10-K 1 a17-2803_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

x      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal Year Ended January 27, 2017

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number 1-11735

 

99 CENTS ONLY STORES LLC

(Exact name of registrant as specified in its charter)

 

California

 

95-2411605

(State or other Jurisdiction of Incorporation or
Organization)

 

(I.R.S. Employer Identification No.)

 

 

 

4000 Union Pacific Avenue,
City of Commerce, California

 

90023

(Address of Principal Executive Offices)

 

(zip code)

 

Registrant’s telephone number, including area code: (323) 980-8145

 

Securities registered pursuant to Section 12(b) of the Act:  None

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 the Securities Act.  Yes o  No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes x  No o

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o  No x

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter)  is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x
(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

 

Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

The registrant is privately held.  There is no trading in the registrant’s membership units and therefore an aggregate market value based on the registrant’s membership units is not determinable.

 

As of April 19, 2017, there were 100 units outstanding of the registrant’s membership units, none of which are publicly traded.

 

 

 


 


Table of Contents

 

Table of Contents

 

 

 

Page

Part I

 

Item 1.

Business

4

Item 1A.

Risk Factors

14

Item 1B.

Unresolved Staff Comments

28

Item 2.

Properties

29

Item 3.

Legal Proceedings

29

Item 4.

Mine Safety Disclosures

29

Part II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

30

Item 6.

Selected Financial Data

31

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

33

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

49

Item 8.

Financial Statements and Supplementary Data

50

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

95

Item 9A.

Controls and Procedures

95

Item 9B.

Other Information

96

Part III

 

Item 10.

Directors, Executive Officers and Corporate Governance

97

Item 11.

Executive Compensation

100

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

112

Item 13.

Certain Relationships and Related Transactions, and Director Independence

114

Item 14.

Principal Accounting Fees and Services

115

Part IV

 

Item 15.

Exhibits, Financial Statement Schedule

116

Item 16.

Form 10-K Summary

116

 

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As used in this Annual Report on Form 10-K (this “Report”), unless the context suggests otherwise, the terms “Company,” “99 Cents,” “we,” “us,” and “our” refer to 99¢ Only Stores and its consolidated subsidiaries prior to the Conversion (as defined and described below in Item 1 “Business-Conversion to LLC”) and to 99 Cents Only Stores LLC and its consolidated subsidiaries at the time of or after the Conversion.

 

SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION

 

This Report contains statements that constitute “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended.  The words “expect,” “estimate,” “anticipate,” “predict,” “will,” “project,” “plan,” “believe” and other similar expressions and variations thereof are intended to identify forward-looking statements.  Such statements appear in a number of places in this Report and include statements regarding the intent, belief or current expectations of 99 Cents Only Stores LLC and our directors or officers with respect to, among other things, (a) trends affecting our financial condition or results of operations, (b) our business and growth strategies (including our new store opening growth rate) and (c) our investments in our existing stores, warehouse and distribution facilities and information systems, that are not historical in nature.  Readers are cautioned not to put undue reliance on such forward-looking statements. Such forward-looking statements are and will be based on our then-current expectations, estimates and assumptions regarding future events and are applicable only as of the date of such statements.  We may not realize our expectations and our estimates and assumptions may not prove correct.  In addition, such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and actual results may differ materially from those projected in this Report, for the reasons, among others, discussed in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” sections.  We undertake no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.  You should carefully review the risk factors described in this Report and other documents we file from time to time with the Securities and Exchange Commission, including our quarterly reports on Form 10-Q and any current reports on Form 8-K.

 

Fiscal Periods and Basis of Presentation

 

On December 16, 2013, the board of directors of the Company’s sole member, Number Holdings, Inc., a Delaware corporation (“Parent”), approved a resolution changing the end of the Company’s fiscal year.  Prior to the change, the fiscal year of the Company ended on the Saturday closest to the last day of March.  The Company’s new fiscal year end is the Friday closest to the last day of January, with each quarterly period ending the Friday closest to the last day of April, July, October or January, as applicable.

 

Our fiscal year 2017 (“fiscal 2017”) began on January 30, 2016 and ended January 27, 2017 and consisted of 52 weeks.  Unless otherwise stated, references to years in this Report relate to fiscal years rather than calendar years. Our fiscal year 2016 (“fiscal 2016”) began on January 31, 2015 and ended on January 29, 2016 and consisted of 52 weeks.  Our fiscal year 2015 (“fiscal 2015”) began on February 1, 2014 and ended on January 30, 2015 and consisted of 52 weeks.  Our fiscal year ended January 31, 2014 (“transition fiscal 2014” or the “ten months ended January 31, 2014”) began on March 31, 2013 and ended on January 31, 2014 and consisted of 44 weeks.  Our fiscal year 2013 (“fiscal 2013”) began on April 1, 2012 and ended on March 30, 2013, consisting of 52 weeks.  Our fiscal year 2018 (“fiscal 2018”) will consist of 53 weeks beginning January 28, 2017 and ending February 2, 2018.  Unless otherwise stated, references to years in this Report relate to fiscal years rather than calendar years.

 

EXPLANATORY NOTE

 

During the fourth quarter of fiscal 2017, we determined that deferred tax liabilities as of January 29, 2016 were overstated by $6.5 million and the deferred tax valuation allowance was understated by $6.5 million. The total net deferred tax balances as of January 29, 2016 and tax provision for fiscal 2017 were not affected by this error.  We analyzed the impact of the $6.5 million deferred tax liability overstatement on the goodwill impairment charge recorded in fiscal 2016 and determined that the charge was understated by $7.1 million (revised from $6.7 million previously disclosed on Exhibit 99.1 of our Current Report on Form 8-K furnished to the Securities and Exchange Commission on April 20, 2017).

 

Management evaluated the materiality of these errors quantitatively and qualitatively, and concluded that they were not material, to the financial statements of any period presented, but has elected to correct them in the accompanying fiscal 2016 consolidated financial statements.  See Note 1 to the Consolidated Financial Statements in this Report for more information. These corrections are reflected in our discussions of our fiscal 2016 financial results in this Report.

 

The following parts of this Report include discussion of or disclosure related to the correction of the errors:

 

·                  Part I, Item 1A, “Risk Factors”

·                  Part II, Item 6, “Selected Financial Data”

·                  Part II, Item 7, “ Management’s Discussion and Analysis of Financial Condition and Results of Operations

·                  Part II, Item 8, “Financial Statements and Supplementary Data”

·                  Part IV, Item 15, “Exhibits, Financial Statement Schedule”

 

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PART I

 

Item 1. Business

 

With over 30 years of operating experience, we believe, based on our industry experience, that we are a leading operator of extreme value retail stores in the southwestern United States.  As of January 27, 2017, we operated 390 stores located in the states of California (283 stores), Texas (48 stores), Arizona (38 stores) and Nevada (21 stores).  Our stores offer everyday consumable products and other household items as well as seasonal items that are primarily priced at 99.99¢ or less.  We carry a wide assortment of regularly available products as well as a broad variety of first-quality closeout merchandise.  In addition, we carry domestic and imported fresh produce, deli, dairy and frozen and refrigerated food products, which we believe are generally of greater value than what consumers can find elsewhere.  We believe that our differentiated merchandise mix, combined with outstanding value, enables us to appeal to a broad consumer demographic, increases our overall customer traffic and frequency of customer visits, as well as strengthens our customer loyalty.  We believe that our stores are significantly larger than those of other U.S. publicly reporting dollar store chains, which enables us to offer a wider assortment of merchandise and provide our customers with a better shopping experience.

 

As of January 27, 2017, on a trailing 52-week period, our stores open for the full year averaged net sales of $5.2 million per store and $319 per estimated saleable square foot, which we believe, based on our industry experience, is the highest among U.S. publicly reporting dollar store chains.  We opened five stores in California during fiscal 2017.  We closed six underperforming stores in fiscal 2017 upon expiration of their leases, including five in California and one in Texas. In fiscal 2018, we currently intend to open three stores, all of which are expected to be opened in our existing markets.

 

We also sell merchandise through our Bargain Wholesale division to retailers, distributors and exporters.  The Bargain Wholesale division complements our retail operations by exposing us to a broader selection of opportunistic buys and generating additional sales with relatively small incremental operating expenses.  Bargain Wholesale represented 1.9% of our total sales in fiscal 2017.

 

Merger

 

On January 13, 2012, the Company was acquired through a merger (the “Merger”) with a subsidiary of Parent with the Company surviving.  In connection with the Merger, the Company became a subsidiary of Parent, which is controlled by affiliates of Ares Management, L.P. (“Ares”) and Canada Pension Plan Investment Board (“CPPIB”) (together with Ares, the “Sponsors”).  As a result of the Merger, the Company common stock was delisted from the New York Stock Exchange and we ceased to be a publicly held and traded equity company.

 

The total cash merger consideration paid was approximately $1.6 billion. In connection with the Merger, the Company obtained Credit Facilities (as defined below) provided by a syndicate of lenders arranged by Royal Bank of Canada as administrative agent, as well as other agents and lenders that are parties to the agreements governing these Credit Facilities.  The Credit Facilities include (a) first lien based revolving credit facility (as amended, the “ABL Facility”), and (b) first lien term loan facility (as amended, the “First Lien Term Loan Facility” and together with the ABL Facility, the “Credit Facilities”).  The Company also issued $250 million 11% senior unsecured notes due 2019 (the “Senior Notes”).  See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” for more information about our indebtedness.

 

Conversion to LLC

 

On October 18, 2013, 99¢ Only Stores converted (the “Conversion”) from a California corporation to a California limited liability company, 99 Cents Only Stores LLC (“99 LLC”), that is managed by its sole member, Parent.  In connection with the Conversion, each outstanding share of Class A common stock of 99¢ Only Stores, par value $0.01 per share, was converted into one membership unit of 99 LLC, and each outstanding share of Class B common stock of 99¢ Only Stores, par value $0.01 per share, was cancelled and forfeited.  Pursuant to the laws of the State of California, all rights and property of 99¢ Only Stores were vested in 99 LLC and all debts, liabilities and obligations of 99¢ Only Stores continued as debts, liabilities and obligations of 99 LLC.  99 LLC has elected to be treated as a disregarded entity for United States federal income tax purposes.  The Conversion did not have any effect on deferred tax assets or liabilities, and 99 LLC will continue to use the liability method of accounting for income taxes.  99 LLC computes its taxes on a separate return basis, but 99 LLC and Parent will continue to file consolidated or combined income tax returns with its subsidiaries in all jurisdictions.  Parent is a holding company with no active business or operations and has no holdings in any business other than 99 LLC.

 

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Our Competitive Strengths

 

Differentiated Retail Concept

 

We believe our stores offer consumers an extreme value shopping experience that is unique in our industry due to:

 

·                  Our current average store size of approximately 16,000 saleable square feet, which we believe are significantly larger than stores of other U.S. publicly reporting dollar store chains, enabling us to carry a wide assortment of consumable, general merchandise and seasonal products in a clean, attractive and comfortable shopping environment;

 

·                  Our large selection of food and grocery items, which is approximately 57% of gross sales, and includes many of the fresh produce, deli, dairy and refrigerated and frozen food items which we believe generally provide greater value than consumers can find elsewhere.  We believe our extensive food and grocery offerings drive recurring traffic from customers who rely on us for their weekly household needs; and

 

·                  Our wide assortment of closeout merchandise, which helps create an atmosphere of treasure-hunt excitement within our stores.  We believe that our wide assortment of closeout merchandise is a competitive advantage as many of our competitors lack the vendor relationships, management expertise or logistical capabilities to handle as large a percentage of sales as we do in closeout merchandise.

 

We believe, based on our industry experience, that these competitive strengths enable us to have the most productive stores among U.S. publicly reporting dollar store chains when ranked by sales per store and average sales per square foot.

 

Attractive Industry Fundamentals

 

The U.S. dollar store industry is large and growing, and we believe benefits from a number of attractive industry fundamentals which will continue to support our growth, including:

 

·                  Historical and projected growth in dollar store revenues driven by the addition of new dollar stores and the increasing acceptance of dollar stores among consumers;

 

·                  Same store sales growth among U.S. publicly reporting dollar store chains, which are outperforming many other retail channels, particularly U.S. publicly reporting traditional grocery stores;

 

·                  Within the dollar store industry, the opportunity for larger chains, including 99 Cents, to grow faster than the overall industry, the balance of which we believe consists primarily of independent store operators; and

 

·                  Strong historical performance by dollar stores throughout economic cycles.

 

We believe that these attractive industry fundamentals, when combined with the large population size and favorable income and demographic attributes within our existing markets, represent growth opportunities for 99 Cents.

 

Attractive Store Footprint

 

We have over 30 years of experience operating our stores.  We currently operate a large network of extreme value retail stores in California and have a strong presence in three other southwestern states, Texas, Nevada and Arizona.  Our stores are typically clustered in and around densely populated areas.  We believe that many of our stores are more convenient than traditional “big box” retailers that typically occupy larger buildings located in less urban areas as a result of their store size requirements.  We believe that the density of our store geographic coverage is a competitive advantage and would be difficult to replicate.

 

We believe that our southwestern geographic markets have attractive attributes that support our business model.  Our markets generally have large, growing and ethnically diverse populations.  Many of the markets we serve have high proportions of low-income consumers, as well as nearby middle and upper middle income consumers, who we believe are increasingly shopping dollar stores.

 

Strong Vendor Relationships and Sourcing Expertise Both Domestically and Globally

 

We believe that our sourcing expertise and our long-standing, mutually beneficial vendor relationships are competitive advantages. Many of our vendors have been supplying products to us for over 25 years.  We are a trusted partner and a preferred buyer to our vendors, many of whom we believe contact us first when they are selling closeout inventory.  We believe we are a preferred buyer due to our ability to, among other things:

 

·                  Make immediate buying decisions;

 

·                  Acquire large volumes of inventory and take possession of goods immediately;

 

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·                  Pay cash or accept abbreviated credit terms; and

 

·                  Purchase goods that have a shorter than normal shelf life or are off-season or near the end of a selling season.

 

We believe our vendor relationships are also strengthened by our ability to minimize channel conflict for the manufacturer as well as our ability to quickly sell products through well-maintained, attractively merchandised stores.

 

Strong Historical Financial Performance and Compelling Store Unit Economics

 

Our store base has historically demonstrated strong and consistent sales and profitability growth potential as well as compelling unit economics. Our stores have posted positive same-stores sales growth in nine of the past ten years with the same-store sales growth of 2.1% in fiscal 2017. Our newly opened stores generally ramp up quickly and typically reach near full volumes within the first 12 to 24 months.

 

Historically, our stores have demonstrated relatively consistent profitability levels as a percentage of sales. Our stores have a low cost operating model with attractive margins, low maintenance capital expenditures and low ongoing working capital needs. Furthermore, despite headwinds in selling, general and administrative expenses, nearly all stores were 4-wall cash flow positive in fiscal 2017.

 

Our Business Strategy

 

We are focused on three key strategies designed to profitably scale our business while continuing to meet the needs of our customers.

 

Enhancing the Customer Shopping Experience

 

We aim to achieve a sustainable increase in sales by enhancing the customer shopping experience, which we believe will both increase basket size with our current customers and attract new customers, including those that historically have not shopped at extreme value retailers. Key elements of the strategy include:

 

Focus on fresh

 

We believe our fresh food offerings, including produce, deli and dairy products primarily priced at 99.99¢, represent a significant point of differentiation relative to our national dollar store and discount peers and are a key driver of sales growth. Customer research studies that were recently conducted by leading market research firms show that a significant portion of our customers view us as their first or primary destination when shopping for fresh perishable items. Despite the continuing food price deflation in fiscal 2017, we achieved meaningful growth of our fresh offerings through a combination of improved quality and in-stock levels on key SKUs. This was due in part to our successful partnerships with third-party produce providers, as well as improved product availability, relative to fiscal 2016, at our traditional price point of 99.99¢. We believe the overall strength in our fresh food offerings was a key driver of positive customer traffic in fiscal 2017. We are currently testing and intend to make additional targeted investments in our fresh food strategy which includes procurement, supply chain, in-store equipment and training to further improve quality and broaden our merchandise assortment. We are also exploring the possibility of expanding our partnerships with third-party produce providers to broaden assortment and cover additional store locations.

 

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Provide a fun, exciting treasure hunt experience

 

We believe another important component of our differentiated shopping experience is our ability to create a fun and exciting treasure hunt experience that offers a “wow” factor for our customers. This is accomplished through two primary channels. First, our assortment has consistently included a significant portion of closeout merchandise, with a focus on national branded consumer packaged goods and high-value merchandise priced significantly below the typical retail prices of our peers in the discount retail industry. Independent customer research suggests that a sizable portion of our shoppers specifically visit our stores to hunt for these limited-time values, which in turn drives frequency, basket size and customer loyalty. Second, we have accelerated initiatives to broaden our general merchandise assortment priced above $1 as well as our seasonal assortment. Our over $1 general merchandise assortment is primarily comprised of high-value and high-recognition products for everyday household and recreational use, nearly always priced significantly below the everyday retail price of identical or comparable merchandise at peers in the discount retail industry. Our seasonal assortment includes a broad selection of popular and high-value décor, wearables and packaging materials, as well as consumables developed specifically for each season and primarily priced at $1. We believe the improvements in these assortments positively contributed towards our average ticket growth in fiscal 2017. We also believe that these assortments, and the fun and exciting shopping experience that they create on a consistent basis, will, over time, allow us to further improve our customer loyalty as well as acquire new customers.

 

Comprehensive market refresh program

 

Beginning in fourth quarter of fiscal 2016, we launched a comprehensive refresh program in one of our key markets, the city of San Diego, in order to accelerate our efforts to enhance the customer shopping experience. Key aspects of our market refresh program include:

 

1.              Upgrading our store facilities and improving cleanliness;

2.              Broadening our merchandise assortment, in-stock and fresh grocery offerings;

3.              Elevating our customer service; and

4.              Implementing targeted marketing campaigns to attract and retain new customers.

 

Since the completion of the San Diego refresh program in the second quarter of fiscal 2017, we have received positive customer feedback on the overall improvements and achieved strong sales momentum. The overall sales growth of San Diego has significantly exceeded our chain average.

 

We believe a systematic and comprehensive refresh program conducted on a market-by-market basis, when completed expeditiously and in a cost-effective manner, can meaningfully improve the operating performance of each market and generate positive returns on the initial investment. Accordingly, in the fourth quarter of fiscal 2017, we commenced our second refresh program in our Phoenix market. We expect to complete the Phoenix refresh program by early fiscal 2018. We intend to continue assessing the effectiveness of our market refresh programs in fiscal 2018 and evaluate additional potential target markets in a prudent and systematic fashion.

 

Improving Operational Efficiency and Effectiveness

 

We believe a number of opportunities exist to simplify and streamline our operational processes that will enable us to expand margins and improve profitability.  In particular, we are focused on:

 

Reducing shrink and managing scrap

 

We intend to significantly reduce our current elevated levels of shrink and scrap through initiatives designed to address all potential areas of losses, including:

 

1.              Effectively managing inventory allocation and sell-through of perishables items and establishing cold-chain management practices to minimize excess spoilage;

2.              Maintaining supply chain integrity, such as pallet picking and shipping accuracy;

3.              Improving execution of in-store merchandise receipts and product flow to ensure quality of store inventory and mitigate losses due to poor handling; and

4.              Implementing preemptive loss prevention efforts to identify and eliminate theft.

 

In fiscal 2017, we achieved a meaningful reduction in our shrink and scrap expenses relative to fiscal 2016. We believe significant opportunities remain to further reduce our shrink and scrap expenses in fiscal 2018.

 

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Improving merchandise flow

 

We have identified and are pursuing the following three key opportunities to simplify and streamline the flow of merchandise across our entire supply chain:

 

1.              Apply greater discipline to buying by actively managing and optimizing on-hand levels of both re-orderable and closeout merchandise, to reduce warehouse and in-store inventories, improve merchandise sell-through and reduce shrink;

2.              Reduce our reliance on a manual ordering process by implementing an automated merchandise ordering and replenishment system to ensure that the right product is replenished to the right store in the right quantities at the right time; and

3.              Improve our distribution efficiencies by ensuring on-time deliveries to our warehouses and our stores, in order to minimize disruptions to the merchandise flow.

 

These initiatives are designed to achieve lower overall inventory levels and reduce our handling costs and warehousing space requirements, which we expect will contribute to reductions in working capital investments and improved operating margins.  We also believe improving our merchandise flow will position us to achieve higher sales through a more robust allocations process, which will result in an improved in-stock position and fewer missed sales opportunities.

 

In fiscal 2017, improvements in our merchandise flow and clearance of excess inventory allowed us to significantly reduce our inventory levels, which in turn allowed us to rationalize multiple warehouse locations. The inventory reduction was accomplished even as we improved our overall in-stock levels of key, high-volume SKUs and positive same-store sales growth.  Furthermore, we have made and plan to make additional investments in systems and infrastructure to support these merchandising flow improvements.

 

In addition, we believe opportunities remain to further improve the overall merchandise flow in our Texas market, which will be an area of emphasis in fiscal 2018 and beyond.  We expect to accomplish this through a combination of improved inbound logistics to our Katy distribution center as well as refining the regional assortment through localized buying of key re-orderable and closeout merchandise.  We believe these improvements will drive customer traffic and increase margins, which will allow us to achieve profitable growth in the Texas market.

 

Supporting a culture of safety

 

We remain committed to promoting a safe and friendly operating environment and are building a culture of safety by:

 

1.              Engaging and empowering employees daily to develop a safe operating environment, through recurring huddles, hands-on training and constant communication to reinforce our safety message and instill accountability;

2.              Expanding our comprehensive reporting and analytics to support problem identification and provide real-time visibility;

3.              Investing in on-site treatment programs for better workplace care in the event of injuries; and

4.              Consistently evaluating and adopting best practices in safety culture and safety initiatives through a joint corporate safety steering committee, which oversees the implementation of safety improvement measures.

 

We have made substantial progress in building a culture of safety in fiscal 2017, including an over 20% year-over-year reduction in total claims. The reduction in claims is one of the key drivers of a material reduction of our outstanding workers’ compensation liability reserve at the end of fiscal 2017.

 

In addition, we conduct regular evaluations of our real estate portfolio in the ordinary course of business. In fiscal 2017, as a part of the evaluation process, we closed six stores, including one in Texas and five in California. We believe a substantial portion of the volume will be absorbed into other nearby 99¢ Only stores, thereby minimizing the impact on overall sales. The relocation and closures occurred at stores with expiring leases, and did not result in any material termination charges. We may opportunistically close or relocate additional stores in the future to improve overall profitability.

 

Pursuing New Store Growth

 

We opened five new stores during fiscal 2017 and we currently intend to open three new stores in fiscal 2018.  We plan to continue to pursue a disciplined store growth plan in our existing markets over the near term, and will accelerate our store growth in a manageable fashion over the longer term with continued improvement of cash flow and capital availability.  We believe that this will strengthen our competitive advantage in our key geographic regions and enable us to take advantage of economies of scale in distribution, store logistics and marketing.

 

Retail Operations

 

Our stores offer customers a wide assortment of regularly available consumer goods, as well as a broad variety of quality, closeout merchandise. Merchandise sold in our 99¢ Only stores is priced primarily at or below 99.99¢ per item.

 

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The following table sets forth certain relevant information with respect to our retail operations (dollar amounts in thousands, except percentages and sales per square footage):

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

Ten Months Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

January 31,
2014

 

March 30,
2013

 

 

 

 

 

 

 

 

 

 

 

 

 

Net retail sales

 

$

2,023,034

 

$

1,961,050

 

$

1,881,865

(a)

$

1,486,699

(b)

$

1,620,683

 

Annual net retail sales growth rate

 

3.2

%

4.2

%

6.8

%(a)

10.7

%(b)

8.9

%

Store count at beginning of year

 

391

 

383

 

343

 

316

 

298

 

New stores

 

5

 

8

 

41

 

28

 

19

 

Stores closed(c)

 

6

 

 

1

 

1

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

Total store count at year-end

 

390

 

391

 

383

 

343

 

316

 

Average net sales per store open the full years(d)

 

$

5,173

 

$

5,075

 

$

5,366

 

$

5,446

(g)

$

5,327

 

Estimated store saleable square foot

 

6,309,406

 

6,307,255

 

6,189,669

 

5,607,991

 

5,211,483

 

Average net sales per estimated saleable square foot(d)

 

$

319

 

$

314

 

$

328

 

$

330

(e)

$

321

 

Change in comparable same-store sales(f)

 

2.1

%

(2.7

)%

0.4

%(g)

3.7

%(h)

4.3

%

 


(a)         For fiscal 2015, each of annual net retail sales of $1,881.9 million and the annual net retail sales growth rate of 6.8% was calculated based on the net retail sales for the 52-week period ended January 31, 2014.

 

(b)         For transition fiscal 2014, net retail sales of $1,486.7 million were based on a 44-week period and the annual net retail sales growth rate of 10.7% was calculated based on the net retail sales for the 43-week period ended January 26, 2013.

 

(c)          Five stores in California and one store in Texas were closed in fiscal 2017 due to underperformance and the expiration of their respective leases.

 

(d)         Stores open for 12 months.

 

(e)          Average net sales per store and average net sales per estimated saleable square foot are based on trailing 52-week period.

 

(f)           Change in comparable same-store sales for years ended January 27, 2017, January 29, 2016 and January 30, 2015 are based on stores open at least 14 months. For other periods presented change in comparable same-store sales is based on stores open at least 15 months.  This change in definition of same-store sales, if applied retrospectively, would not have had a material impact on the comparability of same-store sales for the prior periods presented.  See Item 6, “Selected Financial Data” for additional discussion.

 

(g)          Comparable same-store sales for fiscal 2015 are calculated based on the 52-week period ended January 30, 2015 as compared to the 52-week period ended January 31, 2014.

 

(h)         Comparable same-store sales for transition fiscal 2014 are calculated based on the 43-week period ended January 25, 2014 as compared to the 43-week period ended January 26, 2013.

 

Merchandising.  All of our stores offer a broad variety of first-quality, name-brand and other closeout merchandise as well as a wide assortment of regularly available consumer goods, including a significant quantity of fresh and perishable food.  We also carry private-label consumer products made for us.  We believe that the success of our 99¢ Only stores concept arises in part from the value inherent in pricing consumable items primarily at 99.99¢ or less per item, many of which are name-brands, which generally provide greater value than consumers can find elsewhere. In addition, we offer selected items priced above 99.99¢ and we believe that we have additional opportunities to expand our selection of these items.

 

A significant amount of our gross sales are from products available for reorder, including many branded consumable items. The mix and the specific brands of merchandise frequently changes, depending primarily upon the availability of closeout merchandise at suitable prices.  A significant amount of our sales are from closeout merchandise, which we believe represents a significantly larger share of closeout merchandise than those of other U.S. publicly reporting dollars stores chains, some of whom carry few or no closeouts.  We currently expect to be able to obtain sufficient name-brand closeouts, as well as re-orderable merchandise, at attractive prices.  We believe that the frequent changes in specific name-brands and products found in our stores encourage impulse and larger volume purchases, result in customers shopping more frequently, and help to create a sense of urgency, fun and treasure hunt excitement.

 

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We believe that we differentiate ourselves from traditional dollar stores by offering a wider assortment of food and grocery items, including frozen, dairy, deli and produce, which collectively account for approximately 57% of our revenue.  Substantially all of our stores have free-standing fresh and refrigerated produce displays as well as built-in refrigerated and frozen food wall units.  We believe that many of our customers shop at our stores weekly for their groceries and frequently shop 99¢ Only stores first before supplementing these purchases at other food stores.

 

Over the past several years, we have expanded our assortment of seasonal and general merchandise. Consistent with our overall merchandising strategy, our seasonal and general merchandise categories offer high-value and high-recognition products, typically for special occasions, recreational and everyday household use. We believe the improved assortment has allowed us a capture a greater portion of our customers’ overall share of wallet.

 

Substantially all of our business is transacted in U.S. dollars and, accordingly, foreign exchange rate fluctuations have not historically had a significant impact on us.

 

Our major product categories at 99¢ Only stores consist of:

 

·                  Fresh merchandise, which includes deli, bakery, dairy, produce and frozen.

·                  Grocery merchandise, which includes beverages, candies, cookies, grocery-breakfast, grocery-canned and other snacks.

·                  Consumables products, which include baby products, food storage, health & beauty, household cleaning, pet supplies, picnic supplies and soft lines.

·                  General merchandise and seasonal, which includes bath & bedding, electronics, hardware & audio, home décor, kitchenware, party supplies, plastics, seasonal, stationery and toys & recreation.

 

Our retail sales by major product category for fiscal 2017, fiscal 2016 and fiscal 2015 are set forth below:

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

Product Category:

 

 

 

 

 

 

 

Fresh

 

26

%

25

%

22

%

Grocery

 

32

%

32

%

35

%

Consumables

 

22

%

22

%

23

%

General merchandise and seasonal

 

19

%

20

%

19

%

Other

 

1

%

1

%

1

%

 

 

100

%

100

%

100

%

 

We target value-conscious consumers from a wide range of socio-economic backgrounds with diverse demographic characteristics.  Purchases are by cash, credit card, debit card or EBT (electronic benefit transfers).  Our stores currently do not accept checks or manufacturer’s coupons.  Our stores’ operating hours are designed to meet the needs of families.

 

Store Size, Layout and Locations.  We strive to provide stores that are attractively merchandised, brightly lit, clean, well-maintained, “destination” locations.  Our stores are typically clustered around densely populated areas where it is convenient for our customers to do their weekly household shopping.  The interior of each store is designed to reflect a generally uniform format, featuring consistent merchandise displays, bright lighting, customized check-out counters and a distinctive color scheme on its interior and exterior signage.

 

Marketing and Advertising.  Our marketing strategy emphasizes a customer first approach through consumer research and data gathering. We have a strategic focus on communicating the magic of closeouts, our broad assortment, seasonal offering and fresh produce to drive incremental traffic and capture additional share of wallet. Our marketing includes multi-media campaigns that include print media, digital & social media, television and billboards as well as our store grand opening program. For example, we have recently launched a new marketing campaign on multiple media platforms titled “Do the 99!”, which uses specially designed graphics and visuals to highlight our assortment for a variety of everyday and special occasions. We are also continuously evaluating new and innovative methods to attract customers to our stores.

 

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Purchasing

 

A primary component of our business model is our ability to identify and take advantage of opportunities to purchase merchandise with high customer appeal at prices lower than regular wholesale.  We purchase most merchandise directly from the manufacturer.  Other sources of merchandise include wholesalers, manufacturers’ representatives, importers, barter companies, auctions, professional finders and other retailers, varying on the season and closeout activity.

 

We continuously seek out buying opportunities from both our existing vendors and new sources.  No single vendor accounted for more than 5% of our total purchases in fiscal 2017.  During fiscal 2017, we purchased merchandise from more than 999 vendors, many of which have been supplying us product for over 25 years.

 

A significant portion of the merchandise purchased by us in fiscal 2017 was closeout merchandise.  We have developed strong relationships with many vendors and distributors who recognize that our merchandise can be moved quickly through our retail and wholesale distribution channels.  Our buyers continuously search for closeout opportunities.

 

Our experience and expertise in buying merchandise has enabled us to develop relationships with many manufacturers that often offer some or all of their closeout merchandise to us prior to attempting to sell it through other channels.  The key elements to these vendor relationships include our (i) ability to make immediate buying decisions; (ii) experienced buying staff; (iii) willingness to take on large volume purchases and take possession of merchandise immediately; (iv) ability to pay cash or accept abbreviated credit terms; and (v) willingness to purchase goods close to a target season or out of season.  We believe our relationships with our vendors are further enhanced by our ability to minimize channel conflict for a manufacturer.

 

Our strong relationships with many manufacturers and distributors, along with our ability to purchase in large volumes, also enable us to purchase re-orderable name-brand goods at prices that we believe are below general wholesale prices.

 

We utilize and develop private label consumer products to broaden the assortment of merchandise that is consistently available and to maintain attractive margins.  We also import merchandise such as kitchen items, housewares, toys, seasonal products, party, pet-care and hardware.

 

Warehousing and Distribution

 

An important aspect of our purchasing strategy involves our ability to warehouse and distribute merchandise quickly and with flexibility.  Our warehousing and distribution facilities are strategically located next to the Long Beach, California and Los Angeles, California port systems, the rail yards in the City of Commerce and the major California interstate arteries.  This enables quick turnaround of time-sensitive products as well as provides long-term warehousing capabilities for one-time closeout purchases and seasonal or holiday items.  Our distribution center in the Houston area has both dry and cold storage capacity, and services our Texas operations.

 

We utilize both our private fleet and owner operators for our store deliveries / backhauls and vendor pick-ups in Southern California.  We have contracted with a dedicated carrier to service our Northern California, Arizona and Nevada stores.  We use two dedicated operators to service our Texas stores.

 

Our primary distribution practice is to have the majority of the merchandise delivered from our vendors to our warehouses and then shipped to our store locations.  We do, however, occasionally utilize direct store deliveries for select product categories.

 

In fiscal 2017, we established partnerships with multiple third-party produce distributors, who currently serve the majority of our store network and deliver a select number of high-volume fresh produce SKUs. We may expand our third-party produce distribution relationships in the future; however, retaining in-house expertise on cold chain distribution remains an integral part of our overall supply chain strategy.

 

Additional information pertaining to warehouse and distribution facilities is described under Item 2, “Properties.”

 

Information Systems

 

We currently operate all of our master data, price management, point-of-sale, merchandising, distribution center inventory, accounting and reporting systems on SAP.  In fiscal 2017, we completed the migration of our human resources and payroll data processing to Ceridian DayForce HCM.  We also operate several proprietary supply chain systems that are tightly coupled with HighJump’s warehouse management solutions.  The proprietary systems include an IBM UNIX-based purchase order and inventory control system that supports store back office personal computer system the Bargain Wholesale business.

 

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We are in the process of extending our SAP systems to support store inventory and perpetual management function that we plan to complete by the end of the first quarter of fiscal 2018.  During fiscal 2017, we also integrated our proprietary store ordering and merchandising platform with an automated forecasting and replenishment package solution.

 

Competition

 

We face competition in both the acquisition of inventory and the sale of merchandise from other discount stores, single-price-point merchandisers, mass merchandisers, food markets, drug chains, club stores, wholesalers, and other retailers.  Industry competition for acquiring closeout merchandise also includes a large number of retail and wholesale companies and individuals.  In some instances, these competitors are also customers of our Bargain Wholesale division.  There is increasing competition with other wholesalers and retailers, including other extreme value retailers, for the purchase of quality closeout merchandise. Some of these competitors have substantially greater financial resources and buying power than us.  Our ability to compete will depend on many factors, including the success of our purchase and resale of such merchandise at lower prices than our competitors.  In addition, we may face intense competition in the future from new entrants in the extreme value retail industry that could have an adverse effect on our business and results of operations.

 

We believe that we are able to compete effectively against other dollar stores as a result of our differentiated retail format, the larger size and more convenient location of our stores, our economies of scale in our operations and more than three decades of experience operating in the industry.  For products where we compete with traditional grocery stores, such as fresh produce, deli, dairy and frozen food items, we believe that we offer greater value than our grocery competitors and our stores are often more convenient. For products where we compete with warehouse clubs and mass merchandisers, we believe we compete effectively on the basis of greater value, no membership fees, more convenient store locations and smaller, easier to navigate stores.

 

We believe we do not currently face significant competition from e-commerce retailers. We believe our low price points, significant mix of fresh food and perishables and relatively low e-commerce adoption rates of our core shoppers serve as barriers against direct competition with major e-commerce retailers.

 

Employees

 

As of January 27, 2017, we had approximately 17,200 employees.  None of our employees are party to a collective bargaining agreement and none are represented by a labor union.

 

Trademarks

 

“99¢ Only Stores,” “Bargain Wholesale” and multiple other product trademarks are listed on the United States Patent and Trademark Office Principal Register.  We believe that our trademarks are an important but not critical element of our merchandising strategy.  We routinely undertake enforcement efforts against certain parties whom we believe are infringing upon our “99¢” family of marks and our other intellectual property rights, although we believe that simultaneous litigation against all persons everywhere whom we believe to be infringing upon these marks is not feasible.

 

Seasonality

 

For information regarding the seasonality of our business, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Seasonality and Quarterly Fluctuations,” which is incorporated by reference in this Item 1.

 

Environmental Matters

 

In the ordinary course of business, we handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations.  Under various federal, state, and local environmental laws and regulations, current or previous owners or occupants of property may face liability associated with hazardous substances.  These laws and regulations often impose liability without regard to fault. In the future we may be required to incur substantial costs for preventive or remedial measures associated with hazardous materials.  We have several storage tanks at our distribution and warehouse facilities, including: an aboveground and underground diesel storage tank at one of our City of Commerce, California distribution centers, a compressed natural gas tank at one of our City of Commerce, California distribution centers; an aboveground propane storage tank at one of our City of Commerce, California distribution centers; an ammonia storage at our Texas warehouse; aboveground diesel storage tank at our Texas warehouse; an aboveground propane storage tank at our leased Slauson warehouse in City of Commerce, California; and an aboveground propane storage tank at our leased Los Palos warehouse in Los Angeles, California. Except as disclosed in Item 3, “Legal Proceedings,” we have not been notified of, and are not aware of, any potentially material current environmental liability, claim or non-compliance, concerning our owned or leased real estate.

 

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Available Information

 

We make available free of charge our annual and transition reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to these reports through a hyperlink from the “Investor Relations” portion of our website, www.99only.com, to the Securities and Exchange Commission’s website, www.sec.gov.  Such reports are available on the same day that we electronically file them with or furnish them to the Securities and Exchange Commission.  The reference to our website address does not constitute incorporation by reference of the information contained on the website, and the information contained on the website is not part of this document.

 

Copies of the reports and other information we file with the Securities and Exchange Commission may also be examined by the public without charge at 100 F Street, N.E., Room 1580, Washington D.C., 20549, or on the Internet at http://sec.gov.  Copies of all or a portion of such materials can be obtained from the Securities and Exchange Commission upon payment of prescribed fees.  Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information.

 

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Item 1A. Risk Factors

 

Risks Related to Our Business

 

Improvement in our operating performance depends significantly on strategies and initiatives designed to increase sales and improve the efficiencies, costs and effectiveness of our operations.  There can be no guarantee that the strategic initiatives we are implementing to improve our results will be successful.

 

Over the past several years, we implemented several strategic initiatives, including accelerating store growth, retrofitting our existing store base and enhancing our merchandising and replenishment systems.  The accelerated timing in implementing these initiatives and the significant change they brought to our operations placed increased demands on our operating, managerial and administrative resources and also contributed to decreased profitability and other declines in our operating results during fiscal 2016.  In response, we are continuing to implement corrective measures focusing on merchandising, supply chain and operational effectiveness that we believe will improve performance over the next several future periods.  These measures are in various stages of testing, evaluation, and implementation, upon which we expect to rely to continue to improve our results of operations and financial condition and to achieve our financial plans.  These initiatives are inherently risky and uncertain, even when tested successfully, in their application to our business in general.  Successful system-wide implementation relies in part on consistency of training, stability of workforce, ease of execution, and the absence of offsetting factors that can influence results adversely.  Failure to achieve successful implementation of our initiatives or the cost of these initiatives exceeding management’s estimates could adversely affect our business, results of operations and financial condition.  Furthermore, there can be no assurance that these measures, even if successful, will improve our financial results and, if they do, there can be no guarantee as to the timing, sustainability or magnitude of any such improvement.  In addition, implementation of these measures has required and may continue to require us to experience short-term cost increases or margin declines.  For example, to clear inventory that had built up as a result of the “Go Taller” and global sourcing initiatives, during fiscal 2016, we undertook a range of promotional activities that adversely affected our margins.  We were also required to undertake similar activities in fiscal 2017 to clear additional inventory.  Poor operating performance could adversely affect our relationships with key vendors, our lenders and other business partners, who may seek to impose stricter credit or other terms on their arrangements with us.  Any or all of the foregoing could restrict our operational flexibility and/or impair our liquidity position, which could further adversely affect our operating results and financial condition and cause the trading price of our debt securities to decline.  This could also impair our ability to attract and retain qualified personnel, including members of management.

 

Inventory shrinkage could have a material adverse effect on our business, financial condition and results of operations.

 

We hold high volumes of inventory and are subject to the attendant risks of inventory loss, spoilage, shrink, scrap and theft (which we collectively refer to as “shrinkage”).  Additionally, our strategic initiatives in merchandising and inventory allocation have in the past and may from time to time in the future exacerbate our inventory shrinkage rates.  In transition fiscal 2014 and continuing into the first quarter of fiscal 2016, we implemented the “Go Taller” program to increase the length and height of shelving and displays at all retail locations.  This remodeling program resulted in increased misplaced and damaged products as items were moved from the shelves to the floor, and increased shipment volumes of inventory to stores, all of which contributed to significant increases in inventory shrinkage.  Although we have responded to recent inventory shrinkage charges by reinstating our in-house Loss Prevention department and implementing inventory procedures retraining, we cannot assure you that actual rates of inventory shrinkage will decline or that the measures we are taking will effectively reduce the problem of inventory shrinkage.  Although some level of inventory shrinkage is an unavoidable cost of doing business, if we were to experience higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, it could have a material adverse effect on our business, financial condition and results of operations.

 

We have potential risks regarding our store physical inventories and our inventory replenishment and forecasting systems.

 

We maintain a perpetual inventory system in our warehouses, and follow a cycle count program that is adhered to over the course of each year in order to ensure that inventories are accurately reported.  We do not maintain a perpetual inventory system in our retail stores.  Physical inventory counts are completed at each of the Company’s retail stores at least once a year by an outside inventory service company.  Based on the results of annual inventory counts, we have made adjustments to inventory estimates, which at times have been significant.  If our controls over inventory records are not appropriately designed or executed to validate the existence, completeness and accuracy of physical inventory quantities, or if our controls related to the validation of assumptions used in the calculation of reserves for excess and obsolete inventory, as well as the completeness and accuracy of the underlying data used in the calculation are insufficient or we do not otherwise continue to improve our inventory processes and procedures, we may fail to adequately reserve for shrinkage and excess and obsolete inventory.  These failures could have a materially adverse effect on our store physical inventory results, shrinkage and margins.  This in turn could materially affect our ability to timely complete our financial reporting obligations and our financial condition and results or operations.

 

Also, our success depends in part on management’s ability to effectively anticipate and respond to changing consumer preferences, product trends and store inventory needs and its ability to translate these preferences, trends and needs into marketable product offerings in advance of the actual time of sale to the customer. Even if we are successful in anticipating consumer demands, we must continue to be able to develop and introduce innovative, high-quality products in order to sustain consumer demand.

 

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There can be no assurance that we will be able to successfully anticipate changing consumer preferences, product trends, store inventory needs or economic conditions and, as a result, we may not successfully manage inventory levels to meet our future order requirements. If we fail to accurately forecast these needs, we may experience excess inventory levels or a shortage of product required to meet the demand. Inventory levels in excess of consumer demand may result in inventory write-downs and the sale of excess inventory at discounted prices, which could have an adverse effect on the image and reputation of our brands and negatively impact profitability.

 

We purchase in large volumes and our inventory is highly concentrated.  Our results of operations may be negatively affected if we are not successful in managing our inventory effectively.

 

Our profitability depends upon our ability to manage appropriate inventory levels and respond quickly to shifts in consumer demand patterns.  To be successful, we must maintain sufficient inventory levels and an appropriate product mix to meet our customers’ demands without allowing those levels to increase to such an extent that the costs to store and hold the goods unduly impacts our financial results or that subjects us to the risk of increased inventory shrinkage.  Our store and warehouse inventory, net of allowance, approximated $175.9 million and $196.7 million at January 27, 2017 and January 29, 2016, respectively.  We periodically review the net realizable value of our inventory and make adjustments to our carrying value when appropriate.  The current carrying value of inventory reflects our belief that we will realize the net values recorded on the balance sheet.  However, we may not do so, and if we do not, this may result in overcrowding and supply chain difficulties.  To obtain inventory at attractive prices, we take advantage of large volume purchases and closeouts.  As a result, we carry high inventory levels relative to our sales. In recent periods, primarily as a result of network capacity changes and global sourcing initiatives, we experienced overcrowding in our warehouses, which placed stress on our distribution operations as well as the back rooms of our retail stores.  This has also resulted in increased inventory shrinkage due to a variety of factors, including spoilage if merchandise could not be sold in the anticipated timeframes.  In transition fiscal 2014, we implemented a new merchandising strategy that significantly increased global sourcing of merchandise from import suppliers, which in part required the purchase of seasonal merchandise up to nine months before its sale.  These initiatives thus resulted in unanticipated inventory buildup that was particularly pronounced with respect to seasonal merchandise.

 

If we are unable to effectively manage inventory levels, we may have to sell large portions of inventory at amounts less than their carrying value or write down or otherwise dispose of a significant part of inventory, which could lead cost of sales, gross profit, operating income, and net income to decline significantly during the period in which such event or events occur.  In response to the inventory buildup created by the global sourcing program, we implemented inventory liquidation initiatives including short-term promotional activities, which negatively impacted our gross margins and operating results.  Margins could also be negatively affected should the grocery category sales become a larger percentage of total sales in the future, and by increases in shrinkage and spoilage from perishable products.  In addition, we offer selected items priced above 99.99¢ and we believe that we have additional opportunities to expand our selection of these items. If we are unable to sell these items above 99.99¢ in the volumes that we expect this could further exacerbate the foregoing risks.

 

We are dependent on new store openings for future growth.

 

Our ability to generate growth in sales and operating income depends on increasing same-store sales of existing stores and on our ability to successfully open and operate new stores both within and outside of our existing markets and to manage future growth profitably.  Our strategy depends on many factors, including our ability to identify suitable markets and sites for new stores, negotiate leases or purchases with acceptable terms, refurbish stores, successfully compete against local competition and the increasing presence of large and successful companies entering or expanding into the markets in which we operate, gain brand recognition and acceptance in new markets, and manage operating expenses and product costs. In addition, we must be able to hire, train, motivate, and retain competent managers and store personnel to support our growth.  Many of these factors are beyond our control or are difficult to manage.  As a result, we cannot assure that we will be able to achieve our goals with respect to growth.  Any failure by us to achieve these goals on a timely basis, differentiate ourselves and obtain acceptance in markets in which we currently have limited or no presence, attract and retain management and other qualified personnel, and effectively manage operating expenses could adversely affect our future operating results and our ability to execute our business strategy.

 

A variety of factors, including store location, store size, local demographics, rental terms, competition, the level of store sales, availability of locally sourced merchandise, locally prevailing wages and labor pools, distance and time from existing distribution centers, local regulations, and the level of initial advertising, influence if and when a store becomes profitable.  A portion of our new store base may include a portion of stores with relatively short operating histories.  We also may not anticipate all of the challenges imposed by the expansion of our operations and, as a result, new stores may not achieve the sales per estimated saleable square foot and store-level operating margins historically achieved at existing stores.  If new stores on average fail to achieve these results, planned expansion could decrease overall sales per estimated saleable square foot and store-level operating margins.  Increases in the level of advertising and pre-opening expenses associated with the opening of new stores could also contribute to a decrease in operating margins.  As we expand, differences in the available labor pool and potential customers could adversely impact us.

 

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New stores opened in new markets have in the past been and may in the future be less profitable than existing stores.  Some of our new stores may be located in areas where we have minimal operating experience or a lack of brand recognition.  Those markets may have different competitive conditions, market conditions, consumer tastes and discretionary spending patterns than our existing markets, which may cause these new stores to be initially less successful than stores in our existing markets.  In transition fiscal 2014, the Company initiated an accelerated store expansion program, along with other strategic initiatives, that placed pressure on our operational, managerial and administrative resources, and caused our operating results to decline.  Consequently, in the third quarter of fiscal 2016, we decided to reduce the pace of future store openings to focus on stabilizing our operations and results.  We cannot provide any assurance that we will resume accelerated growth in the future, which could adversely affect our operating results and competitive position.  If we fail to successfully execute our growth strategy, including by opening new stores profitably and on schedule, our financial condition and operating results may be adversely affected.

 

Opening new stores in existing markets may negatively impact sales at our existing stores.

 

New stores opened in existing markets have in the past been and may in the future result in inadvertent oversaturation and temporarily or permanently divert customers and sales from our existing stores.  Following the implementation of the Company’s accelerated store expansion program in transition fiscal 2014, the Company experienced cannibalization of sales at existing stores that contributed to a decline in profitability at our stores and of our same-store sales, and led to the Company’s decision to reduce the pace of future store openings.  If in the future we expand our store base too aggressively, sales cannibalization between our stores may become significant and affect our sales growth, and we may experience a similar decline in financial condition and operating results.

 

Our operating results may fluctuate and may be affected by seasonal buying patterns.

 

Historically, we have experienced higher volumes of net sales and higher levels of operating income during the quarters that have included the Halloween, Christmas and Easter selling seasons.  If for any reason our net sales were to fall below historical levels during the Halloween, Christmas and/or Easter selling seasons, such a decline could have an adverse impact on profitability and impair the results of operations for the entire fiscal year.  Transportation scheduling, warehouse capacity constraints, supply chain disruptions, adverse weather conditions, labor disruptions or other disruptions during peak holiday seasons could also affect net sales and profitability for the fiscal year.

 

In addition to seasonality, many other factors may cause the results of operations to vary significantly from quarter to quarter. These factors, some beyond our control, include the following:

 

·                  the number, size and location of new stores and timing of new store openings;

 

·                  the distance of new stores from existing stores and distribution sources;

 

·                  the level of advertising and pre-opening expenses associated with new stores;

 

·                  the integration of new stores into operations;

 

·                  the general economic health of the extreme value retail industry;

 

·                  changes in the mix of products sold;

 

·                  increases in fuel, shipping merchandise and energy costs;

 

·                  the ability to successfully manage inventory levels and product mix across our multiple distribution centers and our stores;

 

·                  changes in personnel;

 

·                  the expansion by competitors into geographic markets in which they have not historically had a strong presence;

 

·                  fluctuations in the amount of consumer spending;

 

·                  the amount and timing of operating costs and capital expenditures relating to the growth of the business and our ability to uniformly capture such costs; and

 

·                  the timing of certain holidays, such as Easter and Halloween.

 

Our ongoing implementation and testing of a new SAP software platform could interrupt operational transactions.

 

We depend on a variety of information systems for our operations, many of which are proprietary, which have historically supported many of our business operations such as inventory and order management, shipping, receiving, and accounting. Because most of our information systems consist of a number of internally developed applications, it can be more difficult to upgrade or adapt them compared to commercially available software solutions.

 

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Although our new SAP system became operational at the beginning of the first quarter of fiscal 2016, we are still currently in the process of migrating our operations from our legacy proprietary system to SAP’s enterprise resource planning software, which includes integrated financial and inventory management systems.  There are inherent risks associated with replacing and changing these core systems, including accurately capturing data and possible supply chain and vendor payment disruptions.  In addition, this process is complex, time-consuming and expensive. Although we believe we are taking appropriate action to mitigate the risks through testing, training and staging implementation, we can make no assurances that we will not have disruptions, delays and/or negative business impacts from this forthcoming deployment.  Any operational disruptions during the course of this migration process, delays or deficiencies in the design and implementation of the new SAP system, or in the performance of our legacy systems could materially and adversely affect our ability to effectively run and manage our business.  Our success depends, in large part, on our ability to manage our inventory, pay our vendors and record and report financial and management information on a timely and accurate basis, which could be impaired while we are making these enhancements.   Portions of our IT infrastructure also may experience interruptions, delays or cessations of service or produce errors in connection with systems integration or migration work that takes place from time to time.  We may not be successful in implementing new systems and transitioning data, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive. Such disruptions could materially and adversely impact our ability to fulfill orders and interrupt other processes.  If our information systems do not allow us to transmit accurate information, even for a short period of time, to key decision makers, the ability to manage our business could be disrupted and the results of operations and financial condition could be materially and adversely affected.  Failure to properly or adequately address these issues could impact our ability to perform necessary business operations, which could materially and adversely affect our reputation, competitive position, business, results of operations and financial condition.

 

We could experience disruptions in or increased costs related to receiving and distribution or our transportation network.

 

Our success depends upon whether receiving and shipments are processed timely, accurately and efficiently. As we continue to grow, we may face increased or unexpected demands on warehouse operations, as well as unexpected demands on our transportation network.  We distribute our products primarily by truck and rail. In addition, we rely on a variety of private fleet and common carriers for our store deliveries/backhauls and vendor pick-ups, and we route our products through various world ports, with the greatest reliance on California ports.  In addition, new store locations receiving shipments from distribution centers that are increasingly further away will increase transportation costs and may create transportation scheduling strains.  The very nature of our closeout business makes it uniquely susceptible to periodic interruptions and difficult to foresee warehouse/distribution center overcrowding caused by spikes in inventory resulting from opportunistic closeout purchases. Such demands could cause delays in delivery of merchandise to and from warehouses and/or to stores.  We periodically evaluate new warehouse distribution and merchandising systems and could experience interruptions during implementations of new facilities and systems.  A fire, earthquake, or other disaster at our warehouses or distribution centers could also hurt our business, financial condition and results of operations, particularly because much of our merchandise consists of closeouts and other irreplaceable products.  We also face the possibility of reduced availability of trucks or rail cars due to adverse weather conditions, allocation of assets to other industries or geographies or otherwise, which could disrupt our receiving, processing, and shipment of merchandise.

 

In addition, our reliance upon ocean freight transportation for the delivery of our inventory exposes us to various inherent risks, including port workers’ union disputes and associated strikes, work slow-downs and work stoppages, severe weather conditions, natural disasters and terrorism, any of which could result in delivery delays and inefficiencies, increase our costs and disrupt our business.  A severe and prolonged disruption to ocean freight transportation could cause delays in delivery of merchandise to our stores and in-stock inventory availability.  Efficient and timely inventory deliveries and proper inventory management are important factors in our operations.  Reduced product availability may diminish sales and brand loyalty. Severe and extended delays in the delivery of our inventory or our inability to effectively manage our inventory could have a material adverse effect on our business, financial condition, results of operations and liquidity.

 

We depend upon our relationships with vendors and the availability of closeout merchandise.

 

Our success depends in large part on our ability to locate and purchase quality closeout merchandise at attractive prices.  This supports a changing mix of name-brand and other merchandise primarily at or below 99.99¢ price point.  We cannot be certain that such merchandise will continue to be available in the future at wholesale prices consistent with our business plan and/or historical costs.  Further, we may not be able to find and purchase merchandise in necessary quantities, particular as we grow, and therefore require a greater quantity of such merchandise at competitive prices.  Additionally, vendors sometimes restrict the advertising, promotion and method of distribution of their merchandise.  These restrictions in turn may make it more difficult for us to quickly sell these items from inventory.  Although we believe we enjoy stable relationships with our vendors, we typically do not enter into long-term agreements or pricing commitments with any vendor.  As a result, we must continuously seek out buying opportunities from existing vendors and from new sources.  There is increasing competition for these opportunities with other wholesalers and retailers, discount and deep-discount stores, mass merchandisers, food markets, drug chains, club stores, and various other companies and individuals as the extreme value retail segment continues to expand outside and within existing retail channels.  There is also a trend towards consolidation among vendors and vendors of merchandise targeted by us, and such larger consolidated entities may enjoy greater purchasing power than we do.  A disruption in the availability of merchandise at attractive prices could impair our business.

 

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We face risks associated with international sales and purchases.

 

International sales historically have not been important to our overall net sales.  However, some of the inventory we purchase from domestic vendors is manufactured outside the United States.  In particular, we will continue to purchase inventory from China, though plan to narrow our focus to sourcing general merchandise and seasonal inventory. If we directly import large volumes of merchandise from overseas vendors, we may be required to order these products further in advance than would be the case if these products were manufactured domestically.  International transactions may be subject to risks such as:

 

·                  political or financial instability or disputes;

 

·                  lack of knowledge by foreign manufacturers of or compliance with applicable federal and state product, content, packaging, ethics and other laws, rules and regulations, such as the U.S. Foreign Corrupt Practices Act;

 

·                  foreign currency exchange rate fluctuations and local economic conditions, including inflation;

 

·                  uncertainty in dealing with foreign vendors and countries where the rule of law is less established;

 

·                  disruptions in the global transportation network, such as raw material shortages, factory consolidations, work stoppages, strikes or shutdowns of major ports or airports, or other political or labor unrest;

 

·                  risk of loss due to overseas transportation;

 

·                  import and customs review can delay delivery of products as could labor disruptions at ports;

 

·                  changes in import and export regulations, including “trade wars” and retaliatory responses;

 

·                  changes in tariff, import duties and freight rates; and

 

·                  testing and compliance.

 

The United States and other countries have at times proposed various forms of protectionist trade legislation.  We are subject to trade restrictions in the form of tariffs or quotas, or both, applicable to the products we sell as well as to raw material imported to manufacture those products.  We may also be subjected to additional duties, significant monetary penalties, the seizure and forfeiture of the products we are attempting to import, or the loss of import privileges if we or our vendors are found to be in violation of U.S. laws and regulations applicable to the importation of our products. Our and our vendors’ compliance with the regulations is subject to interpretation and review by applicable authorities.  Any changes in current tariff structures or other trade policies or interpretations could result in increases in the cost of and/or store level reduction in the availability of certain merchandise and could adversely affect our ability to purchase such merchandise and our operations.  The results of the recent United States elections may signal a change in trade policy between the United States and other countries. Because a large portion of our merchandise is sourced, directly or indirectly, from outside the United States, major changes in tax policy or trade relations, such as the disallowance of tax deductions for imported merchandise or the imposition of additional tariffs or duties on imported products, could adversely affect our business, results of operations, effective income tax rate, liquidity and net income. In addition, decreases in the value of the U.S. dollar against foreign currencies, particularly the Chinese renminbi, could increase the cost of products we purchase from overseas vendors. The pricing of our products in our stores may also be affected by changes in foreign currency rates and require us to make adjustments which would impact our revenue and profit.

 

Disruptions due to labor stoppages, strikes or slowdowns, shutdowns or major port or airport or other disruptions involving our vendors or the transportation and handling industries also may negatively affect our ability to receive merchandise and thus may negatively affect sales.  Prolonged disruptions could also materially increase our labor costs both during and following the disruption.  Significant increases in wages or wage taxes paid by contract facilities may increase the cost of goods manufactured, which could have a material adverse effect on our profit margins and profitability.  For example, the costs of labor and wage taxes have increased in China, which means we are at risk of higher marginal costs associated with goods manufactured in China.

 

These and other factors affecting our vendors and our access to products, including the supply of our imported merchandise or the imposition of additional costs of purchasing or shipping imported merchandise, could have a material adverse effect on our business, financial condition and results of operations unless and until alternative supply arrangements are secured. Products from alternative sources may be of lesser quality or more expensive than those we currently purchase, resulting in a loss of sales or profit.  As we increase our imports of merchandise from foreign vendors, the risks associated with foreign imports will increase.

 

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Our success depends on our executive officers and key management individuals.  If we lose any of these key individuals or are unable to hire additional qualified personnel in a timely fashion, our business may be adversely affected.

 

Our future success depends to a significant degree on the skills, experience and efforts of a limited number of key management personnel, including our executive management team.  The unexpected loss of the services of any or a significant number of such individuals could result in a loss of management continuity and institutional knowledge and thus adversely affect our business.  Other personnel may not have the experience and expertise to readily replace these individuals.  As a result, our board of directors may have to search outside of the Company for qualified replacements.  This search may be prolonged, and we cannot provide assurance that our executive succession planning, retention or hiring efforts will be successful.  We do not maintain key person insurance on any of our executives or key management personnel.  Further, the market for qualified executive candidates, who possess the desired talent and competencies, is highly competitive, and may subject us to increased labor costs during periods of low unemployment.

 

In recent periods, we have experienced significant management changes.  Specifically, the positions of Chief Executive Officer, Chief Financial Officer and Chief Merchandising Officer each experienced turnover during the past two fiscal years, in some cases multiple times.  After an extensive search with respect to each of these positions, we appointed Mr. Jack Sinclair as Chief Merchandising Officer in July 2015, Mr. Geoffrey J. Covert as President and Chief Executive Officer in September 2015, and Ms. Felicia Thornton as Chief Financial Officer and Treasurer in November 2015.  We will continue to enhance our management team as necessary to strengthen our business for future growth.  Although we do not anticipate additional significant management changes, these and other changes in management could result in changes to, or impact the execution of, our business strategy.  Any such changes could be significant and could have a negative impact on our performance and results of operations.  In addition, if we are unable to successfully transition members of management into their new positions, management resources could be constrained.

 

Failure to attract and retain qualified employees, particularly field, store and distribution center managers, while controlling labor costs, as well as other labor issues, could adversely affect our financial performance.

 

Our future growth and performance depends on our ability to attract, retain and motivate qualified employees, many of whom are in positions with historically high rates of turnover such as field managers and distribution center managers.  Our ability to meet our labor needs, while controlling our labor costs, is subject to many external factors, including competition for and availability of qualified personnel in a given market, unemployment levels within those markets, prevailing wage rates, minimum wage laws, health and other insurance costs, and changes in employment and labor laws (including changes in the process for our employees to join a union) or other workplace regulation (including changes in “entitlement” programs such as health insurance and paid leave programs).  To the extent a significant portion of our employee base unionizes, or attempts to unionize, our labor costs could increase.  In addition, comprehensive healthcare reform legislation has caused our healthcare costs to increase.  We anticipate future increases in the cost of health benefits, partly as a result of the implementation of the Patient Protection and Affordable Care Act (the “ACA”) enacted in 2010, as well as other healthcare reform legislation by Congress and state legislatures, including modification to or the repeal of the ACA.  If the ACA is repealed or modified or if new legislation is passed, such action could significantly increase costs of the healthcare benefits provided to our employees, the ultimate costs of which and the potentially adverse impact to the Company and its employees cannot be quantified at this time.  If we are unable to control healthcare and pension costs, we may experience increased operating costs, which may adversely affect our financial condition and operating results.  Furthermore, our ability to pass along increases in labor costs to our customers is constrained by our low price model.

 

Increases in costs and other inflationary pressures may affect our ability to keep pricing almost all of our merchandise at 99.99¢ or less.

 

Our ability to provide quality merchandise for profitable resale primarily at a price point of 99.99¢ or less is subject to certain economic factors which are beyond our control.  Future increases in costs for items such as merchandise, wages and benefits, shipping, freight, fuel and store occupancy, among others, may reduce our profitability.  The minimum wage has increased or is scheduled to increase in multiple states and local jurisdictions and there is a possibility that Congress will increase the federal minimum wage.  We can pass price increases on to customers to a certain extent, such as by selling smaller units for the same price and increasing the price of merchandise presently sold at less than 99.99¢, but there are limits to the ability to effectively increase prices on a sufficiently wide range of merchandise in this manner while rarely exceeding a dollar.  In certain circumstances, we have discontinued and may continue to discontinue some items from our offerings due to vendor wholesale price increases or reduced availability, which may adversely affect our results of operations.  In addition, inflation could have a material adverse effect on our business and results of operations, especially given the constraints on our ability to pass on incremental costs.  While we currently offer selected quality merchandise priced above 99.99¢, and believe that there are additional opportunities to expand our selection of these items, an expanded offering of merchandise priced in excess of 99.99¢ may not gain customer acceptance, which could damage our brand name and harm our revenues and profitability.  A sustained trend of increased costs and significant inflationary pressure could require us to abandon our customary practice of pricing quality merchandise primarily at a price point of 99.99¢ or less, which could have a material adverse effect on our business and results of operations.

 

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Current economic conditions and other economic factors may adversely affect our financial performance and other aspects of our business by negatively impacting our customer’s disposable income or discretionary spending, increasing our costs of goods sold and selling, general and administrative expenses, and adversely affecting our sales or profitability.

 

We believe many of our customers are on fixed or low incomes and generally have limited discretionary spending dollars.  Any factor that could adversely affect that disposable income would decrease our customer’s spending and could cause our customers to shift their spending to products other than those sold by us or to products sold by us that are less profitable than other product choices, all of which could result in lower net sales, decreases in inventory turnover, greater markdowns on inventory, and a reduction in profitability due to lower margins.  Factors that could reduce our customers’ disposable income and over which we exercise no influence include but are not limited to a slowdown in the economy, a delayed economic recovery, or other economic conditions such as increased or sustained high unemployment or underemployment levels, reduction and/or cessation of unemployment benefit payments and government subsidized assistance programs, concerns over government mandated participation in health insurance programs and increasing healthcare costs, inflation, increases in fuel or other energy costs and interest rates, lack of available credit, consumer debt levels, higher tax rates and other changes in tax laws.

 

Many of the factors identified above that affect disposable income, as well as commodity rates, transportation costs (including the costs of diesel fuel), costs of labor, insurance and healthcare, foreign exchange rate fluctuations, lease costs, measures that create barriers to or increase the costs associated with international trade, changes in other laws and regulations and other economic factors, also affect our cost of goods sold and our selling, general and administrative expenses, which may adversely affect our sales or profitability.  We have limited or no ability to control many of these factors.

 

In addition, many of the factors discussed above, along with current global economic conditions and uncertainties, the potential for additional failures or realignments of financial institutions, and the related impact on available credit may affect us and our vendors and other business partners, landlords and service providers in an adverse manner including, but not limited to, reducing access to liquid funds or credit, increasing the cost of credit, limiting our ability to manage interest rate risk, increasing the risk of bankruptcy of our vendors, landlords or counterparties to, or other financial institutions involved in, the Credit Facilities and other contracts, increasing the cost of goods to us, and other adverse consequences which we are unable to fully anticipate or control.

 

Material damage to, or interruptions to, our information systems as a result of external factors, staffing shortages and difficulties in updating our existing software or developing or implementing new software could have a material adverse effect on our business or results of operations.

 

We depend on a variety of information technology systems for the efficient functioning of many aspects of our business, including our inventory replenishment systems which are necessary to properly forecast, manage, analyze and record our inventory.  We are continually evaluating our information processes and computer systems to better run our business, including through our migration to SAP.  These technology improvements may not deliver desired results or may do so on a delayed schedule.  Additionally, such systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, cybersecurity breaches, natural disasters and human error.  Any material interruptions or the cost of replacements may require a significant investment to fix or replace them, and we may suffer interruptions in our operations in the interim, may experience loss or corruption of critical data and may receive negative publicity, all of which could have a material adverse effect on our business or results of operations.

 

We also rely heavily on our information technology staff. If we cannot meet our staffing needs in this area, we may not be able to maintain or improve our systems in the future. Further, we still have certain legacy systems that are not generally supportable by outside vendors, and should those of our information technology team who are conversant with such systems leave, these legacy systems could be without effective support.

 

We rely on certain software vendors to maintain and periodically upgrade many of these systems. The software programs supporting many of our systems are maintained and supported by independent software companies. The inability of these companies to continue to maintain and upgrade these information systems and software programs might disrupt or reduce the efficiency of our operations if we were unable to convert to alternate systems in an efficient and timely manner. In addition, costs and potential interruptions associated with the implementation of new or upgraded systems and technology could also disrupt or reduce the efficiency of our operations.

 

Impairment of our goodwill or our intangible assets could negatively impact our net income and stockholders’ equity.  We recognized substantial goodwill impairment charges in the third quarter of fiscal 2016 and may be required to recognize additional goodwill and intangible asset impairment charges in the future.

 

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A substantial portion of our total assets consists of goodwill and intangible assets.  Goodwill and certain intangible assets are not amortized, but are tested for impairment at least annually and between annual tests if events or circumstances indicate that it is more likely than not that the fair value of our net assets might be impaired.  Testing for impairment involves an estimation of the fair value of our net assets and other factors and involves a high degree of judgment and subjectivity.  There are numerous risks that may cause the fair value of our net assets to fall below its carrying amount, including those described elsewhere in this Report.  If we have an impairment of our goodwill or intangible assets, the amount of any impairment could be significant and could negatively impact our net income and stockholders’ equity for the period in which the impairment charge is recorded. During the third quarter of fiscal 2016, we determined that sufficient indicators of impairment existed to require an interim impairment analysis of goodwill and trade name, including (i) overall performance deterioration reflected in decreased comparable same-store sales and cannibalization from stores opened in fiscal 2015 under an accelerated expansion program, (ii) increases in inventory shrinkage and buildup of excess inventory, (iii) decreased margin due to disappointing results from sales promotions and (iv) a decision to delay the pace of future store openings.  Our first step evaluation concluded that the fair value of the retail reporting unit was below its carrying value.  We performed step two of the goodwill impairment test that requires the retail reporting unit’s fair value to be allocated to all of the assets and liabilities of the reporting unit, including any intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination, including consideration of the fair value of tangible property and intangible assets.  As a result of the preliminary results of the impairment test, impairment of goodwill was required and based on our best estimate, we recorded a $120.0 million non-cash goodwill impairment charge in the third quarter of fiscal 2016.  The finalization of the preliminary goodwill impairment test was completed in the fourth quarter of fiscal 2016 and resulted in a $20.9 million adjustment in goodwill, lowering the third quarter of fiscal 2016 goodwill impairment charge from $120.0 million to $99.1 million. If operating results continue to change versus our expectations, additional impairment charges may be recorded in the future.  If we have an additional impairment of our goodwill or intangible assets, the amount of any impairment could be significant and could negatively impact our net income and members’ equity for the period in which the impairment charge is recorded.

 

Our operations are concentrated in California.

 

As of January 27, 2017, 283 of our 390 stores were located in California (with 48 stores in Texas, 38 stores in Arizona and 21 stores in Nevada).  We expect that we will continue to open additional stores in as well as outside of California.  For the foreseeable future, our results of operations will depend significantly on trends in the California economy and its legal/regulatory environment.  Declines in retail spending on higher margin discretionary items and continuing trends of increasing demand for lower margin food products may negatively impact our profitability.  California has also historically enacted minimum wages that exceed federal standards; the California minimum wage increased to $10.50 per hour effective January 1, 2017.  Moreover, certain municipalities in which our stores are located have set minimum wages above the applicable state standards.  Any further increases in the federal minimum wage or the enactment of additional state or local minimum wage increases could increase our labor costs.  California typically has other factors making compliance, litigation and workers’ compensation claims more prevalent and costly.  Additional local regulation in certain California jurisdictions may further pressure margins.

 

Natural disasters, unusually adverse weather conditions, pandemic outbreaks, terrorist acts, and global political events could cause temporary or permanent distribution center or store closures, impair our ability to purchase, receive or replenish inventory, or decrease customer traffic, all of which could result in lost sales and otherwise adversely affect our financial performance.

 

The occurrence of one or more natural disasters, such as earthquakes, hurricanes, fires, floods, tornadoes and earthquakes, unusually adverse weather conditions, pandemic outbreaks, terrorist acts or disruptive global political events, such as civil unrest in countries in which our vendors are located, or similar disruptions could adversely affect our operations and financial performance.  To the extent these events result in the closure of one or more of our distribution centers or a significant number of stores, or impact one or more of our key local or overseas suppliers, our operations and financial performance could be materially adversely affected through an inability to make deliveries or provide other support functions to our stores and through lost sales.  In addition, these events could result in increases in fuel (or other energy) prices or a fuel shortage, delays in opening new stores, the temporary lack of an adequate work force in a market, the temporary or long-term disruption in the supply of products from some local and overseas vendors, the temporary disruption in the transport of goods from overseas, delay in the delivery of goods to our distribution centers or stores, the inability of customers to reach or have transportation to our stores directly affected by such events, the temporary reduction in the availability of products in our stores, and disruption of our utility services or to our information systems.

 

We could encounter risks related to transactions with affiliates.

 

Prior to the Merger, we leased 13 store locations and a parking lot associated with one of these stores from former members of management and their affiliates, of which 12 stores were leased on a month to month basis.  In connection with the Merger, we entered into new lease agreements for these 13 stores and one parking lot. Although the terms negotiated were acceptable to us, we cannot be certain that terms negotiated are no less favorable than a negotiated arm’s length transaction with a third party.

 

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Our current insurance program may expose us to unexpected costs and negatively affect our financial performance.

 

Our insurance coverage reflects deductibles, self-insured retentions, limits of liability and similar provisions that we believe are prudent.  However, there are types of losses we may incur but against which we cannot be insured or which we believe are not economically reasonable to insure, such as losses due to employment practices, acts of war, employee, blackouts and certain other crime and some natural disasters, including earthquakes and tsunamis.  If we incur these losses and they are material, our business could suffer. In addition, we self-insure a significant portion of expected losses under our workers’ compensation and general liability programs.  Unanticipated changes in any applicable actuarial assumptions and management estimates underlying our recorded liabilities for these losses could result in materially different amounts of expense than expected under these programs, which could have a material adverse effect on our financial condition and results of operations.  In the fourth quarter of fiscal 2016, we increased workers’ compensation accrual by $7.2 million as a result of higher incurred and projected expenses associated with fiscal 2016 workers’ compensation claims.  We have designed and staffed a focused effort to build a culture of safety at 99 Cents designed to reduce the frequency and severity of workers’ compensation claims against us.  In fiscal 2017, we experienced an improvement in frequency of claims and anticipation of severity of historical claims.  However, we can provide no assurance that costs associated with workers’ compensation claims will continue to decline in the future.  Future increases in workers’ compensation costs, if incurred, could have a material adverse effect on our business, financial condition, and results of operations.  Although we continue to maintain property insurance for catastrophic events, we are effectively self-insured for property losses up to the amount of our deductibles.  If we experience a greater number of these losses than we anticipate, our financial performance could be adversely affected.

 

We self-insure a portion of our health insurance program that may expose us to unexpected costs and negatively affect our financial performance.

 

We self-insure a portion of our employee medical benefit claims. The liability for the self-funded portion of our health insurance program is determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported.  We maintain stop loss insurance coverage to limit our exposure for the self-funded portion of our health insurance program.  Liabilities associated with these losses include estimates of both claims filed and losses incurred but not yet reported.  Unanticipated changes in any applicable actuarial assumptions and management estimates underlying our recorded liabilities for these losses could result in materially different amounts of expense than expected under these programs, which could have a material adverse effect on our financial condition and results of operations.

 

We face intense competition that could limit our growth opportunities and adversely impact our financial performance.

 

The retail business is highly competitive with respect to price, store location, merchandise quality, assortment and presentation, in-stock consistency, customer service, aggressive promotional activity, customers, and employees.  We compete in both the acquisition of inventory and sale of merchandise with other wholesalers and retailers, discount and deep-discount stores, single price point merchandisers, mass merchandisers, food markets, drug chains, club stores and other retailers.  We also compete for retail real estate sites.  In the future, new companies may also enter the extreme value retail industry.  It is also becoming more common for superstores to sell products competitive with our product offerings.  Additionally, we currently face increasing competition for the purchase of quality closeout merchandise, and some of these competitors are entering or may enter our traditional markets.  Also, companies like ours, due to customer demographics and other factors, may have limited ability to increase prices in response to increased costs without losing competitive position.

 

As we expand, we may enter new markets where our own brand is weaker and established brands are stronger, and where our own brand value may have been diluted by other retailers with similar names, appearances and/or business models.  Some of our competitors have substantially greater financial resources and buying power than we do, as well as nationwide name-recognition and organization.  Our ability to compete will depend on many factors including the ability to successfully purchase and resell merchandise at lower prices than competitors and the ability to differentiate ourselves from competitors that do not share our price and merchandise attributes, yet may appear similar to prospective customers.  We also face competition from other retailers with similar names and/or appearances.  We cannot assure that we will be able to compete successfully against current and future competitors in both the acquisition of inventory and the sale of merchandise.

 

We expect competition to continue to increase.  Some of our large box competitors are or may be developing small box formats, and increasing the pace at which they will open the small box formats, which will produce more competition.  We remain vulnerable to the marketing power and high level of consumer recognition of these larger competitors and to the risk that these competitors or others could venture into our industry in a significant way.  Further, consolidation within the discount retail industry could significantly alter the competitive dynamics of the retail marketplace.  This consolidation may result in competitors with greatly improved financial resources, improved access to merchandise, greater market penetration and other improvements in their competitive positions, as well as result in the provision of a wider variety of products and services at competitive prices by these consolidated companies, which could adversely affect our financial performance.

 

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If we fail to protect our brand name, competitors may adopt trade names that dilute the value of our brand name.

 

We may be unable or unwilling to strictly enforce our trademark in each jurisdiction in which we do business. Also, we may not always be able to successfully enforce our trademarks against competitors or against challenges by others. Our failure to successfully protect our trademarks could diminish the value and efficacy of our brand recognition, and could cause customer confusion, which could, in turn, adversely affect our sales and profitability.

 

We are subject to governmental regulations, procedures and requirements. A significant change in, or noncompliance with, these regulations could have a material adverse effect on our financial performance.

 

Our business is subject to numerous federal, state and local laws and regulations. We routinely incur costs in complying with these regulations.  New laws or regulations, particularly those dealing with healthcare reform, hazardous waste, product safety, and labor and employment, among others, or changes in existing laws and regulations, especially those governing the sale of products, may result in significant added expenses or may require extensive system and operating changes that may be difficult to implement and/or could materially increase our cost of doing business.  In addition, such changes or new laws may require the write off and disposal of existing product inventory, resulting in significant adverse financial impact to us.  Untimely compliance or noncompliance with applicable regulations or untimely or incomplete execution of a required product recall can result in the imposition of penalties, including loss of licenses or significant fines or monetary penalties, in addition to reputational damage.

 

We are subject to environmental regulations.

 

Under various federal, state and local environmental laws and regulations, current or previous owners or occupants of property may face liability associated with hazardous substances.  These laws and regulations often impose liability without regard to fault.  In the future, we may be required to incur substantial costs for preventive or remedial measures associated with hazardous materials.  We have several storage tanks at our distribution and warehouse facilities, including: an aboveground and underground diesel storage tank at one of our City of Commerce, California distribution centers, a compressed natural gas tank at one of our City of Commerce, California distribution centers; an aboveground propane storage tank at one of our City of Commerce, California distribution centers; ammonia storage at our Texas warehouse; an aboveground diesel storage tank at our Texas warehouse; an aboveground propane storage tank at our leased Slauson warehouse in City of Commerce, California; and an aboveground propane storage tank at our leased Los Palos warehouse in Los Angeles, California.  Except as disclosed in Item 3, “Legal Proceedings,” we have not been notified of, and are not aware of, any potentially material current environmental liability, claim or non-compliance.  We could incur costs in the future related to owned properties, leased properties, storage tanks, or other business properties and/or activities.  In the ordinary course of business, we handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations.  We have adopted policies regarding the handling and disposal of these products, but we cannot be assured that our policies and training are comprehensive and/or are consistently followed, and we are still potentially subject to liability under, or violations of, these environmental laws and regulations in the future even if our policies are consistently followed.

 

Litigation may adversely affect our business, financial condition and results of operations.

 

Our business is subject to the risk of litigation by employees, consumers, vendors, competitors, shareholders, government agencies and others through private actions, class actions, administrative proceedings, regulatory actions or other litigation.  The outcome of litigation, particularly class action lawsuits, regulatory actions and intellectual property claims, is difficult to assess or quantify.  Plaintiffs in these types of lawsuits may seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to these lawsuits may remain unknown for substantial periods of time.  In addition, certain of these lawsuits, if decided adversely to us or settled by us, may result in liability material to our financial statements as a whole or may negatively affect our operating results if changes to our business operation are required.  The outcome of litigation is difficult to assess or quantify and the cost to defend current and future litigation may be significant.  There also may be adverse publicity associated with litigation that could negatively affect customer perception of our business, regardless of whether the allegations are valid or whether we are ultimately found liable.  Reserves are established based on our best estimates of our potential liability.  However, we cannot accurately predict the ultimate outcome of any such proceedings due to the inherent uncertainties of litigation.  Regardless of the outcome or whether the claims are meritorious, legal and regulatory proceedings may require that we devote substantial time and expense to defend our Company.  As a result, litigation may adversely affect our business, financial condition and results of operations.

 

For a discussion of current legal matters, please see Item 3, “Legal Proceedings.”  Resolution of these matters, if decided against the Company, could have a material adverse effect on our results of operations, accrued liabilities or cash flows.

 

We could be exposed to product liability, food safety claims or packaging violation claims.

 

We purchase many products on a closeout basis, some of which are manufactured or distributed by overseas entities, and some of which are purchased by us through brokers or other intermediaries as opposed to directly from their manufacturing or distribution sources.  Many products are also sourced directly from manufacturers.  The closeout nature of certain of these products and transactions may impact our opportunity to investigate all aspects of these products.  We attempt to ensure compliance, and to test products when appropriate, but there can be no assurance that we will consistently succeed in these efforts.  Despite our best efforts to ensure the quality, safety and freshness of the products that we sell in all of our stores, we may be subject to product liability claims from customers or actions required or penalties assessed by government agencies relating to products, including but not limited to food

 

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products that are recalled, defective or otherwise alleged to be harmful.  Even with adequate insurance and indemnification, such claims could significantly damage our reputation and consumer confidence in our products.  We have or have had, and in the future could face, labeling, environmental, or other claims, from private litigants as well as from governmental agencies.  Our litigation expenses could increase as well, which also could have a materially negative impact on our results of operations even if a product liability claim is unsuccessful or is not fully pursued.

 

We may be adversely impacted if our cybersecurity measures fail.

 

Our relationships with our customers may be adversely affected if the security measures that we use to protect their personal information, such as credit card numbers, are ineffective or perceived by consumers to be inadequate. We primarily rely on security and authentication technology that we license from other parties. With this technology, we perform real-time credit card authorization and verification with our banks and we are subject to the customer privacy standards of credit card companies and various consumer protection laws. We cannot predict whether there will be a compromise or breach of the technology we use to protect our customers’ personal information. If there is a compromise or breach of this nature, there is the potential that parties could seek damages from us, and we could lose the confidence of customers or be subject to lawsuits or significant fines or penalties from credit card companies or regulatory agencies.

 

Furthermore, our servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by any such breaches.

 

We face risks related to protection of data related to our employees, customers, vendors and other parties.

 

As part of our normal business activities, we collect and store sensitive personal information, related to our employees, customers, vendors and other parties. We have certain procedures and technology in place to protect such data, but third parties may have the technology or know-how to breach the security of this information, and our security measures and those of our technology vendors may not effectively prohibit others from obtaining improper access to this information.

 

A security breach of any kind, which could be undetected for a period of time, or any failure by us to comply with the applicable privacy and information security laws, regulations and standards could expose us to risks of data loss, litigation, government enforcement actions and costly response measures (including, for example, credit monitoring services for affected customers, as well as further upgrades to our security measures) which may not be covered by our insurance policies, and could materially disrupt our operations.  Any resulting negative media attention and publicity could significantly harm our reputation, which could cause us to lose market share as a result of customers discontinuing the use of debit or credit cards in our stores or not shopping in our stores altogether and could have a material adverse effect on our business and financial performance.

 

We need to comply with credit and debit card security regulations.

 

In connection with sales, we transmit confidential credit and debit card information.  As a merchant who processes credit and debit card payments from customers, we are required to comply with the Payment Card Industry Data Security Standards (“PCI DSS”) and other requirements imposed on us for the protection and security of our customers’ credit and debit card information.  PCI DSS contains compliance guidelines and standards with regard to our security surrounding the physical and electronic storage, processing, and transmission of cardholder data.  If we are unable to remain compliant with PCI DSS and other requirements, our business and operations could be adversely affected because we could incur significant fines or penalties from payment card companies or we could be prevented in the future from accepting customer payments by means of a credit or debit card.  We also may need to expend significant management and financial resources to become or remain compliant with these requirements, which could divert these resources from other initiatives and adversely impact our results of operations, financial condition, business and prospects.

 

Changes to accounting rules or regulations may adversely affect our results of operations.

 

New accounting rules or regulations and varying interpretations of existing accounting rules or regulations have occurred and may occur in the future. A change in accounting rules or regulations may even affect our reporting of transactions completed before the change is effective, and future changes to accounting rules or regulations or the questioning of current accounting practices may adversely affect our results of operations.

 

In February 2016, the Financial Accounting Standards Board (“FASB”) released a new lease standard, requiring companies to capitalize substantially all leases, including operating leases, in their financial statements. The new lease standard will be effective beginning after December 15, 2018.  The new standard requires lessees to put most leases on their balance sheets but recognize expenses on their income statements in a manner that is largely similar to current accounting. The standard also eliminates real estate-specific provisions for all entities. Currently, substantially all of our leased properties are accounted for as operating leases with limited related assets and liabilities recorded on our balance sheet. The new accounting standard, as currently issued, is currently expected to result in significant changes to our current accounting and would treat each lease as creating an asset and a liability and require the

 

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capitalization of such leases on the balance sheet. While this change would not impact the cash flow related to our store leases, we would expect our assets and liabilities to increase relative to the current presentation, which may impact our ability to raise additional financing from banks or other sources in the future.  However, even if the new guidance is adopted as issued, certain incurrence ratios and other provisions under the indenture governing the Senior Notes (the “Indenture”) and under the Credit Facilities permit us to account for leases in accordance with the existing accounting requirements.  As a result, our ability to incur additional debt or otherwise comply with such covenants may not directly correlate to our financial condition or results from operations as each would be reported under generally accepted accounting principles (“GAAP”) in the United States as so amended.

 

Our failure to implement and maintain effective internal control over financial reporting could result in material misstatements in our financial statements.

 

During fiscal 2016, management identified a material weakness in our internal control over financial reporting with respect to identifying items within our deferred tax balances that could be materially incorrect.  Specifically, we did not provide appropriate oversight of our third-party tax preparer.  A more complete description of this material weakness is included in Item 9A, “Controls and Procedures.”  Although we have implemented certain measures that we believe will remediate this material weakness, we can provide no assurance that our remediation efforts will be effective or that additional material weaknesses in our internal control over financial reporting will not be identified in the future.  Any failure to maintain or implement required new or improved controls, or any difficulties that may be encountered in their implementation, could result in additional material weaknesses, cause us to fail to meet our periodic or annual reporting obligations or result in material misstatements in our financial statements.  Any such failure could also adversely affect the results of periodic management evaluations regarding the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated under Section 404.  The existence of material weaknesses could result in errors in our financial statements that could result in a restatement of those financial statements.

 

Risks Related to Our Substantial Indebtedness

 

We have substantial indebtedness and lease obligations, which could affect our ability to meet our obligations under our indebtedness and may otherwise restrict our activities.

 

Our total indebtedness as of January 27, 2017 was $883.2 million, consisting of gross borrowings under our First Lien Term Loan Facility of $593.9 million, borrowings under the ABL Facility of $39.3 million and $250.0 million of our Senior Notes.  Availability under the ABL Facility (subject to the borrowing base) was $37.2 million as of January 27, 2017.

 

We also have, and will continue to have, significant lease obligations. As of January 27, 2017, our minimum annual rental obligations under long-term leases for fiscal 2018 are $84.8 million.

 

Our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under the Senior Notes and our Credit Facilities. Our substantial indebtedness could have important consequences, including:

 

·                  increasing our vulnerability to adverse economic, industry or competitive developments;

 

·                  requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities;

 

·                  exposing us to the risk of increased interest rates because certain of our borrowings, including borrowings under our Credit Facilities, are at variable rates of interest;

 

·                  making it more difficult for us to satisfy our obligations with respect to our indebtedness, including the Senior Notes, and any failure to comply with the obligations of any of our debt instruments, including restrictive covenants and borrowing conditions, could result in an event of default under the Indenture and the agreements governing such other indebtedness;

 

·                  restricting us from making strategic acquisitions or causing us to make non-strategic divestitures;

 

·                  imposing restrictions on the operation of our business that may hinder our ability to take advantage of strategic opportunities or to grow our business;

 

·                  limiting our ability to obtain additional financing for working capital, capital expenditures (including real estate acquisitions and store expansion), debt service requirements and general corporate or other purposes, which could be exacerbated by further volatility in the credit markets; and

 

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·                  limiting our flexibility in planning for, or reacting to, changes in our business or market conditions and placing us at a competitive disadvantage compared to any of our competitors who are less leveraged and who therefore, may be able to take advantage of opportunities that our leverage prevents us from exploiting.

 

We and our subsidiaries are still able to incur significant additional amounts of debt, which could further exacerbate the risks associated with our substantial indebtedness.

 

We and our subsidiaries may be able to incur substantial additional indebtedness in the future.  The Indenture and our Credit Facilities each contain restrictions on the incurrence of additional indebtedness.  However, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial.  Accordingly, we and our subsidiaries may be able to incur substantial additional indebtedness in the future.  We have additional availability under our ABL Facility subject to the borrowing base of $37.2 million as of January 27, 2017.

 

Subject to certain limitations and the satisfaction of certain conditions, including the receipt of commitments for additional borrowings, we were also permitted to incur up to an aggregate of $50.0 million of additional borrowings pursuant to incremental facilities under the First Lien Term Loan Facility and up to an aggregate of $25.0 million of additional revolving commitments (subject to the borrowing base) pursuant to the ABL Facility.  If new debt is added to our and our subsidiaries’ current debt levels, the risks that we now face as a result of our leverage would intensify and could have a negative impact on our credit rating.

 

We may not be able to generate sufficient cash to service all of our indebtedness or repay such indebtedness when due, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

 

Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal of, and premium, if any, and additional interest, if any, on, our indebtedness, including the Senior Notes.

 

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness, including the Senior Notes.  Our First Lien Term Loan Facility matures on January 13, 2019, and our Senior Notes mature on December 15, 2019.  While the maturity date of our ABL Facility has been conditionally extended to April 8, 2021 in connection with the Fourth Amendment, such extension resulted in higher interest rates and, if our First Lien Term Loan Facility and Senior Notes are not refinanced or amended to extend the final maturity dates thereof to a date that is at least 180 days after April 8, 2021, our ABL Facility will mature on the earlier of (i) the date that is 90 days prior to the stated maturity date in respect of our First Lien Term Loan Facility and (ii) the date that is 90 days prior to the stated maturity date in respect of the Senior Notes. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. The terms of the Indenture and our Credit Facilities or any future debt instruments that we may enter into may restrict us from adopting some of these alternatives. In addition, any failure to make payments of interest and principal on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.  Perceived liquidity issues resulting from any such failure to make payments of interest or principal or restructure or refinance our existing debt could adversely affect our relationships with key vendors, our lenders and other business partners, who may seek to impose stricter credit or other terms on their arrangements with us, including by requiring us to post collateral to secure our obligations, which could in turn materially and adversely affect our business and operations.

 

Failure to comply with the financial requirements under our ABL Facility could result in decreased credit availability and reduced distributions.

 

Additional borrowing under our ABL Facility is dependent on the maintenance of certain liquidity levels, compliance with financial ratio covenants, the borrowing base and other provisions set forth in the ABL Facility. Our ABL Facility contains additional restrictive provisions that are imposed if “excess availability” falls below the greater of (x) 15% of the maximum credit under the ABL Facility and (y) $25.0 million for five (5) consecutive Business Days. Operating under “cash dominion” would increase our reporting requirements, operational complexities for the Company and permit the administrative agent to invoke control rights over certain of our accounts. Further, under the ABL Facility, we could in the future be required to maintain a fixed charge coverage ratio of 1.00 to 1.00 when “excess availability” falls below the greater of (i) 12.5% of the maximum credit under the ABL Facility and (y) $20.0 million.  As of January 27, 2017, our fixed charge coverage ratio was less than 1.00 to 1.00. A decrease in excess availability as a result of decreases in inventory, increases in outstanding debt (including letters of credit) or otherwise, could cause our excess availability to fall below the “cash dominion” trigger, which would subject us to additional requirements and restrict access to borrowings under the ABL Facility, which would adversely affect our liquidity and our ability to execute our strategic plan.

 

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Our debt agreements contain restrictions that limit our flexibility in operating our business.

 

Our Credit Facilities and the Indenture contain various covenants that limit our ability to engage in specified types of transactions. These covenants limit our Parent’s (solely with respect to our Credit Facilities) and our restricted subsidiaries’ ability to, among other things:

 

·                  incur additional indebtedness or issue certain preferred shares;

 

·                  pay dividends on, repurchase or make distributions in respect of our capital stock or make other restricted payments;

 

·                  make certain investments;

 

·                  transfer or sell certain assets;

 

·                  create or incur liens;

 

·                  consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and

 

·                  enter into certain transactions with our affiliates.

 

A breach of any of these covenants could result in a default under one or more of these agreements, including as a result of cross default provisions, and, in the case of our Credit Facilities, permit the lenders to cease making loans to us.  Upon the occurrence of an event of default under our Credit Facilities, the lenders could elect to declare all amounts outstanding under our Credit Facilities to be immediately due and payable and terminate all commitments to extend further credit under the ABL Facility.  Such actions by those lenders could cause cross defaults under our other indebtedness.  If we were unable to repay those amounts, the lenders under our Credit Facilities could proceed against the collateral granted to them to secure that indebtedness.  We have pledged a significant portion of our assets as collateral under our Credit Facilities.  If the lenders under our Credit Facilities accelerate the repayment of borrowings, we may not have sufficient assets to repay our Credit Facilities as well as our other indebtedness, including the Senior Notes.

 

Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.

 

Borrowings under our Credit Facilities are at variable rates of interest and expose us to interest rate risk.  If interest rates continue to increase, our debt service obligations on our variable rate indebtedness will increase even though the amount borrowed would remain the same, and our net income and cash flow, including cash available for servicing our indebtedness, will correspondingly decrease.

 

Changes in our credit ratings may limit our access to capital markets and adversely affect our liquidity.

 

The credit rating agencies periodically review our capital structure and the quality and stability of our earnings.  Any future downgrades to our long-term credit ratings could result in reduced access to the credit and capital markets and higher interest costs on future financings.  The future availability of financing will depend on a variety of factors such as economic and market conditions, the availability of credit and our credit ratings, as well as the possibility that lenders could develop a negative perception of us.  There is no assurance that we will be able to obtain additional financing on favorable terms or at all.

 

Certain investment funds affiliated with Ares and CPPIB own substantially all the equity of Parent, and their interests may not be aligned with those of the holders of the Senior Notes.

 

We are controlled by Ares and CPPIB.  Ares and CPPIB control the election of a majority of our directors and thereby have the power to control our affairs and policies, including the appointment of management, the issuance of additional stock and the declaration and payment of dividends.  Ares and CPPIB do not have any liability for any obligations under the Senior Notes and their interests may be in conflict with yours.  For example, if we encounter financial difficulties or are unable to pay our debts as they mature, Ares and CPPIB may pursue strategies that favor equity investors over debt investors.  In addition, our equity holders may have an interest in pursuing acquisitions, divestitures, financing or other transactions that, in their judgment, could enhance their equity investments, even though such transactions may involve risk to the holders of the Senior Notes.  Additionally, Ares and CPPIB may make investments in businesses that directly or indirectly compete with us, or may pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us.  For information concerning our arrangements with Ares and CPPIB, see Item 13, “Certain Relationships and Related Transactions” for more information.

 

Investment funds advised by entities affiliated with Ares and CPPIB have in the past and may in the future buy or sell portions of our debt in open market transactions at any time.

 

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Item 1B. Unresolved Staff Comments

 

None.

 

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Item 2. Properties

 

As of January 27, 2017, we owned 66 stores and leased 324 of our 390 store locations. Additionally, as of January 27, 2017, we owned four parcels of land for potential store sites.

 

Our leases generally provide for a fixed minimum rental, and some leases require additional rental based on a percentage of sales once a minimum sales level has been reached.  Management believes that our stable operating history and ability to generate substantial customer traffic give us leverage when negotiating lease terms.  Certain leases include cash reimbursements from landlords for leasehold improvements and other cash payments received from landlords as lease incentives.  A large majority of our store leases were entered into with multiple renewal periods, which are typically five to ten years and occasionally longer.

 

The large majority of our store leases were entered into with multiple renewal options of typically five years per option. Historically, we have exercised the large majority of the lease renewal options as they arise, and anticipate continuing to do so for the majority of leases for the foreseeable future.

 

The following table sets forth, as of January 27, 2017, information relating to the calendar year expiration dates for our current store leases:

 

Calendar Years

 

Number of Leases Expiring
Assuming No Exercise of Renewal
Options

 

Number of Leases Expiring
Assuming Full Exercise of Renewal
Options

 

2017

 

4

 

2

 

2018-2020

 

106

 

9

 

2021-2023

 

96

 

16

 

2024-2028

 

110

 

45

 

2029-thereafter

 

8

 

252

 

 

We own our main distribution center and executive office facility, located in the City of Commerce, California.  We lease two warehouse facilities located in City of Commerce, California that expire in March 2018 and January 2030, respectively. We also lease a cold warehouse facility located in Los Angeles, California that expires in February 2029.

 

In calendar 2016, we exited two leased warehouse facilities to reduce our warehouse footprint in Southern California. In July 2016, we sold and concurrently licensed (through March 31, 2017) a warehouse facility in the City of Commerce, California. See Note 10 to the Consolidated Financial Statements for additional information.

 

We own a distribution center in the Houston area to service our Texas operations.

 

As our needs change, we may relocate, expand, and/or otherwise increase or decrease the size and/or costs of our distribution or warehouse facilities.

 

Item 3. Legal Proceedings

 

Information for this item is included in Note 10 to our Consolidated Financial Statements included in this Report, and incorporated herein by reference.

 

Item 4. Mine Safety Disclosures

 

None.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

Subsequent to the Merger, our membership units are privately held and there is no established public trading market for such units.

 

Dividends

 

We do not expect to make any dividends, distributions or other similar payments to Parent in the foreseeable future.

 

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Item 6. Selected Financial Data

 

The selected consolidated financial data presented below as of January 27, 2017 and January 29, 2016 and for the years ended January 27, 2017, January 29, 2016 and January 30, 2015 have been derived from our Consolidated Financial Statements and notes thereto included in this Report.  The selected consolidated financial data as of January 30, 2015, January 31, 2014 and March 30, 2013, and for the ten months ended January 31, 2014 and the year ended March 30, 2013 have been derived from our audited consolidated financial statements that are not included in this Report.

 

Fiscal years ended January 27, 2017, January 29, 2016 and January 30, 2015 are each comprised of 52 weeks.  The period for the ten months ended January 31, 2014 is comprised of 44 weeks.  The fiscal year ended March 30, 2013 is comprised of 52 weeks.

 

In the first quarter of fiscal 2015, we modified our definition of same-store sales.  Previously, we defined same-store sales as sales at stores that have been open at least 15 months. In situations in which the store was relocated, or closed and later reopened in the same location, the affected store was considered a new store for any same-store sales analysis.  A store would only be included in the same-store sales analysis once it had been open, or reopened, for 15 months.  Under the new definition, same-store sales are sales at stores that have been open at least 14 months, including stores that have been remodeled, expanded or relocated during that period. Since we do not have e-commerce sales, such sales are not part of our same-store sales calculation.  This change in definition of same-store sales was a prospective change and was made in order to be in line with our peers in the retail industry.  This change in definition of same-store sales, if applied retrospectively, would not have had a material impact on the comparability of same-store sales for the prior periods presented.

 

Certain amounts as of and for the year ended January 29, 2016 have been revised to correct for immaterial errors as described in Note 1 to our Consolidated Financial Statements.

 

The historical results presented below are not necessarily indicative of the results to be expected for any future period.  The information should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and notes thereto included in this Report.

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

Ten Months Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

January 31,
2014

 

March 30,
2013

 

 

 

(Amounts in thousands, except operating data)

 

Statements of Income Data:

 

 

 

 

 

 

 

 

 

 

 

Net Sales:

 

 

 

 

 

 

 

 

 

 

 

99¢ Only Stores

 

$

2,023,034

 

$

1,961,050

 

$

1,881,865

 

$

1,486,699

 

$

1,620,683

 

Bargain Wholesale

 

38,973

 

42,945

 

45,084

 

42,044

 

47,968

 

Total sales

 

2,062,007

 

2,003,995

 

1,926,949

 

1,528,743

 

1,668,651

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

1,460,595

 

1,441,631

 

1,308,849

 

1,033,077

 

1,117,051

 

Gross profit

 

601,412

 

562,364

 

618,100

 

495,666

 

551,600

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative expenses

 

654,509

 

614,026

 

546,259

 

481,449

 

493,316

 

Goodwill impairment

 

 

99,102

 

 

 

 

Operating (loss) income

 

(53,097

)

(150,764

)

71,841

 

14,217

 

58,284

 

 

 

 

 

 

 

 

 

 

 

 

 

Other expense, net

 

69,052

 

65,649

 

62,734

 

55,195

 

77,282

 

 

 

 

 

 

 

 

 

 

 

 

 

(Loss) income before provision for income taxes

 

(122,149

)

(216,413

)

9,107

 

(40,978

)

(18,998

)

Provision (benefit) for income taxes

 

(3,990

)

31,942

 

3,605

 

(28,493

)

(10,089

)

Net (loss) income

 

$

(118,159

)

$

(248,355

)

$

5,502

 

$

(12,485

)

$

(8,909

)

 

 

 

 

 

 

 

 

 

 

 

 

Company Operating Data:

 

 

 

 

 

 

 

 

 

 

 

Sales Growth:

 

 

 

 

 

 

 

 

 

 

 

99¢ Only Stores

 

3.2

%

4.2

%

N/A

 

N/A

 

8.9

%

Bargain Wholesale

 

(9.2

)%

(4.7

)%

N/A

 

N/A

 

10.0

%

Total sales

 

2.9

%

4.0

%

N/A

 

N/A

 

8.9

%

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

29.2

%

28.1

%

32.1

%

32.4

%

33.1

%

Operating margin

 

(2.6

)%

(7.5

)%

3.7

%

0.9

%

3.5

%

Net (loss) income

 

(5.7

)%

(12.4

)%

0.3

%

(0.8

)%

(0.5

)%

 

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January 27,
2017

 

January 29,
2016(e)

 

January 30,
2015(e)

 

January 31,
2014(e)

 

March 30,
2013(e)

 

 

 

(Amounts in thousands, except operating data)

 

Retail Operating Data (a) :

 

 

 

 

 

 

 

 

 

 

 

99¢ Only Stores at end of period

 

390

 

391

 

383

 

343

 

316

 

Change in comparable same-store sales

 

2.1

%(b)

(2.7

)%(b)

0.4

%(b)

3.7

%(c)

4.3

%(c)

Average net sales per store open the full year

 

$

5,173

 

$

5,075

 

$

5,366

 

$

5,446

 

$

5,327

 

Average net sales per estimated saleable square foot (d)

 

$

319

 

$

314

 

$

328

 

$

330

 

$

321

 

Estimated saleable square footage at year end

 

6,309,406

 

6,307,255

 

6,189,669

 

5,607,991

 

5,211,483

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Working capital (deficit)

 

$

(81,870

)

$

(8,788

)

$

54,808

 

$

50,327

 

$

119,291

 

Total assets

 

$

1,548,306

 

$

1,609,903

 

$

1,873,316

 

$

1,706,568

 

$

1,705,413

 

Capital and financing lease obligation, including current portion

 

$

78,525

 

$

35,806

 

$

25,061

 

$

285

 

$

354

 

Long-term debt, including current portion

 

$

871,513

 

$

881,981

 

$

893,266

 

$

838,676

 

$

739,641

 

Total member’s/shareholders’ equity

 

$

144,019

 

$

261,324

 

$

507,752

 

$

499,087

 

$

638,970

 

 


(a)    Includes retail operating data solely for our 99¢ Only stores.  For comparability purposes, average net sales per store and average net sales per estimated saleable square foot are based on a trailing 52-week period for all periods presented.  Comparable same-store sales is based on a comparable 52-week period for all periods presented, except for the ten months ended January 31, 2014, which is based on a comparable 43-week period of the prior year.

(b)   Change in comparable same-store sales compares net sales for all stores open at least 14 months.

(c)    Change in comparable same-store sales compares net sales for all stores open at least 15 months.

(d)   Computed based upon estimated total saleable square footage of stores open for at least 12 months.

(e)    Certain prior year balance sheet amounts have been reclassified to conform to the current year’s presentation. Specifically, in fiscal 2017, we adopted an accounting standard that requires us to present debt issuance costs related to a recognized debt liability on the balance sheet as a direct deduction from the debt liability, similar to the presentation of original issue discounts (“OID”).  The adoption of this accounting standard resulted in the reclassification of $11.5 million, $14.3 million, $16.7 million, $18.7 million of debt issuance costs (net of accumulated amortization) from deferred financing costs, net to long-term debt, net of current portion on our consolidated balance sheets at January 29, 2016, January 30, 2015, January 31, 2014 and March 31, 2013, respectively. We also early adopted a new accounting standard in fiscal 2017, which requires that all deferred tax assets and liabilities be classified as long-term on the balance sheet.  The adoption of this accounting standard resulted in the reclassification of $16.6 million, $41.6 million, $47.0 million and $33.1 million of deferred income tax from current assets to long-term deferred income taxes liability on our consolidated balance sheets at January 29, 2016, January 30, 2015, January 31, 2014 and March 31, 2013, respectively.  For additional information, see Note 2 to our Consolidated Financial Statements.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in connection with Item 1, “Business”, Item 6, “Selected Financial Data” and Item 8, “Financial Statements and Supplementary Data” of this Report.

 

Overview

 

On January 13, 2012, we were acquired through the Merger. See Item 1, “Business—Merger” for more information about the Merger.

 

We follow a fiscal calendar consisting of four quarters with 91 days, each ending on the Friday closest to the last day of April, July, October or January, as applicable, and a 52-week fiscal year with 364 days, with a 53-week year every five to six years.  Fiscal year 2017 consisted of 52 weeks beginning January 30, 2016 and ending January 27, 2017. Fiscal 2016 thus consisted of 52 weeks beginning January 31, 2015 and ending January 29, 2016. Fiscal 2015 consisted of 52 weeks beginning February 1, 2014 and ending January 30, 2015. Our fiscal 2018 will consist of 53 weeks beginning January 28, 2017 and ending February 2, 2018.

 

During fiscal 2017, we had net sales of $2,062.0 million, operating loss of $53.1 million and net loss of $118.2 million.  Sales increased by 2.9% in fiscal 2017 over fiscal 2016 primarily due to increase in same-store sales of 2.1%, the full year effect of new stores opened in fiscal 2016 and the effect of five new stores opened in fiscal 2017.  Average sales per store open at least 12 months, on a trailing 52-week period, were $5.2 million in fiscal 2017 compared to $5.1 million in in fiscal 2016.  Average net sales per estimated saleable square foot (computed for stores open at least 12 months) on a trailing 52-week period were $319 per square foot for fiscal 2017 compared to $314 per square foot for fiscal 2016. Existing stores at January 27, 2017 averaged approximately 16,000 saleable square feet.  Fiscal 2017 results were positively impacted by decrease in shrinkage compared to fiscal 2016 as further discussed under “Results of Operations— Fiscal Year Ended January 29, 2016 Compared to Fiscal Year Ended January 30, 2015—Gross Profit” and negatively impacted by higher payroll-related expenses as further discussed under “Results of Operations— Fiscal Year Ended January 27, 2017 Compared to Fiscal Year Ended January 29, 2016 — Selling, General and Administrative Expenses”.

 

The senior leadership team continues to focus on key strategies designed to enable us to profitably scale our business while continuing to meet the needs of our customers. These areas are discussed in detail under Item 1, “Business—Our Business Strategy”.  A number of factors could prevent us from achieving our key strategies. See Item 1A, “Risk Factors,” for more information on such factors.

 

In fiscal 2016, we decided to reduce the pace of store openings to focus on stabilizing our operations and results.  In fiscal 2017, we opened five stores in California and closed six stores upon the expiration of their leases, including five in California and one in Texas.  The six closed stores were underperforming our overall chain average and, in a majority of the cases, we believe a substantial portion of the volume will be absorbed into other nearby 99¢ Only stores, thereby minimizing the impact on overall sales. The relocation and closures occurred at stores with expiring leases, and did not result in any material termination charges.

 

In fiscal 2018, we currently intend to open three new stores, all of which are expected to be opened in our existing markets.  We believe that our near term growth in fiscal 2018 will primarily result from new store openings in our existing territories and increases in same-store sales.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements requires management to make estimates and assumptions that affect reported earnings. These estimates and assumptions are evaluated on an on-going basis and are based on historical experience and other factors that management believes are reasonable.  Estimates and assumptions include, but are not limited to, the areas of inventories, long-lived asset impairment, goodwill and other intangibles, legal reserves, self-insurance reserves, leases, taxes and stock-based compensation.

 

We believe that the following items represent the areas where more critical estimates and assumptions are used in the preparation of our financial statements:

 

Inventory valuation.  Inventories are valued at the lower of cost or market. Inventory costs are established using a methodology that approximates first in, first out, which for store inventories is based on a retail inventory method.  Valuation allowances for shrinkage, as well as excess and obsolete inventory are also recorded.  We include spoilage, scrap and shrink in our definition of shrinkage.  Shrinkage is estimated as a percentage of sales for the period from the last physical inventory date to the end of the applicable period.  Such estimates are based on experience and the most recent physical inventory results.  Physical inventory counts are taken at each of our retail stores at least once a year by an outside inventory service company.  We perform inventory cycle counts at our warehouses throughout the year.  We also perform inventory reviews and analysis on a quarterly basis for both warehouse and store inventory to determine inventory valuation allowances for excess and obsolete inventory.  The valuation allowances for excess and obsolete inventory are based on the age of the inventory, sales trends and future merchandising plans.  The valuation

 

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allowances for excess and obsolete inventory require management judgment and estimates that may impact the ending inventory valuation and valuation allowances that may have a material effect on the reported gross margin for the period.  These estimates are subject to change based on management’s evaluation of, and response to, a variety of factors and trends, including, but not limited to, consumer preferences and buying patterns, age of inventory, increased competition, inventory management, merchandising strategies and historical sell through trends.  Our ability to adequately evaluate the impact of inventory management and merchandising strategies executed in response to such factors and trends in future periods could have a material impact on such estimates.

 

In the fourth quarter of fiscal 2015, we recorded a charge for additional inventory shrinkage based upon the results of annual physical inventory counts completed during the quarter.  This resulted in a net charge to cost of sales and a corresponding reduction in inventory of approximately $10.0 million, which was primarily related to the implementation of certain strategic initiatives, including the “Go Taller” store remodeling program.  The “Go Taller” store remodeling program increased the amount of shelving space at our stores by raising the height of store shelves.  During the remodeling and startup phase of the program, our retail stores remained open and many products were moved from the shelves to the floor to accommodate the remodeling, which we believe led to an increase in misplaced and damaged products.  In anticipation of the extra shelf space, more inventory was shipped to our stores, which we believe also increased shrinkage.  A reduction in workforce during transition fiscal 2014 resulted in the outsourcing of our Loss Prevention department, which was not reinstated in-house until the third quarter of fiscal 2016.  These initiatives collectively disrupted our store operations, resulting in increased loss due to theft and misplaced and damaged inventory.

 

Considerable management judgment is necessary to estimate these inventory valuation reserves.  As an indicator of the sensitivity of this estimate, a 10% increase in shrinkage and the excess and obsolete inventory provisions at January 27, 2017, would have increased these reserves by approximately $2.6 million and $0.2 million, respectively, and increased pre-tax loss in fiscal 2017 by the same amounts.

 

In order to obtain inventory at attractive prices, we take advantage of large volume purchases, closeouts and other similar purchase opportunities.  Consequently, our inventory fluctuates from period to period and the inventory balances vary based on the timing and availability of such opportunities.  Our inventory was $175.9 million as of January 27, 2017 and $196.7 million as of January 29, 2016.  Inventory turnover, which we calculate by dividing cost of sales by ending inventory, was 8.3 times as of January 27, 2017 and 7.3 times as of January 29, 2016.

 

Long-lived asset impairment.  We assess the impairment of depreciable long-lived assets when events or changes in circumstances indicate that the carrying value may not be recoverable.  We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual identifiable cash flows are available.  If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, the carrying amount is compared to its fair value and an impairment charge is recognized to the extent of the difference.  Factors that we consider important which could individually or in combination trigger an impairment review include the following: (1) significant underperformance relative to expected historical or projected future operating results; (2) significant changes in the manner we use of the acquired assets or the strategy for our overall business; and (3) significant changes in our business strategies and/or negative industry or economic trends.  On a quarterly basis, we assess whether events or changes in circumstances occur that potentially indicate that the carrying value of long-lived assets may not be recoverable. Considerable management judgment is necessary to estimate projected future operating cash flows.  Accordingly, if actual results fall short of such estimates, significant future impairments could result.

 

During the third quarter of fiscal 2017, we decided to close five retail stores in California by the end of fiscal 2017 upon the expiration of their respective lease terms.  As a result of this decision, we recognized an impairment charge of approximately $0.1 million related to the closure of three of these stores and recorded an impairment charge of $0.1 million related to fixtures that will be disposed of and for which we concluded the fair value was zero.  During fiscal 2017, we also reduced the carrying value of a held for sale property to the estimated net realizable value, net of expected disposal costs, and accordingly recorded an asset impairment charge of $0.2 million.  During fiscal 2016, due to the underperformance of two stores in Texas and one store in California, we concluded that the carrying value of the long-lived assets relating to such stores were not recoverable and accordingly recorded an asset impairment charge of $0.8 million.  During fiscal 2016, we also recorded impairment charges of $0.2 million related to equipment and fixtures that will be disposed of and for which we concluded the fair value was zero. During fiscal 2015, we wrote down the carrying value of a held for sale property to the estimated net realizable value, net of expected disposal costs, and accordingly recorded an asset impairment charge of $0.1 million.  We have not made any material changes to our long-lived asset impairment methodology during fiscal 2017.

 

Goodwill and other intangible assets.  The Merger was accounted for as a purchase business combination, whereby the purchase price paid was allocated to recognize the acquired assets and liabilities at their fair value.  In connection with the purchase price allocation, certain intangible assets were established or revalued.  The purchase price in excess of the fair value of assets and liabilities was recorded as goodwill.  Management has determined that the Company has two reporting units, the wholesale reporting unit and the retail reporting unit.

 

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Intangible assets with a definite life are amortized on a straight line basis over their useful lives.  Amortizable intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable based on undiscounted cash flows, and, if impaired, written down to fair value based on either discounted cash flows or appraised values.  Significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows used in the impairment tests.

 

Goodwill and indefinite-lived intangible assets, such as the 99¢ Only Stores trade name, are not amortized but are instead tested annually for impairment or more frequently when events or changes in circumstances indicate that the assets might be impaired.  Goodwill is tested for impairment by comparing the carrying amount of the reporting unit to the fair value of the reporting unit to which the goodwill is assigned.  We determine fair value based on a combination of the income approach and the market approach prepared by an independent third party valuation firm.  Fair value of a trade name is determined using a relief from royalty method under the income approach, which uses projected revenue allocable to the trade name and an assumed royalty rate. These approaches involve making key assumptions about future cash flows, discount rates and asset lives using then best available information.  These assumptions are subject to a high degree of complexity and judgment and are subject to change.

 

Our judgments are based on historical experience, current market trends and other information.  Key assumptions used in the income approach include growth in net sales, new store openings and same-store sales, trends in cost of sales and selling, general and administrative expense, and changes in working capital.  Future cash flow estimates are based on management’s knowledge of the current operating environment and expectations for the future, discount rates are based on an industry- and investment market- centered weighted average cost of capital for the expected target capital structure and asset lives are based on industry norms and management’s knowledge of our operating history.  The market approach is based upon a review of comparable companies and transactions in our industry, including review of earnings and sales multiples.

 

In each case, these estimates and assumptions could be materially affected by factors such as unforeseen events or changes in general economic conditions, a decline in comparable company market multiples, changes to discount rates, increased competitive forces, our inability to maintain our pricing structure, deterioration of our vendor relationships, failure to adequately manage and improve our inventory processes and procedures and changes in customer behavior which could result in changes to management’s strategies.  Such changes could affect the fair value of our retail reporting unit and ultimately result in an impairment charge.

 

During the third quarter of fiscal 2016, we determined that indicators of impairment existed to require an interim impairment analysis of goodwill and trade name, including (i) overall performance deterioration reflected in decreased comparable same-store sales and cannibalization from stores opened in fiscal 2015 under an accelerated expansion program, (ii) increases in inventory shrinkage and buildup of excess inventory, (iii) decreased margin due to disappointing results from sales promotions and (iv) a decision to delay the pace of future store openings.  Our first step evaluation concluded that the fair value of the retail reporting unit was below its carrying value.  We performed step two of the goodwill impairment test that requires the retail reporting unit’s fair value to be allocated to all of the assets and liabilities of the reporting unit, including any intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination, including consideration of the fair value of tangible property and intangible assets.  As a result of this preliminary analysis and based on our best estimate, we recorded a $120.0 million non-cash goodwill impairment charge in the third quarter of fiscal 2016, which was reflected as goodwill impairment in the consolidated statements of comprehensive income (loss).  The finalization of the preliminary goodwill impairment test was completed in the fourth quarter of fiscal 2016 and resulted in a $20.9 million adjustment in goodwill, lowering the third quarter of fiscal 2016 goodwill impairment charge from $120.0 million to $99.1 million.

 

During the fourth quarter of fiscal 2016, we completed step one of our annual goodwill impairment test for the two reporting units and determined that there was no impairment of goodwill since the fair value of our reporting units exceeded their carrying amounts.  The results of this test showed that the fair values of our retail reporting unit and wholesale reporting unit exceeded their carrying values by substantial amounts.

 

The remaining amount of goodwill allocated to the retail reporting unit and wholesale reporting unit was $368.1 and $12.5 million, respectively, as of January 29, 2016.

 

During the fourth quarter of fiscal 2017, we completed step one of our annual goodwill impairment test for the two reporting units and determined that there was no impairment of goodwill since the fair value of our reporting units exceeded their carrying amounts.  The results of this test showed that the fair value of our retail reporting unit exceeded its carrying value by a substantial amount.  The fair value of our wholesale reporting unit exceeded carrying value by approximately 18%.  As discussed above, considerable management judgment is necessary in estimating future cash flows, market interest rates, discount rates and other factors affecting the valuation of goodwill.  The forecasts used in our fiscal 2017 annual impairment test include growth in net sales, new store openings and same-store sales, positive trends in cost of sales and selling, general and administrative expense.  As described above, these estimates and assumptions could be materially affected by factors such as unforeseen events or changes in general economic conditions, a decline in comparable company market multiples, changes to discount rates, increased competitive forces, our inability to maintain our pricing structure, deterioration of our vendor relationships, failure to adequately manage and improve our inventory processes and procedures and changes in customer behavior which could result in changes to management’s strategies.  If operating results continue to change versus our expectations, additional impairment charges may be recorded in the future.  See Note 1 to our Consolidated Financial Statements.

 

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Additionally, during the fourth quarter of fiscal 2017, we completed our annual indefinite-lived intangible asset impairment test and determined there was no impairment to the trade name since the fair value of the trade name exceeded its carrying amount.  The results of this test showed that the fair value of trade name exceeded carrying value by approximately 18%.  Fair value of the trade name was determined using the relief from royalty method that estimates our theoretical royalty savings from ownership of the intangible asset.  Key assumptions used in this model included sales projections, discount rates and royalty rates, and considerable management judgment is necessary in developing and evaluating such assumptions.  If future results are not consistent with our current estimates and assumptions, impairment charges maybe recorded in future.

 

Legal reserves.  We are subject to private lawsuits, administrative proceedings and claims that arise in the ordinary course of business.  A number of these lawsuits, proceedings and claims may exist at any given time.  While the resolution of a lawsuit, proceeding or claim may have an impact on our financial results for the period in which it is resolved, and litigation is inherently unpredictable, in management’s opinion, none of these matters arising in the ordinary course of business are expected to have a material adverse effect on our financial position, results of operations, or overall liquidity.  Material pending legal proceedings (other than ordinary routine litigation incidental to our business) and material proceedings known to be contemplated by governmental authorities are reported in our reports pursuant to the Securities Exchange Act of 1934, as amended.  We record a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated.

 

There were no material changes in the estimates or assumptions used to determine legal reserves during fiscal 2017 and a 10% change in legal reserves would not be material to our consolidated financial position or results of operations.

 

Self-insured workers’ compensation liability.  We self-insure for workers’ compensation claims in California and Texas. We have established a liability for losses from both estimated known and incurred but not reported insurance claims based on reported claims and actuarial valuations of estimated future costs of known and incurred but not yet reported claims.  Should an amount of claims greater than anticipated occur, the liability recorded may not be sufficient and additional workers’ compensation costs, which may be significant, could be incurred. We do not discount the projected future cash outlays for the time value of money for claims and claim related costs when establishing our workers’ compensation liability.  In fiscal 2016, we increased worker’s compensation liability reserve by $7.2 million primarily as a result of higher incurred and projected expenses associated with fiscal 2016 workers’ compensation claims.  We implemented initiatives designed to create a culture of safety and to reduce the frequency and severity of workers’ compensation injuries.  In the fourth quarter of fiscal 2017, we decreased workers’ compensation liability reserve by $5.6 million, primarily as a result of lower incurred and projected expenses associated with fiscal 2017 workers’ compensation claims.  As an indicator of the sensitivity of this estimate, at January 27, 2017, a 10% increase in our estimate of expected losses from workers’ compensation claims would have increased this reserve by approximately $6.9 million and increased fiscal 2017 pre-tax loss by the same amount.

 

Self-insured health insurance liability.  We self-insure for a portion of our employee medical benefit claims.  The liability for the self-funded portion of our health insurance program is determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported. We maintain stop loss insurance coverage to limit our exposure for the self-funded portion of our health insurance program.  At January 27, 2017, a 10% change in self-insured health liability would not have been material to our consolidated financial position or results of operations.

 

Operating leases.  We recognize rent expense for operating leases on a straight-line basis (including the effect of reduced or free rent and rent escalations) over the applicable lease term.  The difference between the cash paid to the landlord and the amount recognized as rent expense on a straight-line basis is included in deferred rent.  Cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives are recorded as deferred tenant improvements.  Deferred rent related to landlord incentives is amortized as an offset to rent expense using the straight-line method over the applicable lease term.

 

In certain lease arrangements, we can be involved with the construction of the building. If it is determined that we have substantially all of the risks of ownership during construction of the leased property and therefore are deemed to be the owner of the construction project, we record an asset for the amount of the total project costs and an amount related to the value attributed to the pre-existing leased building in property and equipment, net and the related financing obligation as part of current and non-current liabilities.  Once construction is complete, if it is determined that the asset does not qualify for sale-leaseback accounting treatment, we amortize the obligation over the lease term and depreciate the asset over the life of the lease.  We do not report rent expense for the portion of the rent payment determined to be related to the assets which are owned for accounting purposes.  Rather, this portion of the rent payment under the lease is recognized as a reduction of the financing obligation and interest expense.

 

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For store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the cease use date (when the store is closed).  Liabilities are established at the cease use date for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs.  Key assumptions in calculating the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimation of other related exit costs.  If actual timing and potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts.  These liabilities are reviewed periodically and adjusted when necessary.

 

Tax Valuation Allowances and Contingencies.  We recognize deferred tax assets and liabilities using the enacted tax rates for the effect of temporary differences between the financial reporting basis and tax basis of recorded assets and liabilities.  Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

 

We assess our ability to realize deferred tax assets throughout the fiscal year. As a result of this assessment during the second quarter of fiscal 2016, we concluded that it was more likely than not that we would not realize our deferred tax assets.  In the quarters prior to the recording of a valuation allowance in the second quarter of fiscal 2016, we weighed all available positive and negative evidence and determined that it was more likely than not that the deferred tax assets were fully realizable.  In fiscal 2016, management had begun to take meaningful steps to focus on the operational execution of the initiatives launched in fiscal 2015, which were expected to drive performance improvements over the second and third quarters of fiscal 2016.  However, in the second quarter of fiscal 2016, we experienced (i) margin declines due to short-term sales promotions, (ii) delays in sales growth due to cannibalization from new store openings, (iii) increased inventory shrinkage from a buildup of inventory levels, and (iv) increases in support costs as a percentage of sales.  As a result of these second quarter of fiscal 2016 events, we decided to adjust merchandise pricing strategies, delay the pace of future store openings for the remainder of fiscal 2016, revise inventory shrinkage processes and establish selling, general and administrative cost control measures.  We concluded that until the performance issues identified in the second quarter of fiscal 2016 showed improvement, it was more likely than not that we would not realize our net deferred tax assets, and therefore we recorded a $31.7 million increase to provision for income taxes in order to establish a valuation allowance against such net deferred tax assets.  See Note 5 to our Consolidated Financial Statements.

 

We had approximately $163.0 million of net deferred tax liabilities as of January 29, 2016, which was comprised of approximately $57.2 million of net deferred tax assets and $220.2 million of deferred tax liabilities, net of tax valuation allowance of $88.3 million.  The increase in the valuation allowance was primarily related to an increase in losses incurred during fiscal 2016.  We had approximately $161.5 million of net deferred tax liabilities as of January 27, 2017, which was comprised of approximately $32.0 million of net deferred tax assets and $193.5 million of deferred tax liabilities, net of tax valuation allowance of $137.7 million.  Management re-evaluated the available evidence in assessing our ability to realize the benefits of our deferred tax assets at January 27, 2017 and concluded it was more likely than not that we would not realize our net deferred tax assets.  Significant management judgment is required in accounting for income tax contingencies as the outcomes are often difficult to predict.  There are no uncertain tax positions at January 27, 2017.

 

Stock-Based Compensation.  Subsequent to the Merger, Parent issued options to acquire shares of common stock of our Parent to certain of our executive officers and employees. We account for stock-based payment awards based on their fair values.  Stock options have a term of ten years.  For awards classified as equity, we estimate the fair value for each option award as of the date of grant using the Black-Scholes option pricing model or other appropriate valuation models.  Assumptions utilized to value options include estimating the fair value of Parent’s common stock (which is not publicly traded), the term that the options are expected to be outstanding, an estimate of the volatility of Parent’s stock price (which is based on a peer group of publicly traded companies), applicable interest rates and the expected dividend yield of Parent’s common stock. Other factors involving judgments that affect the expensing of stock-based payments include estimated forfeiture rates of stock-based awards.  All of the outstanding options that we have granted to our executive officers and employees (with the exception of options granted to our current Chief Financial Officer and certain directors that contain less restrictive repurchase rights) give the Parent repurchase rights as described in more detail in Note 11 to our Consolidated Financial Statements. In accordance with accounting guidance, we have not recorded any stock-based compensation expense for these grants.  For all other time-based options, the value of the portion of the award that is ultimately expected to vest is recognized as an expense ratably over the requisite service periods, which is generally a vesting term of four or five years.  For options that vest based on achievement of performance targets, compensation expense will be recognized only when it is probable that applicable performance criteria will be met.  As described in Note 11 to our Consolidated Financial Statements, we granted options to our current Chief Executive Officer that are valued using binomial model and a Monte Carlo simulation method.  For the reasons set forth above, the Company has deferred recognition of the stock-based compensation expense for these stock options.

 

Results of Operations

 

The following discussion defines the components of the statement of income and should be read in conjunction with Item 6, “Selected Financial Data.”

 

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Net Sales:  Revenue is recognized at the point of sale in our stores (“retail sales”).  Bargain Wholesale sales revenue is recognized in accordance with the shipping terms agreed upon on the purchase order.  Bargain Wholesale sales are typically recognized free on board origin, where title and risk of loss pass to the buyer when the merchandise leaves our distribution facility.

 

Cost of SalesCost of sales includes the cost of inventory, freight in, obsolescence, spoilage, scrap and inventory shrinkage, and is net of discounts and allowances.  Cost of sales also includes receiving, warehouse costs and distribution costs (which include payroll and associated costs, occupancy, transportation to and from stores and depreciation expense).  Cash discounts for satisfying early payment terms are recognized when payment is made, and allowances and rebates based upon milestone achievements such as reaching a certain volume of purchases of a vendor’s products, are included as a reduction of cost of sales when such contractual milestones are reached or based on other systematic and rational approaches where possible.

 

Selling, General, and Administrative Expenses:  Selling, general and administrative expenses include the costs of selling merchandise in stores (which include payroll and associated costs, occupancy and other store-level costs) and corporate costs (which include payroll and associated costs, occupancy, advertising, professional fees and other corporate administrative costs).  Selling, general and administrative expenses also include depreciation and amortization expense relating to these costs.

 

Goodwill Impairment: Represents the goodwill impairment charge measured by comparing the implied fair value of goodwill (determined as a result of our third quarter of fiscal 2016 interim impairment analysis) with the carrying amount of goodwill. See “Critical Accounting Policies and Estimates—Goodwill and other intangible assets.”

 

Other Expense (Income):  Other expense relates primarily to loss on extinguishment of debt, interest expense on our debt, capitalized and financing leases and other interest.

 

Certain amounts as of and for the year ended January 29, 2016 have been revised to correct immaterial errors as described in Note 1 to our Consolidated Financial Statements.

 

The following table sets forth, for the periods indicated, certain selected income statement data, including such data as a percentage of net sales.  The years ended January 27, 2017, January 29, 2016, and January 30, 2015 each consist of 52 weeks (the percentages may not add up due to rounding):

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

% of
Net
Sales

 

January 29,
2016

 

% of
Net
Sales

 

January 30,
2015

 

% of
Net
Sales

 

 

 

(Amounts in thousands, except percentages)

 

Net Sales:

 

 

 

 

 

 

 

 

 

 

 

 

 

99¢ Only Stores

 

$

2,023,034

 

98.1

%

$

1,961,050

 

97.9

%

$

1,881,865

 

97.7

%

Bargain Wholesale

 

38,973

 

1.9

 

42,945

 

2.1

 

45,084

 

2.3

 

Total sales

 

2,062,007

 

100.0

 

2,003,995

 

100.0

 

1,926,949

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

1,460,595

 

70.8

 

1,441,631

 

71.9

 

1,308,849

 

67.9

 

Gross profit

 

601,412

 

29.2

 

562,364

 

28.1

 

618,100

 

32.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative expenses

 

654,509

 

31.7

 

614,026

 

30.6

 

546,259

 

28.3

 

Goodwill impairment

 

 

0.0

 

99,102

 

4.9

 

 

0.0

 

Operating (loss) income

 

(53,097

)

(2.6

)

(150,764

)

(7.5

)

71,841

 

3.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other (income) expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

(47

)

0.0

 

(4

)

0.0

 

 

0.0

 

Interest expense

 

68,764

 

3.3

 

65,653

 

3.3

 

62,734

 

3.3

 

Loss on extinguishment of debt

 

335

 

0.0

 

 

0.0

 

 

0.0

 

Other expenses, net

 

69,052

 

3.3

 

65,649

 

3.3

 

62,734

 

3.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Loss) income before provision for income taxes

 

(122,149

)

(5.9

)

(216,413

)

(10.8

)

9,107

 

0.5

 

(Benefit) provision for income taxes

 

(3,990

)

(0.2

)

31,942

 

1.6

 

3,605

 

0.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (loss) income

 

$

(118,159

)

(5.7

)

$

(248,355

)

(12.4

)

$

5,502

 

0.3

 

 

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Fiscal Year Ended January 27, 2017 (52 Weeks) Compared to Fiscal Year Ended January 29, 2016 (52 Weeks)

 

Net sales.  Total net sales increased $58.0 million, or 2.9%, to $2,062.0 million in fiscal 2017, a 52-week period, from $2,004.0 million in fiscal 2016, also a 52-week period.  Net retail sales increased $61.9 million, or 3.2%, to $2,023.0 million in fiscal 2017, from $1,961.1 million in fiscal 2016.  Bargain Wholesale net sales decreased by approximately $3.9 million, or 9.2%, to $39.0 million in fiscal 2017, from $42.9 million in fiscal 2016.  Of the $61.9 million increase in net retail sales, $41.1 million was due to a 2.1% increase in same-store sales for all stores open at least 14 months, the effect of new stores opened in fiscal 2017 was $15.8 million and the full year effect of new stores opened in or prior to fiscal 2016 was $12.1 million.  The increase in retail sales was partially offset by a decrease in sales of approximately $7.1 million due the impact of closed stores.  Same-store sales increased 2.1% compared to fiscal 2016, with higher average ticket of 1.7% and higher customer traffic of 0.4%.  The increase in same-store sales was primarily driven by higher sales from fresh offerings as a result of better product availability, improved in-stock levels and the expansion of our third party distributor partnership, as well as improved sales from general merchandise driven by better product assortment and higher seasonal sales achieved in part through improved store execution. These improvements were partially offset by the ongoing deflationary environment in milk and eggs, which persisted throughout fiscal 2017.

 

During fiscal 2017, we opened five stores in California and closed six stores in fiscal 2017 upon expiration of their leases, including five in California and one in Texas.  At the end of fiscal 2017, we had 390 stores compared to 391 stores at the end fiscal 2016. Estimated saleable retail square footage as of January 27, 2017 and January 29, 2016 was 6.31 million and 6.30 million, respectively.  For 99¢ Only stores open all of fiscal 2017, the average net sales per estimated saleable square foot was $5.2 million per store and $319 per estimated saleable square foot.

 

Gross profit. Gross profit increased $39.0 million, or 6.9% to $601.4 million in fiscal 2017, compared to $562.4 million in fiscal 2016.  As a percentage of net sales, overall gross margin increased to 29.2% in fiscal 2017, from 28.1% in fiscal 2016. Among the gross profit components, shrinkage improved by 60 basis points compared to fiscal 2016 as a result of positive trends in recent physical counts that we believe were driven by ongoing initiatives that identify and reduce shrinkage, including loss prevention efforts and adherence to disciplined inventory management processes.  Product margin was flat compared to fiscal 2016 as lower inbound freight and duty costs were offset by our efforts to reduce excess inventory through clearance initiatives as well as an unfavorable product mix shift. Distribution and transportation expenses decreased by 10 basis points primarily due to lower distribution costs.  The remaining improvements in gross profit were attributable to other less significant items included in costs of sales.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses increased by $40.5 million, or 6.6%, to $654.5 million in fiscal 2017, from $614.0 million in fiscal 2016.  As a percentage of net sales, selling, general and administrative expenses increased to 31.7% for fiscal 2017 from 30.6% for fiscal 2016.  The 110 basis point increase in selling, general and administrative expenses as a percentage of net sales was driven by a number of factors.  Payroll-related expenses increased by 120 basis points, primarily due to an increase in the California minimum wage, which went into effect in January 2016, and higher performance compensation expenses.  In addition selling, general and administrative expenses were negatively impacted by the anniversary of a $5.4 million gain realized on the sale of a cold storage facility during the third quarter of fiscal 2016 as well as higher outside services expenses.  These increases were partially offset by a 50 basis points decrease in workers’ compensation accrual, primarily driven by lower incurred and projected expenses associated with workers’ compensation claims in fiscal 2017 and prior years.

 

Goodwill impairment.  During the third quarter of fiscal 2016, we recorded a best estimate of $120.0 million non-cash goodwill impairment charge relating to the retail reporting unit.  The finalization of the preliminary goodwill impairment test was completed in the fourth quarter of fiscal 2016 and resulted in $20.9 million adjustment in goodwill, lowering the third quarter of fiscal 2016 goodwill impairment charge to $99.1 million. Significant changes in assumptions that led to the goodwill impairment included decreases in new store expansion for all future years, slower sales growth from new store additions and gross margin compression.  The goodwill impairment charge did not adversely affect our debt position, cash flow, liquidity or compliance with financial covenants.  See Note 1 to the Consolidated Financial Statements.

 

Operating loss. Operating loss was $53.1 million for fiscal 2017, compared to operating loss of $150.8 million for fiscal 2016.  Operating loss as a percentage of net sales was (2.6)% in fiscal 2017 compared to operating loss as a percentage of sales of (7.5)% in fiscal 2016.  The decrease in operating loss as a percentage of net sales was primarily due to favorable comparison to prior year that included a goodwill impairment charge as well as changes in gross margin and selling, general, and administrative expenses, as discussed above.

 

Interest expense and loss on extinguishment of debt.  Interest expense was $68.8 million in fiscal 2017, compared to $65.6 million in in fiscal 2016.  Interest expense was higher primarily due to amortization of debt issuance costs, interest expense on financing leases and interest on estimated sales tax liability.  Loss on extinguishment of debt was $0.3 million relating to the amendment of the ABL Facility in April 2016.

 

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(Benefit) provision for income taxes.  The provision for income taxes was a benefit of $4.0 million in fiscal 2017, compared to an income tax provision of $31.9 million in fiscal 2016, primarily due to the establishment of a valuation allowance of $31.7 million in the second quarter of fiscal 2016 against deferred income tax assets (as described in Note 5 to our Consolidated Financial Statements).  The effective tax rate for fiscal 2017 was a benefit rate of 3.3% compared to an effective tax rate of 14.8% for fiscal 2016. The effective combined federal and state income tax rates for fiscal 2017 differ from the statutory rates primarily due to recording of additional valuation allowance for losses sustained in fiscal 2017 (as described in Note 5 to our Consolidated Financial Statements) and the benefit of a tax credit carryback for fiscal 2017.  The effective combined federal and state income tax rates for fiscal 2016 differ from the statutory rates primarily due to the non-deductible goodwill impairment charge and the establishment of a valuation allowance in fiscal 2016 (as described in Note 5 to our Consolidated Financial Statements).

 

Net loss.  As a result of the items discussed above, net loss for fiscal 2017 was $118.2 million, compared to net loss for fiscal 2016 of $248.4 million. Net loss as a percentage of net sales was (5.7)% in fiscal 2017 compared to net loss as a percentage of net sales of (12.4)% in fiscal 2016.

 

Fiscal Year Ended January 29, 2016 (52 Weeks) Compared to Fiscal Year Ended January 30, 2015 (52 Weeks)

 

Net sales.  Total net sales increased $77.1 million, or 4.0%, to $2,004.0 million in fiscal 2016, a 52-week period, from $1,926.9 million in fiscal 2015, also a 52-week period.  Net retail sales increased $79.2 million, or 4.2%, to $1,961.1 million in fiscal 2016, from $1,881.9 million in fiscal 2015.  Bargain Wholesale net sales decreased by approximately $2.1 million, or 4.7%, to $42.9 million in fiscal 2016, from $45.1 million in fiscal 2015.  Of the $79.2 million increase in net retail sales, the full year effect of new stores opened in or prior to fiscal 2015 was $112.3 million, and the effect of new stores opened in fiscal 2016 was $17.3 million.  Net retail sales for stores that were open at least 14 months in fiscal 2016 decreased $50.4 million, representing a 2.7% decrease in same-store sales over a comparable 52-week period of the prior year.  The 2.7% decrease in same-store sales was due to a 4.5% decrease in customer traffic, partially offset by higher average ticket of 1.9%.  Same-store sales were affected by a number of factors, including challenges in produce and consumables sales caused, in part, by elevated out-of-stock levels as a result of the unsuccessful implementation of a new allocation and replenishment system as well as the disruptions stemming from the transition back to the legacy allocation and replenishment system and poor product availability, the cannibalization impact of recent new store openings, and the implementation of ongoing initiatives meant to clear on-hand seasonal inventory through promotions and mark-downs.  These challenges were partially offset by higher sales in general merchandise departments caused, in part, by introduction of new product assortments.

 

During fiscal 2016, we added eight new stores: six in California and two in Arizona. At the end of fiscal 2016, we had 391 stores compared to 383 stores at the end fiscal 2015. Estimated saleable retail square footage as of January 29, 2016 and January 30, 2015 was 6.30 million and 6.19 million, respectively.  For 99¢ Only stores open all of fiscal 2016, the average net sales per estimated saleable square foot was $5.1 million per store and $314 per estimated saleable square foot.

 

Gross profit. Gross profit was $562.4 million in fiscal 2016, compared to $618.1 million in fiscal 2015.  As a percentage of net sales, overall gross margin decreased to 28.1% in fiscal 2016, from 32.1% in fiscal 2015. Among the gross profit components, cost of products sold increased by 180 basis points compared to fiscal 2015, which was primarily due to a combination of higher inbound freight and duty costs that negatively impacted gross margin by approximately 90 basis points and lower product margin which also negatively impacted gross margin by approximately 90 basis points.  The lower product margin was primarily driven by margin compression in our fresh, grocery and consumables offerings, which negatively impacted margin by approximately 70 basis points and our efforts to reduce seasonal inventory through accelerated implementation of inventory clearance initiatives, which negatively impacted margin by approximately 30 basis points. These negative impacts were partially offset by a shift in product mix toward higher margin general merchandise products, which improved margin by approximately 30 basis points.  This shift to higher margin general merchandise products was not part of a specific Company strategy but rather due to opportunistic purchases made by us during the period, which are inconsistent in nature, as well as other external economic factors outside our control that lowered product costs generally.  We do not expect this shift to have a continuing impact on gross profit.  Based on the results of physical inventory counts completed during the year, inventory shrinkage increased 130 basis points compared to fiscal 2015.  Distribution and transportation expenses increased 40 basis points primarily due to higher transportation costs.  The remaining change was attributable to other less significant items included in costs of sales.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses increased by $67.8 million, or 12.4%, to $614.0 million in fiscal 2016, from $546.3 million in fiscal 2015.  As a percentage of net sales, selling, general and administrative expenses increased to 30.6% for fiscal 2016 from 28.3% for fiscal 2015.  The 230 basis point increase in selling, general and administrative expenses as a percentage of net sales was primarily driven by increases in store level payroll, workers’ compensation accrual and occupancy expenses, together accounting for 130 basis points, as well as higher depreciation and amortization and outside professional fees. Selling, general and administrative expenses as a percentage of sales were negatively impacted by the opening of new stores in the prior fiscal year and an increase in the minimum wage in California, as well as negative operating leverage as a result of the decline in same-store sales during the second half of fiscal 2016.  Depreciation and amortization

 

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expense was 40 basis points higher due to the information system implementation, new store openings and the implementation of the “Go Taller” store remodeling program. In the fourth quarter of fiscal 2016, selling, general and administrative expense included an increase in workers’ compensation accrual of $6.6 million, representing 30 basis points, which was primarily the result of higher incurred and projected expenses associated with fiscal 2016 workers’ compensation claims.  Outside professional fees were higher primarily due to charges relating to previously capitalized store and distribution center real estate development costs expensed in the second quarter of fiscal 2016 as a result of cancelled projects, as well as costs relating to executive transitions.  These increases were partially offset by a gain of $5.4 million realized on the sale of a cold storage facility during the third quarter of fiscal 2016.

 

Goodwill impairment.  During the third quarter of fiscal 2016, we recorded a best estimate of $120.0 million non-cash goodwill impairment charge relating to the retail reporting unit.  The finalization of the preliminary goodwill impairment test was completed in the fourth quarter of fiscal 2016 and resulted in $20.9 million adjustment in goodwill, lowering the third quarter of fiscal 2016 goodwill impairment charge to $99.1 million. Significant changes in assumptions that led to the goodwill impairment included decreases in new store expansion for all future years, slower sales growth from new store additions and gross margin compression.  The goodwill impairment charge did not adversely affect our debt position, cash flow, liquidity or compliance with financial covenants.  See Note 1 to the Consolidated Financial Statements.

 

Operating (loss) income. Operating loss was $150.8 million for fiscal 2016, compared to operating income of $71.8 million for fiscal 2015.  Operating loss as a percentage of net sales was (7.5)% in fiscal 2016 compared to operating income of 3.7% in fiscal 2015.  The decrease in operating income as a percentage of net sales was primarily due to the recording of a goodwill impairment charge, changes in gross margin and selling, general, and administrative expenses, each as discussed above.

 

Interest expense. Interest expense was $65.6 million in fiscal 2016, compared to $62.7 million in in fiscal 2015.  Interest expense was higher primarily due to interest expense on financing leases and higher average borrowings under the ABL Facility (as discussed below).

 

Provision for income taxes.  The provision for income taxes was $31.9 million in fiscal 2016, compared to an income tax provision of $3.6 million in fiscal 2015, primarily due to the establishment of a valuation allowance of $31.7 million in the second  quarter of fiscal 2016 against deferred income tax assets (as described in Note 5 to our Consolidated Financial Statements).  The effective tax rate for fiscal 2016 was a provision rate of 14.8% compared to an effective tax rate of 39.6% for fiscal 2015.  The effective combined federal and state income tax rates for fiscal 2016 differ from the statutory rates primarily due to the non-deductible goodwill impairment charge and the establishment of a valuation allowance in fiscal 2016 (as described in Note 5 to our Consolidated Financial Statements).  The effective combined federal and state income tax rates for fiscal 2015 differ from the statutory rates primarily due to the non-deductibility of certain costs.

 

Net (loss) income.  As a result of the items discussed above, net loss for fiscal 2016 was $248.4 million, compared to net income for fiscal 2015 of $5.5 million. Net loss as a percentage of net sales was (12.4)% in fiscal 2016 compared to net income as a percentage of net sales of 0.3% in fiscal 2015.

 

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Effects of Inflation

 

During fiscal 2017, fiscal 2016 and fiscal 2015, inflation did not have a material impact on our overall operations.  Increases in various costs due to future inflation may impact our operating results to the extent that such increases cannot be passed along to our customers.  See Item 1A, “Risk Factors—Risks Related to Our Business— Increases in costs and other inflationary pressures may affect our ability to keep pricing almost all of our merchandise at 99.99¢ or less.”

 

Liquidity and Capital Resources

 

Our capital requirements consist primarily of purchases of inventory, expenditures related to new store openings, investments in information technology and supply chain infrastructure, working capital requirements for new and existing stores, including lease obligations, and debt service requirements. Our primary sources of liquidity are the net cash flow from operations and availability under our ABL Facility, which we believe will be sufficient to fund our regular operating needs and principal and interest payments on our indebtedness, for at least the next 12 months. Availability under our ABL Facility is not expected to materially affect our ability to make immediate buying decisions, willingness to take on large volume purchases or ability to pay cash or accept abbreviated credit terms.

 

As of January 27, 2017, we held $2.4 million in cash, and our total indebtedness was $883.2 million, consisting of gross borrowings under the First Lien Term Loan Facility of $593.9 million, borrowings under the ABL Facility of $39.3 million and $250.0 million of our Senior Notes. As of January 27, 2017, availability under the ABL Facility (subject to the borrowing base) was $37.2 million and, subject to certain limitations and the satisfaction of certain conditions, including the receipt of commitments for additional borrowings, we were also permitted to incur up to an aggregate of $50.0 million of additional borrowings pursuant to incremental facilities under the First Lien Term Loan Facility and up to an aggregate of $25.0 million of additional revolving commitments (subject to the borrowing base) pursuant to the ABL Facility.  The First Lien Term Loan Facility matures on January 13, 2019, and our Senior Notes mature on December 15, 2019.  While the maturity date of our ABL Facility has been conditionally extended to April 8, 2021 in connection with the Fourth Amendment, such extension resulted in higher interest rates and, if our First Lien Term Loan Facility and Senior Notes are not refinanced or amended to extend the final maturity dates thereof to a date that is at least 180 days after April 8, 2021, our ABL Facility will mature on the earlier of (i) the date that is 90 days prior to the stated maturity date in respect of our First Lien Term Loan Facility and (ii) the date that is 90 days prior to the stated maturity date in respect of the Senior Notes.  We may pursue a refinancing of our other long-term obligations, but potential volatility and challenges in the then-current capital markets, including conditions affecting borrowing costs, could limit our ability to refinance at favorable terms, and could have a material adverse impact on our future financial condition.   We also have, and will continue to have, significant lease obligations.  As of January 27, 2017, our minimum annual rental obligations under long-term leases for fiscal 2018 are $84.8 million. These obligations are significant and could affect our ability to pursue significant growth initiatives, such as strategic acquisitions, in the future. However, we expect to be able to service these obligations from our net cash flow from operations and availability under our ABL Facility, and we do not expect these obligations to negatively affect our expansion plans for the foreseeable future, including our plans to increase our store count, planned upgrades to our information technology systems and other planned capital expenditures.

 

Credit Facilities and Senior Notes

 

On January 13, 2012 (the “Original Closing Date”), in connection with the Merger, we obtained Credit Facilities provided by a syndicate of lenders arranged by Royal Bank of Canada as administrative agent, as well as other agents and lenders that are parties to these Credit Facilities. The Credit Facilities include our ABL Facility and our First Lien Term Loan Facility.

 

First Lien Term Loan Facility

 

Under the First Lien Term Loan Facility, (i) $525.0 million of term loans were incurred on the Original Closing Date and (ii) $100.0 million of additional term loans were incurred pursuant to an incremental facility effected through an amendment entered into on October 8, 2013 (the “Second Amendment”) (all such term loans, collectively, the “Term Loans”).  The First Lien Term Loan Facility has a term of seven years with a maturity date of January 13, 2019.  All obligations under the First Lien Term Loan Facility are guaranteed by Parent and our direct or indirect 100% owned domestic subsidiaries (with customary exceptions, including immaterial subsidiaries) (collectively, the “Credit Facilities Guarantors”).  In addition, the First Lien Term Loan Facility is secured by pledges of certain of our equity interests and the equity interests of the Credit Facilities Guarantors.

 

We are required to make scheduled quarterly payments each equal to 0.25% of the principal amount of the Term Loans, with the balance due on the maturity date.  Borrowings under the First Lien Term Loan Facility bear interest at an annual rate equal to an applicable margin plus, at the Company’s option, either (i) a base rate (the “Base Rate”) determined by reference to the highest of (a) the interest rate in effect determined by the administrative agent as the “Prime Rate” (3.75% as of January 27, 2017), (b) the federal funds effective rate plus 0.50% and (c) an adjusted Eurocurrency rate for one month (determined by reference to the greater of the

 

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Eurocurrency rate for the interest period subject to certain adjustments) plus 1.00%, or (ii) a Eurocurrency rate determined by reference to the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserve requirements, for the interest period relevant to such borrowing.

 

On April 4, 2012, we amended the terms of the First Lien Term Loan Facility (the “First Amendment”) and incurred related refinancing costs of $11.2 million.  The First Amendment, among other things, (i) decreased the applicable margin from LIBOR plus 5.50% (or Base Rate plus 4.50%) to LIBOR plus 4.00% (or Base Rate plus 3.00%) and (ii) decreased the LIBOR floor from 1.50% to 1.25%.

 

On October 8, 2013, we entered into the Second Amendment which among other things, (i) provided $100.0 million of additional term loans as described above, (ii) decreased the applicable margin from LIBOR plus 4.00% (or Base Rate plus 3.00%) to LIBOR plus 3.50% (or Base Rate plus 2.50%) and (iii) decreased the LIBOR floor from 1.25% to 1.00%.  The Second Amendment required scheduled quarterly payments each equal to 0.25% of the amended principal amount of the Term Loans (approximately $1.5 million).

 

In addition, the Second Amendment (i) amended certain restricted payment provisions, (ii) removed the maximum capital expenditures covenant from the agreement governing the First Lien Term Loan Facility, (iii) modified the existing provision restricting our ability to make dividend and other payments so that from and after March 31, 2013, the permitted payment amount represents the sum of (a) a calculation based on 50% of Consolidated Net Income (as defined in the First Lien Term Loan Facility agreement), if positive, or a deficit of 100% of Consolidated Net Income, if negative, and (b) $20 million, and (iv) permitted proceeds of any sale leasebacks of any assets acquired after January 13, 2012, to be reinvested in our business without restriction.

 

As of January 27, 2017 and January 29, 2016, the interest rate on the First Lien Term Loan Facility was 4.50% (1.00% Eurocurrency rate, plus the Eurocurrency loan margin of 3.50%).  As of January 27, 2017 and January 29, 2016, the gross amount outstanding under the First Lien Term Loan Facility was $593.9 million and $600.0 million, respectively.

 

Following the end of each fiscal year, we are required to make prepayments on the First Lien Term Loan Facility in an amount equal to (i) 50% of Excess Cash Flow (as defined in the agreement governing the First Lien Term Loan Facility), with the ability to step down to 25% and 0% upon achievement of specified total leverage ratios, minus (ii) the amount of certain voluntary prepayments made on the First Lien Term Loan Facility and/or the ABL Facility during such fiscal year.  There was no Excess Cash Flow payment required for fiscal 2017, fiscal 2016 and fiscal 2015.

 

The First Lien Term Loan Facility includes certain customary restrictions, among other things, on our ability and the ability of Parent, the Credit Facilities Guarantors (including our subsidiary 99 Cents Only Stores Texas Inc. (“99 Cents Texas”)) and certain future subsidiaries of ours to incur or guarantee additional indebtedness, make certain restricted payments, acquisitions or investments, materially change our business, incur or permit to exist certain liens, enter into transactions with affiliates, sell assets, make capital expenditures or merge or consolidate with or into, another company.  As of January 27, 2017, we were in compliance with the terms of the First Lien Term Loan Facility.

 

As of January 27, 2017, various funds affiliated with Ares and CPPIB held approximately $130.5 million of term loans under the First Lien Term Loan Facility.  From time to time, these or other affiliated funds may hold additional term loans. The terms of these term loans are the same as those held by unaffiliated third party lenders under the First Lien Term Loan Facility.

 

ABL Facility

 

The ABL Facility initially provided for up to $175.0 million of borrowings, subject to certain borrowing base limitations. Subject to certain conditions, we could increase the commitments under the ABL Facility by up to $50.0 million.  All obligations under the ABL Facility are guaranteed by Parent and the other Credit Facilities Guarantors.  The ABL Facility is secured by substantially all of our assets and the assets of the Credit Facilities Guarantors, including a first priority security interest in certain current assets, and a second priority pledge of all of our equity interests and the equity interests of the Credit Facilities Guarantors and second priority security interest in certain other fixed assets.

 

Borrowings under the ABL Facility bear interest at a rate based, at our option, on (i) LIBOR plus an applicable margin to be determined (3.00% as of January 27, 2017) or (ii) the determined base rate (Prime Rate) plus an applicable margin to be determined (2.00% at January 27, 2017), in each case based on a pricing grid depending on average daily excess availability for the most recently ended quarter. The weighted average interest rate for borrowings under the ABL Facility was 4.18% as of January 27, 2017 and 2.53% as of January 29, 2016.

 

In addition to paying interest on outstanding principal under the Credit Facilities, we are required to pay a commitment fee to the lenders under the ABL Facility on unused commitments.  The commitment fee is adjusted at the beginning of each quarter based upon the average historical excess availability of the prior quarter (0.50% for the quarter ended January 27, 2017 and January 29, 2016).  We must also pay customary letter of credit fees and agency fees.

 

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As of January 27, 2017, borrowings under the ABL Facility were $39.3 million, outstanding letters of credit were $31.6 million and availability under the ABL Facility subject to the borrowing base, was $37.2 million.  As of January 29, 2016, borrowings under the ABL Facility were $47.8 million, outstanding letters of credit were $2.5 million and availability under the ABL Facility subject to the borrowing base, was $90.9 million, prior to giving effect to a subsequent amendment to the ABL Facility on April 8, 2016 that decreased commitments available under the ABL Facility by $25.0 million.

 

The ABL Facility includes restrictions on our ability and the ability of Parent and certain of our subsidiaries to incur or guarantee additional indebtedness, pay dividends on, or redeem or repurchase, its capital stock, make certain acquisitions or investments, materially change its business, incur or permit to exist certain liens, enter into transactions with affiliates, sell assets or merge or consolidate with or into another company.

 

On October 8, 2013, we amended the ABL Facility to, among other things, modify the provision restricting our ability to make dividend and other payments.  Such payments are subject to achievement of Excess Availability (as defined in the agreement governing the ABL Facility) and a ratio of EBITDA (as defined in the agreement governing the ABL Facility) to fixed charges.

 

On August 24, 2015, we amended the ABL Facility to increase commitments available under ABL Facility by $10.0 million, resulting in an aggregate ABL Facility size of $185.0 million.  The additional commitments implemented pursuant to the amendment have terms identical to the existing commitments under the ABL Facility, including as to interest rate and other pricing terms. We paid amendment fees of $0.5 million to lenders under the ABL Facility.

 

In addition, the amendment to the ABL Facility (i) modified certain springing covenants triggered by reference to excess availability under the ABL Facility agreement so that, from August 24, 2015 to April 30, 2016, the occurrence of any such excess availability trigger is determined solely by reference to the available borrowing base under the ABL Facility rather than by reference to the lesser of the available borrowing base and the available aggregate commitments under the ABL Facility, (ii) increased the inventory advance rate during such period for purposes of calculating the borrowing base from 90% to 92.5%, (iii) provided for certain additional inspection rights by the administrative agent if there is a material increase in the amount of inventory that is not eligible inventory for purposes of the borrowing base and (iv) provided for certain additional technical waivers and amendments in order to effect the foregoing.

 

On April 8, 2016, we amended the ABL Facility to, among other things, decrease the commitments available under the ABL Facility by $25.0 million, resulting in an aggregate facility size of $160.0 million, and extend the maturity date of the ABL Facility to April 8, 2021; provided however, the ABL Facility will mature on the earlier of (i) the date that is 90 days prior to the stated maturity date in respect of the First Lien Term Loan Facility and (ii) the date that is 90 days prior to the stated maturity date in respect of the Senior Notes, unless the First Lien Term Loan Facility and Senior Notes have been repaid or refinanced in full or amended to extend the final maturity dates thereof to a date that is at least 180 days after April 8, 2021 (the date of such repayment or refinancing, the “Term/Notes Refinancing Date” (such amendment, the “Fourth Amendment”).  The Fourth Amendment also modified the interest rate margins payable under the ABL Facility.  The initial applicable margin for borrowings under the ABL Facility is 2.0% with respect to base rate borrowings and 3.0% with respect to Eurocurrency rate borrowings.  Commencing with the first day of the first fiscal quarter commencing after the closing of the Fourth Amendment, the applicable margin for borrowings thereunder is subject to adjustment each fiscal quarter, based on average historical excess availability during the preceding fiscal quarter.  Furthermore, the applicable margin will be reduced by 0.50% after the Term/Notes Refinancing Date.

 

In addition, the Fourth Amendment (i) reduced the incremental revolving commitment capacity from $50.0 million to $25.0 million, but provides that any such incremental revolving commitment may take the form of a “last-out” term loan, (ii) added restrictions on certain negative covenants in respect of investments, restricted payments and prepayments of indebtedness, including the First Lien Term Loan Facility and the Senior Notes, in each case, until the occurrence of Term/Notes Refinancing Date, (iii) reduced the letter of credit sublimit from $50.0 million to $45.0 million and (iv) provided for certain additional technical waivers and amendments in order to effect the foregoing.

 

In connection with the Fourth Amendment and in the first quarter of fiscal 2017, we recognized a loss on debt extinguishment of approximately $0.3 million related to a portion of the unamortized debt issuance costs. We recorded $4.7 million of debt issuance costs in connection with the Fourth Amendment in the first quarter of fiscal 2017 as part of non-current deferred financing costs.

 

As of January 27, 2017, we were in compliance with the terms of the ABL Facility.

 

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Senior Notes

 

On December 29, 2011, we issued the Senior Notes that mature on December 15, 2019.  The Senior Notes are guaranteed by the same subsidiaries that guarantee the Credit Facilities.

 

Pursuant to the terms of the Indenture, we may redeem all or a part of the Senior Notes at certain redemption prices that vary based on the date of redemption.  We are not required to make any mandatory redemptions or sinking fund payments, and may at any time or from time to time purchase notes in the open market.

 

The Indenture contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness, create or incur certain liens, pay dividends or make other restricted payments and investments, incur restrictions on the payment of dividends or other distributions from restricted subsidiaries, sell assets, engage in transactions with affiliates, or merge or consolidate with other companies.  As of January 27, 2017, we were in compliance with the terms of the Indenture.

 

As of January 27, 2017, various funds affiliated with Ares and CPPIB have collectively acquired $102.1 million aggregate principal amount of our Senior Notes in open market transactions.  From time to time, these or other affiliated funds may acquire additional Senior Notes.

 

Cash Flows

 

Operating Activities

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

 

 

(52 Weeks)

 

(52 Weeks)

 

(52 Weeks)

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net (loss) income

 

$

(118,159

)

$

(248,355

)

$

5,502

 

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation

 

69,030

 

66,402

 

53,911

 

Amortization of deferred financing costs and accretion of OID

 

5,988

 

4,820

 

4,344

 

Amortization of intangible assets

 

1,750

 

1,789

 

1,787

 

Amortization of favorable/unfavorable leases, net

 

2,737

 

1,704

 

735

 

Loss on extinguishment of debt

 

335

 

 

 

Loss (gain) on disposal of fixed assets

 

532

 

(5,416

)

(84

)

Loss on interest rate hedge

 

514

 

1,402

 

1,504

 

Goodwill impairment

 

 

99,102

 

 

Long-lived and intangible assets impairment

 

761

 

2,171

 

149

 

Deferred income taxes

 

(1,595

)

33,394

 

4,212

 

Stock-based compensation

 

692

 

1,538

 

2,846

 

 

 

 

 

 

 

 

 

Changes in assets and liabilities associated with operating activities:

 

 

 

 

 

 

 

Accounts receivable

 

(1,836

)

280

 

(161

)

Inventories

 

20,759

 

99,389

 

(89,796

)

Deposits and other assets

 

6,506

 

1,228

 

(2,258

)

Accounts payable

 

9,377

 

(44,407

)

52,530

 

Accrued expenses

 

18,082

 

(2,081

)

7,586

 

Accrued workers’ compensation

 

(7,220

)

5,898

 

(3,427

)

Income taxes

 

(319

)

7,246

 

(6,413

)

Deferred rent

 

1,982

 

4,096

 

10,105

 

Other long-term liabilities

 

6,656

 

1,457

 

(4,801

)

Net cash provided by operating activities

 

$

16,572

 

$

31,657

 

$

38,271

 

 

Cash provided by operating activities in fiscal 2017 was $16.6 million and consisted of (i) net loss of $118.2 million; (ii) net loss adjustments for depreciation and other non-cash items of $80.7 million; (iii) an increase in working capital activities of $46.1 million; and (iv) an increase in other activities of $7.9 million, primarily due to an increase in other long-term liabilities.  The increase in working capital activities was primarily due to a decrease in inventory and increase in accrued expenses and accounts payable, partially offset by decrease in accrued workers’ compensation.  Inventory decreased primarily as a result of a focused effort on inventory and supply chain efficiencies.

 

Cash provided by operating activities in fiscal 2016 was $31.7 million and consisted of (i) net loss of $248.4 million; (ii) net income adjustments for depreciation, deferred taxes, goodwill impairment and other non-cash items of $206.9 million; (iii) an increase in working capital activities of $67.4 million; and (iv) an increase in other activities of $5.8 million, primarily due to increased deferred rent and other long-term liabilities.  The increase in working capital activities was primarily due to a decrease in inventory and income taxes receivable, partially offset by decreases in accounts payable.  Inventory decreased primarily as a result of a Company-wide strategy to reduce inventory.

 

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Cash provided by operating activities in fiscal 2015 was $38.3 million and consisted of (i) net income of $5.5 million; (ii) net income adjustments for depreciation and other non-cash items of $69.4 million; (iii) a decrease in working capital activities of $40.5 million; and (iv) an increase in other activities of $3.9 million, primarily due to an increase in deferred rent, partially offset by a decrease in other long-term liabilities, and an increase in other long-term assets.  The decrease in working capital activities was primarily due to an increase in inventories and income taxes receivable, partially offset by increases in accounts payable and accrued expenses. Inventory increased as a result of several factors, including the opening of new stores, an expansion of our seasonal merchandise programs, higher volume of purchases sourced directly from international vendors, and the “Go Taller” store remodeling program which increased shelf height (and consequently, merchandising space) across our stores.

 

Investing Activities

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

 

 

(52 Weeks)

 

(52 Weeks)

 

(52 Weeks)

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchases of property and equipment

 

$

(45,791

)

$

(65,950

)

$

(111,387

)

Proceeds from sale of property and fixed assets

 

6,234

 

31,436

 

39

 

Insurance recoveries for replacement assets`

 

937

 

 

 

Net cash used in investing activities

 

$

(38,620

)

$

(34,514

)

$

(111,348

)

 

Capital expenditures in fiscal 2017 consisted of property acquisition, leasehold improvements, fixtures and equipment for new store openings, information technology projects and other capital projects, totaling $45.8 million. Proceeds from sale of property and fixed assets primarily relate to a sale-leaseback transaction completed during fiscal 2017 (see Note 1 to our Consolidated Financial Statements).

 

Capital expenditures in fiscal 2016 consisted of leasehold improvements, fixtures and equipment for new store openings, information technology projects and other capital projects of $66.0 million. Proceeds from sale of fixed assets primarily relate to sale of held for sale properties and sale-leaseback transactions completed during the year (see Note 1 to our Consolidated Financial Statements).

 

Capital expenditures in fiscal 2015 consisted of property acquisitions, leasehold improvements, fixtures and equipment for new store openings, information technology projects and other capital projects, totaling $111.4 million.

 

We estimate that total capital expenditures over the next twelve months will be approximately $53 million to $58 million, comprised of approximately $36 million to $41 million for leasehold improvements and fixtures and equipment for new and existing stores, and approximately $17 million primarily related to information technology upgrades and supply chain infrastructure upgrades and maintenance. We expect to fund a portion of the capital expenditures through divestitures of surplus assets and sale-leaseback transactions. Our estimated capital expenditures exclude anticipated expenditures associated with the rebuild of one of our stores in the Los Angeles area that was impacted by a fire in May 2016, a substantial portion of which we expect to recover through insurance reimbursements.

 

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Financing Activities

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

 

 

(52 Weeks)

 

(52 Weeks)

 

(52 Weeks)

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Payments of long-term debt

 

(6,138

)

(6,138

)

(6,138

)

Proceeds under revolving credit facility

 

264,800

 

471,350

 

305,500

 

Payments under revolving credit facility

 

(273,300

)

(480,550

)

(248,500

)

Payments of debt issuance costs

 

(4,725

)

(487

)

 

Proceeds from financing lease obligations

 

42,592

 

9,359

 

 

Payments of capital and financing lease obligations

 

(1,045

)

(381

)

(88

)

Payments to repurchase stock options of Number Holdings, Inc.

 

 

(390

)

(76

)

Net settlement of stock options of Number Holdings, Inc. for tax withholdings

 

 

(57

)

 

Net cash provided by (used in) financing activities

 

22,184

 

(7,294

)

50,698

 

 

Net cash provided by financing activities in fiscal 2017 was primarily comprised of proceeds from financing lease obligations associated with sale-leaseback transactions, partially offset by net repayments under the ABL Facility, repayment of debt under the First Lien Term Loan Facility and payments of debt issuance costs associated with the amendment of the ABL Facility.  In the second quarter of fiscal 2017, we sold and concurrently licensed (through March 31, 2017) a warehouse facility in the City of Commerce, California with a carrying value of $12.1 million and received net proceeds from this transaction of $28.5 million. Additional information regarding the sale of the warehouse facility is contained in Note 10 to our Consolidated Financial Statements. Additional information regarding sale-leaseback transactions is contained in Note 1 to our Consolidated Financial Statements.

 

Net cash provided by financing activities in fiscal 2016 was comprised primarily of net repayments of borrowings under the ABL Facility and the First Lien Term Loan Facility, partially offset by proceeds from the financing lease obligations associated with sale-leaseback transactions (see Note 1 to our Consolidated Financial Statements).

 

Net cash provided by financing activities in fiscal 2015 was comprised primarily of net borrowings under the ABL Facility, partially offset by repayments of borrowings on the First Lien Term Loan Facility.

 

Off-Balance Sheet Arrangements

 

As of January 27, 2017, we had no off-balance sheet arrangements.

 

Contractual Obligations

 

The following table summarizes our consolidated contractual obligations (in thousands) as of January 27, 2017.

 

 

 

Payment due by period

 

 

 

Total

 

Less than 1 year

 

1-3 years

 

3-5 years

 

More than 5 years

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term debt obligations(a)

 

$

883,162

 

$

6,138

 

$

837,724

 

$

39,300

 

$

 

Interest payments (b)

 

150,100

 

57,860

 

88,616

 

3,624

 

 

Capital lease obligations (c)

 

179

 

67

 

112

 

 

 

Financing lease obligations (c)

 

56,469

 

3,973

 

8,149

 

8,497

 

35,850

 

Operating lease obligations

 

487,672

 

80,790

 

140,013

 

105,701

 

161,168

 

Purchase obligations (d)

 

764

 

764

 

 

 

 

Deferred compensation liability

 

816

 

 

 

 

816

 

Total

 

$

1,579,162

 

$

149,592

 

$

1,074,614

 

$

157,122

 

$

197,834

 

 


(a)         Assumes planned maturity of $39.3 million under the ABL Facility on April 8, 2021; provided however, the ABL Facility will mature on the earlier of (i) the date that is 90 days prior to the stated maturity date in respect of the First Lien Term Loan Facility and (ii) the date that is 90 days prior to the stated maturity date in respect of the Senior Notes, unless the First Lien Term Loan Facility and Senior Notes have been repaid or refinanced in full or amended to extend the final maturity dates thereof to a date that is at least 180 days after April 8, 2021. See Note 6 to our Consolidated Financial Statements.

(b)         Includes interest expense on fixed and variable debt, using fiscal 2017 year end rates and balance. See Note 6 to our Consolidated Financial Statements.

(c)          Includes capital and financing lease obligations and related interest.

 

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(d)         Purchase obligations include legally binding agreements that primarily consist of construction contracts of new stores.  Amounts committed under open purchase orders for merchandise are not included if cancelable without penalty prior to a date that precedes the vendors’ scheduled shipment date.

 

We do not have any liabilities related to uncertain tax positions as of January 27, 2017.  See Note 5 to our Consolidated Financial Statements.

 

Lease Commitments

 

We lease various facilities under operating leases (except for one location classified as a capital lease and seven locations classified as financing leases), which will expire at various dates through fiscal year 2035.  Most of the lease agreements contain renewal options and/or provide for fixed rent escalations or increases based on the Consumer Price Index.  Total minimum lease payments under each of these lease agreements, including scheduled increases, are charged to expenses on a straight-line basis over the term of each respective lease. Most leases require us to pay property taxes, maintenance and insurance.  Rental expenses (including property taxes, maintenance and insurance) charged to expenses in fiscal 2017 were approximately $102.5 million.  Rental expenses (including property taxes, maintenance and insurance) charged to expenses in fiscal 2016 were approximately $97.3 million.  Rental expenses (including property taxes, maintenance and insurance) charged to expenses in fiscal 2015 were approximately $85.5 million.  We typically seek leases with a five-year to ten-year term and with multiple five-year renewal options. See Item 2, “Properties.”  The large majority of our store leases were entered into with multiple renewal periods, which are typically five years and occasionally longer.

 

Variable Interest Entities

 

As of January 27, 2017 and January 29, 2016, we did not have any variable interest entities.

 

Seasonality and Quarterly Fluctuations

 

We have historically experienced and expect to continue to experience some seasonal fluctuations in our net sales, operating income, and net income. During the quarters that have included the Halloween, Christmas and Easter selling seasons, we have historically experienced higher net sales and higher operating income.  Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of certain these holidays, the timing of new store openings and the merchandise mix.

 

New Authoritative Standards

 

Information regarding new authoritative standards is contained in Note 2 to our Consolidated Financial Statements which is incorporated herein by this reference.

 

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

We are exposed to interest rate risk for our debt borrowings.

 

Our primary interest rate exposure relates to outstanding amounts under our Credit Facilities.  As of January 27, 2017, we had variable rate borrowings of $593.9 million under our First Lien Term Loan Facility and $39.3 million under our ABL Facility.  The Credit Facilities provide interest rate options based on certain indices as described in Note 6 to our Consolidated Financial Statements.

 

We may manage interest rate risk through the use of interest swap agreements or interest cap agreements to limit the effect of interest rate fluctuations from time to time.  We were previously a party to an interest rate swap agreement that limited our interest exposure on a notional value of $261.8 million to 1.36% plus an applicable margin of 3.50%.  We are currently not using an interest swap agreement or interest cap agreement to limit such interest rate fluctuations.

 

A change in interest rates on our variable rate debt impacts our pre-tax earnings and cash flows.  Based on our variable rate borrowing levels and interest rate derivatives outstanding as of January 27, 2017 and January 29, 2016, respectively, the annualized effect of a 1% increase in applicable interest rates would have resulted in an increase of our pre-tax loss and a decrease in cash flows of approximately $6.3 million for fiscal 2017 and $1.9 million for fiscal 2016.

 

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Table of Contents

 

Item 8. Financial Statements and Supplementary Data

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

 

99 Cents Only Stores LLC

 

Report of Independent Registered Public Accounting Firm

51

Consolidated Balance Sheets as of January 27, 2017 and January 29, 2016

52

Consolidated Statements of Comprehensive Income (Loss) for the years ended January 27, 2017, January 29, 2016 and January 30, 2015

53

Consolidated Statements of Member’s Equity for the years ended January 27, 2017, January 29, 2016 and January 30, 2015

54

Consolidated Statements of Cash Flows for the years ended January 27, 2017, January 29, 2016 and January 30, 2015

55

Notes to Consolidated Financial Statements

56

Schedule II — Valuation and Qualifying Accounts

117

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Member of 99 Cents Only Stores LLC

 

We have audited the accompanying consolidated balance sheets of 99 Cents Only Stores LLC and subsidiaries as of January 27, 2017 and January 29, 2016, and the related consolidated statements of comprehensive income (loss), member’s equity and cash flows for the years ended January 27, 2017, January 29, 2016, and January 30, 2015. Our audits also included the financial statement schedule listed in the Index at Item 15(b) for the years ended January 27, 2017, January 29, 2016, and January 30, 2015. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of 99 Cents Only Stores LLC and subsidiaries at January 27, 2017 and January 29, 2016, and the consolidated results of its operations and its cash flows for the years ended January 27, 2017, January 29, 2016, and January 30, 2015, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

 

/s/ Ernst & Young LLP

 

Los Angeles, California

 

April 26, 2017

 

 

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Table of Contents

 

99 Cents Only Stores LLC

 

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share data)

 

 

 

January 27,
2017

 

January 29,
2016

 

ASSETS

 

 

 

 

 

Current Assets:

 

 

 

 

 

Cash

 

$

2,448

 

$

2,312

 

Accounts receivable, net of allowance for doubtful accounts of $122 and $140 as of January 27, 2017 and January 29, 2016, respectively

 

3,510

 

1,674

 

Income taxes receivable

 

3,876

 

3,665

 

Inventories, net

 

175,892

 

196,651

 

Assets held for sale

 

4,903

 

2,308

 

Other

 

10,307

 

18,570

 

Total current assets

 

200,936

 

225,180

 

Property and equipment, net

 

507,620

 

542,570

 

Deferred financing costs, net

 

3,488

 

916

 

Intangible assets, net

 

447,027

 

453,242

 

Goodwill

 

380,643

 

380,643

 

Deposits and other assets

 

8,592

 

7,352

 

Total assets

 

$

1,548,306

 

$

1,609,903

 

 

 

 

 

 

 

LIABILITIES AND MEMBER’S EQUITY

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

Accounts payable

 

$

86,588

 

$

79,197

 

Payroll and payroll-related

 

24,110

 

18,421

 

Sales tax

 

19,389

 

13,314

 

Other accrued expenses

 

46,082

 

39,520

 

Workers’ compensation

 

69,169

 

76,389

 

Current portion of long-term debt

 

6,138

 

6,138

 

Current portion of capital and financing lease obligation

 

31,330

 

989

 

Total current liabilities

 

282,806

 

233,968

 

Long-term debt, net of current portion

 

865,375

 

875,843

 

Unfavorable lease commitments, net

 

3,988

 

5,746

 

Deferred rent

 

30,360

 

29,333

 

Deferred compensation liability

 

816

 

709

 

Capital and financing lease obligation, net of current portion

 

47,195

 

34,817

 

Deferred income taxes

 

161,450

 

163,045

 

Other liabilities

 

12,297

 

5,118

 

Total liabilities

 

1,404,287

 

1,348,579

 

Commitments and contingencies (Note 10)

 

 

 

 

 

Member’s Equity:

 

 

 

 

 

Member units — 100 units issued and outstanding at January 27, 2017 and January 29, 2016

 

550,918

 

550,226

 

Investment in Number Holdings, Inc. preferred stock

 

(19,200

)

(19,200

)

Accumulated deficit

 

(387,699

)

(269,540

)

Other comprehensive loss

 

 

(162

)

Total equity

 

144,019

 

261,324

 

Total liabilities and equity

 

$

1,548,306

 

$

1,609,903

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

99 Cents Only Stores LLC

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Amounts in thousands)

 

 

 

Year Ended

 

Year Ended

 

Year Ended

 

 

 

January 27,
2017

 

January 29,
2016

 

January 30,
2015

 

 

 

(52 Weeks)

 

(52 Weeks)

 

(52 Weeks)

 

Net Sales:

 

 

 

 

 

 

 

99¢ Only Stores

 

$

2,023,034

 

$

1,961,050

 

$

1,881,865

 

Bargain Wholesale

 

38,973

 

42,945

 

45,084

 

Total sales

 

2,062,007

 

2,003,995

 

1,926,949

 

Cost of sales

 

1,460,595

 

1,441,631

 

1,308,849

 

Gross profit

 

601,412

 

562,364

 

618,100

 

Selling, general and administrative expenses (includes asset impairment of $761, $2,171 and $149 for the years ended January 27, 2017, January 29, 2016 and January 30, 2015, respectively)

 

654,509

 

614,026

 

546,259

 

Goodwill impairment

 

 

99,102

 

 

Operating (loss) income

 

(53,097

)

(150,764

)

71,841

 

Other (income) expense:

 

 

 

 

 

 

 

Interest income

 

(47

)

(4

)

 

Interest expense

 

68,764

 

65,653

 

62,734

 

Loss on extinguishment of debt

 

335

 

 

 

Total other expense, net

 

69,052

 

65,649

 

62,734

 

(Loss) income before provision for income taxes

 

(122,149

)

(216,413

)

9,107

 

(Benefit) provision for income taxes

 

(3,990

)

31,942

 

3,605

 

Net (loss) income

 

(118,159

)

(248,355

)

5,502

 

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

Unrealized losses on interest rate cash flow hedge

 

(168

)

(152

)

(576

)

Less: reclassification adjustment included in net income (loss)

 

330

 

988

 

969

 

Other comprehensive income, net of tax

 

162

 

836

 

393

 

 

 

 

 

 

 

 

 

Comprehensive (loss) income

 

$

(117,997

)

$

(247,519

)

$

5,895

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

99 Cents Only Stores LLC

 

CONSOLIDATED STATEMENTS OF MEMBER’S EQUITY

(Amounts in thousands)

 

 

 

Member Units

 

Investment
in Number
Holdings,
Inc.
Preferred

 

Retained
Earnings
(Accumulated

 

Accumulated
Other
Comprehensive

 

Member’s

 

 

 

Units

 

Amount

 

Stock

 

Deficit)

 

Income (Loss)

 

Equity

 

BALANCE, January 31, 2014

 

 

$

546,365

 

$

(19,200

)

$

(26,687

)

$

(1,391

)

$

499,087

 

Net income

 

 

 

 

5,502

 

 

5,502

 

Unrealized net gains on interest rate cash flow hedge, net of tax