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Take a Memo - Staples Needed for Your Portfolio

February 09, 2012 | About:
David Chulak

David Chulak

29 followers
Staples Inc. (SPLS)

Recent Price: $ 14.96

Intrinsic Value: $22-$30

Margin of Safety: 32%-40%

Market Cap: 10,463

Enterprise Value: 11,390

GuruFocus Predictability: 3 Stars

Motley Fool CAPS: 4 Stars

Morningstar: 5 Stars

Business:

Staples, founded in 1986, is the world’s largest office products company with revenue just under $25

billion for the trailing 12 months ($24.978). The business has three different segments, including North American Retail, North American Delivery and International.

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Staples has approximately 2,300 super stores, with 83% located in the U.S. and Canada. The remainder are located in 26 different countries, including the UK, Germany, Netherlands, Portugal, China, Norway, Australia, Sweden, Finland, Belgium and Argentina. Inventor of the office products super store, Staples has expanded its business to become the world’s second largest e-commerce company, behind Amazon.

The business consists of sales of office supplies, electronincs, technology and furniture designed for the office or home. In addition, they have printing services and computer repair. They have developed their own brand label which is allowing them to increase their margins.

Market Observations:

Staples has taken a hit due to the economic slump in Europe and the U.S. With the largest percentage of their stores in North America, they stand to benefit as a recovery develops here in the U.S. With their expansion into areas such as China, South America and Australia, they have plenty of room for future growth. While the decline in Europe will continue to impede sales, their higher margin products and cost cutting should enable them to grow modestly as the recovery takes hold.

Weak housing and high unemployment have certainly taken their toll; however, Staples as continued to modestly expand with the number of stores. With only 28 stores in China and 2 in Argentina, the room for future expansion is still great. It is estimated that their growth in stores should be between 30 to 40 per year.

As the largest office products company, they are larger than the two nearest and best-known competitors, Officemax Inc. (OMX) and Office Depot Inc. (ODP). Both competitors are losing market share, which can only enhance Staples' bottom line as the economy improves. Modest growth is predicted for 2012.

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Buy Rationale:

As they continue to grab market share, Staples continues to have a great balance sheet and substantial free cash flow. With their good management strategies, they continue to modestly expand into emerging markets. They are reasonably priced ($14.96) with a margin of safety of 32-40% or an approximate price of $22-30.

While I see no economic moat for the company, they have vastly increased their bargaining power for purchasing supplies and have increased their efficiency in delivering the products to their customers. Their exclusive brand name is allowing them to lower prices, making them a leader. It is estimated that their private brand has lowered prices of some of their products 10-15% compared to other known merchandise, and yet has allowed them to increase their margins, even as prices come down.

Finally, note that Staples is using their cash flow to invest in the business, making some acquisitions, increase dividends and continue their share repurchasing program. Recently, they have increased the amount of share repurchasing from approximately $400 million to $600 million.

Gurus invested:

Currently, GuruFocus indicates that Joel Greenblatt, Mario Gabelli, David Dreman, Arnold Van Den Berg, John Hussman, Brian Rogers, Richard Aster Jr., Robert Olstein, Richard Pzena and Ray Dalio all hold shares in Staples. Richard Pzena holds 3.45% of the shares outstanding (source: Gurufocus).

Competitors and Metrics:

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Though no moat exists, many have speculated that stores such as Walmart, Target and Amazon

will endeavor to compete directly against Staples. Staples, however, continues to take market share from its current competitors of OfficeMax and Office Depot and has been able to increase its margins. It is the low-cost provider, making it difficult, but not impossible to compete. I do not believe that these stores will endeavor to challenge Staples' No. 1 position any time soon.

Valuation:

Note that Staples is selling towards the lower part of its historical trading range. The average P/E over the last 10 years is 19, which is currently at 11.

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GuruFocus' DCF Calculator indicates a fair value of $21.98, at the lower end of our intrinsic valuation

estimate of $22-30.

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Morningstar places Staples' fair value at $25, or the middle of our range. The valuation method I use consists of several methods, including reverse discounted cash flow analysis, dcf (both single and double stage), Graham number, discounted earnings and discounted book value and determining average prices and margins of safety based upon all of them. Further, the analysis extends to finding stocks that sell for less than 10 times EBIT and/or 15 times free cash flow, preferably finding them at 8 times EBIT or less and 12 times free cash flow or less. Staples is currently selling for 7.4 times EBIT and 10.3 time free cash flow.

Once again, using several averages for determining growth rates to use for valuation, I am using an earnings growth rate of 7.64%. This is an average of 10, 5, 3 and 1-year growth rates and Graham’s 10-year average procedure. Averaging out the earnings growth rate down to about 7.6% and lowering the P/E from its historical average of 19 to 14 allows me to use conservative numbers.

Taking current earnings per share value of 1.36 and estimating earnings out five years at 7.64%, adding in dividends and using a P/E of 14, gives me an intrinsic value of $29.96, at the high end of our range and allows us a Buffett-style 15% hurdle by purchasing at $14.90, or about where the stock currently is. Staples' 10-year free cash flow growth rate is 12.7%. Using a perpetuity growth rate of 4% and a discount rate of 12% and lowering the fcf growth rate to 8%, gives me a discounted cash flow intrinsic value of approximately $25 or a margin of safety of 40%.

Last, using a reverse discounted cash flow chart, I can get down to using a 1% free cash flow growth rate to justify the current price.

Financial Health:

Staples has a strong balance sheet with approximately $1.1 billion in free cash flow. Their long-term debt is continuing to diminish and with the share repurchase program looks strong and able to withstand the slow economy. Return on equity, return on assets and return on invested capital have all been trending

up. Margins for the latest quarter have also improved. The debt to equity has gone from 40.40 in 2009 down to 27.70 in the latest quarter.

Management:

Ronald Sargent has been the CEO since 2002 and chairman since 2005. He has been with Staples for approximately 25 years. His salary appears to be fair in comparison to companies around the same size. The trending up of key metrics, such as ROIC, ROA and ROE speak well, though there is room for improvement.

The company appears to be cautious in their guidance due to the economic slump, but appears to have a clear plan for future growth. Mr. Sargent also has served as a director for Mattel Inc., The Kroger Company, Yankee Candle Company and Aramark Corp.

Bull Case:

Low-cost provider, making it more difficult to switch to competitors

Margins continue to increase

The company is situated well to continue expansion into emerging markets and unserved markets and continues to modestly grow.

Adding higher margin products

Impressive cash flow to solidify their No. 1 position and enough cash to weather any financial storms

Experience of management team

Bear Case:

Economic concerns

Little product differentiation

Unable to expand in Europe until recessionary times have eased

Competition from large retailers, including Wal-Mart, Target and Amazon

Cyclical company that continues to hurt due to unemployment

Conclusion:

With low expectations and a good balance sheet, the prospects for Staples look good in the U.S. As the economy slowly improves, the company should exceed the current low expectations. Europe continues to sap the strength out of most companies and will continue to do so until the debt crisis is at least on

a path to recovery. When improvement does come, Staples stands ready to increase its market share and profitability. Management appears to be diligent in improving critical metrics during the crisis and should be able to continue the good record. Its share repurchasing program should continue to bring value to its shareholders with its current undervalued price. It is pushing to increasing the margins in its international arena to match the higher margins in other divisions. Staples is a buy.

Disclosure:

I am long on Staples

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

Rating: 3.7/5 (14 votes)

Comments

batbeer2
Batbeer2 premium member - 2 years ago
Thanks for an article worth reading.

>> While I see no economic moat for the company, they have vastly increased their bargaining power for purchasing supplies and have increased their efficiency in delivering the products to their customers.

For delivery, I believe there is are barriers to entry other than purchasing power. Office supplies are heavy. Particularly in relation to their value. Transport is probably 20-50% of the total cost.

If you are dominant in a particular geographic area, you can send a single truck with supplies through town and drop off supplies at every other office. If your market share is lower, you have to dispatch a truck for each order. Your costs will be higher, and you'll get killed.

Think garbage collection in reverse.
davidchulak
Davidchulak premium member - 2 years ago
Good point. They are truly working on their delivery efficiencies, so they could be working towards building a moat, however small. Just don't think they are there yet. My money says they will get there with there plan. Thanks for the nice words.

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