Shares of office supply company Staples (NASDAQ: SPLS ) recently sank after the company reported an 11% decline in revenue during its fourth quarter. Along with the announcement of 225 store closings over the next two years, Staples appears to be a company struggling to remain relevant. But a look beneath the surface shows that something big is happening at Staples, and it's clear that the company is very different from other troubled retailers that were also forced to shutter stores. Staples is transforming itself into a one-stop-shop for businesses, an Amazon.com (NASDAQ: AMZN ) for businesses, and I like its chances.
An online powerhouse
Staples is already the second biggest online retailer, behind only Amazon, and online sales represent nearly half of Staples' sales. This puts Staples' annual online sales in excess of $10 billion, making the 10% year-over-year growth in the fourth quarter all the more impressive.
This online growth was driven by a vast expansion of the number of available items available on Staples' website. At the beginning of 2013, about 100,000 different items were available online. At the end of the year, this number jumped to 500,000, with new categories like facility supplies, furniture, restaurant supplies, and retail store supplies greatly diversifying Staples' online offerings. During 2014, Staples plans to triple this number to 1.5 million items, giving the company the ability to serve far more industries than ever before. More than 80% of sales on Staples.com are to businesses.
While Amazon has become a one-stop online shop for consumers, Staples is aiming to do the same for businesses. This involves downsizing its retail operations, including closing 225 stores over the next two years and downsizing others, and focusing on growing the commercial business and online sales. The retail stores are still important, with about 50% of revenue coming from business customers, but it's clear that there are too many office supply stores in the United States.
Along with expanding the number of items available online, Staples is working to make the online purchasing experience better for its customers. Last year, Staples bought tech start-up Runa, and it plans to use the company's technology to generate personalized offers for customers and to ensure that prices are competitive compared to the competition.
There's a reason why Staples has managed to become the dominant office supply company, driving rivals Office Depot (NYSE: ODP ) and Office Max into a merger. Even with the retail stores suffering a sales decline during the fourth quarter, Staples' North American commercial business still managed to grow, adjusting for an extra week during the fourth quarter of 2012. Staples has a 3,000 person sales force and existing relationships with over 10 million small business customers and 25 million Staples Rewards customers, and these relationships have helped make Staples' new product categories a success. Online growth of 10% for a $10+ billion online operation within in an industry suffering from weakening demand is a testament to the loyalty of Staples' business customers.
Customer service is a big differentiator, and with its sales force able to offer customized pricing and work with its business customers directly, Staples has an advantage over online-only competitors like Amazon. Staples' fleet of 1,400 trucks and a mature distribution network allow Staples to offer free next-day shipping to its business customers, something that likely isn't cost effective for Amazon. While Staples has control over the entire process, from distribution to delivery, Amazon relies heavily on UPS, FedEx, and the USPS. Amazon can ship packages out of its distribution centers quickly and efficiently, but its reliance on third parties to make deliveries diminishes any advantage it may have in that area. Amazon could offer next-day delivery to businesses, but it would be an expensive proposition. In this case, Staples' focus on serving business customers gives it an advantage over more general retailers like Amazon.
A turnaround play
While Staples' profits have declined recently due to weak demand for traditional office supplies, Staples' success with broadening its product offerings so far suggests that its goal of becoming a one-stop-shop for businesses is well within reach. Unlike other struggling retailers, Staples is still quite profitable, with free cash flow of about $740 million, or $1.13 per share, last year. This puts shares of Staples at about 10 times free cash flow, and although the free cash flow has been guided lower for next year, the momentum of Staples' new product offerings will eventually more than make up for weakness in core office supplies. Once this happens, Staples will return to growth.
This all depends on online rivals like Amazon being unable to steal business customers away, as well as the newly merged Office Depot being unable to become a more viable competitor. If Staples' competitive advantages hold, and business customers remain loyal to Staples, then the stock is currently a bargain.
The bottom line
Staples is transforming itself into a one-stop shop for businesses much like Amazon has done on the consumer side, and while short-term results will be pressured by declining demand for traditional office supplies, the long-term story is a promising one. My favorite kind of turnaround is a company that remains profitable throughout the process, and Staples' continuing profitability gives it the flexibility it needs to successfully transform its business. I like Staples' chances.
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