Coming up with a “value” for SPLS is going to be tricky. There have been drastic changes in the past few years, and the moving parts are not yet done moving.

However, my cluelessness is not going to deter me from making bold (stupid?) assumptions, and coming up with some estimate of a base case. I will probably arrive at a silly number; hopefully, the exercise will give me a skeleton on which to hang future data-points.

As I remarked in my previous post, SPLS has 3 divisions: NAS, NAC, and IO. The first is profitable, but shrinking, and the last is unprofitable and shrinking faster. The B2B delivery business, NAC, has decent margins, and is the primary source of value.

# Cash Flows

To smoothen out the turmoil in the last few years, I make the following assumptions for the three divisions to come up with 5-year cash flows:

**NAS**: Current revenues are $8.97B with 4.5% EBIT margin. Management is actively shrinking the overall business. I model a 6% decline in revenues, with EBIT margins staying put at 4.5% in the first three years, followed by a slower decline of 5% in the next two. I use EBIT margins of 3% for the last two years, even though it is quite likely that the shrinkage of office supply space (its main competitor ODP is also shutting stores) might improve these margins.**NAC**: This is the center. If the center holds, SPLS has hope. Most recent revenues were $8.5B at 7% EBIT margins. I assume that this segment will actually grow revenues at 1.5%-3%, while simultaneously improving margins from the current 7% to 9% over the next 5 years. Should ODP stumble and give up its relatively large market-share in this business, SPLS should be able to scoop it up, and probably do much better than projected.**IS**: This is the crappy that contributed $2.5B to revenues, but essentially nothing to earnings. I model this business shrinking at rates from 15%-10%, and essentially contributing zero to earnings.

I assume a tax rate of 35%, which is what SPLS has been paying. Perhaps they need better accountants, and fewer M&A lawyers!

Since managements is actually trying to shrink its largest parts, I assume **a negative capex for the next two years, followed by reinvestment rates climbing back to a healthy 20%**.

With these assumptions, the overall cash flows look like (all $ amounts in millions):

**The FCF declines in the first three years, and then picks up modestly.**

# Cost of Capital and Terminal Value

Using a risk-free rate of 2%, an ERP of 5%, a beta of 1.5 I get a 9.5% cost of equity. Using a 1.75% spread on the debt, and a 35% tax rate, I end up with a 2.4% cost of debt. Using a debt ratio of 20%, I get a **cost of capital of 8.1%**.

For terminal value, I assuming zero excess returns (return on capital = cost of capital = 8%), and a 2% stable growth rate. This gives me a 25% reinvestment rate. Using the projected after tax operating income in year 6 ($691 M), and the Gordon growth formula, I get a terminal value of **$8.6 B **in year 5.

# DCF and Adjustments

If I discount all these cash flows at a 10% hurdle, I end up with with a firm value of $7,753M for the operating business. Adding back cash ($825M), subtracting debt ($1,035M) I get an **equity value of nearly $7.5 B.**

I can divide this by the number of fully diluted shares (647 M), and I come up with a **value of $11.60/share**.

Currently shares are trading at $8.70-$9/share, and so they seem modestly undervalued.

# Other Considerations

- For the most part, I’ve used conservative numbers (e.g.: NAS margins getting worse, NAC not fully reflecting the effect of ODP’s downfall, using fully diluted share count, a high tax rate). This no doubt, introduces a negative bias in my valuation.
- Right now, even the most profitable division earns a return marginally above the cost of capital. It has been argued, quite reasonably, in my opinion, that this might actually turn
~~Sauron’s~~Amazon’s gaze elsewhere. In the linked article, the author assigns a value of $7.76 to NAC alone, based on a similar conservative cash flow analysis. - Reasonably competent management, running a company in a “tough niche” of the economy at 10% FCF yield, and returning half of that to shareholders, is unlikely to actively destroy value. They seem to be controlling the things that are under their control.

Overall, I don’t think SPLS is a great stock to own for the long run. There are simply too many possible futures: a large fraction of them are unattractive: ranging from death in the next 5-10 years (Amazon?), to plodding along as usual with marginally better profitability as NAC becomes increasingly more important. There are a few (not many) scenarios to “win” big: ODP becomes roadkill, SPLS monopolizes the B2B delivery business (improving NAC margins to say 10-12%), and NAS segment profitability also improves. The international business improves, or is shut down and its pieces sold or put to productive use.

This is perhaps the only scenario in which I see SPLS playing strong offense; in most possible futures, I see SPLS playing defense.