RJ is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Office supply giant Staples (NASDAQ: SPLS) reported a sharp decline in its second quarter results. Revenue fell 6.6% year-over-year to $5.5 billion, slightly worse than the Street expected. Earnings tumbled 25% to $0.18 per share compared to consensus expectations that called for a much smaller decline. The firm also slashed its fiscal year 2012 revenue outlook to flat revenue growth from low-single-digit expansion. Additionally, the company reduced its full-year earnings outlook to low-single-digit growth (was high single digits), despite an additional operating week during the year.
Europe was notably weaker than North America, as same-store sales fell 9% and total international sales dropped 18% (10% in constant currencies). The firm pointed to slow computer sales, as well as general economic weakness as the main factors behind the region’s poor performance. Though we think macro weakness certainly impacted Staples’ results, we believe some of the weakness can be attributed to the secular decline of the firm’s business model. North American same-store sales fell 2% due to a comparable decline in traffic. Office supplies are a commodity business, and demand for various items such as pens and paper is likely to fall over the long run. Several other businesses like Amazon (NASDAQ: AMZN) and Costco are able to provide the same products at a lower price.
Staples has historically created a lot of value for shareholders, but given the large level of disruption, we think that could change.
Though Staples predicts it will generate $1 billion in free cash flow during fiscal year 2012, we aren’t enamored with Staples’ business model. Staples successfully displaced competitors like Office Depot (NYSE: ODP) over the past several years, but its commodity-product business lines simply aren’t that attractive. That said, Office Depot, which doesn’t boast the same level of service or fulfillment capabilities, will likely continue to lose share, perhaps leaving Staples as the main brick-and-mortar player in the office supply industry in coming years. We suspect Amazon's fulfillment capabilities will continue to grow in the coming years, stealing market share from both traditional retailers. More importantly, Amazon doesn't seem to care about margins, so it could easily steal market share by materially slashing prices. Though that doesn't make us fans of the company, since it doesn't generate any cash, it still means could add to the firm's strong revenue growth.
Office Depot certainly isn't expensive...it's even undervalued on a discounted cash-flow basis.
Unfortunately, we have plenty reason to believe Office Depot is a classic value trap. It simply doesn't have much of a competitive advantage, and its industry is undergoing massive changes.
Ultimately, competition from everyone, ranging from Walmart, Target and Costco to Amazon, Office Depot and Best Buy could negatively impact Staples' margins going forward. Consequently, we aren’t interested in the firm at current levels, as shares score just a 3 on our Valuentum Buying Index (our stock-selection methodology). We think shares are fairly valued and would require a much larger margin of safety before getting excited about the name.
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