Don't Be Tempted to Catch This Falling Knife

In the investing world, there's an old adage about avoiding "buggy-whip" companies. This refers to businesses that become obsolete due to technological advancements over time. As an investor, it's critical to look ahead to try to pinpoint which stocks out there operate buggy-whip business models and avoid them at all costs.

Big-box retail fits the bill now that we're in the digital age; more specifically, this especially applies to retailers of paper and office supplies. That's why you'd be wise to avoid Staples (NASDAQ: SPLS  ) .

Storm clouds gathering
In the Internet age, there's simply not as much need for paper or a variety of other office products as there used to be. Consumers at both the business and personal levels are using a lot less paper. Instead, they're sending emails. Records are becoming much more digitized. In response, people are using fewer staplers, paper clips, and generally all the things that used to pack your company's supply room.

The end result is that Staples as well as other office-supply chains like Office Depot (NASDAQ: ODP  )  are seeing a fundamental deterioration of their businesses. Staples released its first-quarter earnings report on May 20, and the stock immediately collapsed. There's good reason for this: Generally accepted accounting principles earnings per share fell by nearly half due to falling sales and the impact of store closures.

Likewise, Office Depot lost $109 million in the first quarter, a much worse performance than the $17 million loss incurred in the first quarter last year.

Addition by subtraction
With such a drop in share price, you might be tempted into believing Staples is a value opportunity. After all, shares trade for just 12 times earnings, and the stock offers a 4% dividend yield. But it's important to remember the difference between a true value stock and a falling knife. Unfortunately, Staples seems like the latter.

Things aren't going to get much better for Staples this year. The company closed 16 stores in North America in the first quarter and plans to close an additional 80 stores in the current quarter. Moreover, sales are expected to fall again this quarter on a year-over-year basis. And Staples expects to record between $105 million and $155 million in restructuring and other charges in the current quarter that will weigh on profits even more.

There's severe turbulence swirling through the office-supply industry right now. In response, companies are reacting as you'd expect, by consolidating and cutting costs. This will help keep profits afloat in the short term, but it's not a long-term solution. You'll recall Office Depot bought out Office Max and expects to realize an annual run rate of $675 million in synergies through year-end 2016. This will be supplemented by Office Depot's plan to close at least 400 stores by then. Closing so many stores and severely cutting costs will boost profits going forward, but sales are the lifeblood of any retailer. At some point, all these cuts will come at a cost to future growth.

There was hope that Staples' online-retailing endeavor, Staples.com, would reenergize sales and offset the decline in customer traffic at brick-and-mortar locations. Unfortunately, the initiative really hasn't gained as much traction as is necessary to stem the decline of in-store shoppers. Sales from Staples.com grew just 6% in constant currency in the first quarter, which simply isn't going to cut it.

No easy button for Staples to press
On the surface, Staples looks like a cheap stock. The company still expects to turn a profit this year, and it's cash flow positive as well. But you should take into account that this could change if traffic and sales keep declining. Massive store closures are only going to accelerate this.

Staples has a lot of work to do if it's going to engineer a real turnaround for itself. At some point, management needs to demonstrate it has a better plan to reverse its downward spiral other than just cutting costs and closing stores. Until that happens, you'd be wise to avoid Staples.

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