The Outlook for Staples Is a Matter of Perspective

Shares of Staples (NASDAQ: SPLS  ) have plunged near 10-year lows as a result of disappointing results driven by online competition, trends away from paper-based products, and even union-related boycotts. Is the situation really that dire? While competition from Amazon.com (NASDAQ: AMZN  ) and other e-commerce providers has changed the industry landscape, Staples has managed to remain quite profitable in an environment where competitor Office Depot (NASDAQ: ODP  ) has reported significant losses. Taking a deeper look at what the market has reacted to provides a little more context on Staples' current valuation.

Declining revenue
Staples reported a 2.8% decline in revenue in the most recent quarter; this drop is a continuation of a longer-term trend for the company:

SPLS Revenue (Annual YoY Growth) Chart

SPLS Revenue (Annual YoY Growth) data by YCharts

In a relatively stagnant market, Staples has lost share to peers such as Office Depot. It is important to note that some of the revenue decline is intentional; in an effort to maximize earnings, Staples is in the process of shutting down unprofitable stores and "right-sizing" many locations to smaller footprints.

The competitive environment that Staples is facing also includes wholesale providers such as United Stationers (NASDAQ: USTR  ) and Amazon.com's AmazonSupply.

AmazonSupply Beta-Source: Amazon.com

Amazon.com's expansion into Staples' core business market is already having an impact on Staples even in its early beta form; Amazon.com currently offers over 130,000 office products with free two-day Prime shipping and has a long history of being successful at disrupting traditional brick-and-mortar stores. To combat this, Staples recently unveiled a 110% price match policy that includes Amazon.com.

Consistent profitability
While going head-to-head with Amazon.com on price will likely impact margins, Staples has been consistently profitable unlike Office Depot:

SPLS Operating Margin (TTM) Chart

SPLS Operating Margin (TTM) data by YCharts

Hidden strengths
There are a number of misconceptions regarding Staples that are worth mentioning. First, the discussion of online competition should be supplemented by the little-known fact that Staples is the third largest e-commerce player behind just Amazon.com and Apple. Along with that e-commerce scale comes a distribution network that can provide next day delivery to 95% of the population in North America. 

Roughly 80% of Staples revenue is derived from businesses (and 20% from consumers), which provides a stable base that is less susceptible to changes in spending habits like many retailers are currently experiencing. With just 17% of revenue coming from outside of North America, there is also a largely untapped international growth potential.

Additionally, Staples has invested in ways to develop its mobile platform and services such as copy and print services. The company's recent acquisition of PNI Digital Media is evidence of the company's commitment to these growth initiatives.

Returning shareholder value
Consistent profitability has provided Staples with the ability to use solid free cash flow to invest in the business as well as reward shareholders through buybacks and dividends.  As a result of the recent decline in Staples' share price, Staples' dividend yield equates to 4.3%. In comparison, Office Depot does not pay a dividend and United Stationers' dividend yield is just 1.4%. Staples' payout ratio is only 57%, so there is not much risk that this healthy payout will decline.

A market overreaction? 
To be clear, Staples is not a growth story. Quite simply, the office supply market is not expected to experience noteworthy growth going forward. If turnaround efforts including $500 million in cost reductions over the next two years and the closure of 225 underperforming stores succeed, the conversation may be a bit different as investors look at international opportunities and e-commerce growth. Until such time, Staples should be considered as more of a turnaround.

As far as turnaround stories go, Staples is quite low-risk. Consistent profits, a manageable debt-to-equity ratio of just 0.2, a reasonable price-to-earnings multiple of 13, and an excellent dividend payment are fourth strengths that help prevent significant downside risk from today's prices. Investors that believe in management's plan to improve performance may reasonably come to a conclusion that there is a gap between the market's fears priced into the stock and what Staples may look like a few years from now.

While Staples likely won't appeal to investors looking for strong growth, it certainly has appeal to investors seeking strong income through dividends. The dividend yield of 4.3% puts Staples right on par with utilities and other high-yielding investments. Adding a high-yielding consumer goods company could certainly provide some diversity to an income portfolio likely weighted heavily toward utilities, REITs, and other high-yielding sectors.

Even with valid investment theses based on income and turnaround potential, Staples will find itself hard-pressed to beat the market over the next five years without any strong growth catalyst. Focusing on retailers with stronger growth potential is a better route for finding investments that can provide the best long-term returns.

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