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Office Depot Is Oversold and Undervalued

- By The Acquirers Multiple

One of the cheapest stocks in our All Investable - Deep Value Stock Screener is Office Depot Inc (ODP).

Office Depot sells specialty retail products and services to consumers through three segments: North American Retail, North American Business Solutions and International. It operates under the Office Depot and OfficeMax brands. Products include school supplies, computers and wireless communications, office equipment, as well as services for technology products and copy and print centers.


A quick look at the company's share price history (below) over the past 12 months shows that the stock has been hammered, down 30% and trading at $4.62, significantly lower than its 52 week high of $7.91 back in April of this year.

(Source:Google Finance)

The reason the stock has been hammered is due to its failed merger attempt with Staples Inc. (SPLS) earlier this year. On May 16, Office Depot announced termination of its merger agreement with Staples. As you can see, investors were disappointed by the news and the stock dropped 46% from $6.26 on May 9 to $3.33 on May 19. As a result of the termination, the company received a cash payment from Staples of $250 million on May 19.

No one would disagree that its been a tough year for the company. In its recent third quarter 2016 earnings results, Office Depot reported sales had dropped 7% from $3 billion in Q3 2015 to $2.8 billion in Q3 2016. The decline was caused by the disruption during the attempted Staples acquisition together with the impact of U.S. store closures, and customer losses in its Business Solutions Division.

During the third quarter, the company closed seven stores, and now anticipates closing approximately 65 additional stores in the fourth quarter. In total, Office Depot will close approximately 125 stores in 2016.

The company has also made the decision to sell all of the businesses in its International Division, announcing a deal to sell its European business to the AURELIUS Group, a leading European-based asset manager and selling all its remaining international businesses in Australia, New Zealand, South Korea, and mainland China while retaining its sourcing and training operations in Asia. This is expected to be completed within the next 12 months.

So, that's the bad news. But what seems to get overlooked in what has clearly been a disruptive year for Office Depot are some of its positive developments.

For example, let's take a closer look at the company's income statement for the last five quarters:

Quarterly Income Statement (amounts in millions)
Fiscal Period Sep16 Jun16 Mar16 Dec15 Sep15
Revenue 2,836 3,218 3,544 5,524 3,046
Gross Profit 726 747 856 1,295 787
Gross Margin % 25.6 23.21 24.15 23.44 25.84
Selling, General, & Admin. Expense 584 681 741 1,190 626
Operating Income 117 253 71 -26 81
Operating Margin % 4.13 7.86 2 -0.47 2.66
Net Income (Continuing Operations) 330 210 46 -52 42
Net Income (Discontinued Operations) -286 -- -- -- -36
Net Income 44 210 46 15 6
Net Margin % 1.55 6.53 1.3 0.27 0.2



(Source, Company Reports, sec.gov)

What we see when we compare the third quarter 2015 to third quarter 2016 is:

  • Gross margins have held steady at 25%.
  • Operating income has risen 44% from $81 million to $117 million.
  • Operating margins have risen 55% from 2.66% to 4.13%.
  • SG&A Expenses have fallen 7% from $626 million to $584 million.
  • Net Income has risen 600+% from $6 million to $44 million.



The reason for the positive trend is the company's focus on reducing costs across the organization. Office Depot is starting to see cost savings from its streamlined retail store operating model included in the second phase of its store optimization and closure plan. Reductions in general and administrative costs have been achieved due to its more simplified operations, the removal of redundancies, and reductions in unnecessary expenses.

Selling its international businesses will provide further cost reductions as it continues to focus on its North American business segments. Other cost savings will come by way of its supply chain conversion of the legacy OfficeMax distribution facilities to the Office Depot order management system. The company will finally have its entire delivery network on the same system, enabling it to reduce inventory levels, harmonize SKUs and free up capacity to begin adding additional Jan-San and other maintenance and repair products to its assortment.

Expanding the assortment of Jan-San, safety and MRO products is also expected to provide significant cross-selling opportunities to existing customers.

The company is clearly focused on implementation of its new three-year strategy, announced back in August, which includes four pillars:

  1. Accelerating growth in its contract channel.
  2. Optimizing and reinventing its North American retail business model.
  3. Implementing a number of multi-year cost savings programs.
  4. Enhancing shareholder return.



Average quarterly new customer commitments fell substantially in 2015 and early 2016 when compared to its 2014 run rate due mainly to the uncertainty surrounding the Staples acquisition. Following that uncertainty, the company has successfully competed for new business and won a number of new multi-million dollar customer accounts. In the third quarter 2016, Office Depot's new customer commitments were higher than any of the previous eight quarters.

In terms of optimizing its North American retail business model, the company is testing its 'Store of the Future' model. These stores will have a much smaller footprint of approximately 15,000 square feet compared to the more traditional 20,000 to 30,000 square foot formats. The 'Store of the Future' is expected to provide significant improvements in store design and products, and considerably more space for the company to expand its key service offerings, such as copy, print, and tech services provided by its specially trained team.

Strong balance sheet

As you can see below, Office Depot continues to have a strong balance sheet:

Quarterly Balance Sheet (amounts in millions)
Fiscal Period Sep16 Jun16 Mar16 Dec15 Sep15
Cash, Cash Equivalents, Marketable Securities 801 1,118 879 1,069 958
Accounts Receivable 718 1,055 1,106 1,166 1,231
Inventories, Other 1,216 1,560 1,575 1,698 1,586
Current Portion of Long-Term Debt 28 37 37 56 56
Long-Term Debt 1,163 1,425 1,437 1,453 1,467



(Source, Company Reports, sec.gov)

At the end of Q3 2016, the company had $800 million in cash and cash equivalents, most of which will stay on the balance sheet even with the sales of its international businesses. We can already see the result of the company's operational cost savings with significant reductions in accounts receivables, down 41% and inventories, down 23% from the pcp. As mentioned above, further inventory improvements are expected in Office Depot's new 'Stores of the Future' where the company will change approximately one-third of its products, removing slower-selling and lower-margin SKUs and adding a more relevant assortment.

What's also noticeable is that the company has $1.19 billion in total debt, with continuing strong free cash flow this is not an issue. On Sept. 15, the company paid $262 million in cash to redeem its 9.75% senior secured notes due in 2019. Retiring this high coupon debt provides $24 million in future annual interest savings.

Shareholder friendly

A quick look at the company's quarterly cash flow statements (below) shows the company has started its shareholder return initiatives.

Quarterly Cashflow Statement (amounts in millions)
Fiscal Period Sep16 Jun16 Mar16 Dec15 Sep15
Cash Flow from Operations 299 287 -139 65 196
Purchase Of Property, Plant, Equipment -22 -23 -26 -54 -38
Issuance of Stock -56 -25 -- -- --
Net Issuance of Debt -260 -6 -26 -7 -12
Free Cash Flow 277 264 -165 11 158



(Source, Company Reports, sec.gov)

Office Depot repurchased 16 million shares of its outstanding common stock during third quarter 2016 for a total cost of $56 million. In addition, a quarterly cash dividend of 2.5 cents per share was paid on Sept. 15 to shareholders for a total of $13 million.

Through the end of the third quarter, the company has repurchased a total of 23 million shares for an aggregate cost of $81 million and has $170 million remaining in its current authorization.

Since announcing its new shareholder initiatives just a few months ago, Office Depot has dedicated around 95% of its year-to-date free cash flow to improving shareholder returns. These actions clearly demonstrate its ongoing commitment to returning capital to shareholders and enhancing overall shareholder value.

Free cash flow

Office Depot continues to generate loads of free cash flow. A quick look at the company's cash flow statement above shows the company had $512 million in operating cash flow over the trailing 12 months and capex of just $125 million. That left the company with $387 million in free cash flow. Even with the planned divestiture of its International Division, the company still expects to generate a similar amount of free cash flow from its continuing operations in 2016. With a enterprise value of $2.78 billion and $387 million in free cash flow (ttm) that means the company has an FCF/EV yield of 13%.

The Baupost Group

Lastly, one thing I always look at when investigating a company is its current ownership summary. A quick look at Office Depot's summary shows a new position by the Baupost Group on Sept. 9 for 13 million shares valued at $58.8 million. The Baupost Group is of course run by one of the smartest investors on the planet, Seth Klarman (Trades, Portfolio). While this is a tiny position compared to the rest of its holdings, it does highlight some degree of interest in the company.

Valuation

Office Depot is cheap on every multiple. It's trading on a P/E of 8, a P/B of 1.29, a P/S of 0.17, a FCF/EV yield of 13% and an Acquirer's Multiple(R) of 6.36, or 6.36 times operating earnings*. The Acquirer's Multiple(R) is calculated as:

Enterprise Value/Operating Earnings*

The Acquirer's Multiple(R) uses operating earnings in place of EBIT and EBITDA and is constructed from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up.

* The Acquirer's Multiple(R) uses the CRSP/Compustat merged database "OIADP" line item defined as "Operating Income After Depreciation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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This article first appeared on GuruFocus.