Office Supply: What to Buy, What to Sell

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

Let me be blunt, in the office supply superstore arena, the battle has already been won. These companies have been battling it out with each other for years. They also have been trying to fend off competition from more traditional retailers like Walmart and Target. If you believe there is a future for focused superstores, there is one company to consider adding to your buy list: Staples (NASDAQ: SPLS). Unfortunately, the two companies that compete with Staples might both be good candidates to short. These two underdogs are OfficeMax (NYSE: OMX) and OfficeDepot (NYSE: ODP)

Just looking at the companies side by side speaks volumes. Take a look at their expected growth and valuation and you may see what I mean.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Price</strong></p> </td> <td> <p><strong>P/E on '12 earnings</strong></p> </td> <td> <p><strong>Growth expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> </tr> <tr> <td> <p>Staples</p> </td> <td> <p>$15.47</p> </td> <td> <p>10.38</p> </td> <td> <p>9.86%</p> </td> <td> <p>1.05</p> </td> <td> <p>2.58%</p> </td> </tr> <tr> <td> <p>OfficeMax</p> </td> <td> <p>$5.86</p> </td> <td> <p>9.93</p> </td> <td> <p>-0.68%</p> </td> <td> <p>-14.6</p> </td> <td> <p>0.00%</p> </td> </tr> <tr> <td> <p>OfficeDepot</p> </td> <td> <p>$3.08</p> </td> <td> <p>38.5</p> </td> <td> <p>30.30%</p> </td> <td> <p>1.27</p> </td> <td> <p>0.00% </p> </td> </tr> </tbody> </table>

At first glance Staples looks like the best value. It is the only company of the three that pays a dividend. It also has the lowest PEG ratio. Some might say, but what about OfficeDepot's expected growth? Shouldn't I consider buying their stock, if they have the highest expected growth rate? The answer is no. I don't believe analysts know what to expect from OfficeDepot. If you look at what the three companies have done compared to analysts estimates, you can see a pattern there too.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Earnings Beat</strong></p> </td> <td> <p><strong>Earnings Miss</strong></p> </td> <td> <p><strong>Avg. Beat or Miss</strong></p> </td> </tr> <tr> <td> <p>Staples</p> </td> <td> <p>2</p> </td> <td> <p>1</p> </td> <td> <p>1.25%</p> </td> </tr> <tr> <td> <p>OfficeMax</p> </td> <td> <p>3</p> </td> <td> <p>1</p> </td> <td> <p>25.58%</p> </td> </tr> <tr> <td> <p>OfficeDepot</p> </td> <td> <p>2</p> </td> <td> <p>2</p> </td> <td> <p>62.50% </p> </td> </tr> </tbody> </table>

Analysts seem to know what Staples is going to do, they are less sure about OfficeMax and they are generally not close on OfficeDepot. This is what gives me confidence that Staples expected growth of 9.86% is likely to occur. Where OfficeMax is concerned, they have a negative expected growth rate. Even if they beat earnings by the amount they have been, that's not going to make OfficeMax a buy. Where OfficeDepot is concerned, the projected growth rate of 30%+ seems like a lot of smoke and mirrors. With the company missing estimates twice in the last year by 100% I don't believe analysts really know what OfficeDepot will do.

As another point of comparison, of these three companies, only Staples has repurchased shares in each of the last 4 quarters. While OfficeMax has made share repurchases in 3 of the last 4 quarters, their cash flow argues that this will not continue. OfficeDepot is going the opposite direction and has issued more stock than they repurchased in the last year. Staples clearly leads the way when it comes to managing their share count. This bodes well for future earnings per share and could lead to some nice surprises down the road.

The most telling factor I see to differentiate between these three companies, is their cash flow and balance sheets. Staples leads the way by a large margin in both categories. Staples has produced about $0.08 of free cash flow per $1 of assets in the last year. In addition, they have the strongest balance sheet with a debt-to-equity ratio of 0.219. By comparison, neither OfficeMax or OfficeDepot have positive cash flow in the last year. In fact, OfficeMax shows negative cash flow of $0.018 per $1 of assets, and OfficeDepot shows negative cash flow of $0.023 per $1 of assets. When it comes to their balance sheets, OfficeMax and OfficeDepot can't compete with Staples. Each company has a higher debt-to-equity ratio than Staples, with OfficeMax at 0.351 and OfficeDepot coming in at 0.868.

So you have a choice, a company that is cash flow positive, pays a dividend, is growing, and has the best balance sheet. Or you can buy one of its two competitors. Both cash flow negative and have worse balance sheets. I'm willing to back up my assumptions by making CAPSCalls on all 3. Staples get the green thumbs-up, the other two get the red thumbs-down. Like Staples says, “that was easy”.

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