The important back-to-school season for office supply company Staples (NASDAQ:SPLS) turned out better than analysts were predicting, with the company beating both earnings and revenue expectations during the third quarter. The company reported results Wednesday morning. Online sales surged, the commercial business expanded, and retail profitability, while in decline, held up far better compared to the second quarter. Excluding the effects of store closings and foreign exchange rates, Staples managed to grow sales during the quarter, thus marking an important milestone in the company's turnaround effort. The stock was up more than 8% as of 11:20 a.m. Let's take a deeper look at Staples' third-quarter results.

Earnings rundown
Staples performed better on both the earnings and revenue fronts during the third quarter compared to what analysts were expecting:

Metric

Average Analyst Estimate

Actual Result

Non-GAAP EPS

$0.36

$0.37

Revenue

$5.94 billion

$5.96 billion

Source: Staples and Yahoo! Finance 

Total sales fell 2.5%, but grew by 0.5% adjusting for store closings and foreign exchange rates. Staples generated $328 million in operating income during the third quarter, giving the company a 5.5% operating margin. This is 50 basis points lower compared to the same period last year, but the size of this decline was far less drastic than it was during the second quarter.

In the retail business, comparable-store sales, which exclude online sales through Staples.com, fell by 4%. Online sales partially made up for this weakness, rising by 9% year-over-year, slightly better than the 8% growth reported in the second quarter. Retail margins held up far better in the third quarter, with the segment operating margin declining to 7.7%, down from 9.5% one year ago. This compares to a 1.2% operating margin during the second quarter.

The North American Commercial business posted another quarter of growth, with sales growing by 3.3% year-over-year. The operating margin fell slightly, but the commercial business remains a stable, reliable source of profits for Staples. International sales fell by 4%, but Staples managed to wring a small operating profit out of the segment. International has been a weak spot for Staples for quite some time.

Staples has guided for non-GAAP EPS of between $0.27 and $0.32 for the fourth quarter, in line with analyst estimates. Staples raised its full-year guidance for free cash flow from $600 million to $800 million, an indication that the worst may be over for Staples as it closes stores and focuses more heavily on the e-commerce channel.

What it all means
The third-quarter results reported by Staples paint a picture of a company that is not in the kind of trouble that justifies the poor performance of the stock so far this year. Nearly half of Staples' total sales are online, including both retail sales through Staples.com and the commercial websites, and this number will grow as the company continues to close underperforming stores. Staples has closed 127 stores year-to-date, and expects the total store closings to reach 170 by the end of the year.

The retail stores are still performing poorly, with comparable-store sales in decline, but profitability was surprisingly good during the third quarter, despite intense competition for back-to-school dollars. Staples.com, which recorded nearly $600 million in sales during the third quarter, or about 21% of total sales in the North American Stores and Online segment, is growing quickly, and that growth appears to be accelerating.

The strength of the commercial business should be viewed as the most important indicator of the strength of Staples as a whole, and that business is doing well. Staples is growing sales to commercial customers while both retail sales are falling and demand for core office supplies is waning, an accomplishment that suggests Staples' strategy of expanding beyond office supplies into adjacent categories is paying off.

Staples proved during the third quarter that it can continue to generate considerable profits from its retail business, despite declining comparable-store sales and weak demand for core office supplies. The online and commercial businesses are growing, and Staples' increased guidance for free cash flow puts the current stock price at just about 10 times this number. Things are getting better at Staples, and the turnaround is in full swing.

Timothy Green owns shares of Staples. The Motley Fool owns shares of Staples. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.