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Tuesday, May 11, 1999

An Investment Opinion
by Warren Gump

MaxChange Needed

After being the lagging sister of the office supply superstore industry, could it be that OfficeMax (NYSE: OMX) is getting ready to once again compete? Today the company announced that Q1 earnings jumped 27% from the prior year. Before jumping over to your online broker, however, you will probably want to look a little deeper at the company. (But you know that; you're Foolish and always take time to consider a company before making a transaction.)

As the market for office superstores has surged, OfficeMax's stock has been left in the dust. Over the past three years, OfficeMax shareholders have endured a 30% loss in value, whereas market leader Staples (Nasdaq: SPLS) has surged over 200%. Here is a chart showing the performance of the two companies.

What has caused the discrepancy in stock price performance? No big surprise here... earnings. Staples grew its bottom line 70% between fiscal 1997 (ends in January) to fiscal 1999. Earnings for the current year are expected to jump up another 28%. OfficeMax, on the other hand, only saw a 45% growth in earnings during the same time period. While such growth over two years is impressive in most industries, the performance pales in comparison to Staples' results. Even worse for stockholders, analysts are expecting slower growth from OfficeMax. Since the value in most growth stocks lies in future results, this has hampered (to put it mildly) OfficeMax's stock price. For the current year, OfficeMax earnings are only expected to grow 15%, although the long-term growth rate is projected to be 20%. (Staples has a 30% estimated growth rate.)

Where has OfficeMax gone wrong? One of the big problem areas has been computers. The company got caught up in this promotional, low margin business in an attempt to boost sales. While sales jumped up, profits didn't see a commensurate gain since margins were so low. As computer price declines accelerated, the company couldn't increase the number of units sold to offset the lower prices, causing a decline in same-store sales. Realizing that the company didn't have a significant advantage in this market (a situation competitors had already recognized), management decided to decrease its emphasis on computer sales.

For the past couple of quarters, OfficeMax has broken out results for its computer business unit so that investors can evaluate the performance of that segment as well as the rest of the store. When you look at these results, it's easy to see why the company's stock has been floundering. On sales of $93 million in last year's fourth quarter, the division lost $8.3 million. Even more surprising is the fact that the company had a loss at the gross profit line of $3.2 million. This means the company was selling products for less than it cost the company to buy them! While that business model may work today for Internet companies trying to gain a first-mover advantage, it certainly doesn't work for an old-line retailer.

Results for this latest quarter didn't improve very much in computers. Overall sales decreased to $67.8 million, as same-store sales declined 40% due to the deliberate reduction of low margin sales. Gross profit was still a negative $1.8 million and the net loss for the segment was $7.3 million. While the net loss is a $1 million improvement over the prior year, there's still a way to go to reach profitability.

The company announced in January that it is testing out a new computer department that will be stocked exclusively with IBM equipment. In three test stores, IBM will staff the computer department with its own personnel. The remaining three stores in the test will be staffed by OfficeMax employees. While no details on this test were disclosed today, the company is at least trying to develop a solution to extricate itself from the current quagmire.

OfficeMax is posting satisfactory results excluding computers, although these results lag competitors. During the first quarter, same-store sales (not including computers) were up 3% at OfficeMax. A decent figure, but not spectacular. Last year, Staples same-store sales gains were five percentage points higher than those earned by OfficeMax. I would be somewhat surprised to see relative performance shift in OfficeMax's favor. (Staples has not yet released Q1 results.)

Office Depot (NYSE: ODP), the other major office superstore chain, posted Q1 comparable store sales of 2%. While that is below the 3% posted by OfficeMax's "core business," Office Depot doesn't segregate computer operations. Looking at the whole store, Office Depot's 2% comparable store gain looks favorable to OfficeMax's total same-store sale decline of about 1%.

Recognizing that the company needs to enhance store performance, OfficeMax announced today that it had hired retail consulting firm Kurt Salmon Associates. Among other things, OfficeMax hopes to get ideas for some "quick hits" that can improve performance quickly. These initiatives will be in addition to longer-term programs such as the implementation of SAP software and a new supply management system that are already underway.

OfficeMax has a lot to prove before it will be interest most investors. Management is talking the right talk (change), but has historically not walked the right walk (strong relative performance). Right now, the market is betting that the company will once again stub its toe. With a Price/Earnings (P/E) ratio of 12 on this year's earnings estimates, OfficeMax trades at a significant discount to competitors Staples (P/E: 39) and Office Depot (P/E: 22). The company's weak performance relative to competitors has led to the market's skepticism. If management figures out a more competitive way to operate its stores, this stock could be poised for a substantial bounce. Then again, if its more of the same, the stock will remain in the bargain bin.

Call Your Boss a Fool.

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