Description

Officemax (OMX) is the third leading office supply superstore company. It operates nearly 1,000 superstores in 49 states, Puerto Rico, and the U. S. Virgin Islands. OMX also operate stores in Mexico and Brazil through joint ventures. OMX also serves customers via the Internet and a direct-mail catalog channels. It has approximately 125 millions shares outstanding. At $4.45 a share, it has a market cap of $556 millions.

The investment themes for OMX are: turn-around far along in progress, improved focus on store execution and assets utilization, un-leveraged balance sheet, significant free cash flow, and depressed valuation both relative to its competitors and on an absolute basis. I will expand on these themes below.

In the last two years, OMX has re-engineered its infrastructure, improved its marketing focus, and improved its operational execution. Most of the costs involved with these re-engineering and restructuring are behind OMX. These costs resulted in losses for both FY2000 (ending January 27, 2001) and FY2001 (ending January 26, 2002).

OMX has also focused on reducing the inventory level per store while still maintaining a high in-stock position. The reduction in inventory resulted in generation of $184 million of free cash flow. Compared with its competitors, OMX still has rooms for inventory turns improvement – further reducing its working capital requirements and improving free cash flow.

The generation of free cash flow allowed OMX to pay down much of its debt. The company continues to project significant cash flow (EBITDA) for FY2003 at $190 millions. Even after expected capex of $90 millions, it is still expected that OMX will generate $100 millions of free cash flow in FY2003. OMX will also benefit from the tax loss carry forward of $165 millions.

OMX is improving its product selection, especially focusing on higher margin products. For example, it discontinued store-based PC sales. OMX is also focusing on higher margin product mix. It is also expanding its offering in printing and mailing services and office furniture. This improved product mix focusing on margin over volume, and the gradual improvement in pricing stability in the industry will result in continued margin expansion. Coupled with expense control, it is expected that the profit will grow rapidly.

Results from improvement in execution have become evidence in the recent quarters. In the first 6 weeks of the third quarter, back-to-school same store sales increased in the “mid-single digit” range against a back-drop of flat back-to-school sales in the general retail industry. Same store sales for the second quarter increased by 3.4%, compared to a 7% decline in comparable store sales for the same period in 2001.

OMX is projecting EPS of $0.10 to $0.14, excluding any tax benefits or expenses for FY2002 and I am projecting $0.44 (fully taxed at 40%) for FY2003. On these assumptions, OMX shares are trading at a projected PE of 10x of FY2003 EPS. Other valuation comparisons with competitors (Office Depot and Staples) are shown in Table 1. On the basis of PE and P/S, OMX is relatively cheap. With continued improvement in results and the leverage of fixed cost, EPS can grow rapidly, resulting in expansion of P/E
and P/S.

The question is: why is the OMX valuation so low? I believe the analysts still hold a show-me attitude since OMX management has not demonstrated that it can deliver earning growth on a consistent basis. Analyst are also concerned that OMX’s turn-around will take longer to materialize if the economy slows down or enters a double dip recession.

On the other hand, a patient long-term value investor will find that in fact this is an opportune time to buy. When the turn-around is evident and consistent results are produced quarter after quarter, the valuation will not be as attractive as it is today. I do not expect rapid price expansion in the next 3 to 4 months. This will provide the patient
investor with an opportunity to buy in. I expect a value expansion as the turn-around is evident. With continue free-cash flow generation and an un-leveraged balance sheet, a value investor can afford to sit back and wait. If everything works out as I have hoped for, OMX can easily be a 3 bagger within the next 2 to 3 years.


Table 1


OMX ODP SPLS
PE 2002 89 13.5 16.2
PE 2003 10 11.9 13.9
P/S 0.11 0.37 0.63
D/E ratio 0.18 0.31 0.21
Inventory as % of sales* 19.4 N/A 13.5
Sale/assets 2.62 N/A 2.62
Price (9/20/02) 4.45 13.66 13.46
EPS 2002 (Analyst) $0.05** $1.01 $0.83
EPS 2003 (Analyst) $0.44** $1.15 $0.97
ROA Negative 6.19% 8.16%
ROE Negative 13.91% 16.40%

* For Fiscal year ending January 2002. Office Depot’s reporting period ends in March, resulting in difficulties in comparison due to seasonal factors.

** My estimates

Catalyst

Catalyst are:

- Improvement in profit growth consistent with guidance as turn-around takes hold
- Continued free-cash generation
- Valuation expansion (P/E and P/S) due to improved results