This Is Too Easy

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

Rich Smith has an ongoing series called, "5 Superball Stocks". In one of these recent articles, he mentioned a company that I've examined before, and at the time I concluded it was the strongest operator among its retail competitors: Staples (NASDAQ: SPLS). He mentioned that with the stock down 32% from its 52-week high, the company looked, "bargain priced." While I don't always agree with Rich's conclusions, this buy appears too easy for investors.

Staples operates in the highly competitive business of office supplies. Its direct competitors, OfficeMax (NYSE: OMX) and Office Depot (NYSE: ODP), are both struggling with the same challenges that face Staples. These companies are trying to compete against retailers like Wal-mart (NYSE: WMT), and the dominant online retailer Amazon.com (NASDAQ: AMZN), as well as many others. This is a case where Staples' focus on one industry actually benefits the company.

In fact, one of the main advantages that Staples has is its ability to ink deals with large corporations for their online office-supply orders. This is one of Rich's primary arguments for the company is that Staples has a unique model of box stores, online sales, and a sales force. He also mentioned that Staples is the second largest online retailer behind only Amazon. Determining whether the stock is "bargain price" or a value trap is a little bit more challenging.

There have been several times in my investing experience that a bargain priced stock turned out to be a trap where the company was slowly but surely declining and was priced accordingly. In the office supply industry, it does appear that there is a race to the bottom between the big three players. However, Staples appears to be better positioned, and most importantly is generating significant free cash flow.

Looking at the company’s last earnings report, sales were down 6%; but on a local currency basis the decline was just 3%. While diluted EPS decreased 18%, the company's financial outlook was tremendously more positive than the earnings-per-share results.

Staples is doing everything it can to maintain its business and improve shareholder returns. The company repurchased 12.1 million shares at an average price of $13.14. This means investors have a chance to purchase the shares at nearly $1 per share less than what management just paid. In addition, the company has retired over 4% of its diluted shares in the last year.

If there are two concerns that investors should keep in mind regarding Staples, it is its operating cash flow and its balance sheet. In the first six months of the year, the company’s adjusted operating cash flow decreased by almost 13%. This lower cash flow meant a weaker balance sheet. Meanwhile, net long-term debt increased from $335 million last year to over $550 million this year.

The good news for Staples investors is free cash flow adjusted for asset and liabilities was still over $400 million. This free cash flow number gives a dividend payout ratio of just under 36%. This is low enough that there should be no question about if the company's dividend is safe. Looking at the relative value investors get by purchasing Staples versus any of their competition, it's really no contest.

Whether it's Staples, OfficeMax, or Office Depot, analysts expect between 9% and 10% growth in earnings from all three companies. However, Staples is the only one trading with a P/E ratio lower than its expected growth rate. Staples pays a 3.5% dividend, which is huge compared to OfficeMax at less than 1%, and Office Depot which pays no dividend at all.

If investors compare Staples to Wal-mart, the numbers look relatively favorable here as well. Wal-mart has its own online sales, a huge retail presence, and can handle almost any office supply order that Staples could fill. The difference between the two is Staples is expected to grow earnings at about 1% faster than Wal-mart, and the company's current yield places Staples at a 1.5% advantage over the world's largest retailer by this measure.

Though competitive pressures in office supply will continue in the short term, I honestly believe that either OfficeMax or Office Depot will be bought out or go under in the next several years. The market for office supplies is too competitive, and these companies will not survive longer term. While some would argue that Amazon should be Staples’ biggest concern, and its AmazonSupply.com site is certainly a competitive threat, unless Amazon is going to send a sales force out to businesses the customized ordering offered by Staples should continue to be a competitive advantage.

The fact that Staples' customers can run to a local store to pick up supplies they have run out of is an advantage that Amazon can't match at the current time as well. As you can see, with reasonable earnings growth, good cash flow, and a decent dividend yield, buying Staples should be as easy as pressing a button.

Dig Deeper

If you’re an investor in retail stocks, you have to look at Amazon.com, the company intent on disrupting the entire sector. Whether you’re researching Amazon itself or one of the companies it's taking sales from, you need to understand the company and its prospects. That's why the Fool has created a new premium report on Amazon, sharing everything investors must know. The report also has you covered with a full year of updates, so click here now to get started.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Staples. Motley Fool newsletter services recommend Amazon.com and 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure