The Changing Dynamics of the Big Box Retailing Concept

By Tom Gibbs - March 6, 2012 | Tickers: AMZN, BKS, HD, ODP, SPLS | 0 Comments

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Nearly all big box specialty retailers are beginning to experience an inflection point in the overall effectiveness of their “value-added” sales approach.  Such a period is often characterized by significantly reduced profitability, industry shakeup, and consolidation of redundant brands.  Book retailers including Barnes and Noble and Books-A-Million, and even recently-bankrupt Borders have been experiencing continually decreasing sales over the past several years from less expensive online retailers including Amazon.com (NASDAQ: AMZN), tablet and e-reader book downloads, and even illegal pirating of books, music albums, and movies on the Internet.

Electronics retailer Best Buy (NYSE: BBY) has come to a similar inflection point in the life cycle of its business, and management is starting to see that the one-stop-shopping experienced offered by the big box retail concept is starting to become increasingly inefficient.  Competitors in Circuit City and RadioShack have declined in overall presence over the past decade.

Office supply stores, including Staples (NASDAQ: SPLS), Office Depot (NYSE: ODP), and Officemax have not been immune to the dramatic shift in the retailing sector, and have also experienced a meaningful drop in overall profitability. 

Chart displays return on net operating (RNOA) assets between 2002-2011, RNOA explained in footnote

All industries are subject to changing dynamics over time – the business field hardly operates in a vacuum – and shifting consumer tastes, new competition (direct competition, i.e. Officemax vs. Staples), and new ways of conducting business (more indirect competition, i.e. Amazon.com vs. Staples) continually pose a threat to a given firm’s ability to generate excess earnings over the long run. 

Having the ability to thwart such inroads made by competition and having the ability to stay relevant to consumers takes a corporation that contains several rare qualities.  First, sheer size is generally adequate to survive the first wave – Best Buy, Barnes and Noble, Home Depot (NYSE: HD), and Staples are all operating relatively well compared to their aforementioned competition (Home Depot has been performing much better than Lowes over the past five years).   

However, to completely change a business model that has been effective and has enjoyed profitability for a prolonged period of time requires that the expansive firm is flexible, can afford to cut capacity, and has a strong brand name to effectively rebound with a leaner strategy. 

The problem with the big box retailing concept in general, as hinted at previously, is that there are now inherently better ways of doing business.  Especially with the gross amounts of information now available online, many consumers are finding increasingly less value added with big box retailers’ employment of knowledgeable sales staff.  Through the personal research of different products, consumer review pages, and OEM websites, an individual can forego an actual store visit, can save money (as long as retailers like Amazon.com have a no-tax advantage), and can actually learn something (that has value too, no?). 

Similarly, many consumers place increasingly less value on a one-stop-shop environment than they did when big box retailers took over the positioning of traditional mom-and-pop retailers.  This does not necessarily hold true for general merchandise retailers like Wal-Mart or Target, but for a specialty retailer, only a limited portion of their expansive showroom space caters to a particular individual per visit.  For instance, a consumer that is given a mission by their small business employer to pick up select items at the local Staples outlet will not find any value in the displays of computers, printers, or office furniture.  Having all of the supplies in one expansive room is most likely not as efficient as having the frequently purchased, everyday items displayed in a significantly smaller retail outlet.  The one-stop-shop technique appears nice on paper (“Selling one of everything will increase market share!”), but for the average consumer it does not add any value, and an inefficient product mix only acts to reduce average store profitability. 

Staples Will Improve

Although Staples’ most recent annual filing was received with limited enthusiasm – shares are down more than 6% since the February 29^th conference call – the corporation has shown a considerable willingness and ability to effectively restructure its operations to be able to once again achieve its historic level of profitability. 

Using the arguments presented above, Staples will drastically improve in the long run due to the focusing on:

• Store Structure

All too often the exposure of a given retailer’s weakness begins to appear after a prolonged period of swift growth.  Staples spent years after its 1985 founding in continually building its base of 24,000 square foot superstores in both the North American and European markets.  Between 2001 and 2011, total store closures in these two markets represented nearly 20% of the total stores that the corporation opened.  By the time Staples reduced its year-over-year growth in store count to the low single digits in the late 2000s, total sales per store slowed to a dramatic halt. 

In overextending itself through the continual quest for top line growth, Staples dramatically impaired the overall efficiency of its existing store base.  Existing store sales have taken a huge hit over the past five years, especially in the international market. 

It appears that the retailer has recognized the inefficiency issues brought about by its level of unsustainable growth.  New store construction in the North American market will remain flat in 2012, and the majority of the new growth will be focused on smaller outlets that are more tailored to the regions in which they are introduced.  The traditional “superstore” concept that Staples used as a growth model since its founding has been reduced from 24,000 to 15,000 square feet.  Likewise, the retailer has also introduced smaller urban outlets (10,000 square feet) that are highly competitive in markets like New York City, and has a fleet of copy/printing centers (3,000 – 4,000 square feet) that focus more on the offering of high margin services than commoditized office supplies. 

As store closings continue – an unfortunate, but necessary byproduct of the company’s overzealous growth during the 1990s – Staples will be left with a much more efficient base of lean retail outlets.

• Product Mix

As mentioned previously, the one-stop-shopping experience is becoming less valuable to the general shopper.  This is not only recognizable in the strategic shift many big box retailers are taking with their store layout – Best Buy and Home Depot/Lowes have followed a similar scaled-down store approach as Staples – but in the actual mix of products that are offered within the smaller stores.  Best Buy undoubtedly wins the award for most innovative change with its Best Buy Mobile stores, which get rid of the expansive displays of flat screen TVs, thousands of individual CD and DVD titles, and large and slow moving home appliances in favor of high turnover, high margin products like smartphones, tablets, and notebooks. 

Although Staples has not pushed towards such a dramatic shift yet, it has focused on a similar approach with its smaller traditional stores.  The corporation has slowly migrated away from the selling of slow moving and space consuming office furniture, which has gone from representing 7.5% of sales in the mid-2000s to only 5% of sales in 2011.  Likewise, lower margin tower computers have been squeezed, and now only represent 15% of sales (down from 20%+ in mid-2000s). 

To fill the void, Staples has introduced several high margin services, including in-store copy/printing departments and the expansion of its EasyTech PC repairs/upgrades/tutorials service.  Although Staples does not isolate the effect of these services prior to the 2009 annual filing, service revenues as a percentage of total revenues has increased to 6% in 2011.

Similarly, Staples has substantially expanded its private label office products, which are priced between 10% and 20% less than national branded goods but offer more attractive gross margins.  Staples-branded goods now represent 27% of total sales, up from 15% in 2004.  The number of items in the private label portfolio has expanded five-fold, and now sits at 10,000 individual SKUs.

Continual focus on in-store services and these private label products will act to improve the efficiency of each smaller Staples outlet.

• Internet Sales Focus

With the strategic shift of its brick-and-mortar base comes the incremental improvement of Staples’ Internet retail business.  Although the retailer sells less than one-third of the goods Amazon.com sells online, Staples’ number two position in the Internet segment puts the corporation comfortably above the competition.  Staples’ launching of smartphone and tablet mobile sites will allow the corporation to see a considerable level of residual sales in the non-brick-and-mortar space.  Ranked 13^th in the mobile commerce top 300 list, Staples has significant room, and desire, to improve.

Staples’ meaningful drop over the past trading week, and its current market valuation of 10.8x earnings and 5.4x enterprise value (both on trailing twelve month basis) is not only attractive on an absolute basis, but also relatively – peers in Office Depot and Officemax are priced at average multiples of earnings and enterprise values of 13.9x and 6.2x, respectively.  Considering Staples’ more expansive reach on the worldwide office supplies industry, its more powerful positioning in the Internet retail sector, its history of greater profit generation, and the exhibition of its willingness and ability to evolve with the current shifts of the retail market, Staples is undoubtedly priced at a discount. 

*Footnote: Net operating assets (NOA) = (Total assets - financial assets) - (total liabilities - financial liabilities). Return on net operating assets (RNOA) = (Post tax operating income) / (NOA).

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