Staples: Growth at a Reasonable Price

We believe Staples (SPLS) is one of those stocks that should be present in the portfolio of a conservative investor. The reason: SPLS provides growth at a reasonable price but, above all, with a reasonable level of risk:

• The market is low growth but very attractive due to its very high fragmentation. The three main players have in total a market share of approximately 10-12% (Staples has 3% of the market). This means that there is still a huge consolidation opportunity and SPLS, given its healthy financial conditions, will definitely play a leading role in the process.
• Among the listed players Staples is always the first mover in the introduction of best practices and in gaining efficiency in their operations. The ebitda margin was more than 9% in 2005 and this compares to figures in the range of 3%-6% for the two main listed competitors Office Max (OMX) and Office Depot (ODP). This has also a strategic implication. In a stable industry, especially in the local markets where all the players have a presence, you can increase your market share mainly by using the price leverage. Now, SPLS – with its higher margin – is in the position to decide what strategy to adopt, while price wars are very likely precluded to the other two players that are currently struggling to expand their margins.
• As of 2005 only 18% of total sales at Staples were private label. This compares to many other consumer products where private labels penetration reached 30%-50%. If you consider that private labels generally has a 10% higher margin for SPLS you can easily figure out that the private label trend will definitely contribute to margin expansion in the future years.
• The turnaround of the international division is starting bearing fruits. During the IIIQ international sales grew 10% and operating margins improved 130 basis points to 1.5%; while this is still far below North American margins, there have been clear signs in the past quarters that the turnaround has started. And the improvement shows that the international division will likely contribute to margin expansion in the coming years.
• SPLS clearly underperformed both OMX and ODP in the past year, probably because investors were more focused on the turnaround potential at these two companies. At this point the company is trading in line with the two competitors while still maintaining a leading position and a more solid balance sheet (both MOX and ODP have a negative financial position).     

Staples is trading at a consensus P/E 2007 of 18x and the stock is not a real bargain at the moment. However, the management is committed to delivering 20% annual EPS growth and the excellent track record makes us think that they will be very likely succeed in maintaining the promise. We suggest to put the stock in your watch list and buy it (or buy call options) on weakness whenever it goes below $25.

Disclosure: no position at the time of writing

SPLS 1-yr chart: