SPLS & ODP: Retail Consolidation, Here We Come

Well, here we go again. When Staples (SPLS) reported their second quarter results back in August 2013, the stock fell 15% the next day. Last Thursday, Staples reported fourth quarter results – and plummeted another 15%. At times like these, emotions run high; it’s hard to stay levelheaded – or even confident in the validity of your original thesis – when you watch a large percentage of your position disappear in a few hours (on two separate occasions in a six month period, no less). Painful as it may be, the only thing to do in these times is get back to work. Let’s look at the numbers.

For the company as a whole, fourth quarter sales were down 3.8%, excluding the impact of the 53rd week in 2012; half of that decline was due to the combination of 109 store closings in North America and Europe over the past 12 months, in addition to the headwind from foreign exchange. This sales decline was exacerbated by continued margin weakness, with comparable operating margins down 175 basis points from a year ago, to 5.8% (there’s some impact here from the 53rd week, as we’ll see in the individual segments as well). The combined result was a near 30% decline in non-GAAP EPS for the quarter.

For the full year, sales declined 3.4%; after adjusting for store closures and foreign exchange impacts, the net decline versus 2012 was approximately 2%. To put that number in perspective, a 2% annual decline over the course of a decade would leave you with more than 80% of your original sales; from their peak three years ago, Staples’ sales have declined at exactly that rate: 2% per annum.

As in the fourth quarter, margin pressure was an issue, with comparable operating margins for 2013 of 5.4% down nearly 100 basis points from 2012. For the full year, non-GAAP earnings fell by 17%, to $1.16 per share. This is well short of the $1.30 to $1.35 per share that management was projecting at the start of the year; sales of $23.1 billion for 2013 were $800 million short of management’s low single digit growth target of $23.9 billion.

Retail

For the fourth quarter, the reported comps in North American Retail & Online was off 7% — a truly atrocious result; comparable sales were down double digits in December, due to excess promotional activity from competitors in categories like PCs and tablets, as well as tough weather in some of Staples strongest markets (as you probably know, they have a large presence in the Northeast); management did not quantify this impact. For the full year, comps declined 4%, despite mid-single digit growth in categories like Copy & Print (a big area of focus for SPLS). In the quarter, average order size fell slightly, with traffic off 6%. This certainly looks better than the 15% decline in mall traffic in quarter four (according to J.C. Penney’s CFO Ken Hannah) – but beyond that, it hardly elicits optimism. The company is working to remove unproductive SKUs, filling in excess space with categories beyond office supplies (like Apple (AAPL) products, including the iPad, to more than 900 stores late in quarter four); the long-term solution will be downsizings and store closures.

While the stores struggled, online put up a solid performance: Sales increased 10% in the fourth quarter, after advancing by approximately 4% in the first nine months of the year (after backing out the 53rd week and foreign exchange); traffic and conversion were both higher, with strong technology sales during the holidays driving the results. Staples plan of becoming the online destination for business customers (whom account for 80% of online sales) took a strong step forward in 2013: The company expanded its assortment by five times, to 500,000 SKUs – and as CEO Ron Sargent noted on the call, “We're just getting started.” The expanded assortment has improved the businesses impact on the top-line, and is on a run-rate to add more than $200 million in sales next year; the company plans on tripling the assortment – to more than 1.5 million SKUs – by the end of 2014.

The operating margin for the year at North American stores and online cratered to 6.6%, from 8.3% in 2012 (I’m not sure how to breakout the fixed cost leverage on the 53rd week). The rationale given for the decline largely points to investments in online, as well as gross margin mix shift driven by technology product sales in dot-com; if the company can sustain double-digit growth in this channel, then that trade-off may prove worthwhile (dollars are what count at the end of the day). Considering the pickup in ad spend refocused on ecommerce, as well as the traction gains made in quarter four, I’ll be watching this closely in the coming quarters.

Contract

The Commercial business, which has been a key building block for my thesis from day one, continues to pull its weight. After adjusting for the 53rd week, sales were up 1% in the quarter and up 1.2% for the full year, to $8 billion – with growth in categories like facilities and breakroom supplies offsetting weakness in the core business (on an interesting side note, Staples sales from Facilities & Breakroom will exceed their sales from Paper in 2014, and will likely account for a full 10% of the company’s overall sales). The operating margin, as in the retail business, was pressured, falling about 90 basis points for the full year (to 7.5%); operating income of $605 million for 2013 was down from $680 million in 2012.

But, as is often the case, the headline numbers can be a bit misleading. As always, the investor must ask one additional question: What happened, and why? In reality, margins were impacted by the extra week (“much closer to flat” otherwise), in addition to investments in sales force to capitalize upon future growth opportunities – all of which was a headwind to improved gross product margins. Now that the integration has begun (with some screwy activity in the period prior to the merger close), Staples must take share and continue driving beyond office supplies. If Commercial doesn’t ramp to low single-digit growth throughout 2014, I’ll be disappointed.

If you remember from my original analysis, Staples had just under a 60% share in Commercial in 2011, from approximately one-third of the market 10 years prior – said another way, it flat out obliterated Office Depot (ODP) and Office Max. By my math, Staples Commercial business is still 50% larger than its (now) combined competitor, based on 2013 pro-forma results (meaning it has added a bit more market share in the last few years). Going forward, Staples must continue to win here.

International

I never paid much attention to the International business early on, and thought it might be a nice kicker if anything (in the five years to 2011, income from the division was approximately $125 million a year); it turns out that was dead wrong. Adjusted sales for the International business fell 9% in 2013, after dropping 11% in 2012; the fourth quarter metric was -4% after adjusting for closures and foreign exchange, so there’s a hint of improvement (-6% for the full year with those same adjustments) – but just like in North American retail against mall traffic, better by comparison doesn’t mean much against an atrocious comparison. The company managed to report a profit in Europe for the year, with International as a whole losing $15 million; the 1% drop in comparable sales in quarter four was the best quarterly result from the European business in six years (that says it all). The focus going forward will continue to be on dot-com and commercial, and less on brick and mortar.

Staples ended the year with 282 stores in Europe, 27 in China and a dozen in Australia; collectively, International accounted for less than 15% of Staples' global units at year end.

Balance Sheet and Guidance

As I noted as trends started to weaken through 2013, I think the company’s capital allocation decisions for the year were conservative and appropriate (we see a continuation of that policy with the fourth quarter results, as management left the dividend unchanged for the first quarter). In the fourth quarter, Staples paid off $867 million of debt with cash on hand (that should go a long way in reducing the approximately $120 million in interest charges incurred in fiscal 2013); at the end of 2013, the company has $1 billion in long-term debt, split between maturities in 2018 and 2023. In addition, the company has roughly $500 million in cash on hand, with the current ratio at year end in excess of 1.5X; Staples remains solidly profitable (will outpace ODP’s operating income in 2014 by at least 5X), and is in a sound financial position as we look to the years ahead.

The biggest disappointment from the fourth quarter call came at the end of the prepared remarks: “For the full year 2014, we expect to generate more than $600 million of free cash flow, which reflects cash payments related to previously announced restructuring activities and our considerations for the impact of future 2014 restructuring activities.” This $600 million target compares to a $900 million target in 2013, which the company missed. For the year, Staples reported $1.1 billion in cash flow from operations, with $371 million in capital expenditures bringing full year FCF to $737 million.

With that said, the 2014 target still leaves Staples with room to maneuver: at $600 million even, the company would still have approximately $250 million in cash after paying the dividend (currently yielding approximately 4.2%). The company made more than $300 million in shares repurchases in 2013, buying nearly 21 million shares at an average cost of about $14.30 per share; with the stock down about 20% from their average cost, they should be happy to buy more here (but my read from the commentary is they’re unlikely to exceed FCF for the full year). While it’s not relevant to cash flow estimates, I also think there’s a reasonable chance we’ll see goodwill impairment in 2014.

Consolidating the Industry's Retail Footprint

Let me close with a bit of history: 10 years ago, Office Depot, Office Max and Staples collectively operated just over 3,200 stores in North America. From those stores, it generated $18 billion in retail sales – good for $5,574,000 a piece on average; here’s the breakdown:

Over the next five years, these retailers would collectively increase their store base by nearly 30%, to more than 4,100 locations; however, retail sales for the three chains increased by just 9%, with sales per store compared to five years earlier falling precipitously (as shown):

As we can see, Office Depot felt the brunt of the declines, with sales per store falling by nearly one-quarter. Staples faired the best (taking the top spot for average sales by location by a solid margin), but didn’t escape unscathed either: Sales per store declined by 10% in the five years to 2008 (take these figures with a grain of salt, as I’ll explain in a minute). As a whole, the industry was struggling to put up solid financial results – a struggle that was about to get even worse:

The five years to 2013 were just as tough as the five years prior to 2008 for Office Depot and Office Max (combined results based on pro forma estimates from fourth quarter 2013 ODP presentation). At the end of 2013, the combined company finds itself with more than 1,900 locations in North America, with the average location doing $3.6 million in sales – down by 33% from the average ODP/OMX retail location from a decade ago. The chain’s sales per location are approximately 40% lower than the average for their primary competitor (it should be restated here that Staples moved its online sales into the NA Retail division a few years ago, while ODP reported online sales, unless they are fulfilled from retail locations, in the NA Business Solutions or International division. My rough estimate suggests that Staples.com sales are somewhere between $2 billion and $2.5 billion as of fiscal 2013 – which would certainly change the numbers presented above, but not in a way that would invalidate the general thought process; if you back out $2 billion from the 2013 sales figure for SPLS, the sales per store are still approximately 40% than the ODP average).

Staples, on the other hand, reported an increase in sales per store in the period from 2008 to 2013. Let’s be clear about something: Comparable sales did not increase – in fact, they were down high single digits (cumulatively) from 2008 to 2013. This figure does not properly account for two key factors: (1) online sales, which I discussed in the previous paragraph, and (2) the closure of stores in the terminal period (which boosts sales per store in 2013) as well as a net substitution of underperforming stores for better locations. While that nullifies the figures as shown, it doesn’t change the overall idea: Staples is in a much better position – in comparison to its closest competitor – than it was five years ago. This is true in the retail business, in ecommerce, in the commercial/delivery business and from a financial perspective.

Here’s one final thing to consider from these figures: ODP and OMX have collectively closed about 75 stores per year since 2008 (and about 60 per year after adjusting for Grupo OfficeMax). Clearly, that hasn’t been enough – the impact of secular trends and a dominant primary competitor (plus increased competition from other retailers) means that the new combined company will need to look at making more aggressive moves going forward.

That brings us to some news from Staples: The company will close 225 stores by 2015 in North America – equal to a 12% decline from year-end 2013 levels. Now put this in the context of the information presented above and ask yourself one question: When Office Depot unveils its strategy for rationalizing its real estate footprint and consolidating stores in North America (which will be finalized in the second quarter and executed upon in the back half, per the fourth quarter call), how many stores will it close? Before you answer that question, consider the following: Three-quarters of its domestic leases – covering more than 1,400 locations - will expire over the next five years. In states like Texas and Florida, the combined company has more than 2x the number of retail locations that Staples has (getting to parity in those two states alone would result in the closure of 265 stores).

I’m looking for 125 to 150 closures per year from ODP through 2018 (five years), with some adjustment for downsizings from 20,000 to 25,000 boxes to 5,000 to 12,000 (on a side note, Staples now has 30 of its 12,000 square-foot locations; it is still retaining about 95% of their sales). If Office Depot does not come out with a plan that’s at least this aggressive, I’ll be very disappointed. If it do not choose to get serious about closing big boxes after a year like 2013, I’m not sure what it's waiting for.

This quote from Staples' CEO Ron Sargent captures my overall thought process on closures:

“I'm not sure we need as many stores today as maybe I thought we did five or ten years ago. Back then, I thought maybe 4,000 stores was probably the right number in North America. Today, in North America, my guess is there's probably room for 2,800 stores or 3,000 stores. And if you just carve out Canada, you're -- probably in the US, there's probably room for, I don't know, 2,400 stores in the United States today.”

I wouldn’t be surprised if the number of stores needed kept that pace (falling 50 to 100 per year) for the foreseeable future – meaning that there will be room for about 2,600 combined stores for SPLS and ODP five years from now. That would require closing about 1,100 stores by 2018.

Staples will take out 225 North American stores in the next two years, and I would bet will drop another 50 or so a year from there (on average); that leaves 725 stores to go from Office Depot – equal to 145 stores a year through 2018. Time will tell if this is accurate.

Conclusion

I sold one-third of my position late last year when the stock crossed $16, but have retained the other two-thirds to date. The volatility can be gut wrenching if you look at the stock price enough (by my count, the stock has made a 25% move – higher or lower – eight separate times in the last five years). While I’m cognizant of the problems ahead, I think it’s more than priced in.

I don't plan on changing my position until we get further word from Office Depot – but that might change if Mr. Market starts to get depressed. As always, I look forward to your comments and questions, and hope that you will speak up if you find some holes in my analysis.