Staple's Brisk Clip


By Amy Tsao A strengthening economy has been good news for office-supply retailers, as increased hiring means rising sales of sticky notes, pens, and other cubicle sundries. However, the giants of the business, Staples (SPLS) and Office Depot (ODP), haven't benefited equally. Lately, Staples, long considered the better performer of the two, has distanced itself even further from the competition.

"They're definitely two companies moving in opposite directions," says SG Cowen analyst Joseph Feldman. With the resignation of Office Depot's CEO Bruce Nelson, announced Oct. 4, Staples, based in Framingham, has yet another opportunity to extend the lead on its biggest rival. "In the near term, if I'm Staples, I've got my entire senior management team thinking about how to capitalize on this," Sanford Bernstein analyst Colin McGranahan says of Nelson's sudden departure.

Staples' intense focus on improving operations began about 2 years ago, when it started to slow new-store growth. "When we were growing rapidly, there wasn't much focus on expense controls," says John Mahoney, Staples' chief financial officer and chief administrative officer. "We found there were phenomenal opportunities for improvement." Staples is now in the middle of a multiyear program to improve its supply chain and logistics, it has sharpened its focus on selling the more profitable Staples-brand merchandise, and it has expanded its business-to-business division.

BRAND LOYALTY. The initiatives seem to be paying off -- and at a high cost to Office Depot, which appears to be struggling to execute its strategies. Both outfits' revenues are roughly comparable -- $13 billion in projected sales at Office Depot in 2004 and $14.3 billion at Staples in fiscal 2004, which ends in January, 2005. But that's where the likenesses end.

In same-store sales, a key gauge of organic growth, Staples has consistently bested its rival over the past two years. Office Depot saw negative results in same-store sales over 2003, and in both the first and second quarter of this year it reported 3% gains. Staples reported 5% and 4% increases in the year's first two quarters, on top of positive same-store sales increases in each quarter of 2003.

A big difference in profit margins between the two should continue to increase, says Feldman. He projects operating margins at Staples to inch higher, to 7.8% this year, while Office Depot's should fall slightly, to 3.9%. Staples' gross margins can keep improving, Feldman figures, as it continues to stress its higher-margin line of Staples brand goods. "This drives loyalty," says Feldman. Such products account for 15% of sales but should make up 20% by the end of 2007.

CORPORATE MARKET. Staples also has been pushing hard to improve its back-end computer systems. It's currently in the second year of a three-year strategy that has already produced significant cost savings of around $200 million in inventory reductions. Says Staples' Mahoney: "We have confidence that we can continue margin improvements. The overall goal is to improve margins to around 9.5% to 10%."

And Staples has been gaining ground on its business-to-business delivery division. Traditionally, while it has focused on the small and midsize business customer, Office Depot has courted larger corporate accounts. But that has shifted some recently. "Staples is getting better on the large-corporation side and on the whole spectrum," says Feldman. The retailer says it increased its so-called "contract and delivery" business by 11%, vs. growth of roughly 3% for overall office-supply retailing in 2004's second quarter.

Staples' stock valuation reflects the solid track record -- and expectations for continued leadership. It trades at $30.47, or 19 times forward-year earnings-per-share expectations. Office Depot trades at $15.14, around 12 times next year's consensus EPS forecast. Staples is pricier, but many analysts see the premium as worth paying.

The current management woes at Office Depot may not last long. "It may not be in the next week or next month, but within six months Office Depot will be doing better," McGranahan says. He rates both stocks outperform, expecting each to do well amid the ongoing economic recovery.

THIRD PLAYER. Staples' Mahoney is mindful that a new, more effective management team at Office Depot will be pushing to make it a stronger rival. "They're a great competitor," McGranahan says. "Their performance hasn't been what they hoped for in the last few years, but that doesn't diminish the fact that, in an absolute sense, their performance is really not bad."

Competition also is heating up. OfficeMax, a distant third, could be making a comeback. It was bought last fall by timber and paper giant Boise Cascade (BCC), making it part of an outfit with combined sales of about $8 billion. Says McGranahan: "We're back to a three-player market."

But both Office Depot and OfficeMax have a lot of ground to make up. And McGranahan believes that over the next few years Staples will still "out-execute, outgrow, and outperform." No wonder the leader in office-supply retailing strikes many investors as the sector's smart play. Tsao is a reporter for BusinessWeek Online in New York


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