Staples Crashes: Buying Opportunity or Time to Run?

The recent crash in Staples could be a short-term overreaction; however, things could continue getting worse for the company before they get any better.

May 21, 2014 at 9:45AM

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Source: Staples.

Staples (NASDAQ:SPLS) was crashing by nearly 13% on Tuesday after reporting disappointing earnings for the first quarter of 2014. The market tends to exaggerate when it comes to short-term reactions to negative news, but considering the competitive pressure from players such as Office Depot (NASDAQ:ODP) and (NASDAQ:AMZN), things could continue deteriorating for Staples in the medium term.

Disappointing performance
Total sales during the first quarter of 2014 fell by 3% versus the same period in the prior year to $5.65 billion; this was marginally better than the $5.62 billion forecast on average by Wall Street analysts, but hardly much reason for optimism regarding the health of the business. Revenues excluding the impact of store closings and foreign exchange fluctuations declined 2% year over year.

Sales in North America were especially weak, with a decline of 5% versus the prior year to $2.6 billion during the quarter. Comparable-store sales in North America fell 4% due to a 4% decline in traffic and a flat average order size, while online sales in the region increased 6% during the quarter. Staples closed 16 stores in North America during the quarter, and operating margin in the region declined by 74 basis points to 6.6% of revenues.

International sales fell 4% to $1 billion during the period, while operating margin in the international segment fell by 152 basis points to an operating loss of 2.6% of sales.

Overall company-level gross-profit margin declined 100 basis points to 24.6% and operating margin contracted by 209 basis points to 2.8% of revenues. Earnings per share came in at $0.15 during the quarter, a whopping decline of 43% versus the same period in the prior year, and materially below analysts' estimates of $0.21 per share.

Management is not very optimistic regarding performance in the coming quarter, Staples expects sales to decline in comparison to the second quarter in 2013, and earnings per share are forecast to be in the range of $0.09 to $0.14, lower than the $0.16 per share the company made in the second quarter of 2013.

Competitive challenges
Staples is planning to turn the business around by restructuring its store base and increasing its online presence. However, it won't be easy for the company to reverse the decline while facing huge competitive pressure from both online retailers such as Amazon and traditional competitors like Office Depot.

Amazon is clearly one of the most dreaded and disruptive competitors in the retail industry, and the kinds of products that Staples sells are lend themselves particularly well to online shopping. When purchasing office products, customers want a convenient cost and an efficient service, and it's very tough for retailers in the category to differentiate themselves based on factors such as brand value or customer experience.

Amazon launched its AmazonSupply store focused on business-to-business transactions in 2012. Although the online retailer does not disclose financial figures for AmazonSupply, considering the damage that Amazon has inflicted on retailers in different categories over the years, it does not sound like too much of a stretch to assume that Amazon is a considerable competitive risk to Staples.

The merger between Office Depot and OfficeMax will produce approximately 400 store closings by 2016 as the companies consolidate their operations, and this could be a positive for Staples. On the other hand, the new Office Depot is an industry giant with more than 2,000 stores and nearly $17 billion in annual sales, this means considerable strengths for the company in areas such as economic scale and negotiating power with suppliers.

Office Depot reported a 3% decline in total combined pro forma sales during the first quarter of 2014, so the company is also facing serious difficulties when competing versus online retailers. On a combined pro forma basis, Office Depot sales in the U.S. fell 5% year over year, while same-store sales declined 3% in the country.

Declining sales at Office Depot means that the pricing environment will most likely remain notoriously competitive in the segment as companies struggle to generate sales growth over the coming quarters.

Foolish takeaway
With shares of Staples falling from a cliff after the company delivered disappointing financial performance, investors have valid reasons to wonder if the market is overreacting to the news. This is often the case, but considering the competitive threats and industry headwinds faced by Staples, things could continue getting worse before they get any the better for the company.

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Andrés Cardenal owns shares of The Motley Fool recommends and 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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