Office Depot: Super Cheap or Mistake?

It's time to take a fresh look at my worse performer - Office Depot (ODP). At $12 and change, it has dropped about a third from my original purchase point, which is the impetus for my review. And my conclusion in answer to my question in the title - it is both a mistake and it is super cheap.

Generally, if a stock I own drops about a third or more from my point of purchase, then I decide that I need to review it again to test my original thesis and determine what mistakes I might have made. Of course, I review my stocks on a regular basis, anyway, but I pay special attention to anything that has fallen significantly.

In the case of Office Depot, I must admit to some mistakes. I think I was probably a little optimistic on normalized profit margins.

Office Depot is a cyclical retailer, meaning that revenues and profits rise and fall with the economy. They have heavy exposure to Florida and California, regions that have already tilted into recession due to the real estate bust. Thus, the best way to analyze a stock like this is to normalize (basically average) their profits, and evaluate the peak and trough scenarios. I buy when it is cheap relative to both trough and average profits, and wait for the economy to recover. The hard part of that analysis is always the margin estimates.

My favorite profit margin figure is EBITDA, which strips out major non-cash charges. Office Depot has effected a turnaround in recent years, making the margin forecasts more difficult - past history is not a reliable guide to estimating profits. Look at Staples (SPLS), a very similar competitor that has had stable, abeit higher margins. In recessions, their EBITDA margins dropped by 100 bps from peak to trough, similar to the experience of Office Depot so far (through 4Q 2007). On a quarterly basis, margins can drop by as much as 200 bps - since recessions typically don't hit nicely within a fiscal year, that figure averages to a higher annual number.

So my trough analysis on Office Depot was reasonably accurate.

Where I had made the mistake was on the normalized profit estimates. I had been assuming EBITDA margins of roughly 9% on their retail division - nearly what they achieved in 2005 and 2006. My assumption was based on the fact that the company was driving cost efficiencies and improved asset utilization as a result of improved management, which would in turn close the margin gap with their nearest competitor, Staples (which operates at roughly a 10% EBITDA margin).

What I did not sufficiently take into account was the fact that 2005 and 2006 were peak profit years, meaning that they were running above their normalized profit line as a result of the economic boom. So, even with the efficiency gains factored in, my assumption was too aggressive.

That said, if the company stays the course, then the efficiency gains are likely to be realized in the long term, driving peak EBITDA margins past 9%.

I have cut my normalized margin assumptions, resulting in a cut in my estimate of intrinsic value. While I don't disclose my intrinsic value estimates specifically (they can change without notice), I will say that had I not made the mistake, I probably would have purchased after the stock dropped below $15, instead of $18.50. The upside, based on my estimates, is probably well in excess of a double over three years.

That means that I think the stock is still super cheap. It also means that it is trading at a discount more similar to certain other retailers. I won't be selling anytime soon.

My other cyclical holdings - J.C. Penney (JCP) and Target (TGT) are stocks I have followed a long time. Therefore, I have a much better idea what their normalized profitability levels really are. I reviewed JCP earlier in the week, and I'll be reviewing TGT again soon.

Comments

[vboring]

the biggest home office equipment buyers are RE agents. due to low RE transactions recently, RE agents are feeling poor. a housing-led recession will make RE agents and companies whose primary customers are RE agents suffer.

[ballsschweaty]

I'm glad you plan to ride this into the dirt. Historical financial statement analysis is meaningless.

The stores face intense competition, are poorly run and have mostly young, low paid disgruntled employees.

Unhappy employees are almost always a sign that a company is headed into bankruptcy.

I predict bankruptcy in late 2009.

Enjoy!