Staples SPLS
April 10, 2017 - 11:58pm EST by
pfq783
2017 2018
Price: 9.70 EPS .89 0
Shares Out. (in M): 653 P/E 10.9 0
Market Cap (in $M): 6,334 P/FCF 9.9 0
Net Debt (in $M): 0 EBIT 895 0
TEV ($): 6,334 TEV/EBIT 7.1 0

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  • Value trap
  • Secular decline
  • Turnaround
  • Potential Merger
  • Failed Acquisition
  • winner
  • deepvalue

Description

On April 4th, the WSJ disclosed SPLS is in early stage talks with private equity firms to explore a sale of the company.  I believe there is a strong likelihood (75%) that the talks will lead to a deal as private equity takes advantage of the public markets’ misperception and mispricing of SPLS as a secularly challenged retailer.  In the event these early talks do not lead to a deal, the intrinsic value of the company supports 10% or less downside in the shares. 

It has been a tumultuous and transformative past 12 months for Staples.  The ODP merger was blocked on antitrust grounds, fifteen months after signing.  SPLS’ CEO since 2002 stepped down and left the board.  A new CEO with 25 years of experience at the company (after 5 years at Bain Consulting) took the helm and wasted no time leaving her mark:  SPLS exited its unprofitable European operations, announced a $300mm 3-year cost-savings program (already achieved $100mm, beating $70mm guidance with “visibility” into another $100mm in 2017), began transitioning the small/mid B2B delivery business to a paid-membership model, and in Q4 2016 reclassified their operating segments by stripping all delivery business (staples.com) out of the retail segment and into their North American B2B segment. 

The new segment disclosure shows SPLS generates 63% of segment EBITDA from its larger, growing N. American delivery business and only 37% of EBITDA from its smaller, shrinking retail business.  Combined segment EBITDA is unchanged for three years while the quality of the EBITDA improves as the mix shifts toward the contract and delivery business.  NA delivery business sales have been unchanged largely due to an underlying mix shift of its own:  sales of ink/paper/printers are in secular decline while SPLS has been growing “BOSS” (beyond office supplies) categories high single digit / low double digit percentage each quarter. 

          2014 2015 2016
               
N. American Delivery sales     10,664 10,731 10,636
N.  American Retail sales     8,055 7,169 6,662
Other (various foreign locales)   965 864 949
Total sales       19,684 18,764 18,247
  % NA delivery     57% 60% 61%
  % NA retail     43% 40% 39%
               
EBITDA              
NA Delivery       768 806 861
NA retail         616 562 495
Other         -2 12 10
Total biz unit EBITDA     1,382 1,380 1,366
  % NA delivery     55% 59% 63%
  % NA retail     45% 41% 37%
               
Unallocated expense (stk comp, SERP)   -64 -49 -73
               
New reclassified segments          
NA delivery EBITDA margin     7.2% 7.5% 8.1%
NA retail EBITDA margin     7.6% 7.8% 7.4%
               
Old segments            
NA stores and online EBITDA margin   6.7% 6.8% Not avail.
NA commercial EBITDA margin     8.6% 8.9% Not avail.

 

A timeline of the past 2.5 years of distractions suggests the above operating results are probably under-achieving:

-          Dec 2014, Starboard builds a 6% stake and goes activist, pushing for ODP merger.

-          Feb 2015, SPLS/ODP merge.

-          May 2016, deal blocked on antitrust grounds related to the office contract/supply business.

-          May 2016, explores sale of unprofitable European operations

-          June 2016, CEO since 2002 resigns.  Leaving board Jan 2017.  Interim CEO worked at SPLS since 1992; previously Bain.

-          Sept 2016, interim CEO gets the job.

-          Nov 2016, sells UK business to Hilco for $1.

-          Dec 2016, sells European business to Cerberus for $50mm.

-          March 2017, re-classifies operating segments.  Retail segment is now pure B&M.  Staples.com folded into NA Commercial.

      March 2017, sells Australia and NZ business to Platinum Equity.

 

SPLS trades today at a 10.1% free cash flow yield with no net debt despite the stability of the business, its market leadership, and its scale advantage.  The stock yields 5% with the dividend more than covered by the NA delivery alone.

Stock price $9.70                    
Shares out 653                    
Market cap 6,330                    
Cash   1,015   Q4 balance, adjusted for euro ops sale, no credit for Q1 cash gen      
Debt   1,048                    
EV   6,363                    
                         
LTM EBITDA 1,289                    
EV/EBITDA 4.9                    
                         
EBITDA   1,289   LTM, $63mm stk comp not excluded, no credit for restructuring program    
Cash int income 10   $1B+ cash balance              
Cash int expense -36   Cash interest on bonds              
Capex   -300   $255mm LTM, $380mm in prior year.  No mgmt guidance        
Tax   -323   33.5% non-GAAP effective tax rate, per mgmt guidance        
Calculated FCF 640                    
% to equity 10.1%                    
% to EV   10.1%                    
                         
LTM FCF   879   adjusted for after-tax ODP term fee and expenses but not $22mm litigation pmt     
FCF yield   13.9%          ^ Not adjusted for $102mm paid restructuring accruals [$56mm accrual remains at               YE 2016]
                      ^^ Working capital benefit and deferred capex, per                               mgmt        

On a recent conference call, SPLS unveiled an intriguing data point:  2/3rds of new mid-market (10 – 200 employees) customers are signing up for their $299 / year Premier membership package.  As AMZN/COST know, paying membership customers like to shop with you to get a “return” on their investment.  And they are relatively sticky. 

 

These are the early results for total paid memberships, starting with Q1 2016:  21k, 26k, 38k, 61k.  Half are mid-market customers, half are small business.  SPLS thinks they have 2% penetration of an $80B market serving mid-market customers, which implies 16% of SPLS NA delivery sales today.  SPLS is ramping their sales force by 1000 people over the next 3 years to address the growth opportunity, paired with managing leads from staples.com.  

It is probably best to explore this growth avenue out of the public market limelight.  The NA delivery business has already expanded EBITDA margins 90 bps on flat sales over 3 years with a distracted management (the segment reclass actually reset NA delivery margins lower… they would have been 9.x% this year in the old presentation).  Further public margin expansion brings to mind the Bezos Axiom: “your margin is my opportunity”.

Speaking of Amazon, I doubt they are being contacted as part of the sale process to private equity.  But they are a logical buyer of Staples, who already has purchasing and customer scale.  Perhaps down the road when the retail stores have mostly melted, or in a deal where Amazon buys NA Delivery and spin-merges SPLS retail with ODP.  Another exit could be private equity spinning retail into ODP.  Or IPO’ing the company after investing in paid membership growth.

Like all LBOs, the math is highly sensitive to input assumptions on leverage and growth.  One conservative possibility:  $11.50 deal price, with 4 turns of leverage would need a $2.3B equity check.  At 7% average pre-tax cost of debt, $300mm capex, no growth, no lower corporate tax rates, they have levered their equity up to 17% base return with $400mm FCF to de-lever or invest for growth.  I think all of these inputs have room to move much higher in a more realistic deal scenario (including the purchase price).

 

SPLS was trading at $8.70 before the WSJ piece, and I expect it would trade back to those levels without a deal.  As Barron’s observed (http://www.barrons.com/articles/lbo-or-not-staples-stock-looks-very-undervalued-1491413854), SPLS could tap their own balance sheet to create a public LBO with a $4 – 5 special dividend or share repurchase and perhaps it would trade with some optionality on this, but I suspect management will be content to keep their investment grade rating intact while they are a public company. 

The new CEO has observed the distractions of the public market firsthand (Starboard activism, promoting a failed merger, paying a competitor $250mm, etc.) and I suspect would prefer to keep the financial benefits of a transition to a paid membership model out of the public realm.  I do not know if SPLS looked for buyers or if they received inbound interest, but half of the SPLS board is new and could be receptive to a premium on the last twelve month price history.  Interestingly, SPLS did not execute on a $100mm share repurchase authorization in 2H of 2016, despite the attractive share price, which makes it a bit easier to justify selling the company to private equity.

At a 75% chance of an $11.50 deal (trades $11.25) and a 25% chance of $8.70 on a break, I view the stock as 1.6 up / 1 down with the probabilities heavily weighted in our favor.  EV neutral is approximately $10.60 and I think I'm much more likely to be wrong being too conservative (on both the upside and downside estimates) than too aggressive.  I think this tees up to be a fantastic deal for private equity, and the deal price could certaintly come in higher.

The main risks are:  corporate tax reform that eliminates interest deduction w/o grandfathering, BAT, a sudden decline in SPLS business, or a big splash by AMZN into the space. 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Signed deal

No deal but share repurchases highly accretive to intrinsic value

Growth initiatives gain traction

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