As the "best in breed" office supplies retailer, Staples (SPLS) is a fantastic business that provides the potential for long-term free cash flow expansion through its Retail (40% sales, 10.7% op margin), Delivery (40% sales, 9.5% op margin, and International (20% sales, 3.0% op margin) business segments. Despite low investor sentiment due to macro concerns, there are significant long-term tailwinds in place for the patient investor. Based on my analysis, the current market price of $15.00 is approximately 40% below the company’s true intrinsic value, providing an attractive entry point with a comfortable margin of safety.
The office supplies industry has taken a significant hit in recent years due to the global economic downturn, but SPLS has been able to weather the storm and is positioned well to capitalize on an eventual industry rebound. Unlike many of its competitors, SPLS has continued to invest in high-growth areas (Technology, Copy & Print) while steadily increasing retail store count in North America (+170 since 2007) and international markets (+77 since 2007). The 2008 acquisition of Corporate Express illustrated the company’s focus on the Delivery segment (serves F500 and other corporate customers), which eventually should feature margins 1-3% higher than Retail while requiring less capital. The majority of SPLS' profits are now generated online (second largest online retailed behind Amazon), which offers a more visible earnings stream because SPLS uses its own fleet of trucks and ~60% of these sales are under sizable long-term contracts with corporate clients. Once full synergies are achieved by 2014, SPLS' long-term targets are 12% Delivery operating margins (9.5% in 3Q11; 8.5% in 2010) and 9% consolidated margins (8.1% in 3Q11; 6.6% in 2010).
SPLS currently has an attractive balance sheet that features a high cash balance of $1.1BB and moderate LT debt of $1.6BB (down from $2.5BB at 2009 year-end). Despite the difficult economy, the company has continued to generate impressive free cash flow which it has used to delever as well as return to shareholders via dividends and share repurchases. I project $1.2BB in FCF in 2012, suggesting a FCF yield of 12%. In addition, ROIC of 11.8% is down from five years ago but trending upward; SPLS ROIC is generally in-line with WMT and well ahead of direct peers OMX (3.4%) and ODP (2.5%). Based on my analysis, I project SPLS could increase ROIC to 14-15% in two years. Another key differentiator for SPLS is its strong, stable management team that has largely been kept intact over the last 15 years. Current CEO Ron Sargent has been with the company since 1989 and CFO John Mahoney has been on board since 1996; in comparison, ODP CEO Neil Austrian came on board in 2011 (after Steve Odland’s disappointing six-year tenure) and OMX CEO Ravi Saligram joined in 2010. Neither Austrian nor Saligram have office supplies industry experience. SPLS management has been through ups and downs in the office supplies space and is much better prepared to understand and react to unique industry pressures.
Near-term Street expectations for SPLS are low, but I believe the company is a very attractive investment for the patient investor with a 3-5 year horizon. If the global recession continues to linger through 2012, SPLS is in the best position of all office supplies retailers to manage through it due to its strong balance sheet and ability to generate sizable free cash flow (+$1BB the last four years). Management will continue to invest in high-growth areas, increase dividends, and repurchase shares (“Probably the best investment that we could make as a company would be to buy back our own shares at this level, because we think the stock is on sale.” – CEO Ron Sargent at 09/2011 Goldman Sachs conference). However, if the global economy shows meaningful improvement, SPLS will gain market share and increase profitability due to its strong competitive position in North America and international markets, dominant presence in Delivery and online sales, and untapped operating synergies associated with the Corporate Express acquisition. In summary, SPLS’ strong balance sheet, ability to generate significant free cash flow, upward-trending ROIC, and shareholder-friendly management makes the company an incredibly attractive investment.
- Initial 2012 Guidance: Despite solid results from the NA Retail and NA Delivery segments in 3Q11, consensus estimates remain low for 2012 after SPLS lowered expectations throughout 2011. Initial 2012 guidance is expected with 4Q11 results, and collectively the Street is expecting 2012 EPS of $1.47, implying YOY growth of approximately 8.8%. However, if management continues to focus on repurchasing shares at low market prices, I project approximately $0.04 in EPS accretion with another ~$600MM in repurchases in 2012. If SPLS is also able to show meaningful operational improvement, I believe 2012 consensus estimates will prove conservative.
- Operational Improvement in International Segment: Investors and analysts appear to be holding off on SPLS until the company can show meaningful improvement in the International segment. Disappointing International results have dominated the Q&A session of recent earnings calls, while analysts generally ignored the excellent free cash flow, shareholder-friendly increases in repurchases and dividends, and market share gains in NA Delivery.
- Additional Share Repurchases (or Insider Buying): SPLS initiated a stock repurchase plan in 2010 after lowering its debt level from the Corporate Express acquisition. Management is targeting $600MM in share repurchases in 2011, and it appears reasonable to assume a similar level in 2012 due to the large amount of cash the company generates. Insider buying would also be a positive signal.
- "Best in Breed" Office Supplies Retailer with Strong Infrastructure in Place. Instead of halting investment over the past few years due to the economy, SPLS has grown NA stores, increased international presence, and drastically improved their reach in the Delivery segment with CXP acquisition. SPLS is in the best position of all office supplies retailers to expand margins and FCF over the next 5 years.
- Significant International Reach with Improving Profitability. Management is targeting 7.5% operating margins in Europe within three years and eventually a similar margin for the total intl business (3.0% in 3Q11) by focusing on G&A adjustments (150-200 bps) and supply chain improvements. SPLS has 377 total international stores, including 200+ in Europe and 20+ in China.
- Impressive Valuation/Cash Flow. SPLS generates $1BB in FCF per year, and has steadily repurchased shares and paid down debt despite core business difficulties. ROIC of 11.8% is well ahead of direct industry peers and has further upside. FCF yield is 10% with potential for 12-13% in 18-24 months.
- Strong Management Team; New Intl Hires. CEO Ron Sargent has been with SPLS for 23 years, much longer than CEO counterparts at OMX and ODP, and has been through up and down cycles before. SPLS reshuffled Intl leadership in late 2010 to address disappointing performance.
- Improving Margins via CXP Synergies. Management is targeting 9% operating margins by 2014 (6.2% in 2009) and 12% op margins in delivery once full synergies are achieved and CXP integration is completed.
- Industry Consolidation. There is concern that the office supplies industry has too many competitors, and greater industry consolidation could provide more breathing room for all market participants.
- Potential Acquisition of OfficeMax (OMX) or Office Depot (ODP). Both companies have jeopardized their competitive positions over the last two years by decreasing capex below maintenance levels, closing stores, and selling real estate. An acquisition by a better capitalized firm could potentially challenge SPLS' industry position.
- Inability to Increase International Profitability. Outside of Germany, SPLS has struggled recently in Europe and Australia recently due to macro issues. However, SPLS is profitable in every European country outside of Belgium, and high-growth markets Brazil, India, and China have generated solid overall growth and reduced operating losses in-line with internal plans.
- Extended Pressure on U.S. and European Employment. SPLS core business is very much tied to labor, and the company may struggle to generate meaningful growth until unemployment rates improve in its mature U.S. and European markets.
- Greater Competition from Online or Big Box Retailers. While SPLS has performed much better than direct peers OMX and ODP, the company will continue to face greater competition from Wal-Mart (WMT) and Target (TGT) in the retail setting and Amazon (AMZN) in the online setting.