Office-supply company Staples (SPLS +0.00%) has had a rough few years, with the stock currently down nearly 50% from where it was at the beginning of 2010. Staples' recent earnings results were a mixed bag, with the retail side of the business performing poorly, and analysts are expecting earnings to decline further as time goes on. In a previous article, I laid out three reasons why Staples stock could rise in the long term; but there are also plenty of reasons why the stock could continue its descent. Let's take a look at three.
A resurgent Office Depot
Staples has long been the dominant player in the office supply industry, able to consistently generate operating margins in the mid-to-high single digits during the past decade. Office Depot (ODP +0.00%), which merged with the smaller Office Max last year, has been struggling for quite some time, with the company losing money in five of the past six years.
SPLS Operating Margin (Annual) data by YCharts.
The integration of Office Depot and Office Max will take time, but the combined firm is expected to realize hundreds of millions of dollars in cost savings. With annual revenue expected to be around $17 billion, the new Office Depot is now much closer in size to Staples.
Staples faces competition from a slew of sources, from online retailers like Amazon to big-box retailers like Wal-Mart, and a competent Office Depot is the last thing that the company needs. There's no guarantee, of course, that combining two poorly performing office supply companies will result in anything other than a larger, still poorly performing company, but Staples risks losing market share if the merger ends up being successful.
Continued retail weakness
A combination of declining demand for office supplies and the ongoing shift toward online retail has left the entire office supply industry with a severe case of overcapacity. Staples plans to close 225 stores while downsizing others, and Office Depot will shutter at least 400 stores during the next few years.
Comparable-store sales for Staples' North American retail business declined by 5% during the most recent quarter, with the operating margin falling to 1.2% from 4.1% during the same period in 2013. The store closings across the industry should help consolidate sales and boost profitability, but there's no telling at what point sales will begin to stabilize.
Staples' retail segment is on the cusp of becoming unprofitable, although higher advertising spending and investments in the online channel are partially responsible for the dramatic decline in operating margin during the previous quarter. It could be that the 625 stores that will be closed by Staples and Office Depot won't be nearly enough. In that case, profitability may not rebound at all, and could even degrade further. Staples' earnings and stock price are both in danger if demand for office supplies ends up being even weaker than the company expects.
Lower margins from online sales
One bright spot for Staples is its Staples.com business, which is the company's website aimed at consumers and small businesses. During the previous quarter, sales on Staples.com grew by 8% year over year, helped by an expansion beyond office supplies into adjacent categories.
Staples already has a strong e-commerce business, with nearly half of its sales occurring online, either through Staples.com, or through its commercial delivery business. Growth in e-commerce can counteract weakness in retail going forward. However, margins tend to be lower online compared with in-store. Even if Staples manages to stabilize sales by boosting the online channel, margins could be permanently lower as a result.
The days of mid-to-high single-digit operating margins could be a thing of the past for Staples, although the commercial delivery business, with operating margins around 6.5%, is actually growing thanks to the aforementioned expansion of product offerings. The North American retail business, which managed an 8.3% operating margin during fiscal 2012, may never reach that level again as online sales make up a larger portion of the segment. This could put a permanent damper on the stock price.
Final thoughts
Staples is facing plenty of challenges going forward, including the prospect of a more effective Office Depot, a continuing decline in demand for office supplies, and permanently lower margins due to the shift to online retail. How serious these issues end up being in the long term remains to be seen. But if Staples can't counteract them, the company's earnings and stock price could suffer as a result.
