Shares of Staples, Inc. (NASDAQ:SPLS) surged when the company reported better than expected earnings for its third quarter last month. While the stock is still below the highs from earlier this year, it has rallied roughly 35% since June. The office-supply retailer's turnaround effort appears to be making progress, and while problem areas remain, there are reasons to believe the stock could keep rising as the company executes on its plan.
A growing commercial segment
In the third quarter, Staples' North American stores and online segment, which encompasses retail stores and Staples.com, constituted just 48% of the company's total revenue. Another 16% came from international operations, and the remaining 36% was derived from the North American commercial segment, in which Staples sells directly to large businesses.
While the retail stores are still suffering sales declines, the commercial business is comparatively booming. Revenue increased 3.3% year over year in the third quarter, accelerating from recent quarters. About 40% of Staples' sales in the commercial segment are now in categories beyond office supplies, and these products will drive future growth.
Strength in the commercial segment can make up for weakness elsewhere, and this unit's performance is probably the best indicator of the health of Staples' business. Staples is mainly an enterprise-orientated company, as opposed to a consumer-orientated company, and its fortunes rise and fall with the commercial business. Continued commercial growth, especially if Staples can maintain high single-digit margins, could push the stock price higher.
No-strings-attached free shipping
There's no question that e-commerce, in particular Amazon.com, has disrupted the retail business. It took a while for many traditional retailers to truly embrace online sales, and Amazon has captured a dominant chunk of the e-commerce market in the United States.
Sales at Staples retail locations have declined, and the company is slashing its store count. But sales at Staples.com, which caters to consumers and small businesses, have seen accelerating growth. During the third quarter, Staples.com sales rose by 9%, making up about 21% of the total sales in the North American stores and online segment.
One driver of this growth has likely been the no-strings-attached free shipping that Staples offers through its rewards program. Unlike Amazon and many other retailers, which require a minimum order size to qualify for free shipping, Staples' free rewards program offers free shipping on every order, regardless of size, and many items arrive on the next business day.
This free shipping certainly shrinks margins, but it also has the potential to draw in customers who are dissatisfied with Amazon's slow Super Saver shipping and unwilling to pay for Amazon Prime. If Staples can continue to rapidly grow online sales, helping to make up for in-store weakness, the stock price might not be done rising.
Store closings driving efficiency at remaining locations
Both Staples and competitor Office Depot are closing hundreds of stores, dramatically reducing the number of office supply superstores in the United States. While this translates into lost sales for Staples, a fraction of those sales are transferred to remaining stores. In fact, Office Depot stores that close also transfer a fraction of sales to Staples, and the result is that remaining locations see a sales boost.
With comparable-store sales declining, increasing revenue at the store level is critical if Staples wants to maintain its retail profit margin. During the third-quarter conference call, Staples management stated that its stores, excluding online sales, managed an operating margin near 10% during the quarter. This number was buoyed by the back-to-school season, but the fact remains that Staples stores are a very profitable part of its business. By closing less profitable stores, remaining locations should be better able to maintain high profit margins despite weak demand for core office supplies.
The key for Staples going forward is to get its retail business to the right size and to stabilize sales, and the mass store closings should help the cause. Once investors see improving performance at the stores, something that hasn't happened yet, the stock could become much more attractive. How long it takes to stabilize the retail business is anyone's guess, and Staples could be forced to close even more stores than planned, but any sign that things are improving could send the stock soaring higher.
Timothy Green owns shares of Staples. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and 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.