Why Office Depot Could Go to $0

If you managed to pop into an Office Depot (NYSE: ODP) recently, I'm guessing you encountered at least one of the following:

1. Aisles of shelves packed with merchandise, but void of shoppers.
2. Workers milling about, eager to pounce on every scant shopper.
3. Crickets.

Though it may not happen soon, the office-supply superstore appears destined for the same niche, big-box retailer graveyard that recently enfolded Circuit City and Borders. Let me explain.

A business on a downward escalator
Office Depot's 2010 revenue of $11.6 billion was down 4% from 2009, and drastically lower than its 2007 peak of $15.5 billion. (Contrast that to competitor and industry leader Staples (Nasdaq: SPLS), whose sales rose to a new record in 2010, and have climbed steadily in spite of the economic downturn.) Last year, Office Depot closed 22 North American stores, on top of the 121 that it closed in 2009. That compares to the 23 stores opened over both years, making the last two years the first time since 2002 that Office Depot closed more stores than it opened.

While it's easy to blame the recession and, in particular, the downturn in small businesses for Office Depot's recent plight, the sheer magnitude of its struggles compared to Staples, OfficeMax (NYSE: OMX), and other retailers in general suggest that the company's woes are far more secular in nature. One-stop mass merchant giants such as Costco (Nasdaq: COST), Target (NYSE: TGT), and Wal-Mart (NYSE: WMT) are undoubtedly putting the squeeze on its margins. Moreover, many of Office Depot's basic office supply products can be purchased at Amazon.com (Nasdaq: AMZN). At the very least that lets consumers comparison shop online.

And then there's the whole issue of paper. With the rapid rise of mini-notebooks, smartphones, and tablet devices, the ability to electronically share and present documents is getting cheaper and more seamless than ever. That puts a hurt on the sale of paper, printers, ink, pens -- stuff that makes up a decent portion of Office Depot's merchandise.

The Depot's hidden debt
In order for any company to go bankrupt, it almost always has to run into liquidity problems. But bulls could argue that Office Depot's balance sheet isn't as dire as it looks. After all, the company closed out 2010 with $628 million in cash against just $732 million in debt and capital leases, with an average interest rate less than 6%. The biggest chunk of that debt, $400 million in senior notes, doesn't come due until 2013.

But a deeper dive into Office Depot's books should make even the cheeriest of bulls much less sanguine. Facing a cash crunch in 2009, Office Depot raised $325 million by selling convertible preferred shares to BC Partners, a private equity concern. The stipulations on the securities are actually quite onerous. Office Depot pays a 10% dividend on them, and BC has the right to convert the preferred shares to common shares at a price of $5. Assuming full conversion, BC would acquire a 20% ownership interest in Office Depot, severely diluting existing shareholders. Based on the 10% dividend rate, Office Depot is on the hook for roughly $9 million per quarter in "interest" payments to BC. Worse still, BC can redeem the preferred shares at 101% of the outstanding principal, should Office Depot be acquired or undergo a material change in direction.

The bigger elephant in the room is Office Depot's operating leases. Office Depot owns only a small fraction of its retail stores, meaning that it pays for most of its stores under long-term lease commitments. At the end of 2010, Office Depot's future minimum, non-cancelable lease obligations totaled nearly $2.5 billion, including $483 million due this year alone. Discounting the company's total obligations by the weighted-average cost of its debt, I estimate the present value of Office Depot's operating leases -- a debt-equivalent estimation -- at roughly $2.1 billion.

Taken together, the preferred shares and operating leases add nearly $2.5 billion in "hidden" debt to Office Depot's books, making its $732 million in debt closer to $3.2 billion. That makes Office Depot's balance sheet not nearly as secure as one might think.

Cash flow running low
Office Depot's debt wouldn't be a problem if the company were bringing in cash flow. Unfortunately, that just hasn't been the case over the last several quarters. For simplicity, I've left out one-time adjustments (writedowns, restructuring charges, etc.), working capital changes, taxes (which Office Depot likely won't be paying on a regular basis), and acquisitions, in an attempt to estimate Office Depot's normalized run rate of cash flow.

As you can see, Office Depot was free cash flow-negative in 2010, and free cash flow actually deteriorated slightly last quarter, compared to a year ago. What's more, a recent decision by the IRS took away a good chunk of Office Depot's net operating loss carry-forwards (NOLs), which the company depended on to offset taxes on future profits. That alone will take a big bite out of future cash flows.

Interest expenses and payments on the preferred dividends should continue to consume a good chunk of Office Depot's cash from operations. And keep in mind, Office Depot was closing stores in 2009 and 2010, so those capital expenditures you're seeing are actually deflated a bit. Back in 2007 and 2008, when Office Depot was still opening new stores, quarterly capital expenditures routinely topped $100 million per quarter. With Office Depot's management planning to resume store growth this year, it's a safe bet that the company's free cash flow continues to deteriorate as well.

The Foolish bottom line
Office Depot probably won't hit the magic $0 number -- or as we short sellers call it, nirvana -- but there's a good chance it's heading a lot lower. Its seemingly healthy balance sheet is chock full of hidden debt that will crush the company unless it can somehow turn its business and its cash flows around. From where we stand, that just doesn't look likely.