Description

Buy SPLS equity as it is a best of breed office supplies retailer that generates significant FCF (~12% 2013E FCF yield), is returning significant cash to shareholders ($1.8bn in share repurchases and dividends over last 3 years, 2.7% div yield), has an unlevered balance sheet, and will benefit from both economic/employment improvement and share gains/industry consolidation from weaker competitors. 

• Company overview
• Global office supplier with a North American retail business (1,900 stores, 45% of EBITDA), a North American overnight delivery business (45% of EBITDA) and a struggling international business that is primarily in Europe/Australia, and primarily delivery (10% of EBITDA)
• 80% of total mix is B2B, 20% consumer (despite popular misconception that it is primarily a consumer retailer) – limited exposure to Amazon disintermediation
• #2 e-commerce merchant behind Amazon.com
• Next day delivery covers 95% of North America

• North American fundamentals are stabilizing/beginning to improve…

• Improving payrolls and employment should lead to improving comps
• +2% comp in NA retail in Q411 – best comp since Q409
• NA Retail EBITDA +12%, Delivery EBITDA +10% in Q411
• CEO had positive body language about improvement in the NA market, particularly among small businesses, which should be followed by medium and enterprise by the end of the year

• …but the stock is one of the few retailers well off its 52 week highs and trading at a cheap valuation

• At $14.95, stock is down 28% from its 52 week highs in April 2011 and 44% from its all-time high of $26.70 at the end of 2006
• SPLS trades at 5.3x LTM EBITDA, vs. its 5 year average of 7.8x, and 10x conservative 2012 EPS guidance of HSD growth (assumes no economic improvement)

• Stable EBITDA and FCF generation and shareholder friendly capital allocation (post 2008 $4.4bn acquisition of Corporate Express, which the company seems to have learned from)

• Company has generated at least ~$2bn of EBITDA and at least $1bn of FCF for each of the past 4 years
• Over this time, the company has paid $1bn in dividends, bought back $1.1bn of stock, and paid down $1.4bn of debt
• Company recently announced a 10% dividend increase – expect that buybacks and dividends will continue to be the primary use of FCF

• Unlevered balance sheet presents an opportunity

• Company has $2.1bn in debt and $1.3bn in cash = 0.4x net debt to EBITDA
• IG rated bonds trade sub 2% yield – would need to pay make-whole on a call, which they view as slightly NPV positive
• Company has maintained that it would like to remain IG, but pressure will likely build to increase leverage and return cash to shareholders as economy stabilizes, especially if stock continues to lag

• Other potential catalysts: turnaround in International division and industry consolidation

• International division has been plagued both by execution issues and European economic woes
• Australia is largest international market – problems there should be fixable (European headwinds unlikely to abate in the near-term, however)
• Company believes they can get International EBIT margins to 7%+ (vs. ~2% current and ~8.5% in NA business) – much of this should be achievable through cost cuts and reorganization rather than topline growth
• ODP (Office Depot) and OMX (Office Max) are much weaker competitors (combined market cap of ~$1.5bn vs. $11.5bn at SPLS) that are losing share – industry is probably 20% over-stored
• Both companies will close ~30 stores this year, which will provide an incremental benefit to SPLS (not huge given SPLS 1,900 store base)
• Longer term, these companies should merge, which would have huge synergies and be very beneficial to the entire industry – however, this is likely not a near-term catalyst as this has been on the table for years, and both ODP/OMX are trying to stabilize operations before any merger
• Risks
  • Secular decline concerns
    • Amazon is a threat to the 20% consumer business – some consumers and even some small businesses are definitely migrating to Amazon
    • Paper/ink volumes declining LSD per year – have been recently offset with some price increases, but will likely remain under pressure
    • Furniture (other than chairs) such as filing cabinets are in decline – SPLS looking to move to smaller square footage (15k vs. ~23k today) over time as leases roll off
• International execution issues could continue, compounded by European economic decline
• Highly competitive industry, with Depot and Max often competing on price, as well as mom & pop private players
• Stock will be hard hit if people feel that the budding jobs recovery is reversing course

Catalyst