Staples SPLS
November 03, 2009 - 6:30pm EST by
sandman898
2009 2010
Price: 21.89 EPS $1.12 $1.36
Shares Out. (in M): 722 P/E 19.6x 16.1x
Market Cap (in $M): 15,812 P/FCF 15.8x 12.3x
Net Debt (in $M): 2,332 EBIT 1,498 1,689
TEV ($): 13,480 TEV/EBIT 9.0x 8.0x

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Description

The transformation that results from Staples' (SPLS) purchase of its most successful competitor, Corporate Express (CXP), has been masked by the current economic environment. Many investors seem to not have noticed that SPLS is now the largest global buyer of office products, has transitioned its business from capital-intensive store-based model to one that now generates more than half of its profits as an online retailer, has plenty of room for expansion with only a 10% market share, and plenty of room to expand upon its leadership positions in Brazil, China, and India. In addition, the company moat has expanded materially as it now has massive economies of scale, a more solid capital structure, higher margins, better management team and a superior track record than any of its currently struggling competitors. SPLS is on track to deliver $2/share in FCF by 2011 if the current economic recovery proves sustainable, but if things takes an unfortunate turn for the worse, FCF could easily exceed $3/share as competitors fold.

The wonderful thing about recession, this one and last one, is it makes weaker competitors go away." - Ron Sargent, Staples CEO, Analyst Day 10/30/08

Price

$22.00

 

10E Sales

24,801

0.74x

(x) Shares

 722

 

11E Sales

26,320

0.70x

MV ($MM)

 15,884

 

10E EBITDA

2,272

8.1x

 

 

 

11E EBITDA

2,517

7.3x

(-) Cash

 (633)

 

10E EPS

$1.36

16.2x

(+) Minority Interest1

 246

 

11E EPS

$1.70

12.9x

(+) Debt

 2,965

 

10E FCF

$1.79

12.3x

EV

 18,461

 

11E FCF

$2.10

10.5x

1 SPLS owns 60% of Corporate Express Australia (CXP AU), minority interest adjusted to represent the market value of the remainder

Over the last twelve months, SPLS has generated $24.5B in sales broken down between three business segments: $10.0B delivery, $9.2B retail, and $5.3B international.

 

Staple's Sales Growth

 

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Delivery

16%

19%

22%

8%

13%

9%

13%

18%

19%

12%

35%

15%

Retail

26%

23%

17%

(1%)

4%

7%

9%

9%

9%

1%

(5%)

(8%)

International

51%

42%

48%

11%

31%

54%

21%

9%

13%

16%

70%

14%

Management has offered long-term guidance for each of these individual segments as well as the company overall, which is shown below. Note that the consolidated total company numbers also include stock-based compensation expense which typically negatively impacts margins by 0.8% a year.

 

 

EBIT Margin

Year

Delivery

Retail

International

Total Company

2001

6.8%

4.8%

(0.8%)

4.9%

2002

7.8%

5.8%

(0.4%)

5.9%

2003

8.3%

6.8%

4.0%

6.9%

2004

9.4%

8.5%

3.6%

7.3%

2005

10.3%

9.3%

0.6%

7.7%

2006

10.6%

9.7%

2.1%

8.1%

2007

10.8%

9.5%

3.6%

8.2%

2008

11.1%

8.1%

3.2%

7.9%

2008 (CXP)1

9.0%

8.1%

3.3%

6.7%

2009E Street

8.5%

8.0%

3.3%

6.4%

Long-Term Goal

12.0%

10.0%

7.5%

9.0%

1 Includes CXP starting in July


RETAIL

SPLS, CXP, Office Depot (ODP), and OfficeMax (OMX) were all founded between 1986 and 1988. During their first decade of existence, the four companies were able to flourish and drive out local competition by offering larger selections and lower prices. The three retailers (SPLS, ODP, and OMX) each opened their 500th store around the same time during 1995 and 1996. CXP, which lacked a physical retail presence, had still been able to grow its annual sales to a number that was roughly 65% of that of SPLS. More or less, however, all four companies were roughly tied. Over the following decade, the industry matured and these companies had to compete directly with one another, causing small differences in business models to be magnified as market share gains became increasingly difficult. When the dust settled, SPLS had emerged as the industry leader.

The North American store count below shows a pretty clear delineation in growth rates between the three office superstores starting in the late 1990's. SPLS has doubled, ODP has only grown modestly, and OMX has remained essentially flat. 

 

North America Store Growth

 

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009E

Open

158

154

168

117

72

67

77

102

99

120

107

75

Close

(3)

(3)

(11)

(4)

(33)

(9)

(9)

(6)

(1)

(1)

(4)

(2)

SPLS

840

991

1,148

1,261

1,300

1,358

1,426

1,522

1,620

1,739

1,842

1,935

 

 

 

 

 

 

 

 

 

 

 

 

 

Open

101

130

70

44

21

36

80

100

115

71

59

15

Close

(1)

(7)

(7)

(73)

(13)

(3)

(11)

(22)

(4)

(7)

(14)

(119)

ODP

702

825

888

859

867

900

969

1,047

1,158

1,222

1,267

1,163

 

 

 

 

 

 

 

 

 

 

 

 

 

Open

120

115

54

17

5

-

12

41

44

59

43

12

Close

(1)

(1)

(5)

(48)

(29)

(3)

(47)

(11)

(113)

(9)

(12)

(20)

OMX

832

946

995

964

940

937

902

932

863

913

944

936

More importantly, SPLS caught up and then outperformed its competitors in store productivity as well.

 

Sales per Average Square Foot

 

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009E

SPLS

257

265

265

240

241

249

260

269

281

266

245

229

ODP

310

311

289

273

252

242

249

255

251

234

202

183

OMX

221

230

243

233

240

227

234

235

232

225

196

1

Source: Credit Suisse 06/08/09

SPLS continues to selectively deploying stores in ODP and OMX markets in order to drain their profits. Whenever this happened in the past, ODP and OMX would drastically cut prices in order to fend off the new competition, but this has recently changed. Conversations with industry participants suggest that they cannot afford to fund this competitive strategy anymore and are now simply holding pricing in line for a period of time before closing stores that become unprofitable. Thus it seems like the long-term trend of store closures at ODP and OMX is likely to continue if not accelerate in the future.

Two major competitive transactions tend to stand out in terms of helping SPLS overtake the competition. The first was the takeover of OMX by Boise Cascade in 2003. The integration of Boise's $4B delivery business with OMX's $4B retail business was supposed to create a new industry leader but it suffered from the lack of cohesive management and very poor execution. Nearly all of OMX's prior management team eventually left the company and since then, OMX has been a perpetually disappointing turnaround story.

The second major event is the failed merger between SPLS and ODP in 1996. While the merger was pending, ODP completely shutdown its operations and was caught off guard when the FTC ruled against the deal. Management tried to help the company regain a lead, but in the process, they made a number of hasty decisions that only lead to additional setbacks.

During the 10-month merger process, Office Depot had lost 200 employees in addition to most of its real estate department, nearly freezing expansion in anticipation of transforming into Staples/Office Depot. Many developments and internet technology projects had been cancelled, supply-chain expansion had ceased, and the new marketing programs were withdrawn. All of these events had set back Office Depot nearly a decade, forcing the company to open a series of stores in less than ideal locations after the canceled merger... Also, instead of opening a flurry of superstores all over the country like Office Depot, Staples had expanded by penetrating areas with clusters of stores that were smaller than its traditional stores. As Business Week noted, "Staples is the only office superstore that's increasing its market share - from 34% in 1997 to 37% in 2000." - Office Depot: Taking Care of Business, Page 85-87

Another factor helping SPLS is that unlike its competitors, the company has been largely successful in keeping its management team intact throughout its history. SPLS' current CEO, Ron Sargent, has been with the company since 1989 and the average tenure of the 42 people in senior management is 14 years. In comparison, OMX and ODP have had revolving doors at the executive level. The two current CEOs, Steve Odland at ODP and Sam Duncan at OMX, both joined in 2005 with limited prior experience in the office supply industry. SPLS CFO John Mahoney has been with the company since 1996 while ODP CFO Michael Newman joined after serving a brief stint as the CFO of Platinum Research Organization (filed for bankruptcy in February 2009) and OMX CFO Bruce Besanko was formerly the CFO at Circuit City (filed for bankruptcy in November 2008).

DELIVERY

A few years after opening their first store, SPLS, ODP, and OMX all started new divisions by acquiring small competitors in the fragmented office supply delivery market. While retail superstores mainly sell to the small business owner and to moms' shopping during the all-important back-to-school season, delivery businesses (also often referred to as "direct" businesses) generally operate their own delivery fleet and provide office supplies to much larger organizations.

Some of these sales can be one-time internet orders, but the majority is conducted under recurring distribution relationships, usually under long-term contracts, with annual sales ranging between a few hundred thousand to tens of millions of dollars. As an example of how just how large these contracts can be, in 2004 SPLS won a five-year contract with Bank of America, which was expected to generate $55MM a year in sales.

Below are the North American delivery sales for the big three office superstores. SPLS includes CXP's sales starting in July 2008. Similar to retail growth, delivery sales at ODP and OMX have been essentially flat over the last decade while SPLS has continued to grow.

 

North American Delivery Sales (in $B)

 

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

SPLS

1.9

2.3

2.8

3.0

3.4

3.7

4.2

4.9

5.9

6.6

8.9

9.9

ODP

2.8

3.1

3.6

3.8

3.9

4.0

4.0

4.3

4.2

4.5

4.1

3.6

OMX

3.1

3.4

3.7

3.5

3.5

3.7

4.4

4.6

4.7

4.8

4.3

3.6

SPLS focus on growing delivery may in part be due to the fact that the company's current CEO originally established the delivery business in 1991 and helped promote it at a time when everyone else in the industry was wary of doing anything other than more retail.

Ron Sargent was installed as head of Staples Direct. Because mail order had always been a sideshow to the main event, many parts of the business were not thought through. After taking charge of the unit, Sargent interviewed the hundred or so employees who operated the call center. Though each of these workers constituted the sum total of a Staples shopping experience, at least for customers who shopped only by phone, they did not feel like an important part of the company. They were paid different rates per hour, for no clear reason, and had no idea how to progress in the organization. Sargent provided an ear, brought order to the compensation structure, and designed a career path. He also had to cajole cooperation from employees who were used to focusing on store sales, not catalog sales. Sargent's new unit had no distribution system of its own, so it had to rely on the system that served the stores - but, of course, it didn't carry the same clout...One by one, Sargent addressed these concerns...Looking out into the future, Sargent saw that if we built a separate system of distribution, merchandising, catalog operations, call centers, and other operations to support the delivery business, we could leverage off it to support sales to any size business- not just the smallish ones we already had hooked...Because he was starting from scratch in trying to serve larger customer, Sargent embraced a growth-by-acquisition strategy... Within two years, however, we snapped up five regional stationers...Sargent's job quickly contained two contradictory imperatives: Spur a fast-growing business while simultaneously consolidating and streamlining the acquired companies. - Staples for Success, Page 135-138

While most people tend to think of SPLS as a store-based retailer, in 2009 the company's North American stores only contribute a little over a third of the company's sales. The acquisition of CXP in July 2008 marked a significant transformation because SPLS switched its global sales split between delivery and retail from 40/60 to 60/40. And since delivery margins run 1-3% higher than retail margins while requiring far less capital, the future driver of profitability will be the delivery business.

The cool thing about office supplies it is a product line that's very conducive to being sold online. I mean you don't have try it on, you don't have to taste it, smell it, squeeze it. I mean a case of copy paper online is the same as a case of copy paper in the store. So we got into the delivery business very early back in '91. We built out the infrastructure, the call centers at the time, the distribution network completely separate from the store. And when the dot com era hit, we were ready to step on the gas. And if you look at it today, gosh probably 80%, 85% of our delivery sales are sold online, in one form or another. - Ron Sargent, Goldman Retail Conference 09/09/09

Even better, this business is really just online sales. In fact, while the CXP acquisition has certainly cemented the company's leadership position, SPLS has actually been the second largest online retailer for a few years. Approximately 80-85% of SPLS' delivery sales are now online, and this percentage should slowly increase as legacy customers stop ordering from paper catalogs.

Company

2009 Web Sales ($B)

Amazon

19.2

Staples

7.7

Dell

4.8

Office Depot

4.8

Apple

3.6

OfficeMax

3.1

Sears

2.7

CDW

2.6

Newegg.com

2.1

Best Buy

2.0

Source: Financial Infographics

Adjusting for the higher delivery margins, the majority of SPLS's profits are now generated online. This is arguably a more reliable earnings stream than that of other online retailers given that SPLS uses its own fleet of trucks to control delivery and 65% of these sales are under long-term contracts, and most of which are with Fortune 1000 companies.


INTERNATIONAL

The plan is, in the next five years, most of the profit growth is going to come out of North America. The next five years, most of the profit growth is going to come out of Europe, and that's why we've got to get Europe to 7.5%. And then in the next 10 years, we've got to get Asia ready. So it's really 15 years out--North America, next five years; Europe; and the next five years, Asia. - Ron Sargent, Bernstein Conference 05/28/09

In addition to the delivery and retail segments, SPLS aggregates all of its non-North American sales into its International division. This business will do about $5B in sales in 2009 broken down between 45% European Delivery (65% contract), 25% European retail with 383 stores, 15% Australian Delivery (CXP AU), 10% Printing (losing money, will be sold to Heidelberg), and 5% China/India/South America Delivery. The international market represents a $100B opportunity, dominated by a very fragmented independent dealer network, of which SPLS has less than 5%. This runway should enable the company to continue to grow long-term EPS in the low double-digits. Specifically, European growth should continue for the next five years followed an aggressive expansion into other markets, note that despite the near-term focus on Europe, SPLS is already the largest office supplier in China and India. It should also be mentioned that SPLS is likely to deploy a less capital-intensive, delivery-based model in these new markets. As an example, SPLS entered China in 2004 and is now doing $200MM in business of which 90% is delivery.

 

 

ECONOMIES OF SCALE

SPLS' recent increase in buying power should enable the company to continue to offer its customers prices that competitors will have a hard time trying to match. Most competitors have already been forced down to fairly low margins because SPLS and CXP have been putting pressure on the industry for years and this trend is unlikely to stop any time soon. Gross margins for the big three range between 25-27% and the majority operating leverage in the industry comes from economies of scale. Below is a table showing operating margins for SPLS, CXP, ODP, and OMX by business segment.

Operating Profit (%)

 

98

99

00

01

02

03

04

05

06

07

08

Q1

Q2

Q3

Retail

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SPLS

8

7

6

5

6

7

9

9

10

10

8

7

5

?

ODP

10

7

3

5

7

6

5

6

7

5

0

6

(1)

3

OMX

4

1

(2)

(3)

1

1

1

1

2

4

2

3

(0)

3

Delivery

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SPLS

6

7

4

7

8

8

9

10

11

11

9

7

8

?

CXP

3

4

8

4

6

3

5

5

4

3

-

-

-

-

ODP

2

8

5

8

9

10

7

8

8

5

3

4

3

2

OMX

4

5

6

4

3

3

2

2

4

4

4

2

1

1

International

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SPLS

(5)

(9)

(3)

(1)

1

4

4

1

2

4

3

2

0

?

CXP

4

4

3

3

0

2

3

4

6

6

-

-

-

-

ODP

13

10

12

14

13

13

8

6

7

6

4

2

0

4

While SPLS operating margin advantage over its competitors has widened over time, they have recently hit a tipping point with the acquisition of CXP. The combined entity is now the single-largest purchaser of office products in the world. In order to put this buying power in better perspective, below is a rough overview of the office supply industry.

2008 Sales ($B)

Company

Holdco Ticker

Retail

Delivery

International

Total

Staples

SPLS

9.5

8.9

4.7

23.1

Wal-Mart

WMT

21.0

-

-

21.0

Business Products Group

buying group

-

5.0

10.0

15.0

Office Depot

ODP

6.1

4.1

4.2

14.4

Office Max

OMX

4.0

4.3

-

8.3

Lyreco

private

-

-

3.0

3.0

Askul

2678 JP

-

-

2.0

2.0

United Stationers1

USTR

-

1.9

-

1.9

S. P. Richards

GPC

-

1.7

-

1.7

Costco

COST

1.3

-

-

1.3

Officeworks

WES AU

-

-

1.2

1.2

Spicers

SMDS LN

-

-

1.0

1.0

Warehouse Stationery

WHS NZ

-

-

1.0

1.0

Office Depot de Mexico2

GIGANTE* MM

-

-

0.9

0.9

Amazon

AMZN

-

-

0.8

0.8

W. B. Mason

private

-

0.4

-

0.4

Total

 

41.9

26.3

28.8

97.0

1 Includes Traditional Office Products and Office Furniture
2
50/50 joint-venture with Office Depot, Gigante offered $430MM in July 2008, ODP rejected in October

GAINING MARKET SHARE

It's safe to say that I'm intensely competitive, first of all. And somebody said to me the other day, they said, "You're really lucky because your competitors are struggling." And I said, "Give me a break. I think we've tried to make our competitors struggle." When we went into the last recession, Office Depot was larger than Staples. We did the same thing, investing in customers, we squeezed expenses and we invested for the future. And that made all the difference in the last recession, and we're doing that same playbook this recession. You can spend your time thinking about competitors or customers, and we've tried to change the culture to say, "Less focus on competitors and more focus on customers." And, frankly, we have this concept, we stole it from Jim Collins, 20 miles a day. And the best armies move at 20 miles a day. They don't move 30 miles and then back 10 and then 40 and then back 30. And that's how we operate the Company, where every day you want to make progress, and you look up a year from now and five years from now, and you're a lot farther away from the competitors than you realized. So it's, do I want to grind our competitors to dust? Yes. I'm sure Steve Odland does, I'm sure Sam Duncan does as well. Is it frustrating sometimes? Yes. But it's competition, and we just have a strong desire to win. - Ron Sargent, Bernstein Conference 05/28/09

A lot of sell-side research that looks at recovery margins for ODP and OMX seems to be operating in a vacuum. SPLS' management has commented that the have no intention of taking retail margins above 10%, because it creates an umbrella for its competitors. Thus any cost savings and synergies SPLS gets will be offered back to customers, permanently depressing gross margins and widening SPLS' moat relative to competitors. Below are the street EBIT margin estimates for all three companies over the next two years.

 

Street Expected Operating Profit

Company

2008

2009E

2010E

2011E

SPLS

7%

6%

7%

7%

ODP

1%

(0%)

0%

0%

OMX

2%

1%

1%

2%

SPLS should continue to take market share naturally but the company's largest earnings opportunity would be if the economic and competitive pressure resumes, which would likely cause a competitor to leave the industry.

With one very weak competitor in ODP and one struggling but more solid competitor in OfficeMax, a deeper economic downturn offers a natural hedge for SPLS as the possibility of a material change in the competitive landscape increases proportionally to the depth of the downturn. The impact of any more significant store closures or a potential restructuring could be quite material to SPLS. As an analogy, Circuit City's run-rate revenues before entering a period of severe distress were ~25% of BBY's revenues. In contrast, ODP's revenues are currently 61% of SPLS' global revenues or ~55% on a pro forma basis for a full year of CXP. Similarly, OMX's revenues are 35% of SPLS. We would argue that the office products delivery channel - and contract in particular - would be far more likely to offer a clear transfer of sales to SPLS than the Circuit's liquidation offered to Best Buy. The potential benefit of any consolidation is very material: as an example, if SPLS were to capture just $4bb of ODP's ~$14.5bb in F08 revenues at a 22% contribution margin (SPLS' gross margin is ~29%), the incremental EPS could be ~$0.84, a stunning 70% increment to our current F09 EPS forecast of $1.19. Conversely, at an 11x multiple, this incremental EPS could be worth $9 to the stock price. - Sanford Bernstein, 03/09/09

At the time Bernstein wrote that report, OMX traded below $2 and ODP traded well below $1. Both companies were bleeding retail sales to SPLS, had a vast number of stores that were either too big or in poor locations, and were suffering from significant margin pressure. To make matters worse, with rent-adjusted debt to EBITDAR ratios of more than 6.0x versus 3.5x for SPLS (Goldman Sachs OMX 04/12/2009), neither company had much breathing room to true-up under-funded pensions or maintain the large revolvers needed to fund seasonal working capital requirements. This put SPLS in an excellent position to underbid for delivery contracts, which it did.

On the topline, our checks point to strong share gains in Contract as SPLS wins more business against weakened and retreating competitors while the pricing environment remains quite rational. With both ODP and OMX focused primarily on cash flow and aggressively cutting back on sales and service capability, SPLS is able to compete more effectively while corporate customers are increasingly risk averse. - Sanford Bernstein, 03/09/09

In Contract, bid activity is accelerating sharply, and Staples' win ratio is at an all-time high: of 23 contracts that were bid in the national accounts category in the last 90 days, 12 stayed with incumbents, but, tellingly, Staples won 11 of the 11 that switched suppliers. - Sanford Bernstein, 03/25/09

In hindsight, claims ODP's and OMX's respective deaths were premature. However, long-term share losses are critical blows to ODP and OMX for three reasons. First, beneath the surface of what is perceived to have been a horrible cyclical decline in overall sales is an even worse secular decline in market share. Sales losses in delivery to SPLS are unlikely to return, even if the economy recovers, and the diseconomies of scale and operating leverage in retail have rendered delivery as their only real remaining source of profitability. Second, at razor thin margins and with a 20% contribution margin on incremental sales, any additional loss of market share will have a material impact on the bottom-line. Third, both companies have permanently jeopardized their competitive positions by cutting capex to below maintenance levels, closing stores, under funding pensions, and selling and leasing back real-estate.

While the market has rebounded considerably, ODP barely survived 2008. At the time, its European vendors were unable to insure accounts receivable from ODP. If the company had not successfully replaced its revolver with an asset-based loan secured by a significant portion of the company's assets, it is likely that vendors would have pulled working capital and the company would have had to file last year. Instead, the company called a meeting of all of its vendors and was able to convince them that there would be enough cash to pay all 30-day payable claims for the remainder of the year.

In order to stay alive in 2009, ODP requested tax refunds for prior year taxes, paid out all excess cash from its Mexican JV, cut inventory per store to very low levels, and sold 20% of the company to BC Partners, which invested $350MM for convertible preferred stock that pays a 10% dividend. Full-year guidance of $80-90MM required the closing 103 stores, lowering capex to maintenance levels, engaging in sale-leaseback transactions for all of its remaining North American stores, its European DCs, as well as its Netherlands HQ, and the factoring its European receivables (the rest are already pledged against its ABL).

On top of all this, ODP also has a material outstanding legal issue:

We are currently cooperating with the Florida and Missouri Attorneys General with respect to civil investigations regarding our pricing practices that relate primarily to government customers. We first became aware of the Florida matter in the second quarter of 2008 and the Missouri matter in the first quarter of 2009. We are also cooperating with the U.S. Department of Defense ("DOD"), the Department of Education, and the General Services Administration ("GSA") with respect to their joint investigations that are being conducted in coordination with the Department of Justice regarding our pricing practices that relate to sales to certain federal agencies. We first became aware of the GSA matter on December 29, 2008, the DOD matter on January 20, 2009 and the Department of Education matter on February 19, 2009. No claim for relief has been made in any of these matters and management cannot predict their ultimate outcome. - ODP, 2008 10-K

The lawsuit originated when a former employee claimed that ODP made undisclosed changes to a $600MM government-wide procurement plan that county, state, and federal government agencies used to procure offices supplies. A number of these agencies are requesting refunds and are then canceling or rebidding their contracts with ODP (www.naplesnews.com/news/2009/mar/28/fort-myers-man-blows-whistle-office-depot-then-blo/)

As a recent example of this actually impacting ODP's relationships with its customers, on 05/06/09 the state of California announced that it would be pulling its $25MM/year contract with Office Depot and that, "it is anticipated that the new contract will be awarded mid August and if awarded, to a new supplier." (www.documents.dgs.ca.gov/pd/delegations/pac050609.htm)

Finally, in an effort to breakeven, ODP is alienating the very vendors it depends upon for working capital.

In addition to the line review process, several vendors mentioned that ODP also put in place a 1% payment discount on receipts as of January 2009. The payment discount was essentially an immediate price cut to the supplier without much in the way of recourse. One can ask the question about how much blood can one squeeze from a stone. Recently, ODP relationship with its private label toner and ink suppliers was severed under questionable circumstances. ODP claims that it dropped its supplier but industry sources claim the supplier was losing money on the shipments because of charge backs from ODP and dropped ODP. We understand that the supplier filed for Chapter 11 recently and included in its receivables monies it is in dispute with ODP over what it views as improper chargebacks. It will be interesting to watch the results to see how the courts rule on the validity of these chargebacks as they will impact margins in the future. - Credit Suisse 06/08/09.

The company is feeling pressure but has yet to publicly attribute sales losses to the lawsuit.

Overall, our business in California has not improved and in fact, we are worried about it. You know we have a large public sector business out there and the state has been challenged with falling tax revenues and so forth. So they are cutting back at every level in the public sector and that is spilling over into jobs and of course small businesses have been hurt too. So we are just not seeing any kind of recovery in California.  - Steve Odlan, Q3 Earnings 10/29/09

While the BC deal bought ODP another one or two years, they may have only stalled the inevitable, particularly if they were to lose the contract with the government procurement plan. Below is an estimate of the potential impact to SPLS if ODP were to eventually go away.

 

 

 

 

Assumed Contribution

Segment

Sales

% SPLS

Adj. Sales

Margin

EBIT

Income

EPS

Delivery

4,142

40%

1,657

20%

331

199

$0.27

Retail

6,112

30%

1,834

15%

275

165

$0.23

International

4,241

10%

424

15%

64

45

$0.06

Total

14,495

27%

3,915

17%

670

442

$0.61

Compared to ODPX, OMX is in a pretty good position, but its still a share donor to SPLS. Their current strategy is to market themselves to females, sort of a "Staples for Women" concept. While this may work for a while, it is difficult to see how OMX can remain competitive longer-term. Below is an estimate of the potential impact to SPLS if OMX were to shut down.

 

 

 

 

Assumed Contribution

Segment

Sales

% SPLS

Adj. Sales

Margin

EBIT

Income

EPS

Delivery

4,310

40%

1,724

20%

345

207

$0.28

Retail

3,957

30%

1,187

15%

178

107

$0.15

Total

8,267

35%

2,911

18%

523

345

$0.47

OMX and ODP might be able to hold on for a few more years, but the good news is that these two companies are not SPLS' only competition that is under pressure. Combined, these big three retailers only account for approximately 15% of the estimated $300B global office supply market and perhaps 40% of the $100B North American delivery market. A significant amount of the remaining business is actually serviced by regional suppliers. These competitors are all under considerable pressure in the current economic environment. The largest of these regional competitors is W. B. Mason, which operates in NY, MA, PA. Interestingly, W. B. Mason's website noted that in 1991 "economic recession devastates the office supply industry," a year in which, "privately owned suppliers drop from 14,000 to 3,500." While the owners of these businesses may be willing to temporarily cut price, forgo salaries and defer necessary expenses in order to hang on one more year through difficult times, if the current sales environment continues, a number of regional office suppliers will be forced out of business. Below is a rough estimate of the potential impact to SPLS from share gains from these competitors.

 

 

 

 

Assumed Contribution

Segment

Sales

% SPLS

Adj. Sales

Margin

EBIT

Income

EPS

Delivery

20,000

20%

4,000

20%

800

480

$0.66

It seems reasonable to conclude that SPLS will take significant market share over the next few years. A number of analysts have highlighted this fact and made attempts to estimate the potential impact, but because the timing of any impact is extremely difficult to pinpoint, very few analysts assume any market share gains in their published estimates.

FINANCIALS

In 1H 2009, retail margins are essentially flat year-over-year as the company demonstrated its ability to hold retail margins above 8% despite the economic environment. Delivery and international margins were much lower, however, if one deconsolidates CXP it becomes evident that SPLS' other two divisions performed reasonable well and that the real reason for the much lower consolidated margins this year is almost entirely due to CXP which was only generating 2-3% operating margins. There is substantial earnings power that can be unlooked as SPLS brings CXP up to speed over the next three years. Specifically, CPX had lower online penetration (60% versus 90%), lower average order sizes ($160 versus $220), 7x more orders under $20 (all of which lose money), a suboptimal distribution network (40% larger fleet with less sales), a less variable sales force (20% variable versus 40%), and less overhead leverage.

After the CXP acquisition was announced, three-year synergies were expected to be $200-300MM. In October 2008, pretty much as the world was coming to an end, SPLS' management upped their synergy guidance to more than $300MM. Synergies in the first year of $120MM will come from consolidating buying power, synergies in the second year will come from cutting G&A, and synergies in the third year will come as a result of removing significantly overlapping distribution centers and rationalizing SPLS fleet of 1,100 trucks with CXP's fleet of 700. Management also hinted that there are additional consolidation activities that may occur. On 04/22/09, Bernstein put out a note that estimated more than $450MM in cumulative synergies by 2011. Ignoring the potential for additional upside, the $300MM of announced synergies will add nearly 6% back to CXP's margins and will boost consolidated operating margins by 1.25%.

The next opportunity that the company has highlighted is to take SPLS' private label business from 23% of sales in 2008 to 30%. CXP was around 25% so the combined company should around 24% today. With unprecedented buying power and tighter budgets prompting consumers to quickly switch to private label products, SPLS should be able to accomplish this in three years.

Year

2002

2003

2004

2005

2006

2007

2008

Goal

Private Label % of Sales

10%

13%

15%

18%

20%

22%

23%

30%

Margins on private label run roughly 7-8% higher than branded, albeit at 10% lower sales prices, which combined represents an opportunity to expand operating margins by an additional 0.5%.

Sales Type

% of Sales

Private Label Opportunity

Office Supply

42%

Large

Business Machines

28%

Small

Computers

18%

None

Furniture

7%

Moderate

Services

5%

N/A

Total

100%

30-35%

While the 30% goal appears very achievable, over a longer-time horizon, there may be room to increase this even further. ODP had previously stated that private label had the potential to be as much as 35-40% of sales and SPLS management believes that it could be 35%.

I have that debate regularly with the guy who runs it. I think 30% of our sales is an interim goal. He thinks that's a "by the time he retires" goal. So I think we're going to have to step on the gas a little bit and not grow this thing 50 basis points a year or 75 basis points a year. I think we're going to have to make some dramatic change. Just this past week we introduced, I don't know if you know OXO, the kitchen gadget company. We've been working with them for the last six months or a year and just introduced a line that are now in the stores, OXO Office Supplies. So it's a private label, it's a brand. But that kind of innovation and that kind of thinking, I think 30% is what we stated. Should it be 35%? I think it should. - Ron Sargent, Staples CEO, Bernstein Conference 05/28/09

Adding all of this up, here is what SPLS EBIT should look like around 2011 assuming no economic recovery, no upside to announced cost synergies, all competitors stay in business, private label does not increase past 30% of sales, and additional sales based only on new store growth:

 

Sales ($B)

EBIT Margin

EBIT ($MM)

Notes

LTM (11/01/08-08/01/09)

24,476

6.21%

1,520

Excludes one month of CXP

(+) 2009 Synergies

24,476

0.41%

100

Assumes 20 already realized in LTM

(+) 2010 Synergies

24,476

0.49%

120

G&A cuts and decline in amortization

(+) 2011 Synergies

24,476

0.25%

60

Warehouse/fleet integration

EBIT w/Synergies

24,476

7.35%

1,800

 

Private Label Growth

24,305

0.49%

120

23>30% sales, margin +7% but sales -10%

EBIT w/Private Label

24,305

7.90%

1,920

 

(+) 150 Net New Stores

25,055

0.45%

113

150 * $5MM x 15% contribution margin

Pro Forma EBIT

25,055

8.11%

2,032

Management's Long-Term Goal = 9%

Capital expenditures have traditionally been dominated by new store growth with minimal capital in the delivery business and a significant amount of growth expenditures in international. This will decline as store growth slows down from 100 a year to less than 50 while delivery is actually going to be closing overlapping distribution centers for the foreseeable future. Capex this year will be around $350MM, which includes a significant amount of growth investment in the international segment. Over-time, capital expenditures net of international growth investment should continue approach maintenance levels of $200MM.

 

$MM

Per Share

Notes

Pro Forma EBIT

2,032

$2.82

 

(-) Interest

(245)

($0.34)

High-end of guidance

EBIT

1,787

$2.48

 

(-) Taxes

(608)

($0.84)

34% Blended tax rate

Income

1,180

$1.63

 

(+) D&A

500

$0.69

Guidance from Q4 less accelerated amortization

(-) Maintenance Capex

(200)

($0.28)

Company and analyst commentary

FCF

1,480

$2.05

 

Sell-side estimates currently assume SPLS reports earnings of $1.12 this year, growing 21% to $1.36 in 2010, and growing 25% in 2011 to $1.70. To get above street EPS of $1.70 versus the $1.63 shown above, one merely needs to assume that SPLS pays off debt issues when they mature and retains all remaining cash. This is an overly conservative assumption given that the company should be able to take its net debt to zero by the end of 2011. In 2009, nearly all of the cash flow this year will be used to pay down the company's outstanding commercial paper and revolver. Of the debt that will remain afterwards, $500MM will come due in 2011, $325MM in 2012, and $1.5B in 2014. SPLS bought back $512MM of stock in 2004, $663MM in 2005, $776MM in 2006, and $761MM in 2007, and $85MM in 2008, so there is upside to street numbers if the company decides to resumes its buyback instead of hording cash at low interest rates.

Finally, sell-side sales estimates over the last year have fallen from nearly $30B to $25B. Some of this decline in sales is related to the decline in the dollar but the majority is due to companies buying roughly 15% less office supplies than they would in a normal environment. There is perhaps $4B of sales recovery if and when the office supply industry recovers, which would boost EPS by $0.72.

RISKS

1. Wal-Mart/Sam's Club and Costco

Some of the larger big-box retailers are looking for new verticals to drive revenue now that the consumer is cutting back. Wal-Mart (WMT) has always gone after back-to-school sales but more recently Sam's Club and Costco (COST) are going after the home and small businesses segment. In particularly, COST is targeting restaurant customers which should not hurt SPLS too much. The benefit of big box retailers targeting the small business customer is that while it does hurt SPLS retail business, it hurts competitors as well, making it all the more likely that they are unable to survive and their national contract accounts would be up for grabs. It is highly unlikely that either WMT or COST would be able to service a nationwide account like Bank of America with an online ordering system integrated at the customer level and daily deliveries. Again, SPLS now sells more office supplies than WMT.

2. Amazon

Amazon launched an online office supply store in June 2008. Clearly any retail business in operation 10 years from now will have to at some point come to terms with how it can compete with AMZN. That said, it is unclear if AMZN's has a competitive advantage over SPLS other than perhaps a better brand with the small business consumer who is ordering personal products and perhaps a few pens as well. Both companies own their own distribution centers but SPLS has its own delivery network and AMZN will have to figure out how to compete with the rock-bottom prices SPLS offers in its private label business on generic products. More importantly, in 2009, SPLS total sales are still expected to exceed those of AMZN.

3. ODP/OMX Merge

Our sources have indicated that it is highly unlikely OMX would want to be exposed to ODP's legal risks and poor real estate. In addition, significant store overlap would result in closures and additional comps to SPLS. While the probability is unlikely, there would be considerable risk to this thesis if say COST decided to recapitalize and turnaround a competitor in order to compete in the delivery segment.

4. Obsolescence of Paper

There is a reasonable chance that 50 years from now everyone in an office is walking around with a Kindle and paper use has declined to zero. SPLS should still have a reason to exist as a distributor of furniture and technology while one can short printing companies such as XRX, PBI, IRM, CAJ, or LXK that have much greater risk of permanent business obsolescence.

Catalyst

Strong 2H results

Competitive departures

Pick up in International profitability/growth

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