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Value Contest Submission: SPLS
Posted by: The Science of Hitting (IP Logged)
Date: August 10, 2012 09:43AM

Six months ago to the day, fellow GuruFocus writer David Chulak laid out the bull case for Staples (SPLS). While the stock performance has been less than stellar (closed today at $13.31), the fundamentals remain strong – and with the window again open for a value contest submission on SPLS, I would like to throw my hat into the ring.

Staples is the world's leading office products company, serving consumers and businesses of all sizes across North America, Europe, Australia, South America and Asia. The company operates via three business segments: North American Delivery, North American Retail and International Operations; here’s the annual breakdown of revenues and business unit income:

Revenues 2007 2008 2009 2010 2011
NA Delivery $6.6B $8.93B $9.64B $9.85B $10B
NA Retail $10B $9.49B $9.36B $9.53B $9.66B
International $2.74B $4.67B $5.27B $5.17B $5.3B
Total $19.37B $23.08B $24.28B $24.55B $25.02B
Unit Income 2007 2008 2009 2010 2011
NA Delivery $713M $803M $787M $841M $878M
NA Retail $949M $770M $775M $770M $804M
International $98M $154M $122M $167M $98M
Total $1.76B $1.73B $1.68B $1.78B $1.78B

This provides us with a starting point to address some of the questions that surround Staples and the office supply industry as a whole. For one, is the threat from Amazon and e-commerce showing up in the retail numbers, or is the recent weakness tied to global economic headwinds? Secondly, what impact has competition had on Staples’ delivery business? Finally, what will be the future impact of operating internationally, particularly in Europe? The answer to these key questions is the basis for my investment in SPLS common stock.

NORTH AMERICAN RETAIL: THE HUNTER OR THE HUNTED?

When the average person thinks of Staples, this is invariably what will run through their head: a big box with a red sign. At the end of 2011, the company operated just over 1900 of those boxes in North America, with 1583 in the United States and 334 in Canada. As a specialized retailer, Staples has been thrown into the mix with the likes of Best Buy (BBY) and Borders, companies that have become (or in the case of Borders, used to be) showrooms for Amazon. As I noted in a recent article (which I won’t reprint here, but suggest you read), I think the comparison between Staples and Borders is unwarranted; here is one critical reason that shouldn’t be overlooked – leverage:

“In fiscal year 2010, Borders reported its fourth consecutive annual loss of more than $100 million, with just $158 million in stockholders’ equity remaining on the balance sheet; sales had declined 21% (cumulatively) over the previous two years, and the company was subject to $2.6 billion of contractual obligations, with $2.3 billion tied to operating lease obligations.

Let’s compare this to Staples: sales have increased nearly 30% since fiscal year 2007 (despite a global recession), which has drove consistent free cash flow generation in excess of $1 billion annually. Contractually, the company has outstanding operating lease obligations of $4.6 billion, or two times the amount of Borders, despite having 4x the number of stores in their portfolio. In addition, roughly 25% of all leases are coming up for renewal in the next three years, leaving management with the option to close, remodel/resize, or renew leases at lower rents.”

Not only is this true for Staples, but this is the case for their key competitors in North America, Office Max (OMX) and Office Depot (ODP); while we can’t directly analyze market penetration among Staples and Amazon (largely due to the company’s poor sales transparency), we can look at SPLS in comparison to their largest competitors and from an industry-wide perspective:

2004 2005 2006 2007 2008 2009 2010 2011
SPLS $8.32B $9.02B $9.89B $10B $9.49B $9.36B $9.53B $9.66B
ODP $5.94B $6.51B $6.79B $6.83B $6.11B $5.11B $4.96B $4.87B
OMX $4.48B $4.53B $4.25B $4.27B $3.96B $3.56B $3.51B $3.50B
Total $18.8B $20.1B $20.9B $21.1B $19.6B $18B $18B $18B

Here is that same data, but in terms of market share:

2004 2005 2006 2007 2008 2009 2010 2011
SPLS 44% 45% 47% 47% 49% 52% 52.9% 54%
ODP 32% 32% 32% 32% 31% 28% 27.6% 27%
OMX 24% 23% 20% 20% 20% 20% 19.5% 19%
Total 100% 100% 100% 100% 100% 100% 100% 100%

The above graphic should speak for itself: The measurable data that we have shows that while the industry has hit a wall in the face of the economic crisis, Staples has outpaced its closest competitors. Looking forward, the key won’t be overall industry growth (although an economic recovery would certainly help); it will be based on same store sales growth driven by store closures across OMX’s and ODP’s retail portfolio. This is critically important to understand, and a key part of my thesis: Staples will continue to grow their North American Retail business despite macroeconomic weakness and increased e-commerce; they will continue to be the hunter picking up share from Office Depot and Office Max.

As has been noted in recent conference calls, Office Depot and Office Max are accelerating their move to either close or resize stores as leases expire; for example, Office Depot noted Tuesday during their Q2 call that 60% of their North American retail locations have lease expirations between now and 2017 – with the potential for a material number of downsizings (they currently have about a dozen 5,000 square foot stores) or flat-out store closures. Office Max is in a similar situation, with 75% of all their stores coming up for renewal between 2011 and 2015; they’ve announced that they expect to close 35 stores this year, and 15-20 per year for the foreseeable future (a number that could be revised upwards based on roughly 100 renewals annually).

While the impact of downsizing retail boxes is a bit of an unknown, the result of a store closure is pretty straightforward: Retailers in the region should pick up a good portion of the abandoned business. Looking at the numbers through 2016 provides some encouragement:

Closures per Year Stores in 2016 (Estimate) Increase in Sales per Store
50 3775 10.8%
75 3650 14.7%
100 3525 18.7%

The sales per store figure assumes that the lost sales are evenly distributed across the reminder of the office supplies retail industry; as I noted above, the real result would likely be an increase in sales and store profitability (disproportionately to the bottom line since those incremental revenue dollars are higher margin) for the remaining retailers – which in almost all situations will include Staples. This math assumes flat industry sales over that time period, which I think is a bit conservative considering the potential boost the industry would see from continued macroeconomic growth (albeit slowly); regardless of the economic environment, the potential 2-3% increase in annual same store sales (and mid-single digit growth in same store profitability) that will come from store closures is currently being overlooked by the market.

On the economy, I would like to point out one thing discussed during Office Max’s Investor Conference in May that’s probably overlooked (many people simply lump any headwinds faced by the office supply industry as structural): the economy has lost 9 million non-farm jobs from the peak in 2008; of the 3.5 million added back since then, only 40% or so (roughly 1.5 million) are beneficial to company’s like Staples (others were in construction, etc). The retail business is dependent upon small and micro business formation, which has struggled badly; this is some food for thought that should be considered when assessing the comp figures in the retail business.

NORTH AMERICAN DELIVERY: FLYING UNDER THE RADAR

I highlighted the basics on the NAD business in an article back in March:

“While most people think of Staples as a retailer, that’s actually not its largest operation: 60% of the company’s sales come from the delivery side of the business, which is comprised of contract (accounting for more than 50% of North American Delivery mix), catalog, dot-com (Staples.com, Quill.com, etc.), and the direct sales business, which collectively serve businesses of all sizes. As an example of their breadth, the company serves more than 60% of the Fortune 100; at the same time, they have more than 200,000 mid-market customers in North America alone. In this segment, the company is increasing share in the mid-market, which is where the profitable business is; in addition, they are continually expanding their Facilities & Breakroom supplies business ($800 million in sales and double-digit growth in 2011) with no signs of slowing down – they currently hold just a low-single digit share in the highly fragmented $23 billion market.”

Rather than state my opinions, let’s look at the same statistical comparison presented above:

2004 2005 2006 2007 2008 2009 2010 2011
SPLS $4.20B $4.95B $5.91B $6.61B $8.93B $9.64B $9.85B $10B
ODP $4.05B $4.30B $4.58B $4.52B $4.14B $3.48B $3.29B $3.26B
OMX $4.37B $4.63B $4.71B $4.82B $4.31B $3.66B $3.63B $3.62B
Total $12.6B $13.9B $15.2B $15.9B $17.4B $16.8B $16.8B $16.9B

And in terms of market share:

2004 2005 2006 2007 2008 2009 2010 2011
SPLS 33% 36% 39% 41% 51% 57% 59% 59.4%
ODP 32% 31% 30% 28% 24% 21% 20% 19.3%
OMX 35% 33% 31% 30% 25% 22% 22% 21.4%
Total 100% 100% 100% 100% 100% 100% 100% 100%

These numbers speak for themselves: From a dead heat in 2004, Staples yet again dominated their competition. Today, the company has a stranglehold on the industry (and growing), while their two main competitors have lost share continuously for years on end. As usually happens, scale leads to outsized profitability: Staples operating profit from the delivery business has more than doubled since 2004, and has continued growing despite 8%-plus unemployment:

2004 2005 2006 2007 2008 2009 2010 2011
EBIT $396M $507M $624M $713M $802M $786M $841M $878M
Margin 9.4% 10.2% 10.6% 10.8% 9.0% 8.2% 8.6% 8.8%

Compare this result to OMX and ODP, who have seen their profitability in the delivery business halve over the same period (to $77 million and $145 million, respectively). As with retail, I think the trend will continue as economies of scale and pure financial strength overpower OMX and ODP.

This is the funny thing about Staples: Here we have a business than has increased revenues and EBIT 13.2% and 12.0% per annum since 2004, respectively, in the face of the worst economic period since the Great Depression; despite this, you rarely here mention of this business…

International Operations: Struggles Across the Pond


Staples international operations have not been spared from the rout in Europe (the largest regions by number of stores are the UK and Germany); let’s look back at what I said in March:

“The company’s international business ($5.3 billion in fiscal year 2011 sales) is struggling, with decent results in the European Contract business being mitigated by weakness in the European Retail business (2011 sales in the local currency were -2%, 0%, -7%, and -5% by quarter, respectively). The company has announced significant cost reductions to attack the general and administrative expense, which is the largest difference for the company between the profitability margins in North America and internationally.”

Again, finding the sweet spot between structural and cyclical headwinds is difficult; I would start by pointing out that the international business accounts for less than a quarter of Staples’ sales (21% in 2011), and that this is another region where scale and financial flexibility should hold sway in the end, particularly in the contract business (estimated at half of international sales).

Much like ODP’s exit from Canada in mid-2011 (which left Staples on its own among the U.S. office superstore chains), I expect Office Max to pull back from its Australian contract business as they face up against a stronger competitor in Staples after the 2008 acquisition of Corporate Express (SPLS has 23 distribution centers in the region, compared to 8 for OMX).

For now, the name of the game at retail is controlling operating costs; while sales have essentially been flat since 2009, unit income decreased from $122 million to $97 million over that same period. While they may struggle for the time being, Staples has the financial strength to ride out the storm; here’s a critical piece of commentary from the Q3 2011 call that tells you what the company is positioning the European business for long-term:

“We're frustrated obviously with our European Retail results, but we continue to believe that it's a good long-term business for us. We're profitable in every country in Europe except for Belgium, and that's 6 stores. Customer reach that we've done continues to show and confirm that the office superstore has a real appeal in terms of convenience, the full line of products that it offers and services. As is the case in the U.S., multichannel is an important part of the business, and I think a distinctive advantage for Staples. We also see a lot of room for improvement, as is evidenced by what you just shared about the last several years, and some good evidence of traction for things like copy center, tech services and attachment selling. So I think although the comp trends have been very difficult, we continue to see a role for the retail business in Europe, although I think certainly, our growth in Europe in the years to come will be more in the mid-market and the dot-com space than it would be with new retail stores.”

Conclusion

At a Sanford Bernstein conference in June, here’s what Staples CEO Ron Sargent said: “In 23 years [in this business], I have seen the ups and the downs; I think this is a business cycle issue, not a secular issue.”

I’ll stick with what I said a few months back: Over the last five years, the company has averaged more than $1 billion in FCF/annum, with nearly $1.2 billion in the most recent year and conservative 2012 guidance of simply exceeding the $1 billion threshold again. In the past couple of years, the company has spent roughly $400 million per year in capital expenditures (already subtracted in the calculation from FCF), which I’m going to say is 100% maintenance to be conservative.

With a market cap of $9.2 billion (as of the close Thursday), the company’s FCF yield is more than thirteen percent; that was used in 2011 on the dividend ($278 million; current yield of 3.3%) and share repurchases ($605 million), which collectively resulted in a payout of 75% of the company’s free cash flow generation for the year.

The actual cash return to shareholders (assuming the P/E is static at roughly 9.5x) is roughly 9.6% per annum at that ratio, and should hit double digits with a tweak in capital allocation (debt repayments will free up an additional $50-100M starting this year); again, just to be clear, this assumes that the company’s growth initiatives are unsuccessful, the international business doesn’t improve, and that the company doesn’t grab share from two weaker competitors (closing stores on a net basis domestically) in Office Max and Office Depot.

At a recent investor conference, Mr. Sargent said that he believed earnings growth over the next 5-10 years would be in the high single digit to low double digits range; today’s market price (using a 12% discount rate) implies that free cash flow will be stagnant in perpetuity.

Using 8% growth over the next decade as a conservative proxy of Mr. Sargent’s expectations (and in-line with GDP in perpetuity), my calculations peg intrinsic value near $24/share, about 80% above Thursday’s close; I believe that the fundamentals warrant an investment in SPLS at the current valuation.



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Re Value Contest Submission: SPLS
Posted by: soule45 (IP Logged)
Date: August 10, 2012 02:58PM

Very nice work. You make a compelling case.


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Value Contest Submission SPLS
Posted by: Bregan (IP Logged)
Date: August 10, 2012 03:56PM

Nice analysis on the different segments. Since SPLS has problems with growth, how big effect do you think that the Australian acquisition had on the post-2007 revenue growth?


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Value Contest Submission SPLS
Posted by: Adib Motiwala (IP Logged)
Date: August 11, 2012 08:29AM

Good work. I would recommend adding the following

1) Balance sheet. how much cash v/s debt and maturities. are they paying off debt etc,
2) valuation. price , Shares outstanding, market cap, net debt, EV and then various valuation metrics (absolute, relative to comps, history etc)
3) capital allocation: you touched on that briefly. expand to show the history of dividend and repurchases and at what prices. Also, talk about their M/A in the last few years and what prices they have paid and how it worked out.
4) management : anything that may be worth discussing.

thanks
Adib


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Value Contest Submission SPLS
Posted by: The Science of Hitting (IP Logged)
Date: August 11, 2012 04:11PM


Soule45,

Thanks for that; I'm glad it was helpful.

Bregan,

For year end January 2009, Corporate Express added $4.2 billion in sales (with $2.3B in NAD and $1.9B in the International business); obviously the organic results don't make the share gains look as impressive, but the results through that point are still pretty staggering. I would also point out that this financial flexibility (and ability to purchase scale) is unique to SPLS among the three companies.

Adib,

At the end of the most recent quarter the company had $6.2 billion in current assets compared to $3.9 billion in current liabilities (includes $438M in debt that will be paid of this year, cutting interest expense materially); cash of $1.2 billion compares to $1.5 billion in long term debt.

On the valuation, I presented price to FCF (assuming all CapEx is maintenance); I think the growth implied at the current price is overly pessimistic.

On capital allocation, dividends increasing but has plenty of room to go at roughly 25% of sustainable FCF; I'm not too happy with the buyback strategy, but think it will be forced on management as cash builds and they avoid M&A (my impression has been that you won't see a big Corporate Express type deal for a couple of years at least) - at least that's what I hope for.

On management, Ron Sargent has been with the company for 23 years, and has been CEO since 2002; he beneficially owns roughly 2 million shares ($27M value) compared to annual compensation of roughly $10M per annum since 2009. This is subjective, but my impression is that they get it: I would expect continued growth of the dividend and repurchases in the future in addition to continued delivery investment and pull back on retail (both domestically and internationally, as noted above).

Thanks for all the comments!


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Value Contest Submission SPLS
Posted by: batbeer2 (IP Logged)
Date: August 11, 2012 04:50PM

Hi Science of Hitting

Thanks for an article worth reading.

>> On the valuation, I presented price to FCF (assuming all CapEx is maintenance)

I believe SPLS spends more on CapEx than its competitors. You can divide capex by PP&E or if you prefer, divide capex over revenue. For this reason, I think your assumption that capex is strictly maintenance is conservative. Also, SPLS is clearly taking market share. This too implies capex is more than what would be needed just to maintain the business.

In the delivery segment, there are some lesser known pure-play competitors. They are pretty good at what they do but lack a retail presence (which may be a good thing). Check out USTR.


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Value Contest Submission SPLS
Posted by: The Science of Hitting (IP Logged)
Date: August 11, 2012 05:45PM

Batbeer,

Agreed on being overly conservative with full CapEx in FCF calculation - the problem comes with putting a number on the growth piece; I simply used the full amount to show that SPLS is a value regardless.

On USTR, thanks for the name; I'll have to look it over this week.

Thanks as always for the comment!



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Value Contest Submission SPLS
Posted by: Adib Motiwala (IP Logged)
Date: August 12, 2012 08:28AM

thanks. the reason i said to list price, share count is that it would be useful to see the context if one were to view this articles months later.. thats all. good work


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Value Contest Submission SPLS
Posted by: The Science of Hitting (IP Logged)
Date: August 12, 2012 09:47PM

Adib,

That's a good point; the stock was at $13.31 the day the article was posted, and the diluted share count is 689.4 million (market cap of $9.17B). Thanks!


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Value Contest Submission SPLS
Posted by: swnyc2 (IP Logged)
Date: August 14, 2012 11:56PM

Nice article. Would someone be willing to make the contrarian case? Interestinglyl, almost 10% of the outstanding shares are sold short. While that provides an opportunity for a short squeeze, it also is evidence of conviction by others that the stock is still substantially overpriced.


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