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99¢ ONLY STORES

Form 10-Q

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FORWARD-LOOKING INFORMATION

This Quarterly Report on Form 10-Q (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 filing and include statements regarding the intent, belief or current expectations of 99¢ Only Stores (the “Company”)the Company and its directors or officers with respect to, among other things, (a) trends affecting the financial condition or results of operations of the Company, and (b) the business and growth strategies of the Company (including the Company’s store opening growth rate), that are not historical in nature.  The term the “Company” refers to 99¢ Only Stores and its consolidated subsidiaries prior to the conversion to a California limited liability company effective October 18, 2013 and to 99 Cents Only Stores LLC and its consolidated subsidiaries on or after such conversion.  Readers are cautioned not to put undue reliance on such forward-looking statements.  Such forward-looking statements are and will be based on the Company’s then-current expectations, estimates and assumptions regarding future events and are applicable only as of the date of such statements.  The Company may not realize its expectations and its estimates and assumptions may not prove correct.  In addition, such forward lookingforward-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.  The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.  Readers should carefully review the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission (the “SEC”) or posts on the Company’s website, including the Company’s Annual Report on Form 10-K containing the Company’s most recent audited financial statements for the fiscal year ended March 30, 2013.

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99¢ ONLY STORES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

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

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99¢ ONLY STORES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

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Goodwill and Other Intangible Assets

In connection with the Merger purchase price allocation, the fair values of long-lived and intangible assets were determined based upon assumptions related to the future cash flows, discount rates and asset lives utilizing then available information, and in some cases were obtained from independent professional valuation experts.  The Company amortizes intangible assets over their estimated useful lives unless such lives are deemed indefinite.

Goodwill and indefinite-lived intangible assets are not amortized but 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.  The Company has the option of performing a qualitative assessment before calculating the fair value of the reporting unit (i.e., step one of the goodwill impairment test). If the Company does not perform a qualitative assessment, or determines, on the basis of qualitative factors, that the fair value of the reporting unit is more likely than not less than the carrying amount, the two-step impairment test would be required. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, goodwill is impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of goodwill. Management has determined that the Company has two reporting units, the wholesale reporting unit and the retail reporting unit.

The Company performs the annual test for impairment in the fourth quarter of the fiscal year and determines fair value based on a combination of the income approach and the market approach. The income approach is based on discounted cash flows to determine fair value. The market approach uses a selection of comparable companies and transactions in determining fair value. The fair value of the trade name is also tested for impairment in the fourth quarter by comparing the carrying value to the fair value. 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.

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.

During each of the second quarter and first quarterhalf of fiscal 2014 and fiscal 2013, the Company did not record any impairment charges related to goodwill or other intangible assets.

Derivatives

The Company accounts for derivative financial instruments in accordance with authoritative guidance for derivative instrument and hedging activities.  All financial instrument positions taken by the Company are intended to be used to manage risks associated with interest rate exposures.

The Company’s derivative financial instruments are recorded on the balance sheet at fair value, and are recorded in either current or noncurrent assets or liabilities based on their maturity.  Changes in the fair values of derivatives are recorded in net earnings or other comprehensive income (“OCI”), based on whether the instrument is designated and effective as a hedge transaction and, if so, the type of hedge transaction.  Gains or losses on derivative instruments reported in accumulated other comprehensive income (“AOCI”) are reclassified to earnings in the period the hedged item affects earnings.  Any ineffectiveness is recognized in earnings in the period incurred.

Purchase Accounting

The Company’s assets and liabilities have been recorded at their estimated fair values as of the date of the Merger.  The aggregate purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed, based upon an assessment of their relative fair value as of the Merger date.  These estimates of fair values, the allocation of the purchase price and other factors related to the accounting for the Merger are subject to significant judgments and the use of estimates.

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Income Taxes

The Company utilizes the liability method of accounting for income taxes.  Under the liability method, deferred tax assets and liabilities are recognized using enacted tax rates for the effect of temporary differences between the book and tax bases 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. The Company’s ability to realize deferred tax assets is assessed throughout the year and a valuation allowance is established accordingly.  The Company recognizes the impact of a tax position only if it is more likely than not to be sustained upon examination based on the technical merits of the position. The Company recognizes potential interest and penalties related to uncertain tax positions in income tax expense.

Stock-Based Compensation

The Company accounts for stock-based payment awards based on their fair value.  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.  For awards classified as equity, the Company estimates 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.  The Black-Scholes model considers, among other factors, the expected life of the award and the expected volatility of the stock price.  Stock options are generally granted to employees at exercise prices equal to the fair market value of the stock at the dates of grant.  Former executive put rights are classified as equity awards and revalued using a binomial model at each reporting period with changes in the fair value recognized as stock-based compensation expense.

Revenue Recognition

The Company recognizes retail sales in its retail stores at the time the customer takes possession of merchandise. All sales are net of discounts and returns and exclude sales tax.  Wholesale sales are recognized in accordance with the shipping terms agreed upon on the purchase order. Wholesale sales are typically recognized free on board origin, where title and risk of loss pass to the buyer when the merchandise leaves the Company’s distribution facility.

The Company has a gift card program.  The Company does not charge administrative fees on gift cards and the Company’s gift cards do not have expiration dates.  The Company records the sale of gift cards as a current liability and recognizes a sale when a customer redeems a gift card.  The liability for outstanding gift cards is recorded in accrued expenses.  The Company has not recorded any breakage income related to its gift card program.

Cost of Sales

Cost of sales includes the cost of inventory, freight in, inter-state warehouse transportation costs, obsolescence, spoilage, scrap and inventory shrinkage, and is net of discounts and allowances.  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.  In addition, the Company analyzes its inventory levels and the related cash discounts received to arrive at a value for cash discounts to be included in the inventory balance.  The Company does not include purchasing, receiving, distribution, warehouse, and occupancy costs in its cost of sales.  Due to this classification, the Company’s gross profit rates may not be comparable to those of other retailers that include costs related to their distribution network and occupancy in cost of sales.

Operating Expenses

Selling, general and administrative expenses include purchasing, receiving, inspection and warehouse costs, the costs of selling merchandise in stores (payroll and associated costs, occupancy and other store-level costs), distribution costs (payroll and associated costs, occupancy, transportation to and from stores and other distribution-related costs) and corporate costs (payroll and associated costs, occupancy, advertising, professional fees and other corporate administrative costs).

Leases

The Company follows the policy of capitalizing allowable expenditures that relate to the acquisition and signing of its retail store leases.  These costs are amortized on a straight-line basis over the applicable lease term.

The Company recognizes 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 rent.  Deferred rent related to landlord incentives is amortized as an offset to rent expense using the straight-line method over the applicable lease term.

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For store closures where a lease obligation still exists, the Company records 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 estimates of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ from the Company’s estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.

As of March 30, 2013, the Company’s estimated lease termination costs accrual was $0.7 million relating to a Texas store. During the first quarter of fiscal 2014, the Company reversed the lease termination costs accrual, and as of June 29, 2013, the Company did not have any remaining Texas store closure obligations.

Self-Insured Workers’ Compensation Liability

The Company self-insures for workers’ compensation claims in California and Texas.  The Company establishes a liability for losses of 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. The Company has not discounted the projected future cash outlays for the time value of money for claims and claim-related costs when establishing its workers’ compensation liability in its financial reports for June 29,September 28, 2013 and March 30, 2013.

Self-Insured Health Insurance Liability

During the second quarter of fiscal 2012 ended October 1, 2011 (the “second quarter of fiscal 2012”), the Company began self-insuring for a portion of its employee medical benefit claims.  The liability for the self-funded portion of the Company health insurance program is determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported.  The Company maintains stop loss insurance coverage to limit its exposure for the self-funded portion of its health insurance program.

Pre-Opening Costs

The Company expenses, as incurred, all pre-opening costs such as payroll, rent and marketing related to the opening of new retail stores.

Advertising

The Company uses a variety of marketing approaches with a primary focus on print and radio advertising. The Company expenses advertising costs as incurred. Advertising expenses were $1.4$1.7 million and $1.3 million for the second quarter of fiscal 2014 and 2013, respectively.  Advertising expenses were $3.1 million and $2.6 million for the first quarterhalf of fiscal 2014 and 2013, respectively.

Fair Value of Financial Instruments

The Company’s financial instruments consist principally of cash, accounts receivable, interest rate derivatives, accounts payable, accruals, debt, and other liabilities.  Cash and interest rate derivatives are measured and recorded at fair value.  Accounts receivable and other receivables are financial assets with carrying values that approximate fair value.  Accounts payable and other accrued expenses are financial liabilities with carrying values that approximate fair value.  See Note 7 for further discussion of the fair value of debt.

The Company utilizes the authoritative guidance for fair value, which includes the definition of fair value, the framework for measuring fair value, and disclosures about fair value measurements.  Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants.  Fair value measurements reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model.

Comprehensive Income

OCI includes unrealized gains or losses on investments and interest rate derivatives designated as cash flow hedges.

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First Lien Term Loan Facility

TheAs of September 28, 2013, the First Lien Term Loan Facility providesprovided for $525 million of borrowings (which may be increased by up to $150.0 million in certain circumstances).  As of June 29, 2013, allAll obligations under the First Lien Term Loan Facility are guaranteed by Parent and the Company’s direct wholly owned subsidiary, 99 Cents Only Stores Texas, Inc. (“99 Cents Texas” and together with Parent, the “Credit Facilities Guarantors”).  In addition, the First Lien Term Loan Facility is secured by pledges of certain of the Company’s equity interests and the equity interests of the Credit Facilities Guarantors.

TheAs of September 28, 2013, the Company iswas required to make scheduled quarterly payments each equal to 0.25% of the original principal amount of the term loan (approximately $1.3 million), with the balance due on the maturity date, January 13, 2019.  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, (A) a Base Rate determined by reference to the highest of (a) the interest rate in effect determined by the administrative agent as “Prime Rate” (3.25% as of June 29,September 28, 2013), (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 Eurocurrency rate for the interest period multiplied by the Statutory Reserve Rate or 1.50% per annum) plus 1.00%, or (B) an Adjusted Eurocurrency Rate.

On April 4, 2012, the Company amended the terms of the existing seven-year $525 million First Lien Term Loan Facility, and incurred refinancing costs of $11.2 million. The amendment, among other things, decreased the applicable margin from the London Interbank Offered Rate (“LIBOR”) plus 5.50% (or base rateBase Rate plus 4.50%) to LIBOR plus 4.00% (or base rateBase Rate plus 3.00%) and decreased the LIBOR floor from 1.50% to 1.25%.  The maximum capital expenditures covenant in the First Lien Term Loan Facility was also amended to permit an additional $5 million in capital expenditures each year throughout the term of the First Lien Term Loan Facility.

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The Company determined that a portion of the refinancing transaction should be accounted for as debt extinguishment. In accordance with applicable guidance for debt modification and extinguishment, the Company recognized a $16.3 million loss on debt extinguishment related to a portion of the unamortized debt issuance costs, unamortized original issue discount (“OID”) and refinancing costs incurred in connection with the amendment for the portion of the First Lien Term Loan Facility that was extinguished.  The Company recorded $0.3 million as deferred debt issuance costs and $5.9 million as OID in connection with the amendment.

As of June 29,September 28, 2013, $5$1.7 million of the amount outstanding under the First Lien Term facility bore an interest charge of 6.25% (3.25% Prime Rate, plus the margin of 3.00%), while the interest rate charged on the remainder of First Lien Term Loan Facility was 5.25% (1.25% Eurocurrency rate, plus the Eurocurrency loan margin of 4.00%).  As of June 29,September 28, 2013, the amount outstanding under the First Lien Term Loan Facility was $507.4$504.4 million.

Following the end of each fiscal year, the Company is required to prepay the First Lien Term Loan Facility in an amount equal to 50% of Excess Cash Flow (as defined in the First Lien Term Loan Facility agreement and with stepdowns to 25% and 0% based on achievement of specified total leverage ratios), minus the amount of certain voluntary prepayments of the First Lien Term Loan Facility and/or the ABL Facility during such fiscal year. The Excess Cash Flow required payment for fiscal 2013 was $3.3 million and was made in July 2013.

The First Lien Term Loan Facility includes restrictions on the Company’s ability and the ability of Parent and certain of the Company’s subsidiaries to, incur or guarantee additional indebtedness, pay dividends on, or redeem or repurchase, the Company’s capital stock, make certain acquisitions or investments, materially change the Company’s business, incur or permit to exist certain liens, enter into transactions with affiliates or sell its assets to and make capital expenditures or merge or consolidate with or into, another company.  As of March 30, 2013, the Company was in compliance with the terms of the First Lien Term Loan Facility.  In June 2013, the Company failed to comply with the covenant that required delivery of audited financial statements for the fiscal year ended March 30, 2013 within 90 days of the completion of fiscal 2013 as required under the First Lien Term Loan Facility.  Prior to the expiration of the applicable 30-day grace period under the First Lien Term Loan Facility, the Company delivered the required financial statements.  Accordingly,As of September 28, 2013, the Company is in compliance with the applicable reporting obligations and other terms of the First Lien Term Loan Facility.

On October 8, 2013, the Company completed a repricing of its First Lien Term Loan Facility, borrowed $100 million of incremental term loans under that facility and amended certain other provisions thereto.  See Note 16 for more information regarding the amendment to the First Lien Term Loan Facility.

During the first quarter of fiscal 2013, the Company entered into an interest rate cap agreement.  The interest rate cap agreement limits the Company’s interest exposure on a notional value of $261.8 million to 3.00% plus an applicable margin of 4.00%.  The term of the interest rate cap is from May 29, 2012 to November 29, 2013.  The Company paid fees of $0.05 million to enter into the interest rate cap agreement.

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In addition, during the first quarter of fiscal 2013, the Company entered into an interest rate swap agreement to limit the variability of cash flows associated with interest payments on the First Lien Term Loan Facility that result from fluctuations in the LIBOR rate.  The swap limits the Company’s interest exposure on a notional value of $261.8 million to 1.36% plus an applicable margin of 4.00%.  The term of the swap is from November 29, 2013 through May 31, 2016.  The fair value of the swap on the trade date was zero as the Company neither paid nor received any value to enter into the swap, which was entered into at market rates.  The fair value of the swap at June 29,September 28, 2013 was a liability of $1.5$2.3 million.  See Note 6 for more information on the Company’s interest rate cap and interest rate swap agreements.

ABL Facility

The ABL Facility provides for up to $175.0 million of borrowings (which may be increased by up to $50.0 million in certain circumstances), subject to certain borrowing base limitations.  All obligations under the ABL Facility are guaranteed by the Company, Parent and 99 Cents Texas (collectively, the “ABL Guarantors”).  The ABL Facility is secured by substantially all of the Company’s assets and the assets of the ABL Guarantors.

Borrowings under the ABL Facility bear interest for an initial period until June 30, 2012 at an applicable margin plus, at the Company’s option, a fluctuating rate equal to (A) the highest of (a) Federal Funds Rate plus 0.50%, (b) rate of interest in effect determined by the administrative agent as “Prime Rate” (3.25% at the date of the Merger), and (c) Adjusted Eurocurrency Rate (determined to be the LIBOR rate multiplied by the Statutory Reserve Rate) for an Interest Period of one (1) month plus 1.00% or (B) the Adjusted Eurocurrency Rate.  The interest rate charged on borrowings under the ABL Facility from the date of the Merger until June 30, 2012 was 4.25% (the base rate (prime rate at 3.25%) plus the applicable margin of 1.00%).  Thereafter, borrowings under the ABL Facility will have variable pricing and will be based, at the Company’s option, on (a) LIBOR plus an applicable margin to be determined (1.75% as of June 29,September 28, 2013) or (b) the determined base rate (prime rate) plus an applicable margin to be determined (0.75% at June 29,September 28, 2013), in each case based on a pricing grid depending on average daily excess availability for the most recently ended quarter.

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In addition to paying interest on outstanding principal under the Credit Facilities, the Company was required to pay a commitment fee to the lenders under the ABL Facility on unused commitments at a rate of 0.375% for the period from the date of the Merger until June 30, 2012.  Thereafter, the commitment fee will be adjusted at the beginning of each quarter based upon the average historical excess availability of the prior quarter (0.50% for the quarter ended June 29,September 28, 2013).  The Company must also pay customary letter of credit fees and agency fees.

As of June 29,September 28, 2013 and March 30, 2013, the Company had no outstanding borrowings under the ABL Facility, outstanding letters of credit were $1.0$1.6 million, and availability under the ABL Facility subject to the borrowing base, was $141.2$133.9 million as of June 29,September 28, 2013.

The ABL Facility includes restrictions on the Company’s ability, and the ability of the Parent and certain of the Company’s subsidiaries to, incur or guarantee additional indebtedness, pay dividends on, or redeem or repurchase, its capital stock, make certain acquisitions or investments, materially change ourits business, incur or permit to exist certain liens, enter into transactions with affiliates or sell our assets to, make capital expenditures or merge or consolidate with or into, another company.  The ABL Facility was amended on April 4, 2012 to permit an additional $5 million in capital expenditures for each year during the term of the ABL Facility.  As of March 30, 2013, the Company was in compliance with the terms of the ABL Facility. In June 2013, the Company failed to comply with the covenant that required delivery of audited financial statements for the fiscal year ended March 30, 2013 within 90 days of the completion of fiscal 2013 as required under the in the ABL Facility. Prior to the expiration of the applicable 30-day grace period under the ABL Facility, the Company delivered the required financial statements.  Accordingly,As of September 28, 2013, the Company is in compliance with the applicable reporting obligations and other terms of the ABL Facility.

The ABL Facility was amended on October 8, 2013.  See Note 16 for information regarding the amendment to the ABL Facility.

Senior Notes

On December 29, 2011, the Company issued $250 million aggregate principal amount of 11% Senior Notes that mature on December 15, 2019 (the “Senior Notes”).  The Senior Notes are guaranteed by 99 Cents Texas (the “Senior Notes Guarantor”).

In connection with the issuance of the Senior Notes, the Company entered into a registration rights agreement that required the Company to file an exchange offer registration statement, enabling holders to exchange the Senior Notes for registered notes with terms identical in all material respects to the terms of the Senior Notes, except the registered notes would be freely tradable.  The exchange offer was closed on November 7, 2012.

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