Source: Office Depot
The office supply space has definitely not been the place to make money lately, with share prices of industry leaders like Office Depot (NASDAQ:ODP) and Staples (NASDAQ:SPLS) being pressured by declining sales and evaporating profit margins. The companies have anecdotally been hurt by a rise in new competitors to the space, as everybody from online purveyors to mass merchandisers angles for a share of the office supply business.
Despite the difficult business climate, though, Office Depot came through with better-than-expected profitability in its latest financial update; solid cost savings from its 2013 merger with Officemax subsequently led to a double-digit gain in its share price. So is the company a good bet for investors at current prices?
What's the value?
Office Depot is currently the largest domestic operator of office supply stores as a consequence of its merger with OfficeMax, a deal that nearly doubled its store footprint. However, the company is likely to relinquish that title back to Staples in the near future because it plans to close roughly 400 stores, including 150 stores in 2014. Office Depot's grand plan will likely allow it to hold on to the incremental customer base gained from the OfficeMax merger while eliminating duplicate costs and redundant stores, thereby making itself a more profitable entity.
In Office Depot's latest fiscal quarter, it looks like the plan is working; this is evidenced by higher operating profitability that led to a 33.3% jump in adjusted operating income. While the company's gross margin remained under pressure because of a highly promotional selling environment, cost savings at the corporate level more than offset the gross-margin decline.More importantly, in the process of assimilating OfficeMax, Office Depot has identified even more cost savings than originally anticipated, so management raised its profitability outlook for the current fiscal year.
Copy & Print is just the beginning
Of course, operating costs can only be whittled down so far. Office Depot ultimately needs to find a way to improve its gross margin, ostensibly through greater inroads in the services area. The company has found some positive momentum in this area through its Copy & Print Depot operation, but it seems to be a bit behind Staples, which generates roughly 7% of its total sales from the services area.
Like Office Depot, Staples has been generating positive sales momentum with its copy and print services, a lonely area of growth for the company in its latest fiscal year. Staples is also aggressively going after 3-D printing services; it recently announced a partnership with major manufacturer 3D Systems, which will include 3-D printing demonstration areas and specially trained personnel in a pilot group of stores. Undoubtedly, the goal is to improve Staples' operating margin, which dropped sharply in fiscal 2013 compared to the prior year.
A better way to go
There seems to be little doubt that Office Depot is on the right track as it slowly tries to improve its profitability, thereby fulfilling the rationale behind the merger with Officemax. That being said, the company still seems to be a work in process, given that its updated outlook still only equates to an adjusted operating margin of around 1%. As such, investors looking for gains in the office supply space should probably go with an operator that views office supply sales as a complementary business initiative, like FedEx (NYSE:FDX).
The transportation giant participates in the office supply space through its national network of roughly 1,800 FedEx Office stores, which sell a limited variety of office supplies and services. Unlike Office Depot and Staples, though, the stores don't seem to be a profit center in and of themselves; rather they seem to be a conduit to sell more of the company's delivery services, while providing convenient access points for its customers. On that score, the stores seem to be doing their part, as FedEx has continued to report overall volume gains for its business in fiscal 2014, including a strong 9% volume increase for its FedEx Ground franchise.
The bottom line
Shares of Office Depot received a lift from its recent financial update, no doubt benefiting from management's rosier outlook for the current fiscal year. However, with organic sales growth negative and operating margins razor thin, sustainable profit growth will likely be difficult for Office Depot to achieve and investors should let this opportunity pass by.