NO " EASY " BUTTON FOR OFFICE PRODUCT DISTRIBUTORS

[Anonymous]

No ‘Easy’ Button for Office Products Distributors

But industry leader Staples might have an advantage.
With initial unemployment claims still above 400,000–the threshold where economists believe more "net" jobs are being added than lost–unemployment is expected to remain above 8% for the remainder for the year, proving the economic recovery in 2011 is not as robust as expected.

Likewise, office products distributors have been pinched amid the lackluster economic environment (consistent with prior cycles) because of their inherent ties to unemployment. High unemployment levels negatively affect overall office product distributor revenue, as these companies are exposed to nearly all customer categories (individual consumer, small business, and large business). Corporations are hoarding cash or returning it to shareholders in the form of increased dividends and/or share repurchases.

Individual consumers are still strapped, as Morningstar’s director of economic analysis, Robert Johnson, called out in a recent report. In his view, the sharp downward revision to the fourth quarter 2010 and first quarter 2011 estimates of consumers’ real disposable income was quite disappointing. Not surprisingly, the sluggish economic recovery has put pressure on  Staples (SPLS),  Office Max (OMX) and  Office Depot (ODP). Shares of Staples and the already battered-down Office Depot are down over 20%, and OfficeMax is off 40% from recent highs.

The weaker-than-expected economic recovery led Staples’ management to take a more conservative stance and soften its 2011 top-line growth outlook to the low single digits from the previous forecast of low-to-mid single digits. Consequently, we lowered our fair value estimates on all three office products distributors, as we believe the slower economic recovery will pressure top-line growth and margin expansion opportunities across the sector.

Negative implications for our fair value estimates
Staples is still our favorite among the group, even though we recently lowered our fair value estimate for its shares. For fiscal 2011, we expect same-store sales and delivery growth in the low single digits. International will be a challenge, as the firm is performing a strategic review to increase share, but currency fluctuations should offset the weakness, helping to support low-single digit growth. Despite investments in the business to drive sales, revenue from higher margin products and services, coupled with fixed cost reductions internationally, should result in modest margin expansion of 60 basis points (and an operating margin of 7.2% for the year). We remain committed to our thesis and believe that the firm’s growth will be driven by its dominant market position and margin expansion initiatives, coupled with a continued–albeit slow–improvement in the economic environment.

We cut a bit more deeply for Staples’ competitors. We lowered our fair value estimate more sharply for shares of Office Max. The soft sales environment, combined with OfficeMax’s investments in the business, should lead to modest margin erosion of 30 basis points and bring operating margins to 1.9%. We also lowered our fair value estimate for Office Depot. While domestic same-store sales continue to flounder, we forecast flat revenue in Office Depot’s international business, and although we expect Office Depot’s recent efforts to adjust its cost structure, which should bear some fruit, we still project an operating margin of 0.6% this year, a 50 basis point year-over-year improvement. Although current valuation multiples appear punitive for these two retailers, we’re focused on their waning competitiveness over the long term.

Competitive Challenges
Another issue plaguing office products distributors is competition. The commodity-like nature of office-related products and low switching costs between retailers have made it easy for nontraditional office products retailers such as  Wal-Mart (WMT),  Costco (COST), and  Amazon (AMZN) to enter the market. Over the long term, these newer entrants–all known for being low-price competitors–could pressure prices within the category, leading to margin erosion for the three traditional office products players. That said, we believe the market is overreacting to this competition–at least in the case of Staples. While these retailers do pose a material threat, in our view, Staples’ scale and distribution efficiencies should position the firm to compete effectively. Additionally, the Staples’ dominant market shares in regions such as Australian and Western Europe should help stymie competition.

Further, we contest that Staples will likely benefit from this increased competition, as we expect peers OfficeMax and Office Depot will be slowly edged out. As such, we assert that the market is underestimating Staples’ growth potential and margin expansion capabilities. Case in point, Staples has already taken market share from struggling rivals in the North American market, and its contract business continues to realize low single digit growth from new customer acquisition as well as from increased order sizes from existing customers. Office Depot and OfficeMax, however, have seen low single digit declines in this segment and acknowledge the loss of customers. On the retail side, Office Depot recently announced it was exiting the Canadian market, providing Staples a clear opportunity to grow in that region. Internationally, margins have lagged, but we believe a more focused strategy will prove fruitful. Staples intends to target international regions with a high expected GDP growth where it has already developed scale, including Germany, China, Brazil, and Scandinavia. In our view, having a more focused market penetration strategy by increasing marketing, but reducing promotional activity, should boost the firm’s dominance in these areas.

Office products distributors are combating this competitive threat by broadening the scope of their businesses and adding services. The rising trend of outsourcing among small businesses presents an opportunity for all office products distributors to service a core customer group in a different way. In addition to the traditional copy and print services, which the firms have offered for years, all three have started to provide technology services as their product assortment of computers has increased. From our perspective, while in-store services currently represent a small portion of the firms’ revenue bases, this initiative should be an increasingly meaningful free cash flow driver. To be sure, revenue growth in these areas has been positive for all three players–even the two laggards.

We recognize the office products distributors aren’t the only game in town with respect to service offerings, with competition coming from  FedEx Office (FDX) and  Best Buy’s (BBY) Geek Squad. We estimate the largest competitor in copy and print services, FedEx, controls low double-digit market share in this arena and operates nearly 2,000 locations worldwide. All three office products firms are opening smaller, stand-alone stores in order to better position themselves against FedEx, and we believe they will be able to leverage their familiar brand names, known for providing office-related solutions. Similarly, the tech service category has a large competitor: Best Buy’s Geek Squad. Best Buy’s service revenue (an approximation of the Geek Squad) is roughly 6% of Best Buy’s revenue, or just over $2 billion. We’re not as confident in the office products distributors’ potential for success compared to copy and print services given Best Buy’s established name in tech solutions. First, the firm’s consumer electronics sales are considerably higher (at $14.4 billion) than either OfficeMax or Office Depot, limiting cross-selling opportunities. Second, the human capital element is trickier with technical support services compared to copy and print services. A specially trained employee is necessary to provide this service. While we believe expanding copy and print services have the potential to drive growth, we’re skeptical that tech services will be able provide a meaningful source of differentiation for the office products distributors over the long run. Of the three, we believe Staples is best-positioned to take share in both service categories in which it operates, thanks to clear positioning and strong brand name.

Leadership Issues
In the highly competitive office products industry, we believe a strong, cohesive management team with a clear strategy is paramount to revenue growth and margin expansion. OfficeMax replaced its retiring president and CEO in late 2010 with Ravi Saligram, who previously held the role of Aramark’s international and chief globalization officer. While we have some reservations regarding Saligram’s lack of retail experience, we are encouraged by his strong record of driving revenue growth and margin expansion at Aramark’s international segment. Frankly, we were underwhelmed by Office Depot’s choice in CEO and disappointed that the firm didn’t go in a different direction after the prior CEO stepped down in fall 2010, having been in the post for just five years. Neil Austrian, who had been serving as interim CEO and chairman, was named to the permanent position. With leadership changes at OfficeMax and Office Depot, the tenure of Staples’ management team is a clear differentiator. The average 15-year tenure and stability of Staples’ management team is an often overlooked investment merit, particularly considering the shuffling of the ranks at OfficeMax and Office Depot. In our view, this qualitative data point has been a key contributing factor to a quantitative one: Staples has maintained average operating margins over the past five years that more than twice that of its two direct competitors.

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June 7, 2011 at 12:39 PM