Description

I advocate shorting United Stationers (“USTR” or the “Company”).   The Company faces numerous secular and structural challenges which I envision will cause a substantial earnings miss and thereby re-rate the stock lower. 

I suspect the insiders who have sold more than $15.5M of USTR stock YTD agree.  For context, insiders own ~2% of shares and they sold a total of $1.1M in 2012.  Moreover, three of the Company’s top five executives (as defined by the 2012 proxy) departed since the end of January 2013, including the CFO who resigned last week, effective immediately, and the CIO/SVP of eBusiness Services who resigned in early August. The CFO resigned after replacing the previous CFO a couple of years ago.  The President of USTR Supply will be assuming the CFO position while the CEO assumes the Supply leadership role on an interim basis.  There has yet to be an announcement for who has assumed the important eBusiness Services leadership role.  The Group President of Lagasse and ORS Narco departed at the end of January.  It is reasonable to assume that recent leadership changes might cause some disruption in business execution.  Although each of these departures was characterized as being motivated in pursuit of another career opportunity, it’s unusual to see 60% of a Company’s top five executives leave a good situation in such a short timeframe.  Perhaps the near-term outlook at USTR, after a rise in its stock by more than 4x the market in the past year, is no longer a good situation? 

United Stationers is a leading wholesale distributor of business products.  The Company has demonstrated a pattern for driving returns.  Since 2002, its ROE has ranged from 11.6%-16.4% in 2012 and its ROIC has ranged from 9.4%-12.9%.  However, I assert there are recent non-recurring benefits and ongoing challenges that will cause the Company’s performance to fall short relative to expectations that are discounted by the more than 70% rise in the stock in the past year.

A summary of the Company’s financial performance since 2008 is shown below.

                        2008                2009                2010                2011                2012                LTM

Sales                $4,987             $4,710             $4,832             $5,005             $5,080             $5,058

EBITDA         $233                $218                $247                $238                $243                $256

EBIT               $189                $177                $210                $204                $207                $218

FCF                 ($161)              $224                $88                  $102                $158                $151

EPS                 $2.02               $1.96               $2.19               $2.51               $2.82               $2.93

The pattern of management departures and insider selling are among the red flags that reinforce my bearish perspective.  There has also been much turnover at the Board level in the past three years.  I believe the management departures and insider selling have been partially prompted by concern among those executives regarding both secular and structural challenges, most notably in the Company’s office product category which comprises over 60% of Company revenue, as well as a stretched valuation driven by an unsustainable recent trend in margin improvements.  There are better opportunities for the three recently departed top five executives and better investment opportunities for the selling insiders.    

At ~8.5x EBITDA (near the high end of the 5-9x range during the last cycle), I think the stock has limited upside and a short investment is likely to generate a return of at least 20% as management struggles to meet expectations in its ongoing pursuit to reposition the Company’s business mix from office products to potentially higher growth and higher margin channels. 

The Company sells ~130,000 products for more than 1,400 manufacturers to ~25,000 reseller customers.  In 2012, the Company’s largest supplier was Hewlett-Packard Company, which represented approximately 18% of its total purchases.  The Company’s customers include independent office products dealers, contract stationers, office products superstores, computer products resellers, office furniture dealers, mass merchandisers, mail order companies, sanitary supply distributors, drug and grocery store chains, e-commerce dealers and other independent distributors.  In 2012, USTR’s largest customer W.B. Mason Co. accounted for 11.6% of net sales and USTR’s top five customers accounted for approximately 26% of net sales.  Although business with Staples, which comprised 10.7% of USTR’s revenue in both 2009 and 2010, has been declining with USTR, the Company’s business with W.B. Mason grew by 8.9% from 2011. In Q2 2013, private label brand products accounted for ~16% of sales.  Sales with the national channel accounted for 11% of sales.  Based on Q2 2013 sales, the Company’s sales mix was as follows:  30% technology products, 27% janitorial/breakroom, 26% traditional office products, 11% industrial, and 6% office furniture. 

None of the national office product superstores (i.e., SPLS, ODP, OMX) is a 10% customer.  Sales generated to the nationals have declined in four of the past five quarters and are down over 19% from 2009-2012.  As a wholesale distributor, USTR is vulnerable to disintermediation as customers scale and shift to more direct sourcing.  This has been evidenced by Staples which did $517M with USTR in 2010 but less than $500M in each of the past two years.  Furthermore, the Company’s office product mix, more than 60% of overall sales, has and will continue to be challenged as the national chains increase their overall market share at the expense of USTR’s higher margin independents.  I anticipate that this disintermediation dynamic will further challenge USTR assuming the pending merger of OfficeMax and Office Depot closes.      

Given the well-documented office product industry challenges (e.g., stagnant job growth, digital migration marginalizing consumables like paper/toner/ink), a merger between OfficeMax and Office Depot was announced earlier this year.  The closure is expected by year-end and although USTR management believes the Company is well-positioned to benefit from the combination, I assert the Company is vulnerable to both top-line and bottom-line pressures as a result of the synergies being pursued by the merged companies.  

OfficeMax and Office Depot recently provided a merger update that reaffirmed its target to achieve $400-600M of total annual cost synergies by the end of the third year following the close of the merger.  An estimated total of $130-200M in synergies are expected to come from purchasing efficiencies related to the combined cost of goods sold, including vendor optimization and SKU harmonization.  This represents ~2% of the combination’s North American spend.  Another ~$70-100M in estimated synergies is expected to result from combining the North American supply chains.  Management of the pending merged companies believe that supply chain network optimization, along with transportation and delivery efficiencies, will generate these significant savings.  This represents 8.5% of the combination’s North American supply chain spend. 

Although USTR’s management is communicating little concern regarding the impact to USTR from the pending merger, it’s inconsistent with the synergy message recently delivered by the management teams of the pending combination.  The notion of “vendor optimization” and “supply chain network optimization” appears to render part of USTR’s business with OMX/ODP to be vulnerable at both the top-line (i.e., the customers further internalize as they optimize their supply chain) and the bottom-line (i.e., the increased balance of power from the combination causes pricing/margin pressure for business that USTR retains). 

Within the office products segment, the primary composition is technology which represented 30% of overall Company Q2 2013 sales.   Approximately half of USTR’s technology sales mix is product sourced from Hewlett-Packard.  Although it is a well-documented secular challenge, the technology mix suffers from the ongoing shift to tablets and a stagnant consumable market for ink and toner.  USTR’s technology business has incurred nine consecutive quarters of decline.  The Company’s technology product category has declined in ten of the past twelve quarters.  Within the office products segment is also furniture, at 6% of overall Q2 2013 sales, and traditional office products, 26% of overall Q2 2013 sales.  These two areas declined in each of the past two quarters.  In the past two years, technology and office furniture each declined, by 5.5% and 6.3%, respectively.  Traditional office products grew over that period by 2.5%.

As witnessed most recently in the Q2 2013 results at Staples, the office supplies sector is challenged.  In North American stores, same store sales declined 3% as customer traffic was down 2% and growth in tablets, facilities/breakroom supplies, and copy/print services was more than offset by weakness in business machines and technology accessories, ink and toner, and computers.  Although some might argue that weakness at Staples is company-specific, I think it is largely related to increased office automation that reduces demand for paper, pens, paper clips, binders and file cabinets.  While Staples cited growth in tablets, the migration to tablets marginalizes USTR’s technology mix.  When it comes to tablets, USTR’s largest technology vendor Hewlett-Packard has no position and therefore USTR is poorly positioned to capitalize on the tablet trend. 

Further challenging USTR is the increased presence of Amazon in the office supply market which marginalizes the national accounts as well as the independents.  According to a recent Deutsche Bank survey of 18 products sold online, Amazon’s prices were, on average, over 25% lower than those of Staples, Office Depot, and OfficeMax.  Moreover, Amazon’s pricing for ink and toners was over 35% lower.  Other than the comps getting easier within USTR’s largest product category (at 30%), it’s difficult to gain confidence that the technology product category will grow for USTR on a sustainable basis.

USTR is only generating growth in janitorial/breakroom and industrial.  USTR management estimates its wholesale penetration in office products resellers is 40-50% but only 7-9% in janitorial/breakroom supplies and 1-3% in industrial supplies.   The Company has seized the janitorial/breakroom and industrial supplies segments through recent acquisitions and it is likely that management will continue pursuing tuck-ins to scale these segments in the near future.  In janitorial/breakroom, the Company’s presence has been driven by its acquisitions of Lagasse (the name by which this segment operates) in 1996, Peerless Paper in 2001, and Sweet Paper in 2005.  The industrial segment has been driven by acquisitions of ORS NASCO in 2007 and OKI Supply in 2012. 

As further evidence of the disintermediation dynamic, Staples embraced breakroom supplies as a category push to offset ongoing weakness in other parts of its business mix.  In ramping this category, they leveraged USTR’s infrastructure but with the validation of the category, Staples has been further internalizing this supply chain.  Management recently acknowledged that the national chains have internalized more of this supply chain component and therefore historical growth from them will continue to moderate. 

Despite softer sales versus expectations in the past two quarters, management was able to post better earnings based on a stronger gross margin.  On a year-over-year basis, in the past quarter, gross margin improved by 108 basis points and operating margin improved by 70 basis points.  In the prior quarter (Q1 2013), gross margin improved by 85 basis points and operating margin improved by 20 basis points.  The past two quarters have benefitted partially from mix and management execution but mostly from non-recurring vendor allowances.  In each of the past two quarters, supplier allowances in rebate contributed 50 basis points in gross margin improvement.  The operating margin in Q2, at 4.6%, was the highest for the Company in more than a decade and although part of the improvement can be ascribed to management execution, the supplier allowance was the largest source of improvement.  I believe the market might be discounting that recent growth in margin is a sustainable trend, regardless of sales growth. 

In regards to the Company’s janitorial/breakroom supply business, I should note that I have been around a similar business for over 45 years.  It’s a ruthless business.  My father competes against Lagasse and despite his business being less than 1% of the total sales generated by Lagasse, he has recently taken business from them.  My father also recently received supplier allowances which are a common practice of the business.  However, his company used part of such to invest in gaining share.  It should be obvious that a competitor with less than 1% the sales of another will not get the same pricing benefits from the same vendors.  Therefore, the anecdotal fact that my father has been able to take business away from Lagasse is meaningful.  To the extent that USTR aims to improve its organic growth profile, price investment (i.e., gross margin erosion) is likely.

Although supplier allowances are common practice with USTR’s vendors, the substantial majority of such is not fixed (over 80% is typically variable) and therefore one should not impute the magnitude of the benefit as recurring.  As evidence of the recent surge in supplier allowances at USTR, I highlight that account receivables for supplier allowances increased by over 19% from year-end 2011 to 2012.  Framed as a percentage of inventory, the increase was 12.6% from 11.0%.  This benefit would have accrued to USTR’s earnings in recent quarters.  In Q2 2013, there is some evidence of moderation of supplier allowances as a percentage of inventory, at 11.6%, but still growing from the prior year’s quarter at 11.1%.  With inventory turns having declined at USTR in each of the pat six quarters, by 3-9% year-over-year, it’s reasonable to assume that supplier allowances (where over 80% is variable) will moderate until management is able to drive increased inventory turns. 

The Company has greatly benefitted from supplier allowances but the trend is unsustainable.  To continue garnering the supplier allowance benefit at its recent pace, management will ultimately have to drive organic growth which might require price investment and therefore a lower gross margin.  Otherwise, the inventory turns will grow through better inventory management which would likely imply less supplier allowances.  There is a delicate balance that management confronts and I assert that margin will be compromised in the near-term relative to market expectations.  Gross margin in the current and following quarter confronts a high hurdle to anniversary and in the absence of achieving a pace of supplier allowance benefits discounted by the market, I believe the Company will disappoint.  The last two quarters have witnessed softer top-line versus expectations but the market embraced the better bottom-line.  I do not envision management can continue delivering the bottom-line upside surprise.  With regards to tougher gross margin comps, Q32012 increased by 50 basis points to 15.8% and Q42012 increased by 170 basis points to 16.2%. 

The recently-departed CFO said on the Q2 2013 call, “As you know, the comps are going to get tougher because we saw some pretty solid gains going into the tail end of the last year and the early part of this year.”  He later continues in responding to a question regarding supplier allowances, “On a more tactical standpoint, as we saw toward the end of last year, being positioned to be able to take advantage of favorable sort of allowance environments and be able to work with our supplier is very important.  So as we go into the tail end of the year, it’s going to be an important lever for us.  Tough comps, again, because we had such a strong finish last year on the allowance area…”  One might argue that these comments are already discounted by the market and the fact that some analyst at Fidelity, which owns 16% of USTR, listened to the conference call and heard this is likely but the probability that I ascribe to the concern that the CFO, who resigned from USTR soon after communicating such concern, is much higher than current and incremental longs are ascribing to it.  For context, even Jefferies which has a $38 target with a hold rating is forecasting 50 basis of gross margin growth in the current quarter as well as 60 basis points of operating margin growth.  I am dubious this margin will be achieved.

Management recently said, “We are in the process of repositioning our business in light of the changes taking place in our industries.  We aspire to become the premier provider of digitally sourced business essentials.”  Management’s repositioning strategy makes sense.  Based on the issues I described pertaining to USTR’s office product category, the Company should improve the mix of its business for the longer-term.  However, with such a repositioning often comes transitory and execution challenges.  The departure of three of a Company’s top five executives within nine months does not inspire confidence regarding smooth execution.

The best shorts are often situations where management is committing questionable accounting and/or business practices.  That is not what I assert here.  I believe USTR is well-managed but confronting too many secular and structural issues to sustain its current valuation and the stock will be re-rated when expectations are missed.  We have recently witnessed a pattern of challenges across USTR’s peer group (including SPLS and Sysco Foods which competes with Lagasse) as well as USTR’s largest supplier (HPQ).  I don’t think existing nor incremental shareholders are ascribing enough risk to the Company’s challenges, at the current valuation.  Moreover, as described, the pattern of management departures and insider selling convinces me that the near-term is likely to be different than discounted by the current price.  That all said, there are of course numerous risk considerations for being short.  These include the stock being a relatively crowded short already (as defined by days to cover), a cash-generative business model with a manageable debt load that is buying back shares (although the reduction to fully-diluted shares is insignificant), and management is aware of the challenges and migrating its business mix accordingly (however, I assert the headwinds in the core office products category at over 60% of sales will overwhelm the repositioning benefits in the shorter-term).  Most importantly, I think the recent benefits of margin growth against disappointing sales is not sustainable when supplier allowances which have been the primary margin benefit are over 80% variable and USTR is contending with declining inventory turns.  Management will either have to accept lower supplier allowances or invest in organic growth through margin degradation.  It might have to accept both in the near-term.  Time will tell but the prior CFO, CIO, and Group President of Lagasse will not have to incur the consequences.

Catalyst

Missed expectations caused by substantial change in supplier allowances in the near term

Ongoing share gains among the office superstores which are increasing their direct sourcing, thereby compromising higher margin independents who incur weakness to their business as the superstores grow in scope and scale

Closure of pending OMX/ODP merger and consequential damage to USTR as the combination implements its synergies

Transitory/execution challenges in repositioning business mix from over 60% office product category