Staples: Accelerating Growth in a Decelerating Market

Morgan Stanley analyst Gregory Melich expects retail sales to grow only 3 percent in 2008, down from a previous forecast of 4.5 percent. This would make 2008 the slowest annual growth period for retail sales since 2003.

Melich's forecast assumes average home prices fall about 6 percent from where they are now, leading to about $100 billion less in total consumer spending, half of which he predicts would come from traditional retail categories.

Thomson Financial disagrees with the assessment of a 6% cut on the average home though agrees that 2008 will be somewhat lower than 2007 in real growth terms. In any event there seems to be a consensus that not all retail is equal. The divergence amongst analysts is limited to which of the retail stocks will continue to deliver in 2008.

Melich's assumptions regarding Staples (SPLS) are fairly basic. As depicted below, there is an already noticeable trend taking hold in 2007 that according to Melich (our interpretation of what he is saying) will continue and expound in 2008. The North American Retail segment will grow at market growth rates, meaning 3% (Melich) yet the above peer growth will come from North American Delivery and a more pronounced growth rate from International Operations.

The trend as seen from the latest 10-Q:

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In the same filing Staples Inc. breaks down the percentages and explains how this was achieved. Supporting Melich's take is the fact that same store sales for North American Retail actually declined 2% in Q2 2007. This may not be a good litmus test as Q3 and Q4 are traditionally the stronger quarters. If there were to be a decline in Q3 and Q4 then we would be very nervous about 2008 altogether, regardless of whatever the International division accomplishes in 2007. For the time being, we view Q2 as a minor setback and look forward to a bounce-back in Q3 and Q4.

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The 10-Q text below contains some interesting information. For instance; North American retail had a dismal first half in office furniture, basic supplies and office printers and copiers. However, the copy and other consumables departments (ink for existing printer machines) did well. This implies that business is continuing to churn though is cautious about any expenses not related to the every day business activities.

North American Retail: Sales for North American Retail increased 4.9% for the second quarter of 2007 and 3.6% for the first half of 2007 compared to the first quarter and first half of 2006. The growth primarily reflects an increase in non-comparable store sales, partially offset by a decrease in comparable store sales of 2% for the second quarter of 2007 and flat comparable store sales for the first half of 2007. We added 28 stores to the North American store base in the second quarter of 2007 and 52 stores in the first half of 2007. As of August 4, 2007, the North American store base included 1,672 open stores compared to 1,539 stores as of July 29, 2006 and 1,620 stores as of February 3, 2007. The increase in sales also reflects the positive impact of Canadian exchange rates to the U.S. dollar of $18.4 million for the second quarter of 2007 and $16.1 million for the first half of 2007. Our comparable store sales decrease for the second quarter and flat performance year-to-date reflects negative performance in furniture, core office supplies and business machines, partially offset by positive performance in our copy and print center business, computers and ink. Business unit income as a percentage of sales decreased to 7.4% for the second quarter of 2007 and 7.7% for the first half of 2007 from 7.8% for the second quarter and first half of 2006. The decrease in business unit income as a percentage of sales primarily reflects deleverage in fixed costs resulting from a decrease in comparable store sales, increased investments in marketing and a decline in product margin rate partially offset by expense control and increased sales in higher margin categories including Staples brand products and copy and print services.

North American Delivery: Sales for North American Delivery increased 16.1% for the second quarter of 2007 and 15.5% for the first half of 2007 compared to the second quarter and the first half of 2006. The sales growth for the second quarter and first half of 2007 reflects the continued success of our customer acquisition and retention efforts, increased penetration of existing customers and more effective marketing spend. Business unit income as a percentage of sales increased to 10.7% for the second quarter of 2007 and 10.1% for the first half of 2007 from 10.5% for the second quarter of 2006 and 9.9% for the first half of 2006. The increase in business unit income primarily reflects improvement in our supply chain and more efficient and effective marketing to acquire and retain customers. These gains were partially offset by our increased investment in growth initiatives and a decline in product margin rate.

International Operations: Sales for International Operations increased 18.2% for the second quarter of 2007 and 17.2% for the first half of 2007 compared to the second quarter and first half of 2006. The increase primarily reflects the positive impact of foreign exchange rates of $39.0 million and $97.5 million for the second quarter and first half of 2007, growth in our international delivery businesses on a local currency basis, as well as an increase in comparable store sales of 7% and 4% for the second quarter and first half of 2007. As of August 4, 2007, the store base included 290 open stores compared to 262 stores as of July 29, 2006 and 264 stores as of February 3, 2007. Business unit income increased to $4.4 million and $19.9 million for the second quarter and first half of 2007 from a $7.7 million loss for the second quarter of 2006 and income of $2.8 million for the first half of 2006. This primarily reflects sales growth in our European businesses along with our continued focus on expense management.

For now we are hesitant to declare SPLS a winner for 2008. We would like to see what SPLS does in Q3 before drawing any conclusions. If SPLS beats our $0.40 EPS estimate for Q3 then we might be inclined to review 2008 based on stronger International performance.

Disclosure: No conflicts