The Misunderstood Story of Staples

What people write about:

Staples's longer-term prospects are troubled due to competition from Amazon and the decreasing usage of paper.

What people are missing:

The bull case:

  • Competition is actually decreasing due to ongoing industry consolidation. Office Depot and OfficeMax are now one, and their ongoing integration efforts will give Staples opportunities to gain share, in addition to having one less competitor.
  • The potential for a SPLS-ODP merger in 2-3 years. With the FTC approval of the OMX-ODP merger, we've now removed one of the biggest barriers between continued consolidation in the industry. If SPLS and ODP are able to merge, it would lead to significant margin opportunities.
  • Free cash flow generation. The company generates a 7% free cash flow yield, which could be returned to shareholders through a dividend or buyback.

The details:

Let's first get into the consensus view on Staples. Staples' results have struggled over the last several years as comps have declined significantly from increasing digitization of the workplace and the ongoing shift towards other channels. The digitization of the workplace has led to declining paper usage and declining office supply demand. Meanwhile, people have begun to purchase more of their items online and at mass merchants like Walmart. The net impact is declining sales, declining margins, and declining earnings. These trends are well-understood by investors, and are written ad-nauseam by the media. At <13x 2014 EPS, the stock already prices in a lot of these issues. But as long as these trends continue, the stock will continue to gradually drift down. 

What most investors miss is the bull case. First, as mentioned above, ongoing industry consolidation is a major tailwind that has the potential to turn sales and margin trends around. It was only last year that Office Depot and OfficeMax merged together. The merger presents several opportunities for Staples, including share gains and the loss of one of their major competitors. Even more tantalizing is the potential for an eventual merger between Office Depot and Staples in 3 years, which is now legally plausible due to the FTC's approval of the ODP-OMX merger (and was not plausible prior to that decision). Second, Staples is more defensible than most investors realize. The company generates a significant amount of free cash flow -- enough that if they were to decide to return all of it to shareholders, you'd be receiving a 7% dividend each year. Obviously they won't be returning all of it, but it means that the company can use their cash in a number of ways to generate returns for shareholders (like a potential merger down the road). 

My stance:

The funny thing is that I actually do believe Staples stock will drift down over the next year. However, shorting Staples is making a bet that the decline will continue at a rate that is greater than what investors expect. It's also making a bet that the industry consolidation will not help Staples offset their margin pressures. Finally, it's taking on the risk that investors begin to believe in a SPLS-ODP merger, which could very well send the stock higher. When weighing that risk/reward, the consensus short thesis seems far less obvious than most people make it out to be.