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The Science of Hitting
The Science of Hitting
Articles (454) 

SPLS - Tough Q2, Thesis Is Unchanged

September 03, 2013 | About:

With Staples (SPLS) off more than 10% on weak earnings, I’ve received a few messages asking what I thought about the numbers. Due to some time constraints, this article has taken a bit longer to publish than I would have liked. With that said, sometimes a few days to clear one’s mind is just what is needed after a big move (up or down) in the company under review. Now that the dust has settled, it’s time to take a look at Staples second quarter and first half results.

Let’s start with the big picture: Sales declined 2% in the quarter, to $5.3 billion. Year to date, sales have declined by 2.8% to $11.1 billion, compared to a 3% drop in the first half of 2012. As always, I think it’s important to put these numbers in context: Office Max (OMX) and Office Depot (ODP) both reported 5% sale declines in the first half of the year, suggesting that Staples has at least maintained its position among its closest peers as the best house in a tough neighborhood heading into the back half of 2013.

North American Stores & Online sales decreased 3% in the first half of 2013, with comparable store sales off 3% due to lower traffic (-2%). This decline was partially offset by a 3.3% increase in sales from Staples.com (management expects this growth rate to accelerate in the back half of the year), with the delta between these measures coming from store closures. As I noted in my original thesis (here), reducing the retail footprint among the big three is a big part of the story; I believe we’re on the cusp of some material developments in this regard in the coming months.

By the way, store closures are one option; downsizing stores is another. To date, Staples has opened eight of their 12,000 square-foot store models (less than half the square footage of their earlier 25,000 square-foot boxes), with the majority of these stores retaining 95% of their sales (and some over 100% of previous sales volume). They have another 30 to 40 currently in the pipeline, which will start to add some relevancy to these numbers (particularly as a test of the retention figures); at those levels, these boxes will account for 2% to 3% of all U.S. stores.

Between Staples, Office Max and Office Depot, plenty of closures and downsizings are on the horizon. Staples is on track to close 40 stores for the year and downsize or relocate an additional 45. The company has 175 to 200 leases ending in the next 36 months, giving it room to adjust more than 10% of its U.S. store base while limiting unnecessary costs (I find it revealing that the company is targeting approximately 1,000 stores for their mobile launch, against a domestic retail store base at year-end 2012 of approximately 1,550 locations).

OMX and ODP have been quiet about their plans as a combined company (probably to avoid any kinks in the process to regulatory approval), but we should have word on their store strategy in the coming months – a strategy that will result in serious change to their 2,000-plus store network.

The sales decline was driven by computers, ink and toner, and technology accessories, with partially offsetting growth coming from tablets and other mobile technology, facilities and breakroom supplies, and copy and print services. Simply put, there was weakness in core office supplies, and Staples continues to be on the receiving end of the decline in PC sales. Expecting a positive change from the current trend in either category is unrealistic in my view. While this will ebb and flow from quarter to quarter, the longer term trend has suggested a relatively tepid (albeit consistent) decline in these categories; everybody and their brother understands why this is happening. Such drawbacks much be put into context of the current valuation when considering SPLS shares, with the double-digit FCF yield offering some solace to investors.

The division had income of $272 million, off 20% from the prior year ($340 million). The operating margin declined by 120 basis points in the first half of the year, to 5.2%, driven by lower product margins [“When you're evolving your mix from paper-based products to more technology-based products, the margins aren't nearly as good”] and costs related to investment in Staples.com. Again, let’s take a look at what this means for our peers: Office Max was barely profitable at retail in the quarter, and Office Depot’s North American retail division lost $28 million in Q2; the 3,500 retail stores operated by these three companies in the United States cannot and will not last for much longer. The one company that can be most selective through this process will be Staples; simply put, the company must capitalize on this opportunity.

Moving to North American Commercial, sales increased a little over one percent in the quarter, and were just shy of $4 billion year to date (up 1.5%); weakness in core office supplies was offset by strong growth in adjacent categories, with Facilities & Breakroom up more than 20% in the second quarter (continuing a trend of double-digit growth in the category).

CEO Ron Sargent added the following when asked about Facilities & Breakroom, a key area in Staples' push to become the one-stop shop for businesses of all sizes (which may be easier said than done; I think Staples needs to continue to focus on key differentiators from Amazon, with next day shipping – and currently free on orders over $19.99 – being a great example):

“We've got several other categories that we're working on hard just like facilities and breakroom [these include Safety, Early Education, Office Gifting, and others], but facilities and breakroom already is way over $1 billion in sales for us, and the contract area, in particular, growing in the 20% range last quarter [high mid-teens comp at retail is nothing to scoff at either]. So we think it's very early, probably in the first inning or maybe the second inning of our plans for facilities and breakroom… It's a big category, and it's growing nicely.”

Despite marginal sales growth in the period, operating income declined by nearly 8%, to $278 million; the operating margin collapsed from 7.7% to 7.0% for the six month period. Why? Let’s look at the breakout in the 10-Q: “Business unit income as a percentage of sales was 7.0% in the first half of 2013 compared to 7.7% in the first half of 2012, primarily driven by increased marketing costs, lower product margins and investments in sales force.”

Increased marketing and investments in sales force sound (potentially) promising. Joseph Doody, president of North American Commercial, discussed this further on the call (emphasis added):

“If you look at our operating margin, we said we deleveraged, as you know, by about 85 or so basis points. About 3/4 of that was sales force and marketing. As we indicated, the marketing was heavily on the Quill side to drive growth, the sales force investments, clearly, on the contract side. And it's primarily an investment in specialists, specialists in facilities, specialists in print, promotional products, technology and furniture, to really drive those categories in alignment with our OP reps that are out there, that are the strategic leaders within those accounts. So it's really penetrating our existing customers, as well as new customers in beyond office supply categories, as well as our core.”

Sargent said it a bit more succinctly: “We are adding salespeople because we think the opportunity is going to be better and better as time goes on.”

The benefits of this spend, particularly in contract, will take time (with Doody suggesting a 12-to-18 month time period): “There is going to be change depending upon which one you go with [ODP or OMX]. You don't know what platform is going to be the long-term platform, and you're going to have to go through another change… We obviously tell these users of our competitors about it. But they're not going to change just based on fear. It's a major decision to be made, and fear alone will not make the change. So when there is disruption, that's when there will be action. And there has not been disruption yet.”

As always, it’s important to think about what this means for the company as a whole. Year to date, the North American Commercial business has accounted for just over a third of Staples' total sales, and nearly 55% of its operating income. The potential impact of any commercial share gain from the Max/Depot merger process must be considered with those figures in mind. By the way, both of those companies have reported lower sales in the first half of 2013 from their contract businesses. As noted in my original write-up on Staples, the company’s share gain in Contract since the turn of the century is likely the most important industry trend of all; from a near even split among the three a decade ago, Staples now controls the majority of the market.

In International, sales continue to plummet. Year to date, they are down double digits, to less than $2 billion; a business that reported more than $5 billion in sales in every year from 2009 to 2011 is on track to come in below $4 billion in fiscal 2013. In the first half of the year, the International segment reported an operating loss of $30 million, compared to a loss of $25 million in the first half of 2012. The company has completed 49 European store closures during the 12 months preceding the second quarter of 2013, which has reduced the store count in the region by more than 15%. The comp store sales decline of 4% in the first quarter accelerated in the second quarter, with the delivery businesses in Europe and Australia sounding like they did not fare any better.

The company continues to target $900 million in free cash flow for the full year (I would not get too caught up in where cash flow metrics land in any given year – this can be achieved by toying with working capital for a short period of time), but lowered sales and earnings guidance. It expects a low single-digit top-line decline (against 2012 sales on a 52-week basis of $23.9 billion) and full year diluted EPS from continuing operations of $1.21 to $1.25, down from the previous guidance of $1.30 to $1.35. Sargent said the following before going to Q&A on the call:

“Clearly, we are not happy to be taking down guidance this morning. I believe we're making good progress on our strategic reinvention, but it hasn't been fast enough to offset the tough trends in some of our core categories. We remain committed to our growth priorities, and as I said earlier, we're going to be even more aggressive reducing costs going forward.”

The tough trends are industry wide, and largely structural (though there’s certainly a cyclical component crimping the international operations). Anything that negatively impacts Staples is likely to hit its smaller rivals in Office Depot and Office Max just as hard (and in many cases more so), and we saw that yet again in the second quarter. As we go into the back half, OMX and ODP are preparing for life as a single entity; if recent results are any indication, I would expect them to come out of the gates with a plan that will go a long way in rationalizing the industry’s retail footprint. Staples will continue to slim down as well: The difference is that they have the financial wherewithal to use a scalpel rather than a meat ax. With an estimated mid-single digit return on assets for North American Stores and Online, selective downsizing and store closures can improve the long-term financials for what is already a solidly profitable business.

As in contract, this will take some time, and requires a bit of patience from investors. I continue to believe that those with the perseverance to see it play out will be happy they did so a few years from now. For those wondering about the dividend, the shares yield 3.45% as of Friday’s close, on a forward payout ratio under 40%.

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: 4.3/5 (18 votes)


William.b.thomson - 4 years ago    Report SPAM

I have often looked at Staples with an appreciation of their dominance and their internet presence. The valuation has also appealed to me. What has bothered me is the obvious, but for me, the profoundly obvious. I manage my business out of my home and have for thirteen years. The only IT product I buy at SPLS is printers. The rest of the categories are declining for me all the time. I use less paper, less ink and less of pretty much everything they sell.

My worst "epiphany" about this relentless decline came several months ago. I walked into a

SPLS store, looked around and said to myself, "I have no reason to be here." They have a wonderful online presence and that is great, but I don't think it is enough. They have the "Omni channel" idea well executed but what are they going to do with all that retail space? It is a heck of a nut to swallow.

I can't believe it but my last ink purchase was from Amazon. I understand that there is much more to the story but the retail footprint is a real ball and chain.
Waup7707 - 4 years ago    Report SPAM
I haven't bought ink for years. Instead, I get $9.99 ink refill service from Costco. My family of five printed only dozens of pages a year. I haven't printed photos for years. All my photos and videos are securely stored on the cloud for free (50GB on Dropbox) and can be shared easily around the world. My family has been buying electronics, games, school supplies, shoes, pet toys & supplies, and even bubble gums online.

I grew up without computer and internet. However, I am very comfortable and enjoy shopping online for the great price and convenience. All my children grew up with internet as a big part of their life. Going forward, I can only see online consumption takes ever bigger chunk of our economy. My son in college even bought furniture and mattress from Amazon!
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Your situation surely isn't different from that of most people (or so I assume); I think the same thing could be said ("I have no reason to be here") in a store like Best Buy, where most things are either (A) cheaper and/or (B) more convenient to have shipped to your home. How many people can you really get to walk in the store and pay the list price on a new TV, computer, etc? Now, moving beyond the anecdotal, Staples numbers clearly show that their retail locations (in North America), on average, are actually quite good business; that's getting tougher, but not at a rapid pace (it's been low single digits for a while, with some signs of acceleration in the most recent Q driving the big hit to the stock in my opinion). I certainly don't think these headwinds will abate, but I think they are manageable; the industry reducing retail space is of fundamental importance to this investment.

The retail "ball and chain", as you call it, will disproportionately affect OMX & ODP; they will end up with more stores than Staples in North America at the close of the merger, but will be doing about 30% less in per store sales (off first half 2013 numbers). As I imply in the article, I think Staples might see 1000 as a target for the US; we'll wait to see what OMX & ODP say, but I wouldn't be surprised if we saw 100+ stores closed each and every year (on average) starting in 2014. I think this is critical to seeing how SPLS can maintain (or possibly even improve) per store economics; add in the kicker from Contract, and I think shares look quite reasonable at less than 10X FCF. Thanks for the comment!


That's the future, and this is a key challenge for Staples: how do you eliminate/mitigate the brand perception differences (namely the assumption - and in many cases reality - of higher costs)? One way they've tried to do that is next day shipping, a nice feature for businesses that may have run short on something in need (like ink or paper) that they need ASAP; if you're comparable on price, people will seriously consider your offering before defaulting to Amazon. Another way they've attempted to do this (in my view) is through promotions and sales; as they noted on the call, they've pulled back on this a bit in the quarter, with the result being somewhat tepid growth (+3.3%). Finally, Staples should be outselling Amazon in their key office supply categories (difficult to say for sure due to Amazon's lack of transparency by product category); there's no reason why SPLS shouldn't be able to demand the best prices from suppliers. Overcoming the brick & mortar costs is more difficult, and Staples will have plenty of decisions to make in the coming three years about how to start addressing this (close stores or downsize); importantly, they have a solid balance sheet and can act in a rational manner in doing so.

The good thing for Staples is that they're generating hundreds of millions in free cash flow each year, and can address their core issues in an expeditious - but thoughtful - manner; OMX & ODP don't share the same luxury. Changing the brand image will be an arduous task, and throwing money at the problem can't be the company's primary focus; in addition to organic growth that I expect to be siphoned from the OMX/ODP deal (in contract & retail), Staples must find a way to compete with Amazon for the growing piece of the office supply market that is moving online.

Thanks for the comment!
Praveen Chawla
Praveen Chawla premium member - 4 years ago

Its possible to thrive profitably in a declining industry as the tobacco companies have shown. They do have an advantage that cigarettes are highly regulated and you cannot buy them on line. I think staples can take a page from their playbook and boost dividends and share buyback while shrinking their retail footprint.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

We shall see; SPLS pays most/all its free cash flow back to investors in buybacks and dividends. As I note, a big part of that thriving in a declining industry is picking off some retail and contract share from smaller peers (OMX & ODP); if that doesn't play out as I hope, I would be very shocked / disappointed, and it would be a big blow to my thesis. Thanks for the comment!
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM
Extra Note: Consider reading the transcript from the GS conference, where CEO Ron Sargent spoke:

DfiinancialH - 3 years ago    Report SPAM

Do you still own this stock?

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