In a bind: Staples caught in struggling industry

Share

In August, 2010, in these pages, I pointed out that Staples Inc., set back by a recent earnings miss, had become the clear top performer among North American office supply retailers. The price retreat, I concluded, was an opportunity to buy the best company in the industry at a discount.

This is what being the top performer in the sector has meant: Staples is down by merely one-third since that point, while competitors Office Depot and OfficeMax are down by half and by 60 per cent, respectively.

Before this devolves into another one of those admit-your-mistakes columns, I should note that all three stocks gained beautifully in the autumn of 2010, appreciating anywhere from 30 per cent to 75 per cent.

This suggests that the pessimism that weighs down the industry – often tied to general fears about the global economy – can be fleeting, and perhaps this is another chance to buy Staples, if not its lesser competitors.

More likely, however, is that, as one analyst says, without irony, "this time it's different." Greg Melich, with International Strategy and Investment Group LLC, says the problems for Staples and the rest of the industry go far beyond the cycles of the economy.

Certainly, Staples remains the class of the industry. With $25-billion (U.S.) in revenue, it easily outsells Office Depot and OfficeMax combined. Staples, with the best margins of the three, strings together profitable quarters; OfficeMax ekes out its gains and Office Depot's recent history is checkered with losses. Staples has a dividend yield of 3.4 per cent; the other two pay nothing.

For this, Staples is currently rewarded with a forward price-to-earnings multiple of right around eight, quite a comedown for a company that typically averaged a P/E twice that, even in 2009.

Mr. Melich thinks that's about right. In October, 2010, he had a "buy" on Staples; in asking the question of whether the company would perform more like struggling electronics retailer Best Buy or ascendant auto-parts seller AutoZone, his answer was the latter.

In August, 2011, he downgraded to "hold" on concerns about the European economy. In May, he cut to "sell" after his research showed that North American office-supply sales weren't following the historical pattern of recovering along with white-collar employment.

"Our analysis shows that the two million white-collar jobs created since the last recession have failed to kick-start office product sales, suggesting that secular headwinds trump cyclical tailwinds," he said. "Staples remains the undisputed leader and winner in its space, but with at least 500 too many stores in the industry, margins appear to have more downside than upside in a mobile-commerce world."

Mr. Melich notes that companies that lead the retail sector, like AutoZone and Home Depot, have multiples of 13 to 15 times earnings; consumer electronics retailers – which he finds more relevant to Staples' situation – are six to eight times earnings.

He says 7.5 times his 2013 earnings-per-share estimate for Staples of $1.60 is $12, his target price, "and the risk to the $1.60 appears skewed to the downside." (Staples closed at $12.57 Monday.)

Certainly, there are more bullish outlooks. David Gober of Morgan Stanley & Co. LLC believes "the market is assuming long-term secular declines for Staples, which we believe is unwarranted." He places an 11.5 multiple on his 2013 earnings and yields a target price of $18. His bull case of a 13 multiple yields $22.

David Strasser and his colleagues at Janney Capital Markets believe Staples' top-flight, high-volume website, coupled with relationships with its biggest business customers, will mitigate some of the threat of Amazon Supply, the e-giant's attempt to gain in the office market. They have a fair value estimate of $18 on Staples shares.

And indeed, the pessimistic Mr. Melich also allows for a bull scenario with a growth multiple of 11 and improved EPS of $1.80, or $20 a share. His bear case, however, is that the recovery stalls and the company's international business gets worse. Seven times EPS of $1.20 yields a price of $8 per share.

It would be a comedown once unthinkable for a company the quality of Staples. Yet the modern world of retailing is increasingly littered by the wounded giants of yore. It's worth considering whether the whole of the office-supply industry may join that sad list.