Staples Is Dominant And Offers Value

| About: Staples, Inc. (SPLS)

Staples (SPLS) is the world leader in office supply products, with more than $25 billion in revenue in 2012 compared to Office Depot's (ODP) $11.5 billion and OfficeMax's (OMX) $7 billion. Staples operates in 26 countries throughout the Americas, Asia, Europe, and Australia.

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Staples' stock currently trades around $16.50, with a 52-week range of $11.94 to $21.50. Let's take a look at the financials.

(In Million $) 2008 2009 2010 2011 2012
Revenue $19,372 $23,083 $24,275 $24,545 $25,022
Operating Cash Flow $1,361 $1,685 $2,084 $1,446 $1,576
Capital Expenditure $-471 $-379 $-314 $-409 $-384
Free Cash Flow $890 $1,307 $1,770 $1,037 $1,192
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Revenue has grown 29% from 2008 to 2012, while operating cash flow has grown 15.8% during the same time period.

Owner Earnings

Owner earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines owner earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges . . . less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume . . . Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess -- and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate owner earnings by taking the five-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow because it has a dilutive effect on the company, but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes given that interest is tax deductible.

(In Million $) 2008 2009 2010 2011 2012
Operating Cash Flow $1,361 $1,685 $2,084 $1,446 $1,576
Interest Payments $38 $149 $237 $214 $173
Stock-based Comp. $0 $180 $174 $146 $151
Avg. Capital Expenditure $-391 $-391 $-391 $-391 $-391
Owner Earnings $994 $1,212 $1,673 $1,049 $1,150
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Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the owner earnings figures to determine Staples' cash return on invested capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the owner earnings divided by the total invested capital. This is a better measure than return on invested capital, or ROIC, because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $) 2008 2009 2010 2011 2012
Owner Earnings $994 $1,212 $1,673 $1,049 $1,150
Invested Capital $9,036 $13,073 $13,717 $13,911 $13,430
CROIC 11.01% 9.27% 12.2% 7.54% 8.57%
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Staples' CROIC for 2012 was 8.57%, which means that given, let's say, $1 million of investment (retained earnings, for example) the company will generate $85,700 in cash on that investment. In the long term, a company should grow at roughly its CROIC. Staples is worlds ahead of it's main competitors in terms of CROIC. Office Depot has a CROIC of 1.6%, while Office Max does not generate positive cash flow. This would suggest that Staples will maintain it's position as market leader without much trouble. Let's take a look at the balance sheet.

Cash and Cash Equivalents $1,060
Investments $0
Debt $1,987
Pension Obligations $0
Minority Interest $7
Net Cash (Debt) $-934
Diluted Float 698
Cash/Share $-1.34
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Staples has about $2 billion in debt compared to about $1 billion in cash, but with interest payments taking up only 15% of owner earnings this debt is perfectly sustainable.


To determine the fair value of a company, I use a discounted cash flow analysis. I use a discount rate of 15%, and you can read more about my view on discount rates here. For Staples, I will use an initial growth rate of 8%, which is in line with the CROIC, and then allow this growth rate to decay over 20 years to 3%, which will then be the perpetual growth rate. For reference, analysts estimate the company's earnings growth to be 9.86% over the next five years. The growth schedule is displayed below.

Year 1 2 3 4 5 6 7 8 9 10
% 8% 7.75% 7.5% 7.25% 7% 6.75% 6.5% 6.25% 6% 5.75%
Year 11 12 13 14 15 16 17 18 19 20
% 5.5% 5.25% 5% 4.75% 4.5% 4.25% 4% 3.75% 3.5% 3.25%
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Using these parameters yields a fair value of $17.66, which is higher than the current market price. Buy targets for various margins of safety are listed below.

Margin of Safety Buy Target
10% $15.89
15% $15.01
20% $14.13
25% $13.25
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As I mentioned earlier, Staples is the dominant player in the office supplies market, with the nearest competitors miles behind it in terms of efficiency. The stock is currently undervalued and has seen market prices within the past few months that would allow an ample margin of safety. Staples should be able to grab a larger share of the market going forward and will remain at the head of the pack for years to come.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPLS over the next 72 hours.