2 Reasons Why Staples, Inc. Will Recover From Its Recent Earnings Disaster

Shares of office-supply company Staples (NASDAQ: SPLS  ) sank when the company reported declines in both revenue and profit for its first quarter, with weak guidance fueling the fire. Staples is one of many retailers to report weak results this quarter, with store traffic and margins drying up, but there are a few reasons to believe that Staples is in better shape than the typical retailer. Here are two reasons why Staples has a good shot at righting the ship.

It's all about corporate
Unlike many retailers, Staples is not really a consumer-orientated company. According to CEO Ron Sargent, about 80% of Staples' total sales are to businesses of varying sizes, with the retail stores catering to smaller businesses and the commercial-delivery segment catering to larger businesses. To some degree, this protects Staples from weakness in consumer spending, although the back-to-school season is still very important for the company.

About 60% of Staples' total sales are delivered, either through its website or through commercial delivery. With online sales growing by 6% in the first quarter, partially making up for a decline in sales in the retail stores, this percentage will undoubtedly grow as time goes on. The commercial-delivery segment also grew during the quarter, a good sign that Staples' large business customers still see value in purchasing from the company.

So while consumers are certainly shifting away from office-supply superstores, partly due to lower demand for core office supplies and partly due to competition, businesses don't seem to be fleeing. Part of the reason for this is Staples' recent expansion of the number of products that if offers, many being outside of the core office supplies Staples is known for. From restaurant supplies to furniture, Staples is transforming itself into a company that can supply businesses with everything they need, not just office supplies. And so far, it appears to be working.

So many store closings
At year-end 2013, Staples operated 1,846 retail stores in the United States. Competitor Office Depot (NASDAQ: ODP  ) operates about 1,900 stores, a number that was boosted by its recent merger with Office Max. In total, there are roughly 3,750 office-supply superstores in the United States between the two companies.

Considering the continuing decline in demand for traditional office supplies, this number is simply too high. Operating too many stores was certainly one reason why Staples' operating profit contracted during the first quarter, and it's clear that this number needs to be brought down considerably.

Staples plans to close 225 stores in total over the next two years, along with downsizing others, and during the first quarter the company shuttered 16 stores with plans to close another 80 stores during the second quarter. By year-end 2015, Staples will have about 12% fewer stores.

Office Depot is being even more aggressive, recently announcing a plan to close 400 stores over the next few years, or about 21% of its total store base. By the time both companies complete their respective store closings, the total number of office-supply superstores in the U.S. will be nearly 17% smaller than it is today.

These store closings will certainly cause sales to decline for Staples, but at least some revenue should transfer to existing stores. Staples estimates that between 20%-25% of sales from closed stores should transfer to existing stores, and that 10%-12% of sales from closed Office Depot and Office Max stores should transfer to remaining Staples stores as well. These additional sales, while resulting in a net reduction in total revenue, will have the effect of increasing the operating profit at existing stores. So while sales declines over the next few years will likely continue, profitability should start to improve. Ultimately, profit growth is far more important than revenue growth.

The bottom line
Staples' retail stores are not doing well, but a focus on business customers along with an enormous number of store closings across the industry should help profitability recover over the next few years. As time goes on, the retail stores will become a smaller part of the company, with both online sales and commercial delivery still growing; but the stores can still be profitable if costs are managed and enough stores are closed. Staples may look like it's in a tough spot, but the plan going forward looks solid. Investors should look for earnings to begin to recover over the next few years.

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9/3/2015 4:00 PM
ODP $7.32 Down +0.00 +0.00%
Office Depot CAPS Rating: *
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Staples CAPS Rating: **