Strong Fundamentals Make Staples a Sound Investment Option

Nauman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Staples (NASDAQ: SPLS) is the largest office products company in the world. The company derives four-fifths of its total revenue by serving businesses, while sales to consumers account for the rest. Staples sells its products in every continent of the world, except for the obvious one--Antarctica. Staples says its goal is to provide customers a broad, cost friendly selection of office products, a wide range of copy/print services, convenient store locations, easy to use websites, reliable and fast order delivery, and above all, an excellent customer service. Staples currently operates via three segments: North American Delivery, North American Retail, and International Operations.

Industry Strength

Staples' two main competitors within the office supply industry are Office Depot (NYSE: ODP), and OfficeMax (NYSE: OMX), whereas in the specialty retail industry in general, Staples competes with Wal-Mart, Costco, Best Buy, Target, and Tesco; however, none of these firms offer office supplies as their core product. Focusing on the office supply space, we spot sluggish growth in the entire industry. Staples has faced flat top-line growth over the past couple of years as demand for its core office supplies are in decline. This is further aggravated by weaknesses in the European economy. The company has attempted to offset this slow revenue growth by expanding its delivery business, growing its on-line business, expanding margins, and by focusing on controlling costs. Staples is also stealing market share from OfficeMax and Office Depot; in fact, both of the staples' rivals are contemplating a merger in order to better compete with the company. But even after the merger, the combined company will generate revenue of less than $18 billion compared with $25 billion in sales last year for Staples.

Current Valuation

Staples trades at 10 times trailing earnings. Analyst expectations are for $1.42 in EPS for the next fiscal year, and the current stock price of is only 10.4 times that figure, compared to its peer average of 16. The firm has an impressive cash flow generation and when I look at the enterprise value implied by the current stock price, it is only 4.7 times trailing EBITDA, lower than the rest of the industry. In fact its current EBITDA multiple is about almost half of its last five-year average EBITDA multiple of between 7 to 8. This multiple compression has been fueled by a sluggish growth in Europe and fear of competitors eating into Staples' market share.

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The current ratio is 1.6; the firm is liquid. Still, the company's significantly leveraged, albeit recently improved, balance sheet remains a concern.

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Staples is paying out a dividend with a yield of almost 4%, and generating a cash flow margin of almost 7%. When compared with its peers, Staples is already exemplary in terms of operating ratio and I don't think the company has as much potential here anymore - I do think a low double-digit cash flow margin is attainable, but getting into the mid-to-high teens would be quite a feat.

The share count has already fallen from 730 million in fiscal 2010 to 682 million at the end of 2012, and considering the management's plan to spend a big chunk of the future cash flow on buybacks and dividends, this trend should continue.

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Foolish Bottom-line

It is my view that the risk to Staples' fundamentals are overwhelmingly skewed to the upside, which presents an intriguing investment opportunity on the long side. However, due to a recent rally, I would wait for the shares to drop-back to the low-to-mid $12 level, as the shares present an attractive risk/reward there. Sub-$12.50 is where I will start a long-term position.

MaaniValueGuru has no position in any stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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