Staples: Overreaction and Opportunity

By Timothy Green - September 8, 2012 | Tickers: ODP, OMX, SPLS | 0 Comments

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Staples (NASDAQ: SPLS), the world's leading office products company, recently reported disappointing second-quarter earnings. North American retail sales fell 2.7% while North American delivery sales were down 0.8%. International sales declined by 18% as Europe continues to weigh down the company's results. In addition to the across-the-board sales declines, the full-year outlook was revised. Staples now expects sales to be flat this year and EPS to rise by a low-single-digit percentage.

On this news shares of Staples tumbled, now trading at about $10.90. The last time shares traded at these levels was in 2003.

SPLS data by YCharts

SPLS data by YCharts

Is Staples really worth the same as it was nearly 10 years ago? Or has the market overreacted? Let's take a look at Staples' financials and find out. Here is the 5-year revenue and free cash flow for Staples. I've also included the results from 2003 for comparison. 

* 2012 refers to the year ending in Jan 2012

Since 2003 revenue has grown by 116% while free cash flow has grown by 83%. Over the past five years revenue has grown consistently, albeit at a slower rate in recent years.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges ... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume ... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess -- and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner Earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 5-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible. 

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Staples' Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability. 

A picture of Staples is starting to emerge. Here we have a company that has consistently grown both revenue and cash flow and operates with a CROIC of around 10%. Staples operates in an entirely different league than its two main competitors, Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX). Office Depot posted a second quarter loss, with sales declining at a higher rate than that of Staples. Office Max has had a negative free cash flow for the last two years and has $1.5 billion of net debt and debt-like obligations on the books, compared to a market capitalization of just over $500 million. Staples also has the advantage of size, with more than twice the revenue of Office Depot and more than three times the revenue of OfficeMax.

The last thing we need before valuing Staples is a quick look at the balance sheet. 

Staples has $1.2 billion in cash and $2 billion in net debt on the books, leaving $1.20 of net debt per share. Interest payments for last year totaled $173 million, which is only 14.5% of the free cash flow. Staples' balance sheet seems solid.

Valuation

I use a discounted cash flow analysis to estimate the fair value of a stock. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. In an effort to be extremely conservative I will project owner earnings to grow at just 3% annually, which means roughly no growth after inflation. Factoring in the net debt calculated above and using the above parameters I arrive at a fair value range of $15.36 - $20.88. Below is a table of buy targets for various margins of safety. 

Conclusion

The recent decline in Staples' stock price offers an opportunity to take advantage of overreaction and pick up a strong company at a bargain price. A single disappointing quarter should not affect your view of the company, especially with the situation in Europe being a significant factor. Staples is the clear pick in the office supply space, making Office Depot and OfficeMax look like amateur hour. Staples has the scale and the experience to continue to dominate its industry for years to come.

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