Office Depot ODP
July 28, 2000 - 1:18pm EST by
2000 2001
Price: 6.13 EPS 1
Shares Out. (in M): 1 P/E
Market Cap (in $M): 0 P/FCF
Net Debt (in $M): 1 EBIT 0 0

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Business at ODP isn't as bad as the market's opinion. They recently released second quarter earnings of 19 cents and they are expected to earn $.85 this year. The stock is just over $6.

Let's look at the reasons that the market hates this stock

1. Retail market saturation for office superstores
2. Price competition from Walmart, Costco etc.
3. Fears of an economic slowdown from Fed tightening
4. Threat from internet suppliers
5. Low barriers to entry
6. Internal execution issues

With all of these issues, I am beginning to wonder why I am recommending the purchase of this stock at all. Here is my response to the above issues.

#1. and #2. - I believe that the true value in ODP relies less on the retail operations than the other divisions.
#3. Slowdown will effect everyone, don't invest in market then.
#4. ODP is going to have $800mn this year in internet based revenue. The general threat to retailers from e-tailers has been shown to be overblown as many e-tailers are in distress. Internet is an opportunity for ODP to decrease cost per order, through lower administrative costs and higher accuracy of order filled.
#5. There may be low barriers to enter the office supply market, but with the three major players trading at such low valuation, who is going to put capital towards such an endeavor. Additionally they do have some purchasing leverage that new entrants would lack.
#6. Internal issues - I am still learning more about these and I will continue to post as I gather more information. But, it does look like they have at least 2 healthy businesses.

ODP operates in 3 major segments. The first is the retail superstore that everyone recognizes and competes with Staples and Office Max. The second is the Business Services Group that sells office supplies to larger companies, often on a contract basis. There is usually a catalog that supports the ordering process and relation established by a sales representative. The third segment is the International Division which sells to retail, commercial, and contract customers in 17 countries.

The Business Services Group has gone through a multi-year process of systems consolidation and warehouse integration. The system consolidation is nearly complete and we should see some expense savings flow achieved (although lower than expected). The warehouse integration is continuing and we can expect some cost savings from that in the future (although I do not have a quantification of that yet). Internet sales with-in this division are expected to grow to $800mn from $350mn last year. While the company hasn't quantified it, I expect that internet sales will had several hundred basis points to the operating margin over time from lower administrative costs, lower catalog costs, lower error rates, higher avg order prices, etc. Operating profits are estimated to be flat this year, after 3 years of growth. There has been considerable consolidation in this area. Most recently BT Office Products and Corporate Express were purchased for multiples of approximately 10x EBITDA. The divisional operating income before corporate G&A for '00 is estimated to be $265mn. Allocating G&A of $140mn gives me Operating income of $125mn. I think that this is an 8x Operating Income business and is worth $1bn.

The Intl division is the real gem. These operations were mainly from the Viking Office Product acquisition of 1998. Despite a strong dollar over the last several years, operating profits have continued to rise at the 12%/yr average for the last 5 years. Operating profits are expected to be $190mn before overhead that I am estimating at $60mn leaving me with $130mn in Operating Income. This is a great growing business, with a lot of strategic value to anyone interested in international expansion. I think that this business is worth 10x operating income or $1.3bn.

The retail stores have experienced weakness lately. But let's not overstate the magnitude of the weakness, comparable store sales were only down 1%. Not exactly a business that is falling apart. And they still produce great cash flow. Trimming existing estimates to $450mn in operating profit before overhead and subtracting $240mn in G&A, leaves me with $210mn in segment operating profits. Most of the $170mn of D&A should be assigned to this division. Cap-X should decline next year, as ODP plans to open fewer stores. There have been some suggestions that store closings will soon be announced. What should I value this operation at? I honestly have no idea, but since I think the first two operations are worth more than the current market cap of $1.9bn, I am not going to spend too much time worrying about it. However, using a valuation of 5x operating income (a pre-tax return of 20%) this division could be worth an additional $1bn.

A final thought. In 1998, Office Depot acquired approximately $2.1bn for Viking Office Products. That is more than the entire market cap of ODP today. I honestly have no idea, but since I think that the first two operations are worth more than the equity market cap of $1.9bn plus $200mn in net debt, it looks like they are paying ME $200mn to take the retail stores off their hands.


Valuation is very low, a stabilization or mildly positive comps in their retail business would dramatically change the multiple that investors assign those operations. Plus continued growth in international and busn services and internet.
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