Staples (SPLS) reported third quarter results on Wednesday; let’s start with the headline figures:
Sales in the quarter were $6.1 billion, down 3.8% from the year ago period; this four percent decline includes two items worth discussing: (1) the stronger U.S. dollar negatively impacted sales by ~1%, and (2) the company closed 107 stores in North America (59) & Europe (48) over the past twelve months, which was also a ~1% headwind to the comparable figure. Adjusting for these factors brings us to a comparable sales decline of 2%. From a company-wide perspective, sales fell 2.7% through the first nine months of 2013, excluding -0.5% from foreign currency.
North American Stores & Online sales fell 5.3% in the quarter, with comps dropping 3%; to put that in perspective, Office Depot’s (ODP) comps fell 2% in the quarter, and Office Max reported a 3% decline. Through the first nine months of 2013, the figures for SPLS, ODP, and OMX were -3%, -4%, and -4%, respectively; the weakness in core office supplies has continually stymied these companies throughout the year. Just remember that between these three companies, 2012 North American retail sales were ~$19.5 billion, with Staples raking in ~60% of that total; picking up share throughout the merger is a sizable opportunity for Staples, and not just in Contract. On a side note, Staples now has eleven small format stores (12,000 square feet), and is on track for 45 by year end; at this point in time, these stores continue to retain more than 95% of their sales.
“NA Stores & Online” operating margin was 9.5% in the quarter, down 90 basis points from a year ago; this decline was driven by increased costs related to investments in Staples.com (where sales were +3% in the Q), as well as the negative impact of fixed expenses on a lower sales base. Investors were not provided with the breakdown, but make no mistake about it – a continued decline in same store sales near Q3 / year to date levels would be a disaster for operating income at the company-wide level; we must see stabilization in these metrics in the coming quarters. It’s worth noting that core office supplies account for ~60% of Staples overall sales, with categories beyond core (business machines, facilities & breakroom, etc) accounting for the other ~40%. The problem is that certain non-core categories – for example, tablets and phones – are lower margin (while other, like facilities & breakroom, are generally higher than the in-house total); in that regard, replacing core office supply sale dollars with tablet sale dollars on a one-for-one basis is a negative for SPLS (with the negative disproportionately affecting the retail operations).
As has been the case throughout 2013, North American Commercial continues to be the lone bright spot: sales increased 0.7% in the quarter, to just under $2.1 billion (year to date sales have increased 1.4% ex-currency); growth in facilities & breakroom (up high-singles), tablets, and furniture more than offset the decline in core office supplies (paper, ink and toner, etc). The operating margin for the segment contracted by 125 basis points to 7.6%, with operating income falling 14% - to $159 million – as a result. As is often the case, looking at the headline figures alone masks what is really going on; here’s the explanation from the press release: “This decline primarily reflects investments in sales force and marketing costs to drive growth.”
Here’s CEO Ron Sargent discussing some of those investments:
“Turning to the reinvention of our contract sales force - our goal here is to become the number one commercial player in categories beyond core office supplies. Earlier this year, we developed a new selling approach which is much more unified and collaborative. It focuses on growing our share in adjacent categories like facilities and breakroom supplies, furniture, technology, print, and promotional products. To accelerate growth, we replaced some of our office product sales reps with specialists in these adjacent categories. We also moved some administrative tasks offshore to provide our strategic account leaders with an extra day of selling per week. Based on the success of our pilot, we're in the process of rolling out this new team selling model across the organization. We're on track to grow sales in these adjacent categories by about $200 million in North American Commercial this year.”
Let me clear about something that was alluded to during the Q2 call – these benefits have not yet started; as Joe Doody, president of the North American Commercial business noted, customers won’t change based on what might happen – but when disruptions surface, they’ll certainly be more willing to consider Staples. In summary, expenses are being booked today for investments that won’t pay off tomorrow – but should be well worth the incurred costs over the coming years. This is simple but powerful example of why judging results by most market participants favorite metric (miss or beat on an EPS basis) is a woefully inadequate approach to security analysis.
International sales fell 8% in the quarter, to ~$1 billion; the segment reported a two percent decline in European retail comps, with the remainder of the sales decrease tied to store closures, weakness in the European delivery business, and continued struggles in Australia. Actions to take out costs that started last year will result in 20% reduction in the European workforce by next year; this is a continued black eye for Staples, and is unlikely to change anytime soon.
Corporate non-GAAP operating margins (which I’ll use instead of GAAP to adjust for the significant charges taken in Q3 2012) fell more than 80 basis points in the quarter, to 7.05%. The combination of the sales decline and margin compression resulted in a 14% decline in non-GAAP operating income, from $500 million to $431 million. I certainly don’t want to give the impression that this entire decline was due to investments for the future that I discussed earlier, because that is not the case (gross margins fell substantially in the quarter and the cost pressure on lower sales is a factor as well); readers should simply recognize that reality is a bit more complicated than the headline figures might suggest.
One other important development in the quarter was the biggest refresh to Staples.com in eight years. For those who have used the Staples website in the past, go take a look and click around - what used to be cluttered and slow now looks cleaner and more responsive (in my personal experience, the difference is night and day - I’d be interested in hearing if others have had the same experience since the change; management reported that the site is now 40% faster). This is only a piece of the puzzle, but goes a long way in closing the gap between Staples and a plethora of reputable e-commerce competitors (AMZN); adding more SKU’s isn’t the only change needed to fuel e-commerce growth (though management has done a pretty good job there as well, with the assortment increasing by nearly 50% in the quarter with the addition of 70,000 SKU’s – with Apple (AAPL) iPad’s to go with previously stocked accessories being a notable win). By year end, the company will surpass 300,000 SKU’s, suggesting another near 50% increase in Q4; at the end of Q3, the expanded assortment from “dot com” was driving more than $3 million in incremental sales per week to the company (when an analyst asked if the expectations were for this to eventually be $20M, $30M, or $50M+ per week, Mr. Sargent responded “the answer is certainly yes”). Here’s Mr. Sargent talking about these efforts in a bit more detail on the call:
“Our business customers have told us that they trust Staples to provide them with many more categories beyond office supplies, so we're aggressively pursuing this opportunity by adding a wide assortment of products that are tailored to specific industries… Over the coming weeks, we'll launch a broad assortment of 20,000 restaurant supplies. We're in the early innings of our vertical strategy and have plans to expand our offering to serve many more industries in the coming months.”
Staples ended the quarter with $1.4 billion in cash & equivalents and $6.25 billion in current assets, against $4.4 billion in current liabilities; this includes ~$900 million in long term debt maturing in January, which the company will repay. It’s clear from recent actions (and a look at the balance sheet) that management does not want to stretch on the capital structure; considering the headwinds in core retail, I personally feel that’s appropriate (though I’d support a material increase in repurchase activity at the right price – when the FCF yield is in the low-mid teens). The recent reduction in debt outstanding will reduce interest expense $50-60 million in FY14.
The biggest change facing the industry continues to be the fallout of the Office Depot - Office Max merger; until we get some more clarity on what their combined future will look like, I’m waiting for one other important thing – the compensation package for Roland Smith, Office Depot’s newly named CEO. We got a few details about his pay this past week, but not any specifics on the performance targets that will determine his bonuses – where the real money is made; it’s a safe bet that the incentives of Mr. Smith’s comp structure will play an important role in the direction that he takes ODP. If overall sales growth is a primary / determining factor, be on the lookout for a “share grab” mentality to take hold, particularly in the contract space; this would be a long term negative for both competitors.
I’ll leave you with one final quote from Ron Sargent, which came when asked about what lies ahead in the post-merger world: “We have a pretty strong, aggressive plan in place to really go after market share not only in our retail business, but also in our online business, as well as our contract business… we're going to take advantage of every opportunity we see in front of us.”
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, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.