authority to conduct an auction. In this regard, the Committee should publicly disclose its charter so that all shareholders and all potential bidders can understand the scope of the Committee's authority. We recognize that this is not customary, but we believe that under these circumstances best governance practices favor more transparency. We also believe that disclosure of the charter – which should assure shareholders that the Committee has the requisite authority – will further encourage potential bidders to engage with the Company, as they will see that the process is not skewed to favor the Schiffer/Gold Family's interests.

Finally, we request the opportunity to meet directly with the Special Committee to discuss some of these issues in more detail. While we appreciate speaking with your advisers, we believe that a direct face-to-face meeting will be most effective at communicating our views. We believe that even the act of having such a meeting will be seen by the market and potential bidders as a positive step, further demonstrating your commitment to an auction process which is not biased in favor of the Schiffer/Gold Family's interests.

We appreciate the opportunity to share our views with the Special Committee, and look forward to discussing these issues in more detail in the near future.

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

FBR Capital Markets Corporation (Nasdaq:FBCM) provides investment banking, merger and acquisition advisory, institutional brokerage, and research services through its subsidiary FBR Capital Markets & Co.  FBR Capital Markets focuses capital and financial expertise on the following industry sectors: consumer; diversified industrials; energy & natural resources; financial institutions; insurance; real estate; and technology, media & telecom.  FBR Fund Advisers, Inc., a subsidiary of FBR Capital Markets Corporation, provides clients with a range of investment choices through The FBR Funds, a family of mutual funds. The FBR Funds are distributed by FBR Investment Services, Inc., member FINRA/SIPC. FBR Capital Markets is headquartered in the Washington, D.C. metropolitan area with offices throughout the United States and in London. For more information, please visit www.fbr.com.

The FBR Capital Markets Corporation logo is available at http://www.globenewswire.com/newsroom/prs/?pkgid=6405 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.

CONTACT: Media:
         Tucker Hewes
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