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.
