I think of this as the “Great Office Supply Smackdown,” which should invoke images of Dwight Schrute and Michael Scott throwing reams of paper at each other. In truth, I expected this battle to be a draw, since these companies are effectively identical as far as what they offer. As it turns out, execution means everything and one is doing so much more effectively than the other.
In first examining Staples (NASDAQ:SPLS), I was impressed with how the company not only turned in a profitable year in 2009 during the financial crisis ($738 million), but how net income only dropped 8% over FY 2008. Even more impressive was the 20% net income rebound in FY 2010. Staples’ trailing 12-month net income has been even more astonishing — $876 million, with a Q3 that blasted to the moon at $326 million. TTM free cash flow is $1.1 billion. With $1 billion in cash, and decreasing debt (now at $1.55 billion, down from $2.5 billion just two years ago, SPLS is churning out free cash flow and paying down debt. At the same time, Staples is distancing itself from its rival. Operating margins are, not surprisingly, pretty thin at 6.38% and net margins even skinnier at 3.91%
All this, and Staples still pays a 2.7% yield, and trades at 10.6 times earnings on 10% annualized growth.
Now, let’s compare to Office Depot (NYSE:ODP) and see if we can ascertain why there is such a disparity. Office Depot kind of, well, got totally crushed even before the brunt of the financial crisis really hit. Backing out a non-recurring loss in FY 2008, the company basically broke even. It lost $626 million in FY 2009, and another $30 million in FY 2010 after backing out a $51 million extraordinary loss. The trailing 12 months haven’t been kind, either, as the company has lost $9 million, backing out the aforementioned extraordinary loss. As for free cash flow — well, it’s negative, to the tune of $90 million. The balance sheet isn’t all that bad, with $452 million in cash and only $647 million in debt. So it won’t surprise anyone to hear that operating margins are 0.6% and there is no net margin.
So what’s the deal? Well, Office Depot has 50% as many stores as Staples, yet employs 80% as many employees. So right there, you can see there is a labor problem. You can see Office Depot has other expense problems when you compare its SG&A expense to Staples’. Office Depot’s comes in at 28% of revenue vs. 20% for Staples. There’s another issue: Staples traditionally spends 2.5 to 3 times more on advertising than Office Depot does, and Office Depot begged off on TV advertising in 2009, which I think set them back at a time when they needed to be playing big.
Staples is growing, Office Depot is moribund. Staples has a solid balance sheet and free cash flow, while Office Depot is struggling to generate any free cash flow at all. Staples is a buy even though it’s slightly overpriced on a PEG basis, but it is the No. 1 office supply brand. Office Depot is at best a sell, and possibly a short. I do not believe a buyer will take it out because the space is crowded enough as it is and Office Depot has no differentiation in its product. It might take awhile, but Office Depot could go under. Aggressive investors might consider shorting it.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.
