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The Science of Hitting
The Science of Hitting
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Staples - Back to Outpacing OMX and ODP

November 15, 2012 | About:

On Wednesday, we got our final piece of the U.S. office supply puzzle: Staples (SPLS). For those who have been following my writings on this sector, you likely remember that a piece of my thesis hinges on store closures and downsizings in the U.S., which will work to materially improve the economics of individual stores over time (obviously this assumes steadiness in overall industry sales – which I hope ends up proving pessimistic due to a rebound in small business as the economy hopefully continues a slow and steady recovery – as well as an unchanged piece of the pie for these players). As I noted from the Office Max (OMX) and Office Depot (ODP) third quarter conference calls, those two companies collectively spelled out plans to close (in terms of square footage) the equivalent of at least 50 stores per year for the foreseeable future. By my calculation, this should result in a low double-digit increase in per store sales (again, assumptions above must hold) by 2016. Let’s take a look at Staples' results for the third quarter to see how they might affect those assumptions:

Total company sales for the third quarter of 2012 were $6.35 billion, a decrease of 2% as reported and -1% on a constant currency basis. On a segment basis, the decrease is due to material weakness in the international segment.

Starting with North American Delivery, sales were up 1% in the quarter to $2.6 billion. This primarily reflects growth of facilities and breakroom supplies (up 20% in the quarter and growing double digits across all channels in North America) and in services like copy and print (solid high margin businesses); this was partially offset by the previously announced loss of two large contract customers during the third quarter of 2011 (management didn’t feel the accounts delivered adequate returns), which resulted in a 70 basis-point decrease in sales.

The operating margin for NAD decreased 76 basis points to 8.73%, due to lower product margins and investments to drive growth in Staples.com with differentiators like free shipping on all ink, toner and paper orders – which drove stronger traffic to the site but also resulted in higher logistics expense (“Accelerating online growth is one of our top strategic priorities, and we're committed to making the right investments today to drive sustainable top line growth”).

In the North American Retail segment, sales were flat year-over-year at $2.6 billion despite weak computer and software sales due to the anticipation of Window 8 (“early response from our customers has been positive”). Comparable store sales were off 1%, with a 2% drop in traffic being partially offset by a 1% increase in ticket. Considering that OMX and ODP reported a 2.6% and 4.0% decline in the third quarter same store sales (largely attributed to PC category weakness), it appears that SPLS handily outperformed the competition in the U.S. market (a reverse of the second quarter numbers that freaked out the analysts). Operating margin was up about a tenth to 10.79%, attributed to lower operating expenses and distribution efficiencies.

International operations continue to disappoint, with sales down 12% (down 8% in constant currency) to $1.1 billion in the quarter; year to date, international sales (as reported) are down a similar 12.2%, lopping off $460 million from the top line through the first nine months of 2012. As part of restructuring European operations, the company will close 46 stores by year-end (half of which are in the UK), as well as six in Belgium (exiting retail operations in the country). In what will hopefully prove to be a big addition to the company, John Wilson, the company’s CFO in the 1990s, has rejoined the company as president of Staples Europe (he specifically noted opportunities in “streamlining and improving our cost structure as we look to the future.”)

As a whole, the company reported a net loss of $569 million in the quarter; excluding the impairment of goodwill and other assets (a total of $811 million in impairment charges for the company’s European Retail & Catalog units), as well as a few other (much smaller) charges incurred during the third quarter of 2012, the company reported non-GAAP net income from continuing operations of $310 million, or $0.46 per diluted share – dead in line with third quarter 2011.

For the full year, the company still expects to generate more than $1 billion of free cash flow ($691 million year to date) – and if they hit that target, the forward FCF yield is approaching 13%. In addition, the company has stuck to their target common stock repurchases for the full year of $450 million; with $383 million repurchased through the third quarter, we can expect an additional $65million to $70 million over the last three months of the year - reducing the shares out by an additional 1%.

One particularly interesting tidbit out of the call is that as the second largest online retailer, Staples e-commerce sales now exceed $11 billion (run rate) per year; to put that into context, 2004 web sales (according to ZD Net) were $3 billion – an eight-year CAGR of 17.6% top line growth. Here’s what CEO Ron Sargent had to say about the segment on the call: “We've significantly increased investment here over the past few years. But to really get the top line going, we need to move faster. This year, we launched an E-Commerce Innovation Center in Cambridge, Massachusetts. The team is focused on developing our e-commerce and mobile commerce offerings… Today, our online circular in the U.S. gets over 700,000 views every week. Our mobile app has over 0.5 million downloads to date, and we're building a strong presence in social media with platforms like Facebook and Twitter.”

In terms of U.S. retail space, Staples has announced a plan to reduce their North American retail square footage by 15% over the next three years; for a company with more than 1,900 stores in the U.S. and Canada (collectively) heading into 2012, this should prove to be a material change (target is net closures of 30 stores per year, as noted on the call). Again, as with OMX and ODP, there’s no telling how these closures and downsizings play out over time (the mix will naturally depend on the early success of the concept - and don't rule out a merger between the two smaller guys). With that being said, there’s no doubt that this shift in the retail landscape will have an impact on the industry over the coming years.

One final note on the Amazon (AMZN) lockers discussed by the media over the past week or two, from the president of Staples U.S. Retail division: “It is being tested in some of our UK stores, as well as a handful of stores in the U.S. It's very early. We think it's a good traffic-driving idea. I don't really have much to say on it other than I'll address your one quick question. There are no limitations. It is product bought through Amazon, not their partners. It doesn't take a lot of space. So it's not a big space commitment. So as part of something that we do, we are -- we've got a lot of different tests out there. We're very anxious to be involved and to learn and to see what works, what doesn't work, and this is one of them.”

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.

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