Will Staples be the Next Unexpected Turnaround in Retail?

The office supply industry has been left for dead to some degree, but value still appears present in the industry.

Jul 2, 2014 at 1:39PM

Office Depot (NASDAQ:ODP) and OfficeMax merged back in November. Since then shares of Office Depot have essentially been flat. The stock traded below $4 per share last month before the company announced an earnings beat last quarter, and the shares now trade near their 52-week high. The stock is still down 85% from its all-time high back in 2006.

The two newly merged companies will be closing 20% of their locations by the end of 2016. Office Depot and OfficeMax expect synergies of $600 million. The company is now hyper focused and near the beginning of its turnaround and could be a solid long-term investment. 

Further consolidation ahead?
There's still the potential for a merger of Office Depot and Staples (NASDAQ:SPLS). The companies differ by enough to suggest that the FTC would approve a merger. The lower prices offered by Amazon.com (NASDAQ:AMZN) could play a key role in convincing the FTC to grant approval.  In the Office Depot-OfficeMax analysis done by the FTC, it found that "today's market for sale of consumable office supplies is broader, due to...explosive growth of online commerce, which has had a major impact on this market." 

The FTC would likely require store closings, but Staples is heavily concentrated in the Northeast. About 33% of its stores are located in the area, meaning the retailer shouldn't see a huge impact from accelerating its store closures. Ultimately relying on Office Depot's retail base. Staples is a much bigger player in e-commerce anyway. About 40% of Staples revenues are derived online. It also has a strong delivery network that it can implement at Office Depot. But it wouldn't just be lower prices from Amazon and market share that the FTC would look at. The potential for a merger between the two would have to benefit the customer and the industry, but would nonetheless help the two better compete against the likes of Amazon and Wal-Mart.

Staples is also a good bit larger than Office Depot so it could easily buy it. Staples generated over $20 billion in revenue last year, compared to Office Depot's $10 billion. Office Depot's market cap sits right at $3 billion. Meanwhile, Staples has $800 million in cash on its balance sheet and generates over $850 million in free cash per year.

Staples also has a debt to equity ratio of only 20%. That's well below Office Depot's 80%. Just assuming that Staples bought Office Depot for $3.7 billion, its debt to equity ratio would be right in line with Office Depot's current ratio. As mentioned, Staples has enough cash to cover 11% of its market cap. Its free cash flow yield is an impressive 10%. Even when accounting for dividends and buybacks, Staples is generating a free cash flow yield of 3.5%.  Even without accounting for dividends and buybacks, Wal-Mart's free cash flow yield is only 3.9%. 

The only issue with an Office Depot purchase is that it would be a long-term move and likely put pressure on the company in the near-term. While its balance sheet and cash flow generating capabilities are very strong, Staples would have to take on more debt or dilute shareholders to get the deal done. Either of which could pressure Staples dividend payment or share buyback program.

Right-sizing retail
As mentioned earlier, Office Depot will close some 20% of its store base over the next couple of years. Some 75% of Office Depot's store leases will be up for renewal in the next half decade, which means that the company can save money by not renewing the leases on underperforming stores, and it will not have to pay steep fees to exit the lease contracts. Staples is also embarking on store closures. It will close up to 225 stores while also reducing the size of its stores.

What about e-commerce?
Amazon doesn't just want to eat the lunches of Office Depot and Staples, it's going after the hardware market. It made a foray into the set-top box TV set market earlier this year with its Fire TV. Now it's in the smartphone market with the Amazon Fire Phone. This could be good news for the office supply retailers if it means that Amazon is somewhat distracted with hardware creation.

Staples is also standing up to Amazon a bit better than other retailers. Staples is the third largest e-commerce site by revenue in North America, behind only Amazon and Apple. While Amazon will likely keep the market share in office supplies that it's gained with its low prices, hopefully Office Depot and Staples can grow their sales with larger-ticket items, such as furniture, as the economy rebounds.

How the shares stack up
Office Depot trades at a P/E of 17 based on next year's earnings estimates with a P/S ratio of 0.23. Meanwhile, Staples trades at a forward P/E ratio of only 11.5, but its P/S ratio is 0.32. Staples also pays an impressive 4.3% dividend yield. It's not a perfect comparison, but to put these multiples into perspective, consider that Amazon trades at a forward P/E ratio of 100 and a P/S ratio of 1.9.

Bottom line
The major brick-and-mortar retailers have been hit hard over the last few years. But the major office supply stores appear to be in deep value territory. With a merger they could team up to better battle Amazon. Regardless, Office Depot and Staples look like solid value plays in a beaten down retail sector.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com 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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