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Staples Stock (SPLS) Is a Steal

Common shares of Staples (SPLS) trade on the NASDAQ at $14 for a market cap of roughly $9.5 billion.

Staples sells office supplies. The company, with 95k employees, operates roughly 2,000 stationery superstores globally and is the No. 2 Internet retailer, second only to Amazon (AMZN) and ahead of Dell (DELL).

Arnold van den Berg, George Soros, Brian Rogers, Whitney Tilson are long SPLS.

Numbers used in this analysis can be found in recent SEC filings:

Business & History



In 1985, Thomas Stemberg is fired after complaining to his boss about the sale of First National Supermarkets’ warehouse division, the division he heads. The division is now sold (without Stemberg) to Supermarket General Corporation, of which Leo Kahn is chairman.

Part of the reason Kahn had been attracted to First National was that it meant getting Stemberg on his team. The two Harvard alumni swap ideas at a Harvard basketball game and after some research decide Stemberg’s proposal to concentrate on office supplies is best.

Traditionally, manufacturers of paper and other items sell their goods to major wholesalers. Wholesalers then sell the goods to dealers and stationery stores. The dealers sell supplies to large corporations, while stores cater to small businesses and individuals. Stemberg’s idea was for a superstore that offered low prices by eliminating two layers of middlemen by buying in bulk, directly from the manufacturers.

1986: The first office supplies superstore opens in Brighton, a suburb of Boston.

1989: IPO, raising $37 million to fund expansion. Though sales had reached $120 million, Staples is still unprofitable due to the cost of rapid expansion.

1996: Staples reaches an agreement to acquire Office Depot for $3.4 billion in stock. Stemberg argues the superstores do not just compete against each other but also with Walmart (WMT), direct marketers, and others. The FTC disagrees and blocks the deal on antitrust grounds.

2002: Ron Sargent (former COO) becomes CEO and is charged with leading Staples through a transition from a growth-oriented firm to a company competing in an increasingly saturated U.S. market.

Sargent launches a remodeling effort and eliminates hundreds of items from the store shelves. Staples now focuses on customers who spend more than $500 per year on office supplies. These customers account for 70% of revenues and 90% of profits. A new slogan, "That was easy" replaces “We got that.”

Internet operations are merged into the company's catalog unit.

Staples surpasses arch rival Office Depot.

2004: SPLS starts operations in China where it's now the largest office supplier with over $ 200m of revenue. Staples is losing money here due to the cost of rapid expansion.

2008: Purchase of Corporate Express for $2.7 billion. The acquisition increases the U.S. delivery business by 50%.

2010: Staples generates $25 billion in sales. $10 B delivery, $9 B retail, and $6 B international; mostly delivery.

Competitive advantages



Direct competition comes from Office Depot (ODP), United Stationers (USTR) and OfficeMax (OMX). By acquiring Corporate Express (CXP), Staples became larger than ODP and OMX combined. Together, the publicly traded giants have 13% of the $300B global office supply market and 40% of the $100B North American delivery segment. All were founded between 1986 and '88.

A glance at the 10-year financials makes it clear SPLS has superior gross margins (>26%). If we exclude delivery specialist United Stationers, we find SG&A as a percentage of revenue is lowest (20%). Meanwhile, Staples is the only one spending an amount on capex that’s roughly equal to DD&A.

SPLS is the only retailer in the group to have increased book value per share since 2001. OMX and ODP don’t pay a dividend and still still managed to lose book value per share.

United Stationers - with no retail operations - does a good job of growing book value and revenue per share. It has done some acquisitions and bought back a load of shares. Still, the company as a whole is basically where it was a decade ago.

Though Staples has dominated this business, this does not mean it wil necessarily do so going forward. We need to understand if there are sustainable advantages.

Advantage 1: I believe superior gross margins come from bargaining power with manufacturers. Staples is the largest purchaser of office products. Wal-mart comes second selling about $ 20B worth of office supplies. This competitive advantage is sustainable.

Advantage 2: Staples has lower SG&A as a fraction of revenue. I believe this is the result of the fraction of revenue from Internet delivery and contract delivery. Delivery requires less (human) capital than classic retail. With delivery, there are significant economies of scale. This advantage is sustainable.

In practice: You've just been hired by Amazon as the manager in charge of taking on Staples. On day one you analyze your competitive position:

0) You've got a popular website; so does Staples. Staples' site is more popular with your target audience though... let's call it a draw.

1) Staples has its own distribution network; you rely on UPS. UPS specializes in parcels not pallets. You can offer a low price but the client soon finds out UPS isn't free.... ouch !

2) Manufacturers won't give you the same deal because you don't have the volume.... ouch !

3) High volume customers want cheap generic (own brand) products, you don't have that. Staples does..... three strikes, you're out.

For good measure we throw a croc into the moat. Staples can and does carry an inventory. Manufacturers like this because business is somewhat seasonal. Your boss at Amazon thinks inventory is a dirty word.

And a (sweetwater) shark. Staples has an extensive database of (potential) clients in the small/home-office space with their individual behaviour and needs. Your database is less comprehensive making Staples' marketing more cost-effective.

You tell your new boss you'd rather go after a different audience; low-volume, high-margin clients looking for specialty products. She likes the sound of that.

Would it matter if you were hired by Wal-mart or Costco instead ?

Balance sheet



Staples has $2.5 billion of debt, $950 million of cash and $1.5 billion of income before interest. A $1.5 billion portion of that debt comes due in 2014. It’s hardly surprising the debt yields less than 3% in the market.

The $1.5 billion of notes that come due in 2014 were issued in 2009 bearing an interest of 9.75%. Refinancing at 3% or retiring that debt would dramatically reduce interest expense of $ 210m.

Risk



Digitization



For decades, people have argued digitization presents a "paperless" risk. This time could be different; don’t bet on it.

Direct Competition



OMX & ODP get their acts together and/or merge. Last year, OMX unveiled a new strategy and hired a new CEO who started working on a five-year plan to boost revenue by offering more services and products tied to computers and catering more to women. OMX used to compete on price; now it doesn’t. Margins in general should rise.

A merger of OMX and ODP (or USTR) would create a formidable company that's still not on par with SPLS. Such a combination would still be smaller and would still not match SPLS' Internet presence. Case in point: the merger of Boise Cascade's $4 B delivery business with OMX's $4 B retail business in 2003 was supposed to create an industry leader. It never happened.

Fraud



Like ODP, SPLS could be caught overcharging on government contracts. That causes a lot of delivery contracts to be breached and awarded to competitors.... http://money.cnn.com/2010/02/15/news/companies/office_depot.fortune/

Management



After raising millions from the IPO in 1986, management has created billions of dollars of value. Senior executives have typically been with the company for more than a decade.

The CEO owns more than a million shares while other officers typically own more than 300k shares. That doesn’t seem like a lot till you realize the CEO is paid about $1.5 million a year. Ron Sargent has 10 x his annual salary in stock and earns less than the CEOs of ODP and OMX. The new guy at OMX makes more than $12 million. He's probably being underpaid for trying to mend a broken company.

Either Staples' managers are idiots or they really love the company. I see no evidence of the former.

Investors could rightly blame management for mistiming the purchase of Corporate Express in 2008. They should also credit the same group for creating an online retailer that is second only to Amazon.

Compare this to ODP CFO Michael Newman. He's the former CFO of Platinum Research Organization (bankrupt per 2009) and OMX CFO Bruce Besanko who used to be the CFO of Circuit City.

Value



Owner earnings

We use FCF as a starting point to estimate the magnitude and sustainability of the cash income available to stockholders.

Since the acquisition of CXP, FCF as reported (GuruFocus) has averaged $1.2 billion. Starting from this, we check to see if FCF doesn't overstate sustainable cash earnings due to unsustainably low capex.

Staples continued spending roughly $450 million on capex; that’s 20% of PP&E which is MUCH more than any competitor spends. The numbers indicate Staples is spending on growth so $1.2 billion is a pessimistic estimate of run-rate owner earnings. Also, interest expense is currently artificially high due to the bad timing of the bond issue.

A pessimistic estimate of IV for an investor seeking 9% (index) returns is 1.2/0.09 = $13 B => $21.

Private market value

Staples paid $2.7 B for Dutch competitor Corporate Express, roughly 20x earnings, 9 x FCF and 7 x EBITDA. The financial numbers are here. CXP had $ 1.6 billion of debt.

Corporate Express itself bid $2.6 billion or 2x revenue for French peer Lyreco. We ignore this data point.

In 2009. BC partners bought 20% of ODP for $ 350m. ODP ran out of cash so they sold shares; still they got 9 x FCF. EBITDA was negative.

The transactions imply Staples, with earnings of $ 800m, EBITDA of $ 1.5 B and FCF of $1.2 B is worth $12 billion => $19.

Catalysts



Share buybacks

Ron Sargent, prior to the acquisition of Corporate Express, used more than half of FCF to repurchase stock. Ten percent was spent on dividends. The stock repurchase plan was reinstated in 2010 they once again have cash to spare on the balance sheet. Using just 50% of current FCF to repurchase shares, will reduce shares outstanding by 10% per annum.

Refinancing of debt

SPLS issued most of its debt in early '09. They’re paying 9.75% on notes now trading at less than 3%. Refinancing that debt or retiring it as it comes due (2014) will have a dramatic impact on interest expense of roughly $200 million. This has a positive effect on the bottom line.

The opportunity exists because



1) The economic outlook is bad.

2) Market participants underestimate the earnings power of a company spending on growth.

Conclusion



Staples has a more solid capital structure, higher margins, a better management team and a superior track record than any of its currently struggling competitors. The company has room for both revenue growth and margin expansion. Mr. market offers us shares of the company at a discount to a pessimistic estimate of intrinsic value.

Disclosure



This is not a recommendation to buy or sell anything. I had no position in any of the stocks mentioned at the time of writing.

Any and all questions welcome as usual.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 3.8/5 (28 votes)

Comments

augustabound
Augustabound - 2 years ago
Private market value is something I'm trying to use a bit more, so I wondered why you use revenue as your base?

I notice some write ups I see use EBITDA and some interviews with gurus mention using this, is there an advantage to one over the other?

DocMoney
DocMoney - 2 years ago
I am a bit concerned about people using private market value because we are not private buyers and have no synergies to extract nor control for which to pay premium.
bmichaud758
Bmichaud758 - 2 years ago
FCF is deceptive in the case of Staples because over $100MM of operating cash flow is stock-based compensation, which is very much an expense as it typically dilutes shareholders via unfavorable strike prices. One can make the case accounting earnings are understated due CAPEX being consistently lower than D&A, but this only adds ~$70MM to earnings, bringing LTM net income to ~$960MM.

ROE over the past two years has been only slightly over a 10% cost of capital (less than 13% in the last two years), thus any retained earnings are only marginally accretive to shareholder value assuming management can even find NPV-positive projects going forward. Also, Staples is subject to tremendous competition and has ZERO pricing power, thus it does not warrant a franchise multiple under a 100% payout scenario (i.e. if a company has the ability to pay out 100% of its earnings yet grow earnings 5% per annum via pricing power, its franchise multiple would be 20X assuming a 10% cost of equity (1/(.1-.05))).

So assuming a 10% cost of equity and that sustainable, distributable FCF to equity is ~$960MM, Staples is fairly valued at its current market cap of $9.6B, and what I would consider a value trap at these levels. Unless of course one can make a credible case for improving ROEs and attractive growth projects going forward.

Of course there is the outside chance of an LBO, but one cannot build a credible case for such an outcome unless there is significant activist money currently in the stock (i.e. Family Dollar).
ken_hoang
Ken_hoang - 2 years ago
thanks for the writeup. SPLS definitely is the bargain when looking at its past operating history. Any specific business risks that they are facing?
tonyg34
Tonyg34 - 2 years ago
The commodity like nature of office products and low switching costs between retailers have made it easy for nontraditional office products retailers such as WMT, COST, AMZN to enter the market. Over the long term, these new low-price competitors could lead to margin erosion. In SPLS case this new competition will likely be offset by the almost inevitable death of OMX and ODP. On the services side SPLS has to compete with FDX in copy and print, and they compete with BBY's Geek Squad in tech service. I don't think that any of these companies service offerings will be able to provide a meaningful source of differentiation for the office products distributors over the long run. I have no opinion on the digitalization of office records, IRM seems to be able to maintain profitability.

So I'm willing to call a draw on the competitive threats front.

With a cash flow yield already above 10% (at current price of $13.50) and a net neutral opinion on competitive advantages, this becomes a debate about the opportunity cost of investing elsewhere (given my muddle-through economic expectations). The refinancing of debt seems like a reliable positive catalyst, kudos to the author for caring enough to take the time to look into it.

You are, of course, going to have to wait until the major N. American and European markets experience something vaguely resembling an economic recovery in order to realize price share appreciation. If the company is able to maintain its FCF and buyback shares you've found a winner.

batbeer2
Batbeer2 premium member - 2 years ago
Hi all, thanks for the comments and questions.

>> I wondered why you use revenue as your base?

Using revenue as a base isn't wrong. Neither is using EBIT(DA) and/or FCF. I personally prefer FCF adjusted for capex but I don't have enough information about recent transactions (yet). If I do find more, I'll use this information to do a better job using diverse bases.

-EDIT- Found some better and more relevant data; article updated.

>> ROE over the past two years has been only slightly over a 10% cost of capital (less than 13% in the last two years), thus any retained earnings are only marginally accretive to shareholder value assuming management can even find NPV-positive projects going forward.

Fair point. Cost of capital for SPLS at present is less than 3%. That's the current yield on their bonds. ROE is depressed now because they issued bonds at 9,75% at the peak of the credit crisis; 2009. IMO they have the option of retiring that debt when it comes due (enough cash(flow) for that) and/or refinancing if rates remain low. In short, the problem you note is very fixable.

>> Unless of course one can make a credible case for improving ROEs and attractive growth projects going forward.

Yes. The acquisition of Corporate express changes the revenue split between delivery and retail from 40/60 to 60/40. Delivery earnings require less capital. You can see this in the numbers for CXP and USTR. Luckily, gurufocus still has them online.

>> over $100MM of operating cash flow is stock-based compensation, which is very much an expense as it typically dilutes shareholders via unfavorable strike prices.

From the march 2010 10-k:

Prior to fiscal 2009, our contributions to the 401(k) Plan were made in the form of common stock, beginning in 2009, these contributions are made in cash, and therefore, are now classified within business unit income.

I see no need to adjust earnings now that the company accounts for this compensation in cash.


>> we are not private buyers and have no synergies to extract nor control for which to pay premium.

None of the approaches I know of is perfect; that's why I think it makes sense to use multiple approaches. Sometimes you will find "private" transactions are at significantly lower prices than the current market price. If that's the case.... think again. I agree that the reverse doesn't prove an asset is cheap.

As an aside... I think an asset is worth more if I don't have control ;-).

For this particular analysis I use transactions of publicly traded companies buying others. These acquirers may have different motives but they do compete for the same assets we do and set a price level.

>> Any specific business risks that they are facing?

Good question. I need some time to think.

- EDIT - Got one. In this industry, suppliers sometimes overcharge on government contracts. That could lose you a lot of business in short order. Updated the article.
bmichaud758
Bmichaud758 - 2 years ago
">> ROE over the past two years has been only slightly over a 10% cost of capital (less than 13% in the last two years), thus any retained earnings are only marginally accretive to shareholder value assuming management can even find NPV-positive projects going forward.Fair point. Cost of capital for SPLS at present is less than 3%. That's the current yield on their bonds. ROE is depressed now because they issued bonds at 9,75% at the peak of the credit crisis; 2009. IMO they have the option of retiring that debt when it comes due (enough cash(flow) for that) and/or refinancing if rates remain low. In short, the problem you note is very fixable."

As of 4/30/2011, SPLS had total capital of $9.4B, which consisted of $7.3B of equity (77%) and $2.1B of debt and minority interest (23%). If the cost of equity (Re) is 10%, the pre-tax cost of debt is 6% (I know it's 9.75%, but I'm assuming they can refi) and the tax rate is 40%, then the WACC is 8.6%.

For purposes of looking at ROE, then the cost of equity is the appropriate return metric, whereas WACC would be utilized for looking at returns on net operating assets (total assets minus non-interest bearing liabilities).

If SPLS refinances its debt from 9.75% down to even 5%, and assuming a 40% tax rate, the after-tax interest rate expense savings on the refi would be $60MM. Capitalized at 10% and divided by share outstanding of 713MM, the per share boost to intrinsic value would be $.85.

">> over $100MM of operating cash flow is stock-based compensation, which is very much an expense as it typically dilutes shareholders via unfavorable strike prices.From the march 2010 10-k:

Prior to fiscal 2009, our contributions to the 401(k) Plan were made in the form of common stock, beginning in 2009, these contributions are made in cash, and therefore, are now classified within business unit income.

I see no need to adjust earnings now that the company accounts for this compensation in cash."

Look at page 5 of the most recent 10Q - for the 26 weeks ending July 30, 2011 stock based comp is $81,470.

">> Unless of course one can make a credible case for improving ROEs and attractive growth projects going forward.Yes. The acquisition of Corporate express changes the revenue split between delivery and retail from 40/60 to 60/40. Delivery earnings require less capital. You can see this in the numbers for CXP. Luckily, gurufocus stills has them online."

Fair enough - however, I would argue that even though that business is less capital intensive, that does not necessarily mean there are growth opportunities. Maybe there are...
batbeer2
Batbeer2 premium member - 2 years ago
Hi Bmichaud758,

Good points, thanks.

You wouldn't believe how bad I am at math (really !) so bear with me if I fudge the numbers.

1) If SPLS refinances its debt from 9.75% down to even 5%, and assuming a 40% tax rate, the after-tax interest rate expense savings on the refi would be $60MM.

Why refinance at 5% if their bonds currently yield less than 3% ?

-EDIT- The current yield on the bonds, IMHO, is the best (not perfect) indicator of the cost of capital for a new project you would have to finance. Given that management is able to grow book value at a decent clip while buying back stock at prices above book value - that's VERY difficult - they know how to allocate capital.

The big problem is that Staples can only call their bonds at treasury rate + .5%. That's not a good idea today, so they have to sweat it out to maturity. You'll notice they've spent about 400m buying back stock this year and still they're sitting on 900m of cash. Saving up to simply retire 1.5B in 2014 is a serious option no ?

2) Look at page 5 of the most recent 10Q - for the 26 weeks ending July 30, 2011 stock based comp is $81,470.

I believe you're right.

bmichaud758
Bmichaud758 - 2 years ago




Hi Bmichaud758,

Good points, thanks.

You wouldn't believe how bad I am at math (really !) so bear with me if I fudge the numbers.

1) If SPLS refinances its debt from 9.75% down to even 5%, and assuming a 40% tax rate, the after-tax interest rate expense savings on the refi would be $60MM.

Why refinance at 5% if their bonds currently yield less than 3% ?

Good point - I did not notice the 3%.

batbeer2
Batbeer2 premium member - 2 years ago


From the Aug - 17 Earnings call:

*****************************************

John Mahoney - CFO

And the only other thing I'd comment on, Ron, is as you get into the business customer, the experience with an Amazon ordering is going to be a little bit more difficult than how we can manage a small business customer's demand. We obviously gear our programs for the small business customer and the simplicity of being able to shop us across all the product categories is a benefit that many small business customers value.

8< 8< 8< SNIP 8< 8< 8<

Daniel Binder - Jefferies & Company

First on, a question really regarding delivery market share versus retail market share gains. You've done just a phenomenal job taking share in delivery and you can see that when we compare the numbers to your competitors. The retail share gains have been a little bit slower by comparison. I'm just curious, if there's anything you think you can do to accelerate that?

********************************************

batbeer2
Batbeer2 premium member - 2 years ago
>> Also, Staples is subject to tremendous competition and has ZERO pricing power, thus it does not warrant a franchise multiple under a 100% payout scenario.

I like your approach but IMO the facts indicate otherwise.

In theory, if two retailers have identical inventory turnover, the one with the best gross margin can drop prices till the competition croaks.

In practice, SPLS is setting the price and OMX and ODP have to match that. They are matching those prices and it's clearly killing them.

In short, IMHO there's evidence SPLS could raise prices without losing market share. They aren't, would you ?
staples.x.exec
Staples.x.exec - 2 years ago


Before you jump in with both feet. I hope you have flippers!

When a company stops high level investment in opening and transitioning new stores after Q2 it should

ring alarm bells.

Secondly when the same company reduces forecasted sales and reduces store level budgets to show an inflated YTD comp and YTD Budget sales, this should also ring bells.

A shrinking retail market for office supplies and a large retail square footage is only going to lead to store closures.

I agree the .com is big, growing and profitable. They will not let this side of the business support the retail foot print.

Store closures, lay offs are around the corner.

There will be a split of the .com business away from the retail side. Amazon ring any bells for you folks.

The copy and print centers and NOT doing the business expected. The Easy Tech business is being down sized as we speak. They are going to demote or fire the lead techs, who are the people who drive the tech business.

When a company redirects its investment capital away from growth and towards measuring its business

(ask them about V.I.B.E.), it means they are circling the wagons.

Trust me I know. I have company shares and I am selling before Q3 results come out.

batbeer2
Batbeer2 premium member - 2 years ago
Good points but they hardly affect the thesis. If Staples needs to reduce spending, the competition is in dire straits.

We may be thinking in different time-frames. I like the prospects of the company for the next 5-10 years. You may be perfectly right regarding near-term results.

Like you, I don't expect growth to come from the old-school retail. It comes from the delivery segment.

Spinning out the online operations may do wonders for the stock price but it doesn't add value. In fact, it destroys value. The webshop would no longer have its own distribution network and less scale. This would put pressure on gross margin in what is admittedly a commodity business.

IMO a breakup would be great for traders and bad for investors.
staples.x.exec
Staples.x.exec - 2 years ago


Ok. I see your point about looking long term, I am right there with you.



Here is what I see and have seen.



As a previously operations led company, they changed to a sales lead culture about 3 years ago.



They implemented a split business model in the stores so that they spread there investment too thin.



As none of the two new businesses paid any real dividends, they are now struggling to have capital to re-invest. They set such high return values from stores at nearly 20% YTD growth, that they will flat line in Q3.



The way they are hoping to avoiding this is by deflating the budgets and goals to appease the market. This is short term figure management to post short term numbers.



With this type of short term management, I don’t see how they can expect the market to think they will grow over the next 5 – 10 years.

batbeer2
Batbeer2 premium member - 2 years ago
>> As none of the two new businesses paid any real dividends, they are now struggling to have capital to re-invest.

Since 2009 Staples has:

- reduced liabilities by 1B and

- added (back) a billion or so to their cash account.

- while paying out roughly 750m in dividends.

That's 2.75B of cold cash they've produced in what has arguably been a bad economic environment. What makes you think they are struggling for capital ?

If they are, what do you think is happening at ODP and OMX ?

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