Description
Staples, the dominant office goods retailer, looks like a short. Serious deterioration in its business environment combined with the need to refi short term debt from last summer’s ill-timed and pricey acquisition of Corporate Express puts their darkening situation out of synch with their valuation.
SPLS still maintains a premium multiple at 7.5x EV/EBITDA and 15x earnings. With a market cap of $12.5 billion and $4.1 billion in debt the EV is approx $16 billion. The general retail space is trading circa 5x EV/EBITDA for low debt companies, and OfficeMax (5.7x) and OfficeDepot (3.7x) are in weaker condition.
Staples has three business units and 2216 total stores doing approx $27B in sales:
North American Retail – 1832 stores in US and Canada. Sales comped down 8% in Q3 (ended Nov 1st), but the October comp was down 12% and management indicated November showed no improvement. This will get worse due to the effect corporate layoffs have on orders. Vast amounts of corporate layoffs have been announced, but most have yet to be executed (there’s a pun for ya). Not wanting to be Scrooge-like, companies are waiting out the Xmas season, but the ax will fall come January. Most of the preannounced layoffs have been in the range of 5% to 30% of headcount, and I believe a vast amount of companies that did not pre-announce are actively planning reductions. When a company fires just 5% to 10% of its workforce, the remaining employees make use of all the extra computer accessories, desk do-dads, business machines, pads/highliters, etc left behind by their departed co-workers. All of those empty desks become competing “mini-Staples stores” which prevent re-ordering from the actual Staples. At a minimum, average order size goes down, which is already happening in Q3. Q4 comps will go below Q3’s negative 8% comp, likely to mid teens negative territory. Q1 will be highly negative as the layoffs effect hits and negative 20% should not surprise.
North American Delivery – This is contract business to large corporate accounts. Sales last qtr were off 1% excluding the acquisition. Most companies that announce layoffs publicly are probably large enough to be serviced in this category. In addition to the layoff effect, consider these Fortune 1000 firms to be in aggressive cost reduction mode which will kill any pricing power hopes. Contracts will be competitively bid and there are literally thousands of distributors. From the Mom&Pops to large distributors, virtually all will be looking to bid aggressively to the large accounts even if it is only as a way to rapidly reduce inventory levels. The acquisition will mask trouble by allowing this unit to show sales growth, but don’t think things are rosy.
International – 334 European stores plus a Delivery business. Comps were down 6% in Q3. Heavily UK oriented, the same job loss situation is happening in their overseas business. In addition, there is a big FX headwind. Currency impacted top line by 100 bps and 0.01 eps during the last reported quarter in which the Euro averaged 1.42. Since then, during Q4 it has fallen to average 1.31 so the headwind has increased though the Euro did rally to 1.40 over the past two weeks.
The acquisition of Corporate Express was announced at the top of the market in May 2008 and closed in early August. They paid 10x EBITDA or $2.8 billion and picked up a contract style business similar to their “Delivery” unit, with $8 billion in sales (half in North America, half international), and a 3.5% operating margin. This was financed with term debt and though they have already refinanced $500m during the current quarter, they need to do another $2.5 billion by July 2009. In early December, cash was sub $300m and credit line availability as of Nov 1 was $686m, so under 1 billion available with a $2.5 billion need in seven months. Not surprisingly, they are going to try and tap the debt market which will be costly.
The street seems to believe management’s annual synergies estimate of $300m will materialize through vendor pricing & terms, increased use of private label brands, inventory reductions, and warehouse/facility integration. This sounds high, especially from the vendors to whom they were already getting best price & terms as the 800 lb gorilla in their space. They don’t plan to reach the 300m estimate for three years and little is expected in the first year. Also, they’ve said 80% of the $300m will be in the North American business which has approximately $4 billion of revenue. So, 6% of sales or $240m will come out of a $4 billion business that already has razor thin op margins of 3.5%. And, this is while the overall business lost 231 basis points of gross margin last quarter. It just doesn’t seem reasonable.
The bull case is a strong management team that has produced double digit top line while expanding margins, and is the clear category leader. The CEO is making rounds talking up differentiating the brand, market leadership, and strong execution. It sounds good, but doesn’t help tanking sales and margins. On a small base, they are opening 10 copy & print shops next year to go after higher margin business a la Kinkos.
Competition
Wal-Mart and others have long had competitive offerings, but now Sam’s Club and Costco are getting in the game with increased offerings and print shops. Office Depot is closing 126 stores, presumably their worst and not enough to make a meaningful share gain for SPLS.
SPLS is currently at $17.57 per share and 7.5x their $2.1 billion of EBITDA. Given the difficult environment, the additional $280m of acquired EBITDA will only offset declines in their core business resulting in flat EBITDA for 2009. Through this difficult year we’ll see their estimates come down and the multiple contract to at least to 6x which would put the stock below $12 or off over 30%. Add to that some potential treble from a refinancing and we could see this stock at $9.
Catalyst
Weakening y/y comps, estimates to be lowered, refi trouble, integration savings delays, fx headwind, in a bad retail environ.