Description

Office Depot (ODP) has been written up twice before on VIC, most recently in March 2007 when the price exceeded $35, and previously in July 2000 with the price at about $6.  With the stock having declined to just $13.60 today (the high price was over $46 last year), I believe that the stock represents a very interesting opportunity for value investors.  My target price is between $23 and $32 over two to three years, based on very reasonable assumptions of revenue growth, operating margins, and stock buybacks over this period.  This would imply a total return of 70% to 135% from the current price. 

Additionally, given the company’s long history of profitable operations, established market position, and low current valuation (8x 2006 earnings, and less than 10x estimated 2007 and 2008 earnings), I believe the long-term downside risk is limited, and the market has over-reacted in the current environment where retail stocks are unpopular given the concerns about an economic slowdown.

The previous two excellent VIC reports on Office Depot discuss the company at length.  Since the more recent one is only nine months old, I will use this writeup to provide a big picture overview of the story and an update on recent events at the company.

As can be seen in the table below, the company’s top line and bottom line increased over the last few years as management pushed to increase operating margins and keep G&A expenses down, while buying back stock aggressively, resulting in big increases in EPS.  The stock price climbed to as high as $46 in 2006 in anticipation of further improvements in margins and EPS growth.  Arguably, the stock price was too high at that point, at well over 25x trailing earnings and over 20x forward earnings.  I would also argue that, having declined by 70% from that level, the stock is now cheap, and provides a low-risk way to play the recovery in the economy and in retailing.

With the slowdown in the economy in 2007, earnings have disappointed investors, so that full-year EPS will be lower than in 2006, and earnings in the first half of 2008 are also likely to be lower than the prior year.  But management expects that earnings will improve after that. 

Management says it has identified margin improvement opportunities that could result in overall net improvement in operating margins of 300 basis points between 2007 and 2012 (see the investor presentation of 12/19/07 on the company’s website).  If this goal is achieved, operating margins could exceed 7% in 2012.  My assumptions in the projections below are that the operating margin is 5.0% in 2009 and 5.2% in 2010, sales grow modestly (less than 5% annually) in 2008 and 2009, and by 5% in 2010, and the company buys back about 2% of its shares annually (which is lower than the buyback rate in recent years).

In this situation, based on a 12-15x earnings multiple, we would earn a 31% to 46% annualized return over two years (with the stock price at $23 to $29 by late 2009), or a 24% to 33% annualized return over three years (with the stock at $26 to $32 by late 2010).

Cash flow

The company’s cash flow has historically been very strong, and management has chosen in recent years to buy back stock aggressively, rather than paying dividends.  In 2006, 2005, and 2004 the company spent $971 million, $815 million, and $66 million respectively on repurchasing stock, and another $200 million in the first three quarters of 2007.  Using free cash flow to create value for shareholders is a key goal of the management team.

Given the slowdown in business, and the focus on using cash flow wisely, management has chosen to scale back on store expansion and capital expenditure plans for 2007 and 2008, in order to focus on improving current operations and preserving cash.  With the sharp decline in the stock price, it is my hope that management is continuing to aggressively buy back stock at the current low price, which should add meaningfully to EPS growth over time.

Risks:

(1)   The economic slowdown continues for an extended period of time.

(2)   Management fails to execute on its plans to improve operations and profit margins.

Catalyst