Description

Introduction

Office Depot is a leading office supplies retailer and direct seller which should have mid-to-high teens EPS growth for the next few years based on mid-to-high single digit topline growth, achievable margin expansion, and meaningful share repurchases.  This business has a diversified global footprint, a returns-focused management team, and expectations that have been reset to conservative levels.  So why does it trade at just 13X a reasonable 2008 earnings estimate, and a meaningful discount to historical levels, direct competitors, a broad set of hardgoods retailers and the S&P as a whole, all of which have demonstrably lower growth outlooks?  

I believe the market is simply mispricing ODP because of a hangover from a go-go turnaround story that got ahead of itself.  Momentum investors and Wall Street analysts who jumped on this bandwagon throughout 2005 and early 2006 have abandoned the stock as earnings comparisons have slowed and expectations have been tempered.  Since May ’06, ODP’s forward multiple has been cut by nearly 40%, but this turnaround still has a lot of runway.  I believe this is an opportunity to own a very solid franchise with upside of 25% over the next 6-12 months and very limited downside. 

Summary

ODP is the #2 office supply retailer in the US - this segment is approx. 43% of profits.  They also have a direct business serving commercial and contract customers in N.A. (Business Solutions Division, or BSD) which contributes 34% of profits and an International business with direct and retail operations accounting for 23% of profits.  Combined ODP has $15B in revenue serving customers in 42 countries.  With a new management (2005) focused on driving efficiencies across business lines, this diversification has provided the framework for renewed growth and improved profitability.  The major operating catalysts for these businesses are 1) accelerating topline growth from increased investments in retail footprint, and direct and international sales force and customer service; 2) margin expansion opportunities through increased private label and direct sourced goods, global purchasing and distribution scale, and overhead savings (for reference, SPLS, which is viewed as best in class, has margins approx 250-300bps, or 35% higher than ODP in US retail and BSD).  These fundamentals have been and should continue to be augmented by management’s disciplined use of capital to improve returns to shareholders. 

ODP suffered from a stagnant store base and weak sales from 2000-2004 (16 straight quarters of negative comps) while its expense base swelled.  Selling expenses grew approx 10% per year, while sales grew at 3%.  This finally led to the resignation of Chairman and CEO, Bruce Nelson, in October 2004 and set the stage for ODP to hire Steve Odland, who made a name for himself as CEO of AZO.  During his tenure, AZO’s operating margins grew 670bps to 18%, EPS compounded at 45%, and shares appreciated approx. 275%.   So far, results at ODP under Odland have been positive.   U.S. retail margins have improved 210bps to 7.0%, BSD margins have improved 120bps to 8.0%, and G&A has declined in absolute $’s and 60bps as a % of sales.  International operations improved in 2006 with constant currency sales +7% and margins +80bps, after a difficult 2005 caused by heightened promotion in the face of a weak Western European economic environment.  ODP has posted 7 straight quarters of 20%+ EPS growth and repurchased 55M shares (17% of outstanding).  ROIC increased 300bps to 15.5% in 2006 and ROE increased 730bps to 22%.  New mgmt is highly incentivized to deliver positive returns, as they have received meaningful options and restricted stock awards.

As Odland’s initiatives gained traction, the stock rose approx 130% between May ’05 and May ’06, driven by positive surprises and estimate momentum.  The market extrapolated the strong initial margin improvements and assumed ODP would quickly grow from 4% EBIT towards a SPLS-like 8%, stretching the forward earnings multiple to 20X+.  ODP has continued to deliver earnings better than expectations, but with the stock priced for perfection, fundamental blemishes began to disappoint. 

In Q206, retail comps were lower than expected at 1%, breaking a string of 3-5% comps, gross margin improvement slowed slightly Q/Q, and a lower tax rate resulted in the lion’s share of the EPS outperformance.  In Q306, sales were robust, but margin growth was slowed by increased store expansion.  Mgmt also announced accelerated retail expansion and remodel plans for 07/08, which gave the market pause on margin expectations.  In Q406, retail comps were a little disappointing at +1% and BSD negatively surprised the market taking a margin hit on investments and integration, but the quarter still beat expectations on very strong retail margins and international performance.  Given concerns about sluggish retail comps, more difficult margin comparisons, accelerated expansion plans, and the potential for global business spending slowdown, the stock has sold off almost 25% since mid-October.  

ODP is now in the penalty box, but I believe it has been overdone.  The market has taken a “show me” stance to this story, but ODP should be able to meet or beat lowered expectations over the next 6-12 months, and once the market realizes there is leverage left in the model, the stock will no longer trade at such a discount and should move back into the $40’s.  

Mgmt has recently shown confidence in its ability to meet lowered expectations.  Mid-to-high single digit revenue growth and margin expansion of 30bps per year in 07/08 (down from projected 50-75bps) should be achievable primarily through square footage expansion, increased private label penetration, and continued G&A rationalization, with meaningful upside potential.  These assumptions work out to low-to-mid teens operating profit growth.  Annual repurchases of $200-250M will add 2-2.5% to EPS growth.  

U.S. Retail

Mgmt believes it can double the current store base in a fragmented industry that has seen little net store growth in the last few years.  ODP projects 150 new stores in 2007 (+13%), focused on existing and new markets alike.  Mgmt is also planning to accelerate store remodels, using the improved M2 format – 500 stores are currently in this format (incl all new stores) which has enhanced the shopping experience, and the rest of the chain should be updated in next 2-3 years.  So far these store investments have been ROIC accretive.    The increased remodels, along with cannibalization in existing markets and continued mix shift to private label are likely to pressure comps in the short term, but this is baked into current expectations.

2006 retail sales increased 6% (comps +2%) and margins grew 100bps.  Margins are being driven by the aggressive push towards private label – currently estimated in mid 20% range of sales with goal of pushing past 30% (each ppt of private label is approx 10bps margin improvement).  Retail margins are also benefiting from improved attachment selling, ramping of copy, print and ship services, which earn double the segment margin, more sophisticated pricing and logistics systems, and cost containment efforts. 

ODP’s retail margins lag SPLS by more than 250bps.  SPLS has a better real estate portfolio, with newer stores, larger in-market concentrations and less competitive overlap.  ODP also has a slightly larger mix of furniture and technology products (40% vs 30%), which are lower margin.  Given these structural differences, it’s probably reasonable to assume SPLS will remain the leader here, but ODP appears well positioned to continue closing the gap by at least another percentage point.

BSD

The direct business (more profitable than retail) is a consistent topline grower for ODP, with organic growth in mid single digit range.  2006 had a lot of moving pieces, as there was a significant acquisition to bolster presence in northeast (Allied), the Viking catalogue brand name (acquired in 1998) was discontinued in U.S., and investments were made to improve and rationalize call center customer services and beef up direct sales force.  Margins were flattish for the year due to a surprising Q4, in which normalized margins were down 200bps due to investments in sales force and customer service functions.  Mgmt said these investments will moderate over the next few quarters.  This is now baked into expectations, and these investments should begin paying dividends as we move through 2007.

ODP’s BSD margins lag SPLS by more than 250bps.  ODP has a slightly larger mix of lower margin contract business vs standard commercial delivery (50% vs 35% for SPLS), but mgmt is focused on optimizing its pricing and customer penetration in this division and again appears positioned to continue closing this margin gap.  Increased private label penetration, supply chain rationalization, and cost containment should further boost the BSD margin.

International

The international business is approx 85% direct and 15% retail, and aside from a group of company owned retail stores in Japan and a number of small acquisitions and JV’s across the globe, ODP’s international operations are almost exclusively in Western Europe, with leading positions in France, the UK, Spain and Germany.  This business basically doubled in size with the 2003 acquisition of Guilbert, a leading contract provider.  International is perhaps the most underappreciated piece of the ODP story.  Results were solid in 2006, with revenues +5% and profits +20%, with improvement accelerating in the second half.  This business is benefiting from economic improvement in Western Europe as well as tuck in acquisitions focused in Eastern Europe and Asia.   Mgmt is working to streamline the international organization, driving out redundancies and developing scale in what has traditionally been independent regional operations.  Call centers are being rationalized, and mgmt is beefing up its sales force to create a more aggressive sales culture.  They appear to be turning the corner after a few challenging years marked by a negative macro environment and difficulty with the integration of Guilbert, which seems to be behind them.

Expectations for international are not exceedingly high: it appears mid single digit revs growth are expected along with margin improvements in line with 30bps expectations.  With strength in the Western European business, the potential to scale into new market penetration, and sales force and cost containment opportunities, this segment could very well provide upside going forward.  At the very least it provides a very solid, diversified profit stream.

It is difficult to find a good benchmark for profitability here, as ODP has more scale than its European competitors.  It does seem reasonable to assume ODP can return to or exceed its 7.8% margin from 2004 (6.8% in 2006).  SPLS, OMX, and Dutch company Buhrmann have European businesses that are much smaller and less profitable than ODP’s, but it is important to point out that like ODP, these operations all improved in 2006 and have positive outlooks for 2007.

Balance Sheet/FCF

ODP has modest debt leverage with approx $450M in net debt at 12/31/06, but they do lease 90% of their retail stores.  Mgmt has not shown the desire to take on additional leverage to fund share repurchase, although I would not be surprised to see a more aggressive short term posture given the recent share price.  Run rate operating cash flow is approx $850M, although working capital mgmt (a hallmark of Steve Odland at AZO) could continue to be a benefit here.  Mgmt has guided to $550-600M capex in 2007 and $600-650M in 2008 to fund expansion and remodel programs; this compares to $343M in 2006.  Clearly share repo will slow from the 2005/06 pace, but $200-250M in excess FCF will still be available, and mgmt has made clear its intent.

U.S. Industry Snapshot

The U.S. office supplies market is estimated to be $325B.  Retail is approx 65% and growing around 2.5-3%.  Commercial/contract is 35% and growing closer to 4%.  The market is extremely fragmented, with the 3 main office supply stores (SPLS, ODP, and OMX) accounting for only 10% of total sales.  These three superstores expanded their footprints rapidly in the late 90’s – growing overall stores base 15-20% annually (‘95-‘99).  Markets got oversaturated and pricing became irrational, crushing comps and margins (‘99-‘01).  Consequently, store growth has been much more controlled averaging 2-3% (‘01-‘06) driven by SPLS, with OMX being a net store closer.  Store expansion is now projected to ramp back to 8-9% (‘07-‘08) driven by ODP, as it increases penetration in current and new markets.  The largest competing channels are independent/specialty retail, contract specialists, discount stores, and grocery, each accounting for approx 20%.  By category, paper products and basic supplies account for 40% of sales, technology and accessories are 40%, furniture is 15% and 5% is other items/services.  

Customer profiles for the office supply stores range from an individual consumer to a small business manager to a Fortune 500 company, thus the different channels of delivery.  At retail, the customer is interested in convenience, though it is still estimated that 65% of traffic and 80% of revenues is business related – primarily small business.  Through direct channels, service is provided to small and medium sized businesses through mail order catalogues and internet interface, while larger clients (corporate and government) generally have direct sales reps and buy on a contracted basis.  Direct clients are also free to shop in store, where any applicable terms apply.  For reference, in the U.S., it is estimated ODP’s retail = 60%, traditional delivery = 20%, and contracted = 20% of revenues.  Internationally, its estimated retail = 15%, delivery = 40%, contract = 45% of revenues.

Risks

Store growth/saturation:  This is my biggest concern given this industry’s past and the reacceleration of store expansion at ODP and OMX.  That said, ODP is under penetrated in a lot of existing markets and certain regions of the country and believes the store base can be doubled profitably, taking share from a still significant independent operator population.  If returns on expansion begin to suffer for some reason, mgmt has said it is willing to pull back and reallocate its capital.  SPLS made a notable comment on a recent conference call, saying they are not seeing any signs of irrational competition or pricing.  In fact they are seeing some of strongest comp sales in most heavily stored markets in the US. 

Cyclicality:  There is no doubt these businesses are closely tied to the business spending cycle – even at retail it is estimated 80% of purchases are business related.  This could be viewed as a positive relative to other retailers in the event some sort of housing related consumer credit crunch.  I also believe it is mitigated somewhat by the continued strength in small business and service related jobs in the U.S.  Certainly ODP’s international exposure is a positive here.

If these two issues are a non-starter for this investment idea, I might suggest evaluating a paired trade, shorting OMX against a long position in ODP.  OMX looks similar to ODP 9 months ago (in fact its turn around has probably attracted money away from ODP), but OMX has an older store profile with an inferior real estate footprint, and its commercial business is structurally lower margin due to its predominantly large contracted customer base.  The caveat here is that OMX is undergoing its own internal transformation, and its margins have improved significantly, so timing need to be carefully considered.  That said, I am confident its business would suffer if saturation, irrational pricing, or recessionary pressures took hold, and given the valuation and much smaller international exposure, I would expect OMX to fair much worse than ODP.

Technology category:  ODP has been accused of relying on the low margin technology category to drive sales growth.  Technology was actually flat as % of total retail sales in 2006, and mgmt has discussed its focus and success in attachment sales and less promotional pricing.  This is a meaningful category and is a necessary evil to some extent, but it does not appear to be a dilutive sales crutch at this point. 

One other notable point while on this topic is the effect of the MSFT Vista rollout.  Computer and software sales were soft leading up to the January 31 launch, as purchases were deferred and vendors cut back on supplies.  ODP commented that sales recovered to normal levels after the release, which should help comps later in the year, although no one seems to think this will be a major driver of incremental sales for the office supply stores (SPLS would not comment on post-Vista trends).

Valuation

Based on current estimates, ODP is trading at almost exactly the same valuation as it was when Steve Odland was hired in early 2005.  Relative to peers and past, the stock just appears too cheap on reasonable expectations at 13.0X 08 EPS, a 15-20% discount to SPLS at 15.6X and OMX at 17.3X.  The hardline retail group (SPLS, OMX, AAP, AZO, ORLY, BBY, PETM, BBBY, WSM, TSCO, HD, LOW) trades at an average 15.8X 08 EPS.

Conclusion

As the momentum of the turnaround at ODP has slowed, I believe there has been a rotation in the holder base causing a temporary anomaly in its valuation. With good diversification and visibility into mid-to-high teens EPS growth with upside potential, I believe ODP should trade closer to 15-16x forward earnings, more in line with peers and its historic multiple.  This would yield a share price in the low $40 range.  Meanwhile at 13x forward P/E and 8x forward EBITDA, I believe there is significant downside protection.  The market’s expectations are relatively low, ODP has a mgmt team that has shown it will aggressively repurchase shares, and in the parlance of our times, it could certainly prove to be a buyout candidate, given its strong market position and FCF characteristics.             

Catalyst