The Long Case for Office Depot

In a recent edition of Value Investor Insight, Randall Abramson of Trapeze Asset Management described why he thinks Office Depot (ODP) is mispriced.

Switching gears, why do you think the market is overreacting to challenges facing Office Depot [ODP]?

RA: The stock is off 65% over the past year as they’ve struggled with a softening economy, particularly in the Florida and California markets that generate 25-30% of their sales. As volume has gone down, they’ve had to discount heavily to clear out inventory, hurting margins. They’ve also significantly cut back on planned growth, cutting in half the planned 150 new store openings for next year. These are clearly challenges, but we consider them short-term and fixable. The office-supply business has actually been a healthy, stable industry over time. If you look at Staples’ returns on capital over time, they’ve remained fairly consistent around 15%, with good capital growth rates as they roll out new locations. The three largest retailers – Staples, Office Depot and OfficeMax – now control only about 10% of the market, so there’s a lot of room to use their scale advantages to displace small specialty stores that still have a large share of the market.

Office Depot has been a laggard behind Staples. Why do you see that changing?

RA: A big part of it is confidence in the CEO, Steve Odland, who took over in early 2005 after a very successful stint as the head of AutoZone, where he proved himself as both a cost-cutter and excellent manager of capital and the balance sheet. He’s put in place an extensive operating overhaul to increase operating margins from the current 4.5% to at least 7.5% – still below Staples’ – within five years. They’re doing things like increasing private-label products, going to more direct sourcing, investing in new IT systems to enhance productivity and reworking the product mix toward higher-margin items.

Are you counting on much growth?

RA: Industry consolidation and smallbusiness growth benefit them in the U.S. and they also have a healthy and growing presence overseas. But at the current stock price, we don’t need a major salesgrowth story for this to be interesting. We’re assuming combined overall growth from new stores and same-store sales to be around 6% per year over the next three years.

So this is primarily a margin-improvement story?

RA: That and the fact that we expect them to continue aggressively buying back shares. The company has repurchased 12% of its shares in the past two years and has the cash flow and balance sheet to maintain that level of buybacks.

With the shares trading around $13.50, how are you looking at valuation?

RA: The company today trades at just over 8x the $1.65 per share we expect it to earn next year, while Staples is currently trading at 14.3x. With moderate growth, margin improvement and share buybacks, we believe within three years Office Depot has, on around $8 billion in revenues, earnings power of close to $3 per share. With returns on invested capital at least getting back to the 16% level it reached three quarters ago, we’d expect the company to support at least a 14x multiple on that $3 of earnings. If that happens, we’d have a triple from today’s share price.

Do recent issues over the accounting for vendor promotional programs worry you?

RA: We’re comfortable with the company’s explanation that the discrepancies found will only result in some shifting of expenses from one quarter to another, and not have any impact on ongoing operating margins. It’s understandable that this caused concern because there have been cases of these types of vendorprogram funds being used to inappropriately boost earnings. We have no reason to believe there’s a darker picture to emerge here.

Office Depot has been mentioned as a buyout candidate before. Is that even more credible today?

RA: The company is not very levered at all, so would make a legitimate LBO candidate if those things ever start happening again. We’d personally love to own a combined Staples/Office Depot and believe there’s a good argument to be made for it passing regulatory muster. We think Office Depot is worth $35 in Staples’ hands today.

Comments

[ballsschweaty]

I went into Office Depot yesterday and I see no change. I see unhappy, disgruntled employees, an operational mess with the aisles obstructed by empty boxes, hand trucks, and a uncompetitive merchandise assortment that includes too many electronics.

I forecast bankruptcy in 2009.

Enjoy.

[ValueInvestor]

I've been short this POS from the mid 30s, but recently covered. Not ready to go long YET, but getting close

[MDB]

Haha. As if your one store sample is statistically significant. And since when are any minimum wage employees NOT disgruntled?

[Shopkeeper]

This stock has a base at about $11.50 and if it drops below that it will probably go to single digits. Executives at this Co. are given way too much credit for any of it's success. The Company is still bloated at the top and even with the CFO leaving, nobody wants to recognize that the problem isn't the industry, it's the OD Management and Board.
The right merchants with the right product mix could grow this business double digits, but private brand is not the answer. Analysts think private brand goods grow profit, they do not if they don't sell. A "dog" private brand item hurts the bottom line even worse than name brand goods because sell thru is totally in the hands of the retailer and a significant margin hit. OD is loaded (based on Steve Odland's direction) with private brand goods that are not in package quantities consumers want, and pricing isn't that attractive either.
The future with OD would be served better with a merchant CEO who knows how to sell, and a decentralized approach that values diverse stores, styles, and management flexibility. OD like many retailers has fallen into the trap of "cookie cutter" theory. Believing that sameness = easier and better execution for better results. Not so. Growing your teams to be agile, responsive, and stand alone capable, generates creativity, independance, and pride...those qualities show up in better customer experiences = sales. Low wage workers aren't the problem, brain dead Corp. leadership is the untold OD story.

[boca guy]

Actually, the way Odland was operating in trying to keep up profits was to cut departments and personnel to the point that they could not sustain themselves - just as he did at his previous company.

I worked there and can tell you that Staples was high in 'customer service' and Office Depot was 'low'. Yes, they talked a good game, but had only a financial view of the customer and not what it took to compete and win. You would not believe what went on with the constant screwings OD did to their small to medium accounts. As an example, OD would charge to deliver to 2nd floor accounts, but Staples would not (we would call Staples and ask them if they would). Guess who the customer switched to? Now they are trying to put some of the pieces in place again - they have contracted with a telemarketing firm to rehire those they let go to see if they could revive the excellent group they had that sold to these accounts. In closing, I hope Staples wipes the floor with them - they deserve it in their lousy customer attitude.