Tuesday, October 25, 2011

Stock up at Staples, Not Office Depot

There's no doubt that the U.S. economy is growing slowly -- the question for investors is whether that's a problem that hurts all office supply comapanies equally or whether some are better able to adapt than others.

A case in point is Office Depot (NYSE: ODP) -- report earnings Tuesday and they were to weaker than expected. The office supply retailer is not adapting well to the slow economy. Is Staples (NYSE: SPLS) better positioned?

Office Depot had a poor second quarter report and its third quarter was down from the year before and worse than expected. Specifically, Zacks expected  EPS of 2 cents a share on revenue of $2.9 billion for the third quarter -- it earned 3 cents the year before.

But Tuesday, it reported no profit at all after adjustments. But it used one-time gains to report $101 million in profit on a 2% drop in sales that was aroung $100 million less than expected. Absent one-time items such as a $99 million reversal of "combined tax and interest accruals for uncertain tax positions" in the quarter, Office Depot adjusted EPS was 0.

In the second quarter, Office Depot lost 6 cents a share that was better than the year before's 9 cents a share loss and analysts' estimate 12 cents a share expectation.

But Office Depot missed revenue expectations of $2.73 billion by around $20 million and generated negative free cash flow of $85 million -- around $25 million worse than the year before.

Not surprisingly, Office Depot is responding by taking the usual restructuring steps. It's cutting costs, closing money-losing stores, taking more expensive items out of inventory and closing distribution facilties with operating slack.

But Staples has bucked this negative trend and traders are betting on a big rebound in its stock. For example, Bloomberg reports that its 2011 back-to-school sales were up over 2010 and it has been able to pass higher prices to customers, CEO Ron Sargent also told a September 2011 conference sponsored that he "expects more mergers and acquisitions in the industry."

Staples has been adding electronics and products that appeal to women. For example, Staples sells  Amazon (NASDAQ: AMZN) Kindle digital readers and it partnered with Martha Stewart to offer home office items targeted at women who account for 60% of in-store customers.

And bullish bets on Staples stock are high -- the ratio of bets on a rise in the price, known as calls that give investors the right, but not the obligation to buy shares at a specific price and time -- to bets on the price falling (known as puts) is at 3.01. This is close to the highest level of bullishness on Staples since June 2003.

So should you buy Staples and avoid Office Depot? Yes. here's why:
  • Office Depot: Shrinking sales and losing money; very cheap stock. Revenues for Office Depot have dropped 4.2% to $11.5 billion in the past 12 months while net income has climbed 87% -- due to a smaller loss of $121 million. Meanwhile Its Price-Earnings-to-Growth (PEG) ratio is very inexpensive (where a PEG of 1.0 is considered fairly priced) at 0.02 on a forward P/E of 15.9 and expected earnings growth of 1,030% to $0.16 in 2012.
  • Staples: Slow sales growth and small margins; but fairly priced stock. Staples sales have inched up 1.1% to $25 billion in the past 12 months while net income has climbed 19.4% to $938 million, creating a slim 3.76% net profit margin. Its PEG of 1.02 is fairly priced on a P/E of 11.61 and expected earnings growth of 11.3% to $1.57 in 2012.
Staples is doing better in an industry that is suffering in the economic doldrums. And it looks like Office Depot is a sitting duck -- possibly resulting in its acquisition by Staples. If that happened, Office Depot's stock would rise. If not, it will keep dropping -- I am not sure those 2012 earnings growth numbers can be achieved -- while Staples could rise if the bulls are right.


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