Description

Staples is ridiculously cheap at the current stock price.  The company’s dividend yield is 3.9% and the stock’s current free cash flow yield is over 13%.  Staples’ stock should be able to increase 50%+ from here with minimal downside risk.

Investors have been fleeing from Staples due to worries about Staples’ European business, due to competitive threats from Amazon, and due to anemic demand for office supply products.  While recognizing that these issues are real and have represented a growth headwind for Staples, the company continues to generate very attractive returns on capital and management is taking increasingly aggressive steps to overcome these issues.  At the same time, Staples should be able to continue taking market share from its weaker competitors, Office Depot and OfficeMax.  I will try to address these issues one at a time.

Europe
It would be an understatement to say that Staples’ acquisition of Corporate Express was a mistake.  The price was high, at 9.7x EBITDA, compared to Staples current valuation of 4.0x EBITDA.  The timing was bad, given that CE was purchased in July 2008, right before a major global recession in white collar employment that hasn’t really ended.  Because of the poor timing, the financing was expensive – Staples has been paying high single digit percent coupons on its debt. Finally, the geographical exposure was and is unattractive.  Other than these issues, the CE acquisition was a stroke of genius. 

Management expected that it could streamline CE’s European business and run it better, bringing operating margins closer to U.S. operating margins.  However, since 2010, margins have actually been declining due to the poor economy in Europe.  Staples has also been slow to implement necessary changes to make this business more profitable.  However, it appears that management has finally lost patience and is now taking more aggressive steps to restructure the business.  They recently announced the closure of 46 stores, representing 14% if their retail network and their intent to sell the money-losing printing business which came with CE.  They are also consolidating “subscale” delivery businesses, which means that markets like Denmark would be served by a delivery distribution center in Sweden.  Importantly, they also named John Wilson, the company’s ex-CFO, as the European division’s new President. 

The debt involved has also hurt EPS.  The company just paid down a $325mm bond with a 7%+ coupon, and a $1.5bn bond is coming due in January 2014 with a 9.75% coupon.  That’s a total of $146.25mm/year in interest payments that will soon disappear, or $0.22/share (and ~$0.15/share after the tax effect).

Investors are currently treating the European business as a liability.  While not as attractive a business as the U.S. business, the European business should be profitable after the restructuring, even with Europe’s economy being as weak as it is.  But Staples is a buy even if you attribute a $0 value to all of Staples’ businesses outside the U.S., which I do in my valuation.

The Amazon.com Threat
I can’t quantify this, but it is safe to assume that Amazon.com has been increasing its share of the office products business.  Without stores, Amazon’s infrastructure costs are lower.  Without sales taxes, their prices are lower.  Without investors who care about profit, their profits can be lower.  Simply put, Amazon’s presence in the office supply market makes it more difficult for Staples to grow revenues and reduces Staples’ pricing power.  The result has been that Staples’ retail business has been growing anemically since 2009.

However, Amazon’s presence is primarily a threat to the Staples retail business.  The delivery business is largely unaffected by Amazon.  The company’s contract customers are not going to use Amazon because Staples provides better prices, better service, and better corporate control.  Amazon is simply not set up to serve medium and large sized businesses when it comes to office products.

Staples is also making adjustments within its retail business to make sure that it can outcompete Amazon.   Management is trying to leverage the competitive strengths Staples has versus Amazon.com.  With its network of physical stores, Staples can provide a seamless cross-channel offering to consumers and small companies who need product immediately.  Staples can also provide services such as technology support, copy & print services, and shredding services, which Amazon cannot easily do, and management plans to further expand its services offering.  Finally, Staples seems intent on competing for consumers and small businesses with Amazon when it comes to selection and pricing, including free delivery. 

With that said, Staples is closing stores and reducing square footage in the U.S. too.  Its proposed strategy can be executed on a smaller, lower cost footprint, but management has been slow to take any aggressive steps until recently.  Current plans are to close ~30 stores/year over the next several years. 

Anemic Demand for Office Supplies  
With white collar employment remaining weak due to the poor economy and office automation reducing demand for paper, the near term outlook for office supplies looks bleak.  If office supply workers use less paper, then they will also use fewer pens, fewer paper clips, etc. 

To offset a slightly declining paper demand trend, Staples has been expanding into new categories.  Staples has become much more aggressive in providing facilities and break room supplies to its customers, and this business at $1bn in annual revenues is growing at 20%/annum.  Management recently announced plans to significantly expand its SKU assortment in order to further penetrate certain industry verticals, hoping to position itself as a single source for companies across many more products than just office supplies.

If these new product initiatives work, or if white collar employment ever starts to increase again, we will see a significant expansion in revenue growth, in the company’s operating margin, and in the valuation multiple that investors assign to this business.

Market Leadership
Despite the numerous headwinds I have mentioned, Staples remains the strongest office supply provider in the United States and Europe.  Compared to its direct rivals, Office Depot and OfficeMax, Staples’ business is far larger, its purchasing power is far greater, and its operations are far more efficient.  As a result, Staples generates high returns on capital, and it should be able to grow EPS even in a slow market by taking market share from its weaker competitors and by buying back shares. 

As just one striking example of the business model advantages that Staples has over its weaker rivals, let’s look at free cash flow.  Over the past twenty four months, Staples has generated $2,163mm in free cash flow, or $3.24 per share.  It has been very aggressive at returning that free cash flow to investors through dividends and share repurchases.  OfficeMax and Office Depot, in contrast, have generated less than $20mm in free cash flow on a combined basis.

Even while Staples faces numerous headwinds, taking market share from OfficeMax and Office Depot should be a revenue and profit growth opportunity going forward.  For years investors have been saying that the office supply market is too small for three competitors.  This certainly is the case today, although I hesitate to predict how and when the industry will eventually consolidate. 

Valuation
I believe a sum of the parts approach makes the most sense here.

The European business is in turnaround mode.  Let’s value it at $0 to be conservative, even though it certainly is worth more than $0.

Turning to North American Retail, I am estimating this year NA Retail revenues will be $9,709mm, business unit operating profits will be $767mm (operating margin of 7.9%), and EBITDA will be $967mm.  The retail business has many of the same headwinds as other retailers, so let’s value it at 3.8x EBITDA, in between the valuation of GameStop and Radio Shak, although I would much rather own Staples than either.  The retail business at a 3.8x EBITDA multiple is worth $3.7bn.

The delivery business is the gem of the company.  I am estimating that this year revenues will be $10.3bn, operating profits will be $872mm (business unit operating margin of 8.5%), and EBITDA will be $1,021mm.  At an 8x multiple, this business is worth $8.2bn.

I am estimating net debt to be $538.2mm.  So I have Staples valued at an EV of $11.8bn and an intrinsic value of $11.3bn, or $16.95/share, using fairly conservative valuation assumptions.  There are a lot of things that could happen that would cause move that valuation up, including better than expected results in Europe or an improved economy.

Risks
I think the company’s market position in office products combined with its free cash flow create a floor on the stock price, but I suppose there are fundamental developments that could turn this into a value trap. 

• Europe could continue to worsen, while management does nothing about it.

• The current global recession worsens and lasts much longer than it already has.

• Management makes execution mistakes that allow Office Depot or Office Max to become more competitive.

• Amazon creates a compelling value proposition for medium and large sized businesses in the office products space.

Catalyst