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The Next Borders?

June 14, 2012 | About:
The Science of Hitting

The Science of Hitting

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Bill Ackman, who is well known for a multitude of successful investments throughout his career, has also made some high profile mistakes; one particularly relevant example was an investment in Borders Group. Ackman started buying the retailer in the third quarter of 2006, eventually acquiring a stake worth $200 million; in February 2010, Mr. Ackman had this to say in a CNBC interview: “I think the company has stabilized. The stock trades as if it’s going bankrupt but we don’t see it as a likely bankruptcy”, and even called it a “low probability event”.

Fast forward 12 months, and that low probability event had played out: Borders filed for Chapter 11 protection in February of 2011. In subsequent interviews, Ackman would go as far as saying this was the worst investment Pershing Square had ever made (March 2012 interview with Andrew Ross Sorkin).

Looking at this investment, what can we learn? Luckily, Ackman discussed the mistakes made with Borders in a CNBC interview in early 2011, saying the following:

“In the case of Borders, we made a lot of mistakes; among them, this is a business with an enormous wind in its face where technology is going to, actually has make a dramatic change in the future of the business, I think is problem number one. Problem number two is the management team really didn’t have, we didn’t know who the management team was. It was a case where a new team was coming in and we thought anyone was better than the old guys, and the team had a tough time and we had to replace management a couple of times. Also it was a very levered retailer, you know it had debt on the balance sheet, plus a significant amount of relatively high cost leases. So it’s levered, new management, it’s a turnaround, wind at your face, my advice is short the stock or move on.”

When asked if this company was finished as a going concern (interview was a month before the bankruptcy was announced), Ackman added this quick comment:

“I think there is an opportunity for a viable superstore business, but it’s not necessarily just a book store company. We’ve been an advocate for a combination between Borders and Barnes & Noble for some time; one of the problems is there’s some overlap in terms of real estate…”

This brings us back to Staples and the office supply chains; let’s breakdown the points presented individually and see if any are red flags for potential investors in Staples (SPLS) - our key concerns are technological impact, management, and leverage (particularly in terms of high cost leases).

TECHNOLOGICAL IMPACT

This is going to be the most difficult point for me to address because many people already have their thoughts in this arena set in stone; however, let me make three quick points that might help to differentiate between Borders and Staples in this arena:

1. Staples – Relevant in e-commerce: As investors know from management’s presentations, Staples is second largest online retailer in North America, right behind the eight hundred pound gorilla in the room (AMZN); their success in this space has been due to a mix of investment and time, with an integrated e-commerce offering being a part of Staples since 2001. Compare this to Borders, which didn’t launch a proprietary e-commerce website until May 2008, a full 13 years after the launch of Amazon.com.

2. Office Supplies are not Books: While e-commerce hurt book sales, the decline has been exacerbated by the proliferation of digital media and tablets/e-readers/smartphones. While the case can be made for a decline in the sale of paper and ink, other products offered by Staples (look at the recent strength in Breakroom supplies as an example) will never disappear due to technological innovation.

In addition, office product purchases are often time sensitive, meaning that consumers are often less focused on price and increasingly interested in convenience (if the printer runs out of ink, most businesses don’t have the luxury of waiting 48 hours for a replacement). A clear example of this is the seasonality in Borders business, with nearly 34% of all sales occurring in the fourth quarter; purchases in this time period were largely tied to holiday gifts, which are often planned and relatively price sensitive.

3. Staples - not just a Retailer: While many people think of Staples as a brick-and-mortar retailer, it’s imperative that investor’s realize that the delivery (B2B) business is the future at SPLS. In 2011, this piece of the business accounted for roughly 60% of sales (and growing) and was the driving force behind the Corporate Express acquisition in 2008.

MANAGEMENT

The concern about new management is relevant in the office supply business, just not to Staples; while both Office Depot (ODP) and Office Max (OMX) have brought on new CEO’s in the past 24 months, Ron Sargent, the CEO of Staples, has been the company's chief executive since 2002. In the past ten years, he has taken the company from a three way tie in both Retail and Delivery to a demanding lead over ODP and OMX in both segments (50-60% market share); to put it succinctly, this management team has a track record and it’s quite impressive.

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.

CONCLUSION

I wouldn’t make the same case for ODP or OMX, but I think Staples has stepped away from the industry. They hold a dominant position in North American Retail and Delivery (which comes with attractive high single digit operating margins), are in the process of building their offering in international markets (integration of Corporate Express really got under way in 2010), and hold a dominant position online that should cause bears to pause before assuming Amazon is the long term beneficiary of the shift to e-commerce.

For these reasons, I think any comparison between Staples and Borders is unwarranted; as such, investors would be well served to reassess the company’s competitive position in the industry before passing up on Staples juicy 14% free cash flow yield.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.3/5 (30 votes)

Comments

batbeer2
Batbeer2 premium member - 2 years ago
>> Ron Sargent, the Chief Executive Officer of Staples, has been with the company since 2002.

If memory serves, Ron Sargent was with the company for a long time before that, just not as CEO.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Batbeer,

Thanks for catching that! Hopefully that's the only typo; noted and changed.
kfh227
Kfh227 premium member - 2 years ago


Well done.
kfh227
Kfh227 premium member - 2 years ago


What are the argument for growth? Looks cheap when looking over hte numbers. But with no growth, the cheapness is warranted.
Cornelius Chan
Cornelius Chan - 2 years ago
I would have thought Costco would be Staples' biggest competitor? I was in Staples last year looking for a new office chair. The stock of chairs all struck me as more or less of the same vaguely sub-par quality. After looking over Costco's chairs I fell in love with one of their big leather ones. A very satisfying buy. 1 for COST, 0 for SPLS.

Another anecdotal evidence would be a comparison of the two companies' websites for office chairs.

Costco vs Staples

You have compared Staples to Borders. What is your opinion of Staples' position among some of their other competition. Thanks!
batbeer2
Batbeer2 premium member - 2 years ago
@ Science of Hitting

Thanks for another article worth reading.

@ C.W.R.

I believe SPLS has a competitive advantage in distributing heavy/bulky cheap, low-margin stuff. They do not compete with "better chairs". They compete by delivering a ton (literally) of paper/notepads/flipovers/staples on your doorstep tomorrow. That's precisely NOT the stuff you want to be hauling back to the office from Costco every week. SPLS has an efficient global distribution network comparable to UPS and a webshop comparable to Dell.

ODP and OMX are toast. Just look at the numbers. USTR is pretty decent.

If you are looking for a superior chair, by all means, go to Costco. If you want rapid and frequent delivery of high volumes of "worthless" office stuff, Staples is the best by far.

Then again, I have never set foot on US soil and wouldn't recognize a Costco shop if I ran into it (again literally).

@ kfh227

The argument for growth (at least that's my argument) is that they can take market share from OMX, ODP and hundreds of regional players. I believe they are the best in the business and they have "just" 20% of the market (more % in the US, less % abroad).


Did I mention I really like the company ?
Cornelius Chan
Cornelius Chan - 2 years ago
@Batbeer2

Thanks for the information.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Thanks for the comments! A couple of responses:

Kfh227: Mr. Sargent has said on recent conference calls that he believes earnings can grow high single to low double digits if the global economic recovery picks up some steam. However, I don't think it's accurate to say that the current valuation is warranted even if this is a flat business over time: in that case, it is a perpetuity with a 14% yield, compared to long term bonds yielding low single digits.

CWR: I don't have much to say about Costco, Wal-Mart, etc, but compared to OMX and ODP, Staples has flat out dominated in the past decade; as I noted above, from a near dead heat, SPLS now holds 50-60% share (among those three names) in North American Retail & Delivery, and even stronger share positions internationally.

Batbeer: Thanks for the kind words!

Cornelius Chan
Cornelius Chan - 2 years ago
Yes, after bothering to do some homework on my own it appears Staples is the strongest company in the office supply industry. Since net income lows of 2009 the company is on the come-back trail, back to pre-crisis levels. The stock shouldn't be so low based on share price follows earnings theory.

Thanks for an interesting presentation.
Josh Zachariah
Josh Zachariah - 2 years ago
Great article, but I'm not sure office supplies are that different than books. I think people do have an idea when they'll need products and they don't let the ink the printer run out before they get a backup. When ink cartridges, thermal paper and other goods are so much cheaper online than at staples then it becomes costly for businesses to not carry emergency inventory.

In my business I use 3 1/8" thermal paper. On amazon 10 rolls sell for $8.10, on staples.com it sells for $28.99. 10 rolls of 2 1/4" thermal paper (common credit card paper in retail businesses) sells for $17.99 on staples. A 50 pack sells for $9.36 on amazon. The only difference is the Staples product is Staples branded whereas Amazon is generic.

After seeing these prices in black and white there is no way I could hold shares in Staples
batbeer2
Batbeer2 premium member - 2 years ago
Hi Josh.

>> When ink cartridges, thermal paper and other goods are so much cheaper online than at staples then it becomes costly for businesses to not carry emergency inventory.

Ehm.... online = Staples. The online revenue of Staples for office supplies is multiples of Amazon's. 1)Amazon, 2)Staples and 3)Dell. That's the top three of global online retail by revenue.

If I surf to "Amazon.com" I can see a lot of stuff and click on it. Finally, when I go to check out, they tell me I live in the wrong place.... #&!mn.

Staples.com, Dell.com and for that matter overstock.com are much better. Those sites know where I live and show me stuff they are able to deliver.

If I need something from Amazon, I brush-up on my German and go to Amazon.de. Of course, they don't have as much as Amazon.com but they will (usually) deliver stuff where I live. Alternatively I can brush-up on my English and go to Amazon.co.uk. They too will deliver stuff where I live. I just need GB Pounds to pay. Either way, I typically don't get delivery within 10 days. And yes, there's a price differential between the two.

In short, Amazon is a total disaster! I probably use Amazon once a year to buy books I really can't find elsewhere.

Thermal paper is not bulky and/or heavy in relation to its price. It has a pretty high price per kg. That is not where Staples gets its competitive advantage. Staples (and Dell) have their own global distribution network while Amazon does not. I wonder how the math works if you need say.... 50 kgs of plain paper.

Let's say you run an office of 150 people. You want regular, prompt delivery. Staples can and will beat Amazon in that regard. Amazon often acts like a broker. Someone else is delivering the stuff you ordered.

For a (government) enterprise that tenders multi-year supply contracts.... Amazon won't even try to get that business. They can't hope to fulfill the terms of the contract consistently with their business model.


Having said that,

1) Your example does point out a pretty large price differential.

2) You can never go wrong passing on a stock.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Pepper,

I certainly won't debate an argument based purely on price; while I think there would be anecdotal evidence for either side on certain products, I accept that as an argument - even if it wasn't true, the perception among your average consumer will be that Amazon is cheaper.

What can Staples do to stop this? One, focus on the delivery business, which is approaching 50% of the business and growing; this is an avenue that isn't comparable to any part of Borders business.

Second, focus on services that cannot be replicated by Amazon like copy and print; again, not something that you're going to see from Borders. It's important to remember that they didn't just lose because Amazon was better at selling books - the iPhone and the Kindle both played a major role in transforming the industry in a way that isn't comparable to the office supply chains.

Third, be the best in the industry and grow by picking off share from competitors; the overlap that Ackman noted in the book store business is also apparent in office supplies, and will be corrected over the coming years as both ODP and OMX close/resize stores - which I think will play to the Staples advantage as they continue taking retail share.

Finally, be cognizant of the potential impact from Amazon and other online retailers as leases come due. As I noted above, this is a luxury that Staples still has; as the next 36 months play out, we will see how management adapts the company's retail presence in the face of competitive pressures.

When broken down by year, the numbers show a few things: the first is that Staples has dominated OMX & ODP; the second is that SPLS has navigated the financial crisis relatively unscathed (in terms of the business, not the stock price) besides having a sizable business in Europe.

The financials show a business that is materially different from what the market perceives; with an FCF yield in the mid double digits, I think SPLS continues to be a steal in the low-teens.

The Science of Hitting
The Science of Hitting premium member - 2 years ago
One other note from Staples website for you Pepper (in case you bought that product on Staples, I've highlighted something you might be happy to know):

"Staples.com will price match prices at select competitors' websites and Staples' retail stores. These select competitors are: Amazon, Best Buy, Costco, Dell, Hewlett Packard, Office Depot, Office Max, Quill, Medical Arts Press, Reliable, Sam's Club, Wal-Mart, WB Mason, and Xerox."

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