In an earlier article (see here), I argued that Staples (NASDAQ:SPLS) may buy out Office Depot (NYSE:ODP) or OfficeMax (NYSE:OMX). With a "sell" rating on the Street for Office Depot, I believe that the firm could even be a strategic activist target. Floundering fundamentals could be corrected under Staples' wing, which, in my view, has a great story going for it in facility solutions and breakroom. Whereas Office Depot has showed some promise internationally, Staples has declined 2% sequentially in the top-line at the most recent quarter. As Staples generates substantial free cash flow, it has the resources to stage a buyout where it can capitalize on a cyclical trough.
From a multiples perspective, Staples is considerably undervalued. It trades at a respective 10.4x and 9.5x past and forward earnings - historical lows - while offering a dividend yield of 2.8%. Office Depot trades at 24.4x forward earnings, but has gross margins that are 180 basis points higher than its competitors. The combination of a high growth company with a high gross margin company is attractive during a recovery.
At the third quarter earnings call, Staple's CEO, Ron Sargent, noted strong performance:
"Total company sales increased to $6.6 billion, operating margin expanded to 8.1% and adjusted earnings per share were up 15% to $0.47 for the quarter. We continue to make progress managing the business in a pretty tough environment and our cash flows remain very strong…
During the third quarter, North American Delivery grew the top line 2%, with growth in both Staples.com and Contract. Sales in North American Retail were flat. And in International, the top line decreased 2% in U.S. dollars and 7% in local currency, as business trends in Europe and Australia were softer than we expected. Operating margins were up in both North American Delivery and North American Retail. And in International, the progress we've made to streamline our cost structure was more than offset by lower-than-expected sales. In total, we had a solid quarter with strong performance in North America and in our growth initiatives and soft performance in International, driven by weak sales".
The firm is one of the best generators of free cash flow, yielding $852M for the year thus far. In addition, management remains committed to returning it to shareholders through its capital allocation policy. Since 2004, nearly $4B worth of shares have been repurchased and the dividend has been continually raised. In the third quarter, an impressive $700M shares were repurchased, which signals confidence in operations and finances.
In addition, Staples has also gained market share with North American retail beating the competition despite macro headwinds. Facilities and breakroom grew sequentially in the double digits during the third quarter. With a potential market of $25B, Staples still has a great degree more to penetrate for meaningful value creation. Going forward, however, I anticipate that a promotional environment will limit margin expansion.
Consensus estimates for the firm's EPS are that it will grow by 7.9% to $1.37 in 2012 and then by 9.5% and 11.3% more in the following two years. Assuming a multiple of 13x and a conservative 2012 EPS of $1.45, the rough intrinsic value of the stock is $18,85, which implies 32.7% upside. The stock is not without its risks: if the multiple were to fall to 8x and a 2012 EPS turns out to be 6.7% below the consensus at $1.40, the stock would fall by 21.1%. The Street currently rates shares a "buy".
Office Depot's third quarter earnings slightly beat expectations. North American retail was down 3.7% y-o-y, but International was up 1% in US dollars. Gross margins notably improved, but sales nevertheless remained soft. In addition, the firm is reducing promotions, which may create a bit of a vicious cycle for profitability. Following the loss of the US Communities Contract, Home Depot is in a bit of a predicament as it continues to decline in market share. Management nevertheless has shown a long-term confidence by reinvesting cost savings and I anticipate a comprehensive global restructuring some time in 2012. Assuming a multiple of 13x and a conservative 2012 EPS of 0.07, the stock has 58.6% downside. Analysts currently rate the company a "sell".
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.