Staples (NASDAQ:SPLS) announced results for fiscal Q3, which ended October 29, that were not materially different than expectations. The company hit the earnings estimate, but missed the revenue estimate by a small amount. The most important takeaway, however, is that SPLS continues to shrink as profit margins continue to expand.
Revenues for the quarter fell 4.3% year over year to $5.355 billion. While comparable store sales were down, a good portion of the overall decline in sales was the result of divestments and store closures. For example, the company sold its Staples Print Solutions business in July, and management has been aggressively closing underperforming stores in all markets. Indeed, the number of stores in the U.S. is down from 1,364 for the fiscal year ended January 31, 2015 to 1,302 for the fiscal year ended January 30, 2016. During the same time, the number of stores in Canada was reduced by 10 to 305, and the number of stores in international markets was reduced by four to 300.
But management is not through shrinking the company. During fiscal Q3, it sold its retail business in the United Kingdom, which had 107 stores as of January 30. And management remains on track to close a total of 50 U.S. stores this fiscal year. The statement of cash flows reveals that net proceeds from the sale of businesses totaled $83 million for the first three fiscal quarters. Because we know that Staples Print Solutions was sold for $85 million, the U.K. retail operations must have simply been given away. Indeed, all management would say is that the U.K. operations were sold for a "nominal" amount.
Although the top end of management's non-GAAP earnings guidance of 23 to 26 cents per share for fiscal Q4 fell short of the consensus estimate by a penny, management increased its guidance for free cash flow for the full fiscal year by $100 million to $700 million. This estimate excludes the $340 million in after-tax fees associated with the termination of the agreement to acquire Office Depot. That deal was blocked by regulators who argued it was anti-competitive. However, those regulators focused primarily on traditional competition in the office supply market. They appeared to ignore new competitors such as Amazon.com (NASDAQ:AMZN).
Thanks to the election of Donald Trump, some investors are now speculating that the Office Depot acquisition could be back on the table. After all, regulators in the Trump administration may be more amenable to a merger of this kind. I'm not betting on that, but I don't have to. That's because my analysis suggests that shares of SPLS are undervalued at the current price even without the merger.
When conducting my analysis, I assumed that revenues would continue declining for two more years and then level off at about $17.8 billion per year. Although I expect non-GAAP operating profit margin to expand, I assumed it would remain flat at 6.5%. This margin has been climbing in recent periods and reached 6.6% in fiscal Q3 even though it was held back by the underperforming International Operations segment. But SPLS plans to rid itself of the European operations. That will significantly boost the margin in this segment. Furthermore, SPLS plans to focus more on North America. Management projects sales from North America to comprise 95% of total sales by 2020. The operating margin in the North American Commercial segment reached 8.1% in fiscal Q3. It hit 7.8% in the North American Stores and Online segment. With a smaller international business and greater emphasis on North America, the overall operating margin should soon be well above 7%.
Yes, SPLS is shrinking. That's exactly why sellers are willing to give away the stock for next to nothing. However, cash flows are strong and margins are expanding. As a result, management should have no trouble maintaining the dividend, which yields an extremely generous 5.2%. This stock should be selling for $12 before long.
Disclosure: I am/we are long SPLS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.