The Reinvention of Staples Is Making Progress

At first glance, it would seem that things aren't going too well at Staples (NASDAQ: SPLS  ) . The company's earnings report last Wednesday showed declining sales, declining profits, and continued store closures, as weak demand for office supplies threatens Staples' top and bottom lines. But digging deeper, a story of reinvention and change becomes evident, and Staples is taking big steps to position itself for a brighter future.

A quick earnings overview
Total revenue fell by 3.8% year-over-year to $6.1 billion, the result of 107 store closures in North America and Europe over the past year, a strong U.S. dollar, and weak demand in general. While operating income swung to a profit from a loss in the third quarter of last year, on a non-generally accepted accounting principles basis, operating profit declined by 13.8% to $431 million. Non-GAAP earnings per share came in at $0.42, down 9% from the same period last year.

Comparable-store sales in North America, excluding online sales, fell by 3% as a result of lower traffic in stores. Online sales were a bright spot, up 3% year-over-year, but they failed to fully make up for retail weakness. The North American commercial business grew by 0.7%, although operating income fell due to lower margins. International operations were the biggest weak point for Staples, with sales falling by 8%.

The company expects full-year revenue to decline in the low-single digits, and non-GAAP EPS to be in the range of $1.21 to $1.25. Free cash flow is expected to be greater than $900 million, or $1.37 per share, and the company plans to continue repurchasing its shares during 2013.

Out with the old, in with the new
Amidst weak demand for the traditional office products which are Staples' specialty, the company is broadening its business model. As sales of ink, toner, and paper products decline, Staples is adding new categories, like break-room supplies and furniture, in an effort to become a one-stop-shop for businesses. During the third quarter, Staples added 70,000 new items on its website, with the goal of adding another 100,000 by year-end.

Growth in these new categories is strong, but not quite strong enough to counteract weakness in traditional office supplies. During the company's conference call, CEO Ronald Sargent stated that he expects growth in these new categories to outpace weakness in old categories within the next few quarters.

Of the new products being sold by Staples, about 20,000 are retail-store supplies. During the conference call, Sargent announced that Staples would be launching an assortment of 20,000 restaurant supplies in the coming weeks, and that the company intends to serve many more industries in the coming months.

This is exactly the kind of shift that Staples needed. While market share could certainly be picked up in traditional office supplies, especially during the disruption caused by the merger of competitors Office Max and Office Depot (NASDAQ: ODP  ) , long-term growth requires Staples to adapt to the changing market.

A focus on e-commerce
Staples is the second-largest online retailer in the world, behind Amazon.com (NASDAQ: AMZN  ) , and the company is doing a few things to grow its e-commerce channel. First, Staples revamped its website during the third quarter, the largest refresh since 2005. Navigation is simpler, search performs better, and the new website is about 40% faster than the old version. The changes should prevent some shoppers from abandoning orders due to long loading times.

In addition to the new website, Staples' recent acquisition of tech start-up Runa, along with the opening of a development center in Seattle, shows that the company is embracing technology and big data in order to drive sales. Some of Runa's capabilities have already been integrated into the website, and the real-time, personalized offers which the technology allows have the potential to increase customer engagement and sales.

Tough competition
With the Office Depot-Office Max merger recently closing, the new company now faces the task of merging into a viable competitor. The merger will remove excess capacity, as areas with both Office Depot and Office Max stores will see some of them close. This is actually a positive for Staples, as these store closures will eliminate some of the competition in markets which are over-saturated. Staples expects opportunities to arise from the disruption caused by the merger, with Sargent having this to say during the conference call:

Our focus is really back to executing on our plan, but we feel that this disruption in the industry will create opportunities for Staples going forward. And our job is to realize those opportunities over the next several years. And we have a pretty strong, aggressive plan in place to really go after market share, not only in our retail business but also in our online business, as well as our contract business. So I think we're going to take advantage of every opportunity we see in front of us.

The downside of the merger for Staples will be a more effective competitor compared to the old Office Depot and Office Max, although it will likely take a few years for the two companies to realize all of the benefits.

Amazon is a thorn in Staples' side, and this year Staples has introduced a new price-matching policy to combat the online retailer. For the first time, Staples is matching prices in its stores against Amazon, a change from the past where Staples only matched Amazon's prices online. While this may seem like it will negatively affect margins, management stated on the conference call that the number of people taking advantage of the offer is small. As Sargent put it:

I mean, it's not a big number but it's more sizzle than it is steak, but it's sizzle I think you have to have.

The bottom line
Staples' plan going forward is to continue being the leader in traditional office supplies while branching out into new areas. Once the revenue generated from these new areas reaches a critical mass, Staples will return to growth. I think it's the right move for the company, and although profits are being squeezed in the short term, the long-term picture looks promising. Given these facts, Staples is certainly worth keeping a close eye on by investors. As always Foolish investors should do their own research before making any investment decisions.

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