Staples, Inc.: Backstory

Staples sells office products and services, which one would think is a boring category. The recent history of Staples, unfortunately, has been anything but!

Circa 2004, there were three national office supply stores: Staples, Office Depot and Office Max, each with about a third of the market. Over the years, Staples gradually emerged as the best and largest operator, commanding over 50% of the market share, and eclipsing its now smaller rivals.

Office Max felt threatened, and promptly merged with Office Depot. Then the Internet cast its shadow, and Walmart began to flex it muscles.

The former competitors soon felt intimidated by the long shadow of Amazon, and decided that the only way they could take on Goliath was if they all became one! Unity is Strength.

Things were going fine for Staples and Office Depot, until the FTC uttered “anti-trust” for the second time in two decades. The planned merger got busted; Staples now has to cough up a $250 million breakup free to Office Depot, and walk its own separate way. The long-time CEO, Ron Sargent, quit in the wake of this fiasco.

With so much action and unpredictability, valuing Staples is going to be problematic. But we will worry about that in the following post. Right now, let us simply focus on what we do know about SPLS, the business.

SPLS has three (moving) parts:

  • North American Stores & Online (NAS):  retail stores and staples.com in NA. In the last fiscal year it accounted for 45% of revenues, and 43% of EBIT. Staples.com is growing slowly (1-5%), the rest of the retail business is in decay mode. Overall, EBIT margins have dropped to 4.5%, and revenues are shrinking at a nearly 6% clip.
  • North American Commercial (NAC): the crown jewel that sells directly to businesses. This is actually a sticky, decent (7-8% EBIT margins), slowly growing (1-2%) business. In the last FY, NAC accounted for 40% revenues and 60% of EBIT. The merger with ODP was almost certainly scuttled because of the success of this division – highlighting its importance to SPLS.
  • International Operations (IO): the lousy, mostly European, operation. It contributed to 15% of revenues in the last fiscal year. But those were empty calories. The division reported a small net loss. The best news is that this part is actually shrinking at nearly 10% per year.

Whatever value SPLS has will be determined by NAC. The NAS and IO operations are commodity businesses that essentially compete only over price. Whatever its missteps, SPLS management has recognized this and is actively shrinking these segments, as part of a multi-year effort.

Since NAS is/was the biggest part of Staples, this has meant a steady decline in revenues from 25B in 2012 to 21B in 2016. Net profit margins have been terrible (2.5-4%), and operating earnings per share have declined from $1.41 to $0.88 over the same period. Due to active divestment, cash flow/share has exceeded net earnings, and this will probably continue through 2017, as more store closures are planned.

SPLS pays a significant fraction of its cash-flow as a $0.48/share dividend, yielding over 5%. The dividend appears sustainable, at least in the medium term. This provides shareholders who are not happy with the collapse in share price to $8-$9, after the failed merger with ODP, with some incentive to hold on for a better selling price. The firm is conservatively capitalized (debt/capital approximately 20%); a well-managed declining retailer is better than a declining retailer,  loaded with debt (example: Borders, Circuit City, Radioshack).

Overall, SPLS is a not a good business. Two of its three segments are probably in steady secular decline. The lowest cost providers (Walmart/Amazon/Internet) are eating their lunch – as they should in a functioning capitalistic economy. NAC is the value driver – together with ODP, SPLS controls the majority of this B2B operation. If ODP stumbles (somewhere I read an apt analogy: SPLS = Barnes and Noble; ODP = Borders), and SPLS is opportunistically able to grab a larger share, it might surprise quite nicely to the upside.

My Backstory

Knowing what I know today, I wouldn’t buy Staples, even at current prices which seem attractive (10x forward PE, 5% dividend yield). I see a medium term upside of about 20% (actual valuation in the next blog), once the after-taste of the failed merger has been forgotten.

That said, SPLS is not a good long-term holding.

I didn’t know this when started buying SPLS between 2011-2014. I built up a 5% position at slightly below $12. In 2015, I sold about half my position at $15/share.

During this period, I was learning about writing covered calls and cash-covered puts to enter and exit positions. These options juiced up my dividend yield (nearly 3x) quite a bit. However, I also learned the dark side of using even these “conservative” options. When Starboard took an activist position, and SPLS soared to nearly $20/share, I wanted to unload my entire position, but could not, since my shares were “trapped” in a covered call.

If I sell the remaining shares at the current price ($8.50-$9) right away, I will end up with a CAGR of 6%. Quite terrible, but not quite the loss, I so richly deserve on this one!

Thesis

In 2011-2012, I bought into Richard Pzena’s pitch: (i) PE of 12, dividend yield of 4%, (ii) honest assessment of shrinking NAS and growing NAC, (iii) its strong defense against Amazon:

Businesses have chosen to remain with Staples. It’s easier to buy through Staples. Amazon fulfills orders through third parties. The typical process for ordering office supplies at a small business is that one person in an office — usually the receptionist — collects requests over the course of a few weeks and places an order. If you order from Staples, the next day you get a box, and everything you ordered is in the box. But if you order from Amazon, it could be fulfilled by 15 different sellers and you might get 15 boxes on different days. You have to keep track of it all.

John Chew presented an even more compelling (in my opinion) analysis. It is well thought out, and the discussion in the comments section made very good sense. He was clever enough to recognize the uncertainty of the ODP merger, when he sold his shares in early 2015.

Lessons

  • Beware of the hidden opportunity costs of covered calls and puts
  • Retail is bloody hard! Profit margins are terrible. Stay away – unless you can find the lowest cost operator that is growing its footprint.

In the next post, I will boldly make some assumptions, and try to come up with an estimate of SPLS’s intrinsic value, to help me decide whether holding on makes sense.

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