Friday, March 2, 2012

Staples For The Long-Term

Wednesday, office products distributor Staples (SPLS) fell by as much as 10% after the company reported its latest quarterly numbers. As a result, Staples now trades with a P/E of around 10 despite recessionary margins (that temporarily lower the "E" in P/E) and an operating history that suggests this company has a strong moat. For long-term investors, Staples may represent a very attractive buying opportunity at its current price, as it is likely to continue to generate strong free cash flow for years to come.


Anonymous said...

Saj, I've been following your blog for the last few months and have found your work to be very good. I'm a bit skeptical of your conclusion on Staples though. I agree with your strategic analysis of Staples and like its free cash flow generation, but I wonder about your view on Staples you worry that the 7.5-8% EBIT margins that Staples did in FY 2006-2008 (CY2005-2007) might have been peak margins rather than normalized? When you look at the average EBIT margin for FY 2005-2012, you get 6.9%, a mere 400 bps from 2012's margin of 6.5%.

If we use Greenwald's EPV method, and apply the 6.9% margin to 2012 Revenue of $25M, we get normalized EBIT of $1.7B. Assume a 35% Tax Rate to get Normalized NOPAT of $1.1B. Excess D&A vs. capex has been minimal, but you could argue $0.1B to be generous based on 2012 results. This gets us to a value of earnings of roughly $1.2B.

Apply a 10% discount rate to this, and you get an initial EPV of $12.3B, then add in net cash of ($0.8B). This gets you a final earnings power value of $11.5B, when Staples market cap is currently $10.7B, which represents 7.5% upside. Sure, if you think based on your good strategic analysis that Staples will be a long-term grower, then my EPV is being harsh for assuming no growth, but as value investors, don't we want to pay for a business at a discount to the no-growth fair value? And even though Stales seems to be a great business vs. Office Depot and OfficeMax, do you worry about Amazon/Wal-Mart/Target? Would love to hear your thoughts on this.

Saj Karsan said...

Hi Anon,

I'd agree with you that using 2007 margins would be optimistic. But if you're using Greenwald's model, wouldn't you actually equate the growth (in addition to the small discount to EPV that you calculated) to being the margin of safety? It's been a few years since I read it, but I seem to recall that being the MOS for companies with a franchise?

Neither of those three outside threats you mention actually have the delivery capabilities to compete where Staples makes the majority of its profits, so for now the value of the franchise seems safe to me...what do you think?

Anonymous said...

Hi Saj,

Great job on the blog. What are your thoughts on the consistent International underperformance? The Q1 call seems to suggest that operations in Europe continues to deteriorate. That business is considerably weaker than the North American business and continues to drain cash. Is there a possibility that the moat can be extended beyond North America or is that a non-factor and the thesis is based on continued outperformance in the U.S.?

In terms of pricing, do you think Staples may even be competitive compared to the discount stores, ex. Wal-Mart/Target given its narrower focus?

Saj Karsan said...

Thanks, Anon!

I think Staples has proven to be competitive enough on price.

Regarding the international operations, I'm not sure their moat can easily be extended past North America. If they can't get European operations to turn around, I would hope they are willing to exit. The good news is that management seems reluctant to make additional capital investments in Europe, so hopefully there is little if any cash drain.