Is Office Depot Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Office Depot's (ODP -1.24%) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Office Depot's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always be reported at a steady rate, we'll also look at how much Office Depot's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Office Depot's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Office Depot managing its resources well? A company's return on equity should be improving, and its debt to equity ratio declining, if it's to earn our approval.

By the numbers
Now, let's take a look at Office Depot's key statistics:

ODP Total Return Price data by YCharts.

Source: YCharts. *Period begins at end of Q3 2009.

ODP Return on Equity data by YCharts.

Source: YCharts. *Period begins at end of Q3 2009.

How we got here and where we're going
With four of seven passing grades, Office Depot seems to be making some progress. However, the currently unprofitable company benefits from climbing out of a deep hole at the beginning of our tracking period, the result of recession write-offs and other one-time hits. Office Depot's free cash flow has fallen by half since 2009, which is perhaps a more enlightening statistic than those tracking its net income. What will it take to pull Office Depot out of its doldrums?

A positive earnings report earlier this month certainly helped, with the market response sending shares close to 52-week highs. It wasn't the only office-supply retailer to outperform expectations that day, as OfficeMax (NYSE: OMX) beat the Street by taking a hacksaw to its costs. However, as my fellow Fool Sean Williams points out, "this looks like the same old Office Depot that's struggling to survive." Cutting costs doesn't create growth on its own.

The problem isn't necessarily limited to these two companies. Staples (SPLS), the office-supply market leader, hit an annual low this summer despite being the only one of the three to post revenue growth over a multiyear period -- not to mention its lower levels of debt and its dividend, which neither Office Depot or Office Max offer. In my earlier article on Staples' slide, I pointed out that this issue affects specialty retailers of several stripes, and is driven by retail consolidation to Wal-Mart (WMT -0.65%) superstores and Amazon.com's (AMZN -1.14%) online juggernaut. Virtually everything you could want from office-supply stores can be found at Wal-Mart or on Amazon. With that sort of competition, Office Depot needs to step up its game.

Unfortunately, the game may be somewhat out of Office Depot's hands. Office supply is one of many sectors heavily dependent on economic growth. Cutting costs can help Office Depot prepare for a slowdown, but it's not going to be enough to fend off competition both within the office-supply store sector and from well-heeled competition in the forms of Wal-Mart and Amazon. Amazon opened an office-supply specialty site earlier this year, and the company's notorious commitment to expansion at the cost of margins makes it a formidable opponent indeed.

Putting the pieces together
Today, Office Depot has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.