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Office Depot's (NASDAQ:ODP) share price has recently seen a rally of roughly 7%, mainly because of Starboard announcing that it has taken a 13.3% stake in the company, making it the largest shareholder at present. Starboard sent a letter of recommendation to ODP's CEO, regarding the company's operations. There have also been rumors that there might be consolidation in the office supply industry, especially regarding Staples (NASDAQ:SPLS), which has received some attention from private equity firms. We recommend staying away from ODP, owing to competitive and macroeconomic pressures driving down sales.

Starboard Value LP, a hedge fund, in its letter to ODP's CEO, termed Office Depot as "undervalued," and proposed various steps that were needed, including cost-cutting (administrative costs as well as advertising spending that does not have significant return), increasing higher margin services like copy and print for North America, and smaller stores. These steps will lead to better operating margins. SPLS has an operating margin of 6.4%, as compared to ODP's 0.7% and OfficeMax's (NYSE:OMX) 1.9%.

Sales for the last quarter were down by 7% as compared to last year; the company was expecting a drop of 3%. The company gave a negative earnings surprise of 55%, by posting a loss of $0.14/share as compared to analyst estimates of a loss of $0.09/share. On September 5, ODP reaffirmed its EBIT guidance of $125-$135 million. Analyst estimates for EBIT were $93 million at the time that this guidance was initially issued in August.

The company has total debt of $674 million, while operating cash flows are $215 million (trailing 12 months); however this cash flow figure has been declining over the years. The quick ratio is 0.76 as compared to Staples' 0.89 and OMX's 1.21, showing that its ability to meet short-term obligations is weaker than its peers.

Inventory turnover (trailing 12 months) for ODP is 6.6x, in line with SPLS' 6.8 times and OMX's 6.7x. Despite having similar turnovers, ODP's profit margin (1% trailing 12 months) is less than SPLS' 3.72%. This shows that ODP needs to change its offering to higher margin products and services.

As is the case for most retailers, ODP faces a significant challenge from Amazon (NASDAQ:AMZN). ODP has a beta of 2.89 because it is linked with overall economic and employment conditions. Unemployment rate has persistently been above 8% over the last few years. With significant revenue headwinds, it will be difficult for the company to undertake new initiatives.

The past five-year growth rate has been -33%, while the next five-year growth rate estimate is 10%. The company does not pay any dividend.

ODP's shares are up 20% YTD, as compared to OMX's 70% and SPLS' -14%. All three companies have high short ratios. ODP's short ratio is 7.3 days as compared to SPLS' 4.6 days and OMX's 11 days.

The average P/E of the last five years is 11x, while the forward P/E for ODP is 32x. The EPS estimate for FY2013 is $0.08, which means a price of $3 at forward P/E of 32x. The mean consensus target price is $2.45. The forward P/E of Staples is 8x, and for OMX it is almost 10x.

We believe that the stock has been beaten down so much that there is little downside left. However, if the measures proposed by Starboard are implemented (easier said than done), we might see short-term improvements in the financial results. The company will continue to face competitive pressures from other retailers. For the aforementioned reasons, we recommend staying away from ODP.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Retail Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.

Source: No Turnaround For Office Depot