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  • SPLS - Still Trading At A Discount After Recent Run-up?  0 comments
    Nov 10, 2013 4:37 PM | about stocks: SPLS

    Staples is the world's largest office products company and second largest internet retailer. Through its world-class retail, online and delivery capabilities, Staples offers office supplies, technology products and services, facilities and breakroom supplies, furniture, copy and print services and a wide range of other product categories. It has operations throughout North and South America, Europe, Asia, Australia and New Zealand.

    The company is present in three key business segments: North American Commercial, which includes the B2B operation Staples Advantage in North America and the SMB dedicated website Quill.com; North American Stores & Online, which includes the retail operation in North America, copy and print centers and Easy Tech; and International Operations, which includes all retail, B2C and online operations in foreign markets.

    Segment performance (FY 2012, USD M)

    Staples has two main competitors in the Brick and Mortar segment, Office Depot and Office Max, which operate with a very similar business model but on a smaller scale. They have ongoing merger negotiations but even then the NewCo would represent 71% of Staples, assuming no store closures. Amazon has also been engaging in direct competition with Staples by assortment expansion, especially in the B2C segment.

    The company is a high free cash-flow generating business - during the last 12 months it totaled $963 M. Even so, this was the worst in the previous 5 years, when average FCFF was ~$1.25 Bn. Most of the difference can be explained by non-recurring restructuring costs of $207 M incurred during 2012.

    A simple valuation exercise, based on net earnings TTM and the non-recurring adjustments to the financial statements proposed by management in 2012 (restructuring costs, goodwill impairment, accelerated intangible amortization and losses with debt refinancing), results in a target price of $18.85, assuming a growth rate in line with inflation.

    Multiple valuations confirm the existence of potential, with valuations ranging from $20 to $28 (between 22% and 74% upside potential). Amazon and Walmart were just included for reference and are not taken into account for the average multiple calculation.

    Looking deeper into Staples and its current assets, an above inflation growth scenario seems more realistic for a DCF valuation.

    Staples.com ranks #2 worldwide in terms of revenue, only behind Amazon, and online sales already account for $10 Bn in sales (~42.5% of total). Staples has been investing in this area with an overall website redesign, increased assortment and physical store integration. Alexa, which publishes a global ranking of websites based on average daily visitors and pageviews, shows staples.com with a 199 positions jump in the last 3 months to the #915 position. Thinking about e-commerce in general, Forrester is projecting a 13% sales increase for 2013 and a CAGR of 10% from 2012 to 2017 for e-commerce as a whole.

    Despite current sluggish growth in the brick & mortar segments, both overall and in same store sales, Staples is in a cyclical industry (core office supplies represent 44% of sales, while office machines, computers, furniture and other services account for the remaining 56%) - meaning clients will postpone expenses until confidence levels are high. Same store sales growth for the North American retail operation have a 0.62 correlation with the Conference Board's Consumer Confidence Index.

    Relation between Staples same store sales growth in North America and Conference Board's Consumer Confidence Index (per quarter, 1998-2013)

    (click to enlarge)

    Despite the ongoing current GDP recovery, recovery of consumer confidence has been occurring at a slower pace and is still significantly below 2007's levels. We expect a more meaningful impact on sales as time passes (due to delayed consumption) and confidence rises. While not an indicator of future sales growth, this indicates that sluggish growth seems related to macroeconomic factors and not a broken business model.

    Conference Board's Consumer Confidence Index (per quarter, 1998-2013)

    (click to enlarge)

    International operations remain the most problematic business segment and have been streamlined in 2012, with 49 store closures (-13%) - first semester figures are showing a decrease of -10% in sales with worsening contribution margins. Therefore, international operations were considered neutral in the base valuation, with a contribution margin of zero. This leaves a potential upside in the case of a successful turnaround, which assuming a contribution margin of 5%, below the current 8% of the North American operations, can be worth $2.65 per share.

    An additional source of growth is category expansion. After recent successful experiences with new categories (e.g. breakroom and facilities) Staples is now looking for further opportunities in technology products, medical supplies, safety supplies, packaging and shipping supplies, and office décor.

    The above reasons, coupled with the fact that store operating costs are fixed and website investment has already been incurred, create an opportunity for high returns without significant additional capex.

    A full DCF valuation based on the assumptions above indicates an intrinsic value of $23. We arrive at this value with moderate sales growth, at a 3.75% CAGR until 2018, and a decreasing gross margin, as a result of increased competition. Forecasted margin decreases from 26.6% in 2012 to 22.5% in 2018 based on an expected gross margin of 27.5% for Amazon deducted of 5% to account for estimated store rental and staff costs.

    Increased competition will come from the merger between Home Depot and Office Max and from Amazon, however we believe these threats are moderate and should not be a game changer for Staples.

    The newly merged co will have management's attention focused in the integration of operations and realization of cost synergies - companies are targeting a total of $400-$600 M in synergies 3 years after the merger. With a discount rate of 10% that amounts to between $3.3 Bn and $5.0 Bn value-added, more than the current combined market cap of $2.9 Bn for the two companies. In between, Staples can improve their competitive position by capturing market share from closed competitor stores.

    As for Amazon, if we look at the case study of Barnes & Noble, who had to cope not only with Amazon penetrating its market but also with the introduction of a new technology, we see that what the main source of value destruction for B&N shareholders is actually a failed attempt to go online. Had B&N not entered the e-reader / e-book segment (presented under the "Nook" segment), shareholders would now be better off.

    Staples today is in a far better position than B&N to cope with the Amazon threat, as they already have a strong online presence with a more attractive value proposition - integration with physical stores. The major threat from Amazon would come from a more aggressive pricing strategy (of a 48% overlap in assortment, prices are on average 19% higher for Staples, according to a report from Mark Miller, industry analyst at William Blair & Co.). To account for this, a decrease in margin has been forecasted in line with Amazon's expected gross margin. It is also important to notice that for the more price sensitive segment, Staples has already developed a proprietary branded product assortment of 10.000 products, offering prices on average 10% to 20% below national brands. These products accounted for 28% of 2012's sales and deliver on average higher gross margins vs. national brands.

    For the above stated reasons, I believe Staples is currently priced at an interesting discount to fair value. A $23 estimate of intrinsic value would imply an appreciation potential of ~45% for Staples, which could be further increased to $25.65 (+60%) with a moderately successful turnaround of the International operations segment.

    Stocks: SPLS
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