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The Science of Hitting
The Science of Hitting
Articles (456) 

Private Equity & Activists Shine to Office Supplies

September 18, 2012 | About:

It’s been a little while since I’ve talked about Staples (SPLS), but the office supply industry continues to garner much attention from the financial community. Our first bit of news came last Friday, when CNN Money author Dan Primack wrote that Fortune had learned that several private equity firms were in preliminary discussion of a potential buyout of the leading office supply retailer. He makes a couple of key points that are noteworthy:

1. Any offer would likely not come until later this year, after the U.S. election; the reasoning is because the private equity firms (who are likely enjoying the recent step back from the spotlight) don’t want the potential public relations hassle that will come a bid for the former Bain investment.

2. The rationale comes from a mix of attractive free cash flow and the added kicker of sales tax on Internet purchases, which is starting to grab hold in some states and might be resolved on a national scale in the near future.

3. The size might be an issue; the author estimates the need for $2.9 billion in equity, which would likely require at least three firms to participate – a potential difficulty, particularly if a Best Buy (BBY) deal goes through in the near future.

The second headline for the industry came today, when it was announced that activist investor Starboard Value LP took a 13% stake (worth just under $100M at the close) in Office Depot (ODP). While Starboard’s letter to the company was not made public, Bloomberg highlighted some of the key points, which focused on the need to move to smaller stores, cut general expenses, and lower advertising spend. As was noted in the Bloomberg piece, ODP’s North American Retail president noted that the company will announce a plan next month for the company’s upcoming leases, which number 500 (equal to 45% of their North American locations) in the next three years.

The piece closed by noting the increasing likelihood of an Office Depot / Office Max (OMX) merger, as was brought up by ODP in a statement on September 16th; the rationale is that the environment has changed materially since 1997, when the Federal Trade Commission blocked a merger between Staples and Office Depot on the ground that it would violate antitrust laws and lead to higher prices for office supplies.

My thoughts on all this is that there’s still a lot to be determined; while the private equity talks are interesting, my belief is that they only have an interest in Staples, which is in the best position by far among the three companies – but the price tag will be a bit of a headwind, particularly considering that there’s no indication that a deal at a 20% premium would be accepted without any question. From all this, the thing I find most interesting is the statement from Office Depot on a potential merger; Staples CEO has discussed in the recent past how this combination seems natural, and I think that an argument could be made for them to band together as one.

The thing I find most shocking about all this is the continued indifference to store closures; I’ve yet to see a single calculation in the financial press on what potential store closures mean for same store sales growth (among those locations remaining in the portfolio) – you would think this is worth discussing when the second largest company in an industry says that they could potentially close or downsize about half of their retail locations in the next 36 months.

As I noted in my value contest submission, that is a critical part of my thesis for investing in SPLS; here’s a graphic which shows the potential industry impact of store closures:

Closures per Year Stores in 2016 (Estimate) Increase in Sales per Store
50 3775 10.8%
75 3650 14.7%
100 3525 18.7%

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 6 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.

I continue to feel confident in the SPLS thesis, and think that the private equity buyout rumors are a positive sign for long term investors; for people considering an investment in the industry (particularly in SPLS), I believe this adds a level of downside protection that shifts the risk/reward balance, albeit slightly.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.4/5 (16 votes)


Swnyc2 - 5 years ago    Report SPAM

Thank you for another nice article on SPLS. I enjoy hearing your thoughts.

However, with regard to store closings, you assume that the effect of store closings is to proportionally raise sales at the remaining stores. However, based on what I've read, there are many people who believe that alternative retailers (such as AMZN, WMT, and COST) are increasing their share of the office supply business. If this is the case, SPLS may not realize as substantial a sales gain you have predicted.

My hunch is that you are correct. Based on historical data, I believe that people are overestimating the rate at which AMZN and general big box retailers will be eating into the office supply business in the near term.

However, it would be nice to not have to rely on a hunch. Do you have any objective evidence describing the extent to which this is happening now and in the immediate future?
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

You're 100% correct - I don't actually assume that it will play out this way, but the assumption from the way I presented the numbers is that the office supply stores in those regions will retain 100% of the sales; obviously, we know this is highly unlikely - but teasing out a number is obviously all but impossible.

My point is simply to project the number of store closures, and what impact that would have on sales; readers can look at the change, estimate what percentage is retained by the office supply industry, and perform an identical calculation. The point is that this will be a tailwind in the future, one that no one appears to be talking about - and as my numbers show, I believe it will have a material impact over time (I can't begin to guess on regional retention, but the recent commentary suggest 100 closures or downsizings a year will prove to be conservative).

Thanks for the kind words!

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