Description

10/19/10

Staples (SPLS) is the leading office supply franchise with a long track record of outperforming its industry, consistently growing share, sales and margins.  At SPLS' core is a valuable direct delivery business (48% of profit) with sticky customers and recurring sales, better ROIC, sales growth and margin potential than the more visible retail business (43% of profit).  Through its delivery business SPLS is actually the #2 internet retailer behind Amazon.  I expect SPLS can grow topline ~5-6% p.a. long term as it continues to take share in delivery, and can grow operating earnings in the low to mid double digits over a 5 year period as retail rebounds and delivery continues to achieve synergies from the $4.4B Corporate Express acquisition. 

SPLS is priced at ~12.7x consensus FY11 earnings, 12.1x earnings ex acquisition amort.  SPLS has a >8% FCF yield which will be primarily directed towards dividends and stock buybacks.  I think a buy and hold of Staples can compound value at a 20% CAGR over the next 5 years (see valuation).  If Staples priced at a 16x forward P/E (18.5x historical avg., 16x current FY10 multiple), it would generate a ~50% return over 15 months.

All in, I think this is a great price for a best in class franchise that is far and away the leader in a category where scale is important, with strong growth and margin runway, generating >40% ROIC and returning cash to shareholders.  By continuing to take share in the downturn, SPLS has largely preserved its margins even as its largest publicly traded comparables (ODP/OMX) have neared EBIT breakeven, which should give it firm footing as it pushes for margin expansion in a recovery.  Many smaller office supply companies have been weakened even more than the ODP/OMX and the market should continue to consolidate.  There is plenty more share in the market for SPLS to take. 

The biggest risk to this idea is if the office supply market enters rapid secular decline.  The market appears satisfied office supplies are a ~3% GDP-type grower, this is the experience through the first wave of digitalization, and I expect the outcome over a medium-term 5-10yr time horizon (which underlies valuations from ODP/OMX to IRM).  Key consumable segments like ink/toner are still steady volume growers, and I expect that a shift in that will only come over a longer generational time horizon (discussed more in the back). 

Company Overview

• $25B sales in 3 segments - North American Delivery, North American Retail & International (mix of delivery and retail in Europe, Australia, and emerging markets)
• In July 2008 purchased Corporate Express for $4.4B
• o Increased SPLS NA Delivery business 50%, almost doubled international business with large European & Australian delivery and retail businesses.
• o Identified $300m of synergies, primarily in delivery business, estimate $120m still haven't hit bottom line
• o Good purchase price - estimate 6.1x EBITA after synergies, but poor timing right before downturn
• o Added $100m of acq. amortization in '09, $60m in '10, which is not added back
• Very strong mgmt team - significantly outperform peers every year, top mgmt averages 16 years tenure at SPLS.

Direct Delivery - $9.6B Sales, $840m EBITA, 8.7% margin.  40% sales, 48% profitability 

• The most attractive SPLS business - direct delivery has sticky customer base with recurring orders, lower overhead and very high ROIC. SPLS is actually the #2 internet retailer behind Amazon.com with $7.7B web sales (#3 is Dell with $4.8B)
• Service N.A. market out of 30 US and 6 Canadian distribution centers
• ~2/3^rd of delivery is contract sales (larger organizations, negotiated pricing, 5-6% margins now, ~8-9% pre Corporate Express), remainder is catalogued pricing through Quill (small/medium businesses) and Staples Business Delivery (small business), which achieve low-double digit margins
• Staples is consistently taking share (see charts). During downturn, sales have declined driven by lower average orders, but Staples continues to see MSD-HSD positive growth from new customers additions. SPLS has higher customer satisfaction ratings and easier to use websites than its competitors, and can deliver excellent value with its scale.
• Fragmented market with competitive advantages from scale. Industry should continue to consolidate benefitting all players. Following Corporate Express acquisition, SPLS is now larger than ODP and OMX combined, but still has only ~10% total share of the market (many regional/private players) and has plenty of room for continued growth.
• Growth - SPLS averaged 12.5% organic growth leading upto the recession. During the downturn organic growth fell to -10%, however SPLS continued taking share with HSD growth from new customers. This share gain is seen in comparison to ODP and OMX delivery where sales declined 5-8% more than SPLS.
• o Model assumes 5-7% organic growth once the industry stabilizes. I think this is conservative in a stable employment environment (e.g. persistently high but not growing unemployment). With historical organic growth averaging 12.5%, and SPLS continuing to add new customer sales at HSD rates through the downturn, I expect there is significant growth upside.
• Margins - SPLS has best in class margin (see charts). With the large superstore competitors running at barely breakeven EBIT margins and smaller competitors in trouble, pricing should be stable/growing, and SPLS margins should increase as the industry recovers. SPLS also has ~$100-120m addt'l synergies to take from its Copr Express acquisition that could improve margins 1-1.2% alone.
• o Model assumes ~50-60bps of margin improvement p.a., bringing margins from 9%in FY10e to 10.8% in FY13. I expect this will be conservative, SPLS achieved 11% margins prior to downturn, and with the added scale of Corporate Express and purchasing/logistics efficiencies should allow SPLS to increase margins significantly from 9%
• o The Corporate Express acquisition added a contract business operating at 3-4% margins. SPLS' prior contract business was operating at 8-9% margins. Currently the combined contract business is mix is 2/3^rd SPLS delivery sales with ~5-6% margins. SPLS is just beginning facility and warehouse rationalization, and coupled with purchasing and operating efficiencies, they should be able to boost this margin back to HSD.

Retail  - $9.4B sales, $774m EBITA, 8.3% margin.  39% of sales, 43% of profitability

• >1,871 stores, now opening ~40-50 per year (2.5% store growth, during 2000s was 5-7%)
• o Run a concentrated "city by city" model. Store footprint has room to grow, SPLS just recently entered Chicago, Miami, Denver, Kansas City, Minneapolis they are still not in St. Louis, Austin, Houston, San Antonio, New Orleans Milwaukee, Tuscon, Las Vegas, etc.
• Typical stores are 15-25k sqft (carry 8k SKUs), with some as small as 4k sqft in urban areas (1.2k SKUs). New store model is slightly smaller, 18k sqft. Nearly all stores are leased, with staggered lease expirations.
• Customers are ~25% casual walk ins, 25% home office/power user, 50% small businesss
• SPLS beats competitors with good easy to find locations, well-maintained stores, and available inventory. Very telling is SPLS typically closes only 5-10 stores a year, while OMX and ODP are closing 20-30, off much lower store bases. SPLS chooses good locations and it stores work, while competitors churn poor locations quickly, eating into cash flow. SPLS scale allows for better purchasing and some exclusivity deals and co-brands with major suppliers.
• SPLS results versus competitors is striking (see ODP/OMX comparison chart) - SPLS drives higher SSS growth, closes much fewer locations, and consistently maintains the highest margins (currently >8% margins as competitors have dropped to breakeven in downturn)
• Growth
• o Store openings going forward are assumed net ~50/year (2.5%). With lower sqft on new stores and closures, this equates to 2% sqft growth /year. Assuming 60% new store efficiency, ~1.2% sales growth p.a. from new stores is modeled.
• o Same store sales growth of 2.5% starting in FY12 is moderately conservative versus a consistent history of 3% SSS growth prior to downturn.
• o Near-term, back to school season this year is being reported as flat (hot start then a fizzle), and tough computer comps are possible lapping the release of Windows 7 and with tablets cutting into laptops/netbooks (though computers are only ~6% of sales).
• Margins have room to grow - SPLS is increasing private label from 22% to 30% (private label has 700-800bps more gross margin so ~60bps opportunity), and increasing services such as printing & easy technology help which are higher margin. Growing SSS will leverage rent/labor expenses.
• o Model assumes margins slowly recover to pre-downturn levels (9.7%) by FY13. Mgmt has targeted 10% margins in retail, and it stands to reason there could be further upside when looking at competitors currently operating at breakeven margins.

International - $5.3B sales, $170m EBITA, 3.2% margin.  22% of sales, 8% of profitability

• International is a collection of supply & retail business in Europe, Australia and emerging markets (25 countries total). Overall it is 2/3^rd delivery, 1/3^rd retail. Much of this was built by various acquisitions since 1992, and may not be fully integrated (still different signage/brands etc)
• Mature business (Europe, Australia) are the majority of this segment, but ~5% of the segment is high growth emerging markets businesses. All businesses have substantial share gain opportunity, and the large European business has significant margin expansion opportunity (~3% now, 7.5% targeted).
• Lack of clarity into these businesses, and a difficult European outlook cap value of the international segment, but at only 8% of SPLS' profitability it is far less material than the 2 primary business lines.
• Growth
• o International has grown mostly through acquisition. However organic growth average ex-currency has been ~5-10% leading into the downturn. The more recent Chinese and Indian ventures should add growth. Going forward, I've assumed 4% organic growth once business stabilized in FY12. FY11 growth benefits 4% from current f/x rates.
• Margin
• o Mgmt has targeted a 7.5% margin by 2012. There is certainly upside from current ~3.2% EBITA margin, but it is difficult to pinpoint. I've assumed margin grows to 5% by FY13.

Market Overview & Competitive Landscape

The office supply market has been growing at a 2.5-3% CAGR leading into downturn. 

 [chart won't paste, see Google Docs link]

In 2009 the office supply market continued to fall, with ODP & OMX reporting double digit retail SSS declines (SPLS reported -2.1%) and ODP & OMX reporting mid-teens delivery sales declines (SPLS reported -10%).

Office supply demand is largely driven by employment, particularly business/white collar employement, which has recently turned positive, ahead of general employment conditions (see Appendix 1).  Employment growth may be muted but will likely stay positive over the next 12-24 months as the employment market slowly recovers.  Office supply market growth continues to benefit from a secular shift from manufacturing to services/white collar jobs in the US economy. 

The office supply market is fragmented.  The 3 offices superstores SPLS, OMX and ODP combined generate ~$37B of sales or ~12% of the market.  Below are two different cuts of the market, on the left, SHOPA estimates of sales by channel, on the right, SPLS' estimates of channel share by key customer type.  There is plenty of share available for superstores to continue growing, particularly in the attractive delivery/contract market.

Among the superstores, Staples has consistently outperformed competitors Office Depot and Office Max by a wide margin.  Staples maintains higher margins, higher organic growth, and consistently takes share from its competitors within the office superstore segment, and from fragemented local competitors in the delivery and retail segments. 

SPLS Best in class -- taking share with the highest margins

Staples has been the clear segment leaders among superstores.  Below Staples organic growth and margins are set against its competitors (margins on a fully allocated corporate overhead basis).  SPLS modeled growth & margin assumptions through FY13 forward are also included in the graphs. 

Financing / use of cash - what will they do with an >8% FCF yield?

Staples has historically been a large repurchaser of equity - from 2000-2007 (pre Corporate Express acquisition), SPLS directed 57% of FCF to stock repurchases, 10% to dividends and 30% to acquisitions (primarily one large acquisition, tuck in acquisitions averaged ~10% of FCF over the period). 

Buybacks - SPLS will likely use most of their cash flow for buybacks.  Buybacks were suspended in '08 following the Corporate Express acquisition, and recently reinitiated in June '10.  SPLS repurchased $125m of stock in the first 6 weeks since resuming buybacks.  Staples is generating $1.2-1.6B cash/year and pays approx. $250m in dividends.  I have modeled ~$800-$1B repurchases per year, which allows enough excess cash flow for SPLS to be net cash positive in FY13.  SPLS was repurchasing ~$800m/year leading into the downturn (off a smaller business base pre-Corporate Express acquisition).

Disciplined acquirer - mostly just tuck in acquisitions in delivery or international.  Excluding FY08's $4.4B Corporate Express and FY02's $1.2B Eur. & NA Delivery acquisition, SPLS has used less than 10% of FCF for acquisitions.  The Corporate Express acquisition was attractively priced and strategically valuable - 5.7x EBITDA, 6.1x EBITA after synergies.  Tuck-in acquisitions in the delivery segment tend to be very synergistic and fairly priced.  Tuck-in acquisitions internationally are harder to assess given the varied mix of businesses. 

Staples has $2.5B of debt and $800m of cash.  $2.3B of Staples debt is callable only at T+50 (too expensive to call at current treasury rates), so will likely only be retired as it comes due, with $1.5B not due until 2014.  SPLS $2.3B in notes are trading at ~2% yields in the market, yet SPLS is paying 9.75% interest on its benchmark $1.5B notes due 2014.  Normalizing interest rates on this debt at 3.5% would generate an additional 12c EPS (10% accretion), but this impact does not hit the model as the debt won't be refi'd till due.

FY10e reported earnings have ~20% upside from "easy" non-operational items

I'm not crazy about buying a business that is 50% retail at 16x FY10 earnings.  But a few non-operational items impacting FY10 earnings can quickly make you comfortable 16x is really 13x on a long-term basis:

• non-cash amortization (9c/share, will continue to burden reported earnings going forward)
• a tax rate temporarily 3% too high (SPLS is taking a hit from expiration of US tax rule allowing deference of foreign earnings) (6c/share, will reverse going forward)
• Non-market interest rates. SPLS refi'd during it's acquisition debt during the crisis in early '09. They are paying 9.75% on notes trading at a 2% yield in the market. This will only change as the notes come due (latest in 2014), but nonetheless I'd consider it an abnormal and medium term temporary impact. (12c/share, will reverse with time)

[chart won't paste, see Google Docs link]

Valuation

SPLS has averaged a next 12 months P/E of 15.7x, 16.7x and 18.5x over the past 3, 5 and 10 years.  SPLS is currently trading at 16.1x FY10 P/E.  Applying a 16x multiple to FY12 cash earnings of  $1.90 would yield a $30.50 stock price, or 50% upside over 15 months.  16x earnings is roughly inline with other best in class retailers and direct delivery businesses today. 

[chart won't paste, see Google Docs link]

On an intrinsic buy and hold basis, at current prices I expect SPLS can compound value at a 20% CAGR over the next 5 years.  In the table below, assuming growth rates well below historical averages and mgmt achieving only 70% of the margin expansion they are targeting, SPLS would compound EBIT at an 11% rate, yielding ~20% annual return when coupled with slightly over 8% FCF yield (which should be primarily directed towards buybacks and dividends).  This of course is buy and hold so assumes no multiple/valuation improvement.

Key Risks

•1)       Do office supplies risk secular decline from digilatization?  This seems a potential risk to me, but it isn't discussed much in the market.  While digitalization presents a "paperless" risk, it also enables the accumulation and production of much larger amounts of data, consuming more office supplies, and opening up new sales opportunities (printer ink, memory sticks etc.).  So far, office supplies have grown steadily through widespread digitalization and there does not appear to be a clear and present danger to the market at the moment.  However this risk needs to be monitored closely as business moves to the cloud. 

•2)       Can OMX/ODP get their acts together?  OMX announced a CEO change last week (incoming CEO old head of Aramark's Int'l business) and unveiled a new strategic plan in April, that sounded a lot like SPLS "easy" strategy (focus on efficiency and solutions rather than low price).  With depressed margins and a heavy debtload (50% of TEV) it is too early to believe OMX can shape itself into a formidable competitor. 

•3)       Competition from WMT/TGT/AMZN - The mass retailers are not new to this space.  They have been consistently cited as a threat since the early '00s.  While they certainly present a capable threat, I don't believe the nature of this threat has changed significantly.

•4)       Negative mix shift in delivery could hurt margins - FBR has a sell on SPLS and believes the delivery channel margins will fall with a mix shift towards contract products.  I don't expect this to be the case, as there is probably 100-120bps of synergies still to come through delivery, and SPLS should be able to boost the 3-4% margin Corporate Express contract business up towards SPLS' standalone contract business' 8-9% margins.  In addition, competitors who are heavy in contract have margins near 0% right now, so I expect margins can only expand in this segment as the market recovers and/or competitors consolidate/exit.

Upcoming events

• SPLS annual investor day is October 27^th. SPLS will provide an update, potentially reaffirm longer term margin goals, and likely introduce FY11 guidance. I expect street expecations for ~20% EPS growth can be hit give a few easy tailwinds (tax rate, synergies), and organic growth turning positive
• ODP and OMX report Q3 on Oct 27^th and Oct 28^th, respectively. It appears back to school season has been flat in retail, which could disappoint the market. SPLS is on a January FYE, so will not report Q3 until November.

Postscript - Office Supply demand - will it grow with flat unemployment?

The graph below shows employment trends in a few sectors of the economy.  First to note, employment y-o-y change above tracks closely to SPLS y-o-y numbers.  Finally in 2Q10 as office employment turned positive, SPLS organic growth/SSS turned positive.  From this level you don't need to see a big reduction in unemployment to grow, flat unemployment levels equate to LSD actual job growth as the population expands, with accelerated job growth possible if unemployment starts to decline, which likely provides moderate upside to the model.

Secondly, there is a notable shift in the US economy away from manufacturing, towards white collar / office jobs.  20-year CAGR for office supply jobs is +4%, compared to -1.8% for goods producing jobs.  This trend should continue as the economy continues shifting from blue-collar to white collar work.

[chart won't paste, see Google Docs link]

Postscript - Will digitalization decrease office supply use per capita?  It is a difficult hypothesis to quantify and substantiate.  So far, digitalization has not been decreasing office supply use, and SPLS continues seeing strong volume growth in categories such as ink & toner.  Qualitatively, while computers allow paperless work, they also enable easy paper generation and increase amount of data and information used, printed, revised etc.  Additionally, digitalization provides new products to be sold through the office supply channel (ink/toner, business machines).  The clear historical trend has been steady office supply growth (~3% 5-yr CAGR heading into downturn) and continued office supply growth is a widely accepted assertion.   I expect over a long horizon, office supplies will decline, but this will be driven more by a generational shift in the workforce over generational time horizon.

Catalyst