The War for the Supply Closet - Can Staples Stave Off Invasion?

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In the wake of the recent announcement of merger talks between Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX), pundits and analysts have increasingly weighed in on the future of the largest office supply chain, Staples (NASDAQ: SPLS). After watching shares decline 45% over the past three years, contrarians are piling on and sounding the horn for a turnaround.

While turnaround stories make great press (who doesn't love reading about Lou Gerstner at IBM and Steve Jobs at Apple?), the fundamentals just don't support the bullish case for Staples. Gerstner and Jobs redefined IBM and Apple; they overhauled strategy and fundamentally changed the way those companies did business. Staples is undergoing no such revolution.

The bulls point toward $1 billion cash on the balance sheet, and total cash flow from operations of nearly $900 million for the first three quarters of 2012. But material increases in competition, amid already lackluster growth, are too significant to justify any reversal in the stock's downward slide.

The Competition

The notable news of late is of course the merger of Office Depot and OfficeMax. The new combined company would have revenues of nearly $18 billion, compared to Staples' revenue of $25 billion last year. Efficiencies gained by combining operations could save upwards of $500 million-600 million in costs, according to various analysts covering the space. The efficiencies would primarily be driven by closing overlapping and underperforming stores. If this deal goes through, Staples would face a new, formidable competitor with significant scale and upside.

The other takeaway of these merger talks, which is just as significant, is the aggressiveness in the industry to upend the status quo. Management at Office Depot and OfficeMax are making bold moves to improve their business. That determination, as of yet, is not evident at Staples.

Furthermore, there is an elephant in the room. Over the last two years, (NASDAQ: AMZN) has been slowly and steadily building its office supply business, and while Staples has a strong online presence, it has come under intense pressure from the low-cost, low-margin Amazon model.

In its Q3 quarterly report, Staples speaks to this problem directly, saying "The decrease in gross profit rate for the third quarter of 2012 was primarily driven by lower product margins in North American delivery." It will not be long before Amazon is offering same-day delivery for the vast majority of the country (it's already starting in major metros such as New York and San Francisco). Staples today can not compete with that level of pricing and operational execution.

Where is the growth?

For the third quarter of 2012, Staples posted a year-over-year quarterly sales decline of 2%, and generated a net loss for the quarter of $596 million, compared to a profit of $326 million for Q3 2011.  The quarterly loss is attributable to a non cash write-down for goodwill and long-lived assets. Adjusting for this gives results comparable to those in Q3 2011.

And, as the bulls will always point out, Staples has over $1 billion of cash on its balance sheet, and cash flow from operations of $895 million cumulative for the first three quarters of 2012. Both of these facts are quite positive for the company.

The issue, then, how the company is using its strong cash position to support its growth. Staples is not spending its cash on growth or innovation. Of the $895 million in operating cash flow, $222 million was paid out as a dividend, $383 million was used to purchase treasury stock, and $423 million was used to pay down debt. On the surface, these are all textbook uses of cash. But now is not the time for Staples to follow the textbook.

Staples is under attack. The traditional competition is making big, fundamental changes to challenge and grow market share; Amazon is entering the market, bringing with it a track record of e-commerce dominance in nearly every industry it has pursued; and Staples is content to pay down debt, buy back stock, and pay a dividend.  

Staples is scheduled to report fourth-quarter and year-end 2012 earnings on March 6. Regardless of the market's short-term reaction to the release, Staples has a long and arduous journey to complete before warranting an investment. In the face of intensifying and motivated competition, Staples needs a revolution.

jayhjenkins 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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