How Does the Future Look for Staples and Office Depot?

One will rise, one will fall, at least in the short term.

Mar 20, 2014 at 10:00AM

It's rarely good news when a retailer decides to close a large number of stores. On the one hand, closing underperforming stores can save the company money and improve profits. On the other hand, the company may just be delaying the inevitable closure of the concept.

In the office-supply industry, there are two companies that made a recent list of retailers closing the most stores, and both Office Depot (NASDAQ:ODP) and Staples (NASDAQ:SPLS) have the dubious distinction of making the list.

What's the problem?
As an investor, there might not be anything more important than making sure the company you invest in has a "moat" of some type. In business terms, a moat simply means that there is something about the business that is unique or proprietary that will protect the company from its competitors.

Office-supply companies like Office Depot and Staples used to have a built-in advantage of convenience. Businesses could visit one of their hundreds of locations and get what they needed to get back to work. But the ability to buy items online has eliminated the convenience issue as the products are shipped directly to the company's front door.

According to Hoover's, the office-supply store industry gets more than 60% of sales from the categories of software and supplies, paper, stationery, and furniture. This puts Office Depot and Staples in direct competition with retailers ranging from (NASDAQ:AMZN) to Best Buy, Wal-Mart, and Target.

Another key characteristic of this industry is the need for greater size to obtain cost efficiencies. Office Depot's recent quarterly sales were about $3.5 billion, Staples generated about $5.9 billion, and Amazon sold more than $25 billion. In an industry where size matters, it's obvious who wins.

The merger won't work
The merger last year between Office Depot and OfficeMax created a company with more than 1,900 retail stores. Since this merger, 22 stores have been closed, and the fact that the company referred to becoming a lean organization multiple times indicates that many more stores will likely be shuttered.

The big problem facing Office Depot is the fact that the company is losing out to its competition across the board. From North American retail sales declining 4%, to business solutions declining nearly 2%, there isn't much for investors to cheer about.

Amazon's domestic sales increased by 26% last quarter, and almost 70% of this was from electronics and general merchandise. It's not hard to believe that a certain portion of this was office supply orders that would have gone to Office Depot or Staples years ago.

In addition, Office Depot only generated about $50 million in core free cash flow over the last 12 months. Compared to more than $650 million of free cash flow at Staples, or more than $300 million in just the last three months from Amazon, clearly scale is not on Office Depot's side by this measure either.

Staples' plan only works in the short term
Relative to Office Depot, Staples looks like it operates in a different industry. The company plans on closing 225 stores by 2015 to focus on its online sales. With nearly half of the company's sales coming from the online channel, and this division growing by 10%, this seems like a sensible move.

Staples was also able to grow its commercial sales by 2%, compared to a decline in Office Depot. With significant free cash flow, in the short term Staples looks like the much safer investment. But the company's size is still a problem relative to its larger competition.

Staples noted that it ended the year with 500,000 products on versus 100,000 a year ago. While this is an impressive achievement, Amazon Supply boasts more than 1.2 million items on its site.

You're dead to me
Unfortunately for both Office Depot and Staples, you can almost hear Kevin O'Leary from ABC's Shark Tank saying, "You're dead to me." O'Leary is famous for being tough on business owners and asking what is proprietary about their business. When he determines that anyone can make their product or provide their service, he usually launches has famous catchphrase.

The bottom line is, Office Depot and Staples offer products that many other retailers can offer, and Amazon in particular has the size to offer better deals. In the short term, Staples seems the much safer option. Longer term, if things continue as they are, neither Office Depot nor Staples seems to have a chance to survive.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends The Motley Fool owns shares of and Staples. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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