Description

Summary:

For each of the past 5 years, Staples has experienced double digit top line growth and EBIT margin expansion.  In addition, the Company generates mid-single digit free cash flow yields, but trades at ~15x forward earnings and ~8x 2007 EBITDA.  At $23, we believe Staples has less than $3 of downside and ~$10 of upside over the next twelve months.  The management team has consistently out executed the competition to generate industry leading growth, profit margins, and return on capital.  Staples is the best asset in the office products space trading at its lowest multiple in four years, despite the continued strong top line and bottom line growth. 

Description of the business:

Staples is the largest retailer of office products in the world.  It operates through three segments: North American Retail (54% of sales), Business Delivery (33% of sales), and International (13% of sales).  Staples sells a wide range of products grouped into: Office Supplies (39% of sales), Business Machines (31% of sales), Computer Products (22% of sales), and Office Furniture (8% of sales). 

The North American retail business (1,600+ stores) competes directly with Office Depot (1,200+ stores) and Office Max (900+) stores as well as other retailers like Wal-Mart, Target, and Costco.  The delivery business competes with Office Depot, Office Max, and Corporate Express (CXP) as well as more than a thousand small, local/regional wholesalers throughout the country. 

Investment Thesis:

·         Delivery business:  Staples is fundamentally misunderstood by the market.  Investors view Staples as a traditional retailer, but fail to appropriately value the gem in the portfolio—the delivery business.  The delivery business (~1/3 of sales) has grown at 15% over the past 5 years while EBIT margins have consistently expanded over the same period of time.
It is important to note that the delivery business is significantly more attractive than the retail business (not simply because it has historically enjoyed faster growth).  Delivery customers are much stickier than retail customers and view their purchases as non-discretionary (hard for businesses to delay ordering paper and toner), which creates a more reliable recurring revenue stream for the business.  In addition, the delivery business provides a much better return on capital than the retail business.  As with any distribution business, there are significant economies of scale in the delivery business and, therefore, as SPLS continues to take share in this business, its competitive advantage in delivery will increase.
Staples should continue taking share from poorly run national competitors (ODP, OMX, & CXP) and smaller, regional distributors who do not have the scale to effectively compete with Staples.  In addition, Staples has built a significant competitive advantage in delivery space—driven by their superior execution over the past decade (and as exhibited by their 400bps margin advantage over their closest competitor).

·         North American Retail:  Staples’ retail business is also best in class across all key financial metrics – sales/sq. ft, operating margin, return on capital are all significantly higher than both Office Max and Office Depot.  Staples continues to grow its store base at 6-7%/year without any decline in new store economics.
Staples has built a retail base in Canada that would be nearly impossible for any competitor to replicate.  In addition, the Company has significant room to grow within North America before saturation is a limiting factor. 

·         Management Team:  Staples is run by an excellent management team with a long history in the industry.  They have proven an ability to grow margins even in the face of slowing comps (e.g. comps were down 2% in Q2 yet operating margins expanded once again).  They are very analytical and far superior to their competitors (partly attributable to the high turnover at both ODP and OMX). 

·         Opportunity to continue expanding margins.  Management has committed to 190bps of margin expansion from 2006-2009 (this is a management team that hits their numbers).  Margin expansion will come from: increasing direct sourcing, increasing private label penetration, streamlining the supply chain, improving the operating leverage in the delivery business, and expanding value added services in the retail stores. 

·         Compelling valuation:  Stock is trading near its lowest multiple in 4 years yet growth remains strong.  The Company generates mid-single digits free cash flow and grows at >10%.  Given the growth and free cash flow, we believe SPLS will generate a high-teens return for shareholders over the next 3-5 years.  While the stock has not performed well over the past four years, the fundamentals of the business have remained very strong.  In addition, the delivery business should command a premium given its financial performance.

·         Opportunity to ‘Get Lucky’:  Almost any industry consolidation would be good for SPLS (especially on the delivery side where there would be significant synergies with acquired businesses).  Most likely acquisition candidate would be Corporate Express who has hired bankers and consultants to ‘explore strategic alternatives’.  We believe Staples is the logical buyer for this business as other competitors don’t appear to have the balance sheet to do this and ODP would likely face regulatory issues in Europe.  While this is pure speculation, on paper, the acquisition would make a lot of sense.  As with any distributor roll up, the cost savings opportunities would be significant—not to mention the value coming from improving the overall management of CXP.

Risks:

Delivery:  To date, Staples has been very successful gaining share in the delivery segment.  This has been driven by better execution than the competition.  Future share gains in delivery may become more difficult as Staples has already picked up the low hanging fruit. 

Macroeconomic Risk:  While we believe Staples is less exposed to economic cycles than the average retailer (because >50% of sales are ‘non-discretionary), Staples would still be negatively impacted by a recession in the U.S. (as exhibited by the soft retail comps in Q2 in select markets). 

Increased Competitive Environment:  To date, the competitive environment in office products has been rational and disciplined.  Office Max and Office Depot have avoided pricing wars and irrational new store openings.  If this situation were to change, Staples could be significantly impacted by competitive pressures. 

Catalyst