Office Depot Stock Price as of Publication: $2.09 per share. 

This article was also published on Barron's per Barron's request (link here). 

You can access the PDF version of the report by pressing here.

Office Depot is not at its best times. Just one year ago, the company was supposed to merge with Staples (the government then blocked the deal citing anti-competitive concerns), its closest competitor, giving Office Depot a valuation of more than $6 billion. At yesterday’s close, ODP’s market cap was standing at $1.28 billion, one-fifth of the merger valuation. The reason? As Barron’s called it, the “A” word, Amazon. 

The company, like most other retailers, is suffering from the digitalization that is being led by Amazon. We think Office Depot is not immune from this disruption and the stock price fall is justified. However, we believe that the market is not factoring in any improvement in the business over the coming years. Also, the market is not crediting Office Depot for any of the transformation efforts the company is making, which we believe that if executed right, has the potential to double ODP’s stock price from the current level. 

Office Depot business description

Office Depot operates three segments; North America Retail, Business Solutions, and CompuCom, the company Office Depot acquired for $1 billion late last year. 

Business Solutions and CompuCom share the same market with a lot of expected synergies between the two divisions (management estimates it’s close to $50 million over the next two years, we believe that if executed right, synergies may reach $100 million). 

Business Solutions offers services for business such as; print and ink subscriptions, web designs, digital marketing services (search engine optimization and digital campaigns), credit-cards processing, and customer relationship management (CRM). While some of these segments are new, like CRM and print/ink subscriptions they are showing early signs of success (explained later). BS Revenues in 2017 were $5.1 billion (46% of total revenues).  

CompuCom is an IT services company which was under the leadership of asset management firm “Thomas Lee Partners”. The company has 6,000 employees, where the majority of them are technicians and engineers. CompuCom offers cloud storage services, design thinking services which helps designers think outside-the-box, and networking & IoT services, all for small businesses. CompuCom revenues in 2017 were $1,077 billion (10% of total revenues). 

North America Retail includes ODP’s brick-and-mortar stores in NA. The company owns 1,378 stores and it is expecting to close 20 stores in 2018 after closing 367 stores over the last three years as part of the transformation process led by CEO Gerry Smith and his predecessor. Sales of the division are declining in low-double digits due to store closing. Same-store-sales are also declining but at a much slower pace, Q4 SSS decline was 4%. Retail revenues in 2017 were around $5 billion (44% of total revenues). 

What the market is getting wrong

The market is valuing ODP as a pure retailer, giving the company a valuation of just 4 times its guided free-cash-flow for this year. What the market is not taking into consideration is that more than 50% of the company’s revenues are now derived from technology and not retail. The company guided for flat revenues for its CompuCom and Business Solutions segments (ODP management guidance was conservative based on historical evidence) , which suggests that giving a low-multiple on these segments is not justified. The retail segment is not in a good shape, but after closing low-performing stores and focusing on the good performing ones, the retail segment should witness some kind of stabilization over the coming quarters. And even if the retail segment did not stabilize, the market is already pricing that in.

Management plans

With its CompuCom acquisition, ODP management added significant value to the company. Not only CompuCom’s business is stable, the segment can add huge value with its 6,000 technicians and engineers. Those technicians will be funneled to Business Solutions segment, adding more expertise to the segment and lowering costs by removing duplicate positions. 

Management is also planning to offer another kind of retail stores “Biz Box: Powered by Office Depot”, as seen in the PDF version.

The store, which was opened on November last year, include CompuCom and Business Services technicians and traditional Office Depot employees, offering customers (small businesses) a range of products and services all in one place. Below you can see the floor plan of the new store.

Office Depot is planning to upgrade an unspecified number of its retail stores to the new design. 

Can management execute? 

The market is not pricing in any success of the transformation efforts. We believe this mispricing of ODP stock price is an opportunity for investors who want to bet on ODP management. We believe that ODP management will be able to turn things around. Unlike most other retailers where senior managers have a career in retail, the CEO and CCR (Chief Customer Officer) have a technology background. The CEO, Gerry Smith, who took the position just one year ago, was VP for Displays and Product Development at “Dell” where he worked there for 12 years. Then he moved to “Lenovo”, where he was the COO after working there for 11 years. Another new executive with technology background is Jerry DeVard who was the COO of “ADT Corp.”, a security service firm which was acquired for $12.3 billion by “Apollo Management”. 

As such, we believe that ODP management can turn things around and that the board, by choosing officers with a technology background, insists on moving the company into a new direction. 

What our model shows

In our model, we assumed that as management guided, CompuCom and Business Solutions revenues would be flat in 2018 and that the retail division will suffer from a 10% decline in revenues. We also assumed that gross profit will decrease a 100 bps from 24% to 23% and that SG&A as a percentage of revenues would improve 20 bps which is around $25 million as management guided. Also, interest expense would increase to $124.5 million ($120 million + 3 rate hikes anticipated this year) due to the additional debt incurred as a result of the CompuCom acquisition and ODP’s effective tax rate would be 22%. 

For fiscal 2019, we assumed a 3% growth in NAR due to easy comps, and a 1.5% growth in BS and CompuCom divisions. We also assumed another $25 million improvement in SG&A expenses and a $4.5 million higher interest expenses due to anticipated 3 rate hikes in 2019 ( ODP’s interest expense would increase by $3 million for every 50 bps increase). 

 Taking our assumptions into account, the estimated EPS for fiscal 19 is $0.31. Assuming a 13% discount rate, the present value of 2019 EPS estimate would be $0.25. 

What multiple should we apply to EPS

The fact is, Office Depot is not a pure-retail play. The company derives more than 50% of its revenues from services for small businesses which are mostly tech. As such, we do not see the current PE multiple of 6.7 should be applied to the PV of 2019 EPS. 

Office Depot Retail and Macy’s face similar threats from digitalization, or Amazon in particular. Also, Business Services and CompuCom shares the same industry with SAP and Accenture. So, we believe that applying the average-forward PE multiples of the three companies mentioned while giving Macy’s a 50% weight, and Accenture and SAP each a 25% weight is the right approach to estimate the proper PE for our estimates. 

Doing the math, the derived PE ratio is 15 which is still way below the average market PE. Applying 15x EPS on the PV of 2019 EPS gives us a ~$3.7 intrinsic value per share, a 60% upside from current level. 

Final thoughts

Our more conservative intrinsic value estimate is derived using the weighted average probability method in which we gave a probability of 40% that the market will value the 2019 EPS at 8x, 50% probability for our estimated PE of 15x, and a 10% probability that the market will value 2019 EPS at 6x only. The weighted average of these outcomes is still attractive, which is $2.77 per share, more than 20% upside from current levels. 

We believe that Office Depot management will execute right. And even if it doesn’t, the downside is already priced in the stock which declined 47% in the last twelve months. 

Sometimes, having Amazon as a competitor is not a bad thing as it takes out the best of the companies, forcing them to innovate and be more efficient. Among all retailers, we believe that Office Depot has the best shot to succeed as the office supplies and small businesses services is not very attractive for a company in the size of Amazon and Office Depot may take advantage of its online/offline presence. We also do not remove the possibility that ODP may be an acquisition target by Amazon giving the low valuation and widespread store presence.  

As a result, we believe that ODP stock has the potential to increase by 20% to 60% over the next 18 months and we rate the stock as a “strong buy”. 

Market OutPerformers – Celeritas Investments.