Fool.com: Office Depot Taking It On the Chin (News) August 31, 1999

Office Depot Taking It On the Chin

By Richard McCaffery (TMF Gibson)
August 31, 1999

Office Depot (NYSE: ODP) announced this morning that earnings for the second half of 1999 would come in around $0.39 per share, 24% less than investors were expecting.

The Delray Beach, Florida chain, the world's largest supplier of office products, said weak sales and price pressures are to blame for the expected shortfall. Competition has increased and rising paper prices have cut into profitability. Adding to the shortfall, the company announced plans to take a $28.3 million charge in the third quarter as part of its plan to close underperforming stores. It will also take a $34.2 million charge to write down inventory that's not selling, most of it out-of-date technology products. At the same time, the company continues an aggressive expansion campaign, expecting to open 140 new stores this year.

After getting hit hard yesterday, the company's shares fell 23% this morning before rebounding later in the day to end at $10 5/8 . But the shares have been sliding from about $22 since early July, in part because of second-quarter warnings from the company. Also, Merrill Lynch analysts cut their recommendation on the firm to "accumulate" from "buy" last month based on an in-house study that the office products industry is reaching saturation. Long term, Merrill expects the company to grow its earnings about 12% annually.

With this in mind, it will be critical for the company to manage its assets and other balance sheet accounts effectively, thereby generating cash for investors even as sales growth slows. How has the company done recently? Return on equity (ROE) is one way to measure management's ability in this regard. It calculates the amount of earnings the company generates from its equity capital. In 1998, Office Depot increased its ROE to 15.8%, up from 14.2% a year earlier, meaning the company is generating $0.16 of earnings for every dollar of equity capital. It's good to see this number trending up, though this morning's announcement will make it tough for that trend to continue.

How does its ROE stack up? If you compare Office Depot's ROE to a super-efficient retail giant such as Home Depot (NYSE: HD), you see that the company has room for improvement: Home Depot's 1998 ROE is 18.5%. It's not an apples-to-apples comparison since Home Depot's merchandise is not under the same price pressure Office Depot is facing, but it does provide a look at the kind of return a retailer of comparative size can squeeze out of its equity.

Office Depot's sales for each dollar of assets provides another look at this, focusing on how much in sales the company generates for each dollar originally invested. Office Depot's sales-to-assets ratio improved to an impressive $2.18 for the 12 months ended in June, up a scratch from $2.17 for the 12 months ended in December.

Looking at some of Office Depot's other margins, it's clear that the company doesn't operate in a very profitable sector. Gross margins improved to 28.2% in the first half of 1999, up from 26.6% in the first half of last year. The good news, again, is that the company is moving its numbers in the right direction. However, comparable store sales for the first half of 1999 grew just 1%.

The company's bad news this morning didn't come without a little sweetener -- a plan to repurchase $500 million in stock. Every little bit helps. But in an increasingly competitive industry, and perhaps a maturing sector, Office Depot will have to work hard to reward shareholders. Investors that think the company has demonstrated its ability to do this for the long term should take a closer look: the company is trading at a 1999 P/E of 12.7.

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