I said the following in my most recent article about Staples (SPLS) and the office supply industry:
“I’ve discussed since then that the commentary from the second quarter conference calls leads me to believe that even my most aggressive estimate (100 downsizes/closures per year) is likely to be too conservative (these estimates were based on the numbers tossed out on conference calls over the past six months or so); as noted by Office Depot’s North American Retail president, we should get some verification of this (if I am correct) on the upcoming third quarter conference calls.”
Today, both Office Max (OMX) and Office Depot (ODP) reported third quarter results; we’ll get the results for Staples next Wednesday, at which point I’ll update the overall investment thesis.
OMX reported Q3 sales of $1.74 billion, a decrease of 1.7% from the year ago period. On a segment basis, contract sales declined 0.3% (+3.9% in the U.S., -7.2% in constant dollars internationally) and retail sales declined 3.1% (including -2.6% same store sales in the U.S. attributed to PC category weakness). In the press release, we were given the following full-year 2012 guidance: “A net reduction in Retail store count for the year with up to 45 store closures and one opening in the U.S., as well as 8-10 store openings and 1-2 store closures in Mexico.”
OfficeMax ended the third quarter of 2012 with a total of 960 retail stores, consisting of 872 retail stores in the U.S. and 88 retail stores in Mexico. At the start of the year, OMX had 978 stores, with 896 in the U.S. and 82 in Mexico; as such, the guidance implies no change in Mexico in Q4, and a further closure of roughly 20 stores in the U.S. (in addition to the 24 closed to date).
To put those 45 closures into perspective, here’s my estimate for industry store counts in 2016 (and what that means for same-store sales) from my original contest submission for Staples:
|Closures per Year||Stores in 2016 (Estimate)||Increase in Sales per Store|
CEO Ravi Saligram talked about the company’s U.S. retail strategy on the call:
“Although our day-to-day retail execution has improved, we continue to face industry wide structural challenges. The economy is not giving us any tailwinds and small business formation is weak. Adding to these issues, we now face a sector weakness in technology. Consequently, we'll be more aggressive in driving 3 specific retail initiatives: first, we continue to execute our store network rationalization with urgency. Specifically, we have already closed 5.4 million square feet of store space and nearly 2 million on a net basis since the beginning of 2005. We’ve also opened only 2 new stores in the U.S. in the last 13 quarters. Year-to-date in 2012, we've already closed 25 stores, which is more than all of last year. In the fourth quarter, we plan to close up to 20 additional stores, which brings the total for 2012 to up to 45 stores. This represents the highest number of store closures in any given year since 2006. In fact, our plan is to reduce our U.S. Retail total square footage by approximately 15% or approximately 3 million gross square feet from the beginning of 2012 through the end of 2015.
This reduction is an addition to the nearly 5 million gross square footage reduction from the beginning of 2005 through the end of 2011. In total, we will have closed approximately 8 million square feet from the beginning of 2005 through 2015 on a gross basis.”
Looking at this problem in terms of square footage becomes difficult, because estimating the pace of closures versus downsizings is all but impossible with such a small sample size on the potential viability of 5,000 square foot stores. As a more simplified measure, the 15% square foot reduction can be applied to the store count – meaning the company plans to close roughly 135 of the 896 domestic stores at the start of 2012; on an annual basis, that’s an average of 34 per year (with the company targeting 5,000 to 15,000 square-foot stores in downsizings, it’s easy to see how the closure/downsizing rate can easily exceed 40 to 45 a year once adjusted for that square footage).
OMX reported Q3 sales of $2.7 billion, a decrease of 5% from the year ago period (down 3% on a constant currency basis). On a segment basis, Business Solution sales were essentially flat, North American retail sales declined 5% (including -4% same store sales in the U.S., attributed again to PC category weakness), and International sales declined 12% as reported (-4% on a constant currency basis).
Looking at U.S. retail, Office Depot operated 1,114 stores in the U.S. at the end of Q3, with three closures (net) in the third quarter. Through the first nine months of the year, the company has closed 17 stores in the U.S. and Canada (net) – implying roughly 10 closures in Q4 to hit the full year target of 25 to 30; year over year, square footage decreased in the U.S. and Canada by 3.4%.
Here’s what CEO Neil Austrian had to say about the U.S. retail strategy on the call:
“The first initiative is executing our North American Retail real estate strategy. We previously told you that we anticipated executing a strategy to downsize our stores on a faster pace by 2013 and also commit significantly more capital to that program. We can now confirm that over the next 5 years, we've committed to spend $60 million a year to downsize or relocate approximately 500 stores into a small- or mid-sized format. We also anticipate closing between 10 and 20 stores a year as their leases expire over the same period. For 2013, we will downsize or relocate approximately 100 larger format stores with expiring leases and expect that the occupancy cost savings from these actions will be approximately $20 million a year beginning in 2013.”
This was expanded upon by Kevin Peters, president of North American operations, later in the call:
“Now as Neil mentioned, we are moving forward with our real estate strategy to significantly accelerate the downsizing of approximately 500 stores coming off of lease over the next 5 years. For 2013, we are committing approximately $60 million of capital to downsize or relocate approximately 100 larger format stores with expiring leases. The majority of these stores will be remodeled into a smaller format of 5,000 to 7,000 square feet and the remainder in 15,000 to 17,000 square feet ranges. We also project closing between 10 and 20 stores in 2013 as their leases expire.”
As noted on the call, the timing is linear at about 100 per year; for the sake of modeling, I’m going to assume that the closures are in-line with 2013 (average of 15), and that the downsizing and relocations are slightly weighted to the smaller format (if they can retain 90% of their sales with one quarter of the square footage, this will become the vast majority of their remodels), with 45 shifting to an average of 6,000 square feet, and the remaining 40 downsizing to an average 16,000 square feet. At the end of Q3, the average square footage per North American retail store was 23,258; here’s a look at the annual change we can expect from this transformation:
|Change||Current Sq Feet||Future Sq Feet||Stores per Year||Total Sq Ft|
|Downsize – Small||23,258||6,000||45||776,610|
|Downsize – Mid||23,258||16,000||40||290,320|
By this calculation, the annual decline in square footage would be 1.3 million square feet; over the course of five years, this would be a total reduction of 6.5 million square feet off the base at the beginning of 2012 of 26.5 million, or nearly 25 percent. Again, while this is not a direct comparison, this is a rough indication that the company will reduce the selling space by an amount equal to nearly 280 stores, or 56 per year.
These measures are very raw, and far from perfect. As Office Depot notes, they believe that they can retain 90% of their current sales in a 5,000 square foot model – and if they do, the measure shown above will be overoptimistic when estimating the scale by which store closures will benefit the remaining players in the space.
With that being said (there are puts and takes in both directions), the magnitude of the numbers is telling – this data suggests that between OMX and ODP, the net impact to the industry could realistically come in at the high end of my original estimate, and will almost assuredly exceed the low end targets. As the math shows, the overall impact on the remaining stores in the industry under any more than 50 scenario is a double-digit increase in sales per store (assuming no change in overall U.S. retail sales).
It's not entirely clear how this will play out in the next few years, but it's increasingly clear that this bump to U.S. retail sales — particularly if coupled with a decent economic recovery — would completely change the perception of SPLS at under 8x trailing FCF.
I will address the OMX-ODP merger talks, as well as the impact of the Amazon (AMZN) locker announcement when Staples releases their Q3 results next week.
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.