In March, Staples, (NASDAQ:SPLS) announced a bold plan to cut costs by closing up to 225 U.S. stores by the end of 2015 and downsizing others to a new 12,000-square-foot format. I applauded this move at the time, as Staples should be more profitable with smaller stores and fewer of them.
Meanwhile, top competitor Office Depot (NASDAQ:ODP) is closing even more stores -- at least 400 by the end of 2016. This should help Staples boost sales in its remaining stores. However, some traditional office supply categories are declining quickly. Staples needs to move faster to downsize stores to the 12,000-square-foot format to stabilize its profitability.
Store closures on track
Store closures are a typical response to an oversaturated market where demand is stagnating. Staples is eliminating some persistently unprofitable stores, as well as stores that are near other Staples locations. Office Depot is working through the same type of process, but its merger with OfficeMax has provided a bigger opportunity to boost earnings by closing stores.
So far, Staples is making good progress on its store closure plans. The company closed 16 stores in North America during Q1, and it has finalized plans to close another 80 in Q2. For the full year, Staples expects to close up to 140 stores, which would represent more than 60% of its planned closures for the next two years.
Despite closing stores, Staples' earnings have been falling hard recently. In Q1, adjusted EPS fell about 31% year over year to $0.18, near the low end of the guidance provided in March. For Q2, Staples expects another significant decline. Adjusted EPS will likely be between $0.09 and $0.14, down from $0.16 last year.
Staples needs to move faster
Store closures -- both its own and those of Office Depot -- should help Staples offset some of the margin pressure it is experiencing today. However, to return to earnings growth, Staples needs to make more progress on the second leg of its downsizing plan: moving more of its stores to the smaller 12,000-square-foot format.
On multiple occasions, Staples executives have affirmed that the test stores for this smaller format retain at least 95% of the sales of a larger store. On the other hand, rent and operating expenses for these smaller stores are dramatically lower. Accordingly, on Staples' Q4 earnings call, CEO Ron Sargent told analysts that Staples was likely to remodel the vast majority of its stores to this smaller format over time.
Unfortunately, it's been slow going so far. Staples only downsized four stores to the new format last quarter, and it expects to downsize roughly 25 stores in total this year. That's a tiny fraction of its North American store base, which will still include more than 1,700 stores at the end of this year. The major cause of delays seems to be reluctance on the part of landlords to go along with Staples' plans.
Downsizing to the smaller format is a key element of Staples' plan to boost its profitability to historical levels. Staples needs to consider taking a more aggressive stance toward landlords. If space of 10,000-15,000 square feet becomes available in the vicinity of an existing Staples store, the company should consider relocating even before its current lease expires.
That would put pressure on other landlords to be more proactive about remodeling Staples stores on their properties to the more productive 12,000-square-foot model. The risk is that this tough negotiation stance would damage Staples' relationships with its landlords, but it still might be the right move. Staples is still a valuable tenant, as it can bring plenty of traffic to a shopping center.
Office Depot is the better play right now
I think Staples and Office Depot will both see strong improvements in their earnings trajectories in the next couple of years. However, Office Depot is already posting earnings growth, thanks to merger synergies. By contrast, Staples needs to accelerate its plans to downsize stores in order to match Office Depot's earnings growth.
Staples does have some clear advantages over Office Depot. It has a big lead in e-commerce, which is where all the future growth lies. It also has the advantage of stability, whereas Office Depot is in the midst of a complex merger integration process. However, until Staples can show meaningful progress on its downsizing initiative, Office Depot looks like a better investment opportunity.
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Adam Levine-Weinberg owns shares of Office Depot. The Motley Fool owns shares of 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.