Buy Staples on the Recent Pullback

By Ashish Sharma - August 24, 2012 | Tickers: AMZN, ODP, OMX, SPLS | 0 Comments

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Recently, Staples (NASDAQ: SPLS) reported below expected results and subsequently lowered its guidance. Q2 results were pressured by weakness in the International segment and within the computers and software category. The management expects an upside to the guidance, if sales trends show a meaningful improvement in the second half of the year. Given the ongoing difficulty in the end markets, the company also announced plans to take more aggressive steps to improve the cost structure of the business and will provide updates at a later date.

The share prices have seen a huge downfall, dropping 15.5% within 2 days after the earnings call. We see this pullback as an attractive entry point as we believe the company has good long term prospects and also provides an impressive dividend yield.

Possibility of SSS upside in H2

The reported Q2 EPS of $0.18 was below last years $0.22 as both sales and margins were below expectations. Despite lower than expected domestic sales, we are not overly concerned as the company has been consistently taking market share in North America from Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX). Going forward, we believe there is a possibility that Staples’ H2 SSS may benefit from elevated store closures in Q1 by Office Max and Office Depot as historically Staples’ SSS benefitted on a 2-quarter lag from prior competitor store closings. This may turn out to be potential catalyst and drive better than expected sales in the later half.

Best-in-Class Profit Margins

Staples was forced to lower prices following irrational pricing from Amazon.com (NASDAQ: AMZN). As a result, operating margins and profit margins suffered but the company has been able to retain its market share and is still making better profits than Amazon. Even with respect to OfficeMax and Office Depot, the company has historically maintained better margins and continues to do so. The following chart depicts last 1 year’s profit margin comparisons of Staples, OfficeMax, Office Depot and Amazon.

Source: Ycharts.com

In terms of sales, Staples is clearly the leader, generating more than doubling revenue as compared to Office Depot and Office Max. The following chart provides comparisons for FY11 revenue, total number of full time employees, and revenue per employee.

Clearly, Staples generates impressive sales per employee as large fixed costs are spread out over more customers. Favorable economies of scale gives Staples a cost advantage which is evident in the company’s margin with respect to its competitors and the company is likely to enjoy it in the future as well.

Impressive Dividend Yield

The company provides an impressive dividend yield of 3.3%. This makes Staples attractive in comparison to its peers as Office Max provides a nominal dividend yield of 1.5% and Office Depot does not provide any dividend at all. The dividend yield is certainly a huge positive as it should help to maintain its valuation.

Despite sales and profit declines this quarter, we believe the company is still on pace to generate over $1 billion in free cash flow this year. While some of this will be used to pay down $325 million in debt due in October, there is still room for around $250 million in share buybacks in the second half in addition to the $272 million year to date. The company can post a mid to high single digit long-term EPS growth through buybacks alone.

We regard Staples as a best-in-class company with a strong global franchise and virtually unrivalled online operations. However, as the largest office supplier globally, we believe the company also has the greatest exposure to the worsening macro environment, especially in Europe. Thus, there is a limited upside in the near-term. But given a really modest valuation (forward P/E of 7.6), better margins than the rivals, and an impressive dividend yield, we believe there are enough positives to consider it as a long term investment.

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