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).
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.
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.
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.
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:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.