Staples Inc: A Best in Class Retailer with a Growing Advantage ($SPLS, $ODP, $OMX)

Staples, Inc (NASDAQ: SPLS) is the world’s largest provider of office supplies, which it sells through its 1,908 superstore locations in United States and 377 locations abroad, as well as via its online and direct delivery system. On Friday, the company reports its Q4 and full year results for fiscal 2011, which is a time when many companies see their shares move quite dramatically. I thought it would be worth pausing now to consider SPLS in order to provide some context for Wednesday’s results.

SPLS has two main competitors: Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX). For a bit of background, the business supplies industry was highly fragmented until the late 1980s/early 1990s, when the superstore concept emerged with SPLS, ODP and OMX emerging as dominant players. In 1996 SPLS and ODP announced their intention to merge. The FTC blocked this transaction, noting that the combination of the top two players would have a deleterious effect on competition. International expansion and growth into related industries became the focus, as further consolidation was eliminated as an opportunity. SPLS has maintained its position as market leader, with significantly more stores, both within the United States and abroad, with ODP in second place and OMX trailing in third.

On any number of metrics, SPLS is the better managed company. The company has a track record of achieving strong returns on equity averaging 15.4%. Comparing it to ODP and OMX is a bit difficult as ODP and OMX suffered significant non-cash write-downs in the recession that render their 10-year average ROEs negative. A better comparison then is to consider free cash flow generation. 

Over the last ten years, SPLS generated an average of $900 million per year in free cash flow, as compared to $316 million and negative $490 million for ODP and OMX. Furthermore, as the following chart shows, while SPLS’s free cash flow has largely been growing, ODP and OMX have been in decline.

Office Supply Retailer Free Cash Flow, 2001 - TTM

Office Supply Retailer Free Cash Flow, 2001 - TTM

As you can see, SPLS has a track record of consistently positive free cash flows, which have by far bested its two direct competitors. 

These are absolute figures, which give little insight into whether one company is more effective in generating free cash flow. After all, I’ve already told you that SPLS is the largest in the industry. It might generate more free cash flow simply as a result of generating more revenues.

In order to determine which company is more effective in generating free cash flow, we can look at free cash flow as a percentage of revenues, and do so over time. This type of analysis shows a distinct advantage on the part of SPLS. Over the last ten years, SPLS has earned a free cash flow margin of 5% on average, whereas ODP And OMX have earned just 2.5% and 1.9% respectively. Over the last 5 years this difference has become even more pronounced, with SPLS, ODP and OMX earning 5%, 1.5% and 1.4% respectively. Translation: for every $1 of revenue these companies receive, SPLS is able to generate more than twice the amount of free cash flow consistently over the decade (and more than three times as much over the last five years, suggesting the advantage is growing).

It is also worth noting here that SPLS has returned much of its prodigious free cash flow to shareholders in the form of share repurchases and dividends. In the first nine months of fiscal 2011, the company has repurchased $513 million worth of shares and paid $210 million in dividends, which amounts to approximately 85% of free cash flow generated over the period.

Going back to the companies’ returns on equity over the decade, it is worth noting that ODP and OMX have a decided advantage in the competition, for these companies have significantly less equity. Indeed, ODP and OMX are far more highly leveraged than SPLS. While SPLS has generally maintained a debt to equity ratio of about 25% (28% currently), ODP has averaged 36% (and is currently sitting at 92%) while OMX has averaged 1.98 (and currently is at 265%, though just 41% if you do not count non-recourse debt). For investors, a smaller debt load is preferable as it provides the company with greater financial flexibility during tough times (like a once in a century recession).

Efficient operations is one thing, but it is also good to invest in growing businesses, so let’s now consider revenue growth among the companies. Over the last decade, SPLS has grown revenues at a CAGR of 8.6%. ODP has managed a paltry 0.4% and OMX has actually shrunk by 0.37% in the same period. For OMX, part of this is due to the sale of its paper division in 2003, but for ODP, the store count actually grew over the period, so it appears same store sales have declined quite dramatically.

I think the above survey nicely illustrates SPLS’ superior operating performance over the period and the growing gap between itself and its closest direct rivals. Keep this in mind as the company reports on Wednesday and its shares inevitably become quite volatile; for the long-term investor, an opportunity might emerge.

What do you think of SPLS?

 

Author Disclosure: None, but may initiate within 72 hours.

Talk to Frank about Staples, Inc

  • Mike

    If you look at a 10 year chart of Staples…the stock price has hit at least $20 at some point every year…Obviously past performance is not a guarantee of future returns…It is the stock market… but a 33% gain from here is a pretty good bet.

  • PSDFinancier

    Hey Frank,

    Hope all’s well. I’ve been following your blog as well as Saj Karsan’s for the last few months and have found both of your work to be very good. However, I’m a bit skeptical of your conclusion on Staples, and wanted to get your thoughts. I agree with your strategic analysis of Staples and like its free cash flow generation, but I wonder about your view on Staples margins…do you worry that the 7.5-8% EBIT margins that Staples did in FY 2006-2008 (CY2005-2007) might have been peak margins rather than normalized? When you look at the average EBIT margin for FY 2005-2012, you get 6.9%, a mere 400 bps from 2012′s margin of 6.5%.

    If we use Greenwald’s EPV method, and apply the 6.9% margin to 2012 Revenue of $25M, we get normalized EBIT of $1.7B. Assume a 35% Tax Rate to get Normalized NOPAT of $1.1B. Excess D&A vs. capex has been minimal, but you could argue $0.1B to be generous based on 2012 results. This gets us to a value of earnings of roughly $1.2B.

    Apply a 10% discount rate to this, and you get an initial EPV of $12.3B, then add in net cash of ($0.8B). This gets you a final earnings power value of $11.5B, when Staples market cap is currently $10.7B, which represents 7.5% upside. Sure, if you think based on your good strategic analysis that Staples will be a long-term grower, then my EPV is being harsh for assuming no growth, but as value investors, don’t we want to pay for a business at a discount to the no-growth fair value, and get the growth for free as upside to our base case? And even though Staples seems to be a great business vs. Office Depot and OfficeMax, do you worry about Amazon/Wal-Mart/Target? Would love to hear your thoughts on this.

  • Frank Voisin

    Hi Brad

    Thanks for sharing that letter! You are correct about the earnings date. My mistake (I have fixed the post).

    Frank