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A Surprise In Office Depot's In-Box?


Just past 5 p.m. the other day, I waited in line at the local Office Depot (ODP) to pay some princely sum for computer printer ink. Then, zap, the lights went out. A little sunlight filtered through the front door, but no money would change hands now. Or would it? Seven minutes later, a backup power system restored the lights. Cash registers began beeping again as if nothing were amiss.

An odd occurrence, but it transmits the vibe around Office Depot. Things suddenly go wrong, then the company muddles through and makes money. The latest outage, if you will, struck on Oct. 4 with the exit of CEO Bruce Nelson. Until they hire a permanent successor, company directors installed one of their own, Neil Austrian, a former Wall Streeter and once president of the National Football League. He told investors the board acted to ensure faster execution of plans to boost sales at its North American stores. Might Office Depot at last gain on archrival Staples (SPLS), which leads it by many measures?

AT LESS THAN $15, OFFICE DEPOT shares have gone nowhere since 1997, when Uncle Sam blocked a merger with Staples. Meantime, shares of Staples have risen to $30 from $12. Investors like its profitability (a first-half pretax margin of 6%, vs. 4% at Office Depot), and growth (2004 same-store sales up 4%, vs. 3%). In 2003, Staples for the first time generated over $1 billion in cash flow from operations, way beyond Office Depot's $652 million.

So the market has had plenty of reason to mark down Office Depot. Investors, however, don't yet seem to be paying full attention to the company's growing skill at managing inventories, a vital sign of retailing health. One way this is monitored is by what's called the inventory turnover ratio, or a retailer's cost of goods sold divided by the average value of its inventories. This measures how hard an investment in inventory is working; the higher the ratio the better. Office Depot, with a set of "crossdocks," or flow-through distribution centers where goods barely touch down before heading to stores, plus big, recent investments in information technology, is picking up its pace. Not only does quicker turnover tie up less cash in inventories but it also cuts the risk that goods will grow obsolete before they're sold -- not so crucial in paper clips but particularly so in computers and other technology items. Although Staples also is turning inventories faster (and suffers a bit in the comparison as its total sales include a smaller proportion from nonretail, direct-to-business accounts), Office Depot enjoys the edge here.

However critical, inventory management alone won't speed Office Depot's growth in profits. As is, Wall Street sees this year's earnings reaching perhaps $1.10 a share, up nearly 15%, from 96 cents in 2003. Office Depot expects to have opened 80 new stores by the end of the year but is picking up the pace with an additional 100 in 2005. If the new stores help the company drive more sales through its increasingly efficient distribution system, the effect on profits could be surprisingly robust.

Shareholders, in any case, already are set to be nicely surprised, as Office Depot has set aside $515 million in cash to repurchase stock over the next 12 to 24 months. At the stock's current level, the full buyback would cut total shares by nearly 11%. This could be a powerful propellant to earnings per share. Suppose net income grows next year by about 15%, to $400 million or so. Without a buyback, that implies earnings per diluted share of $1.26 in 2005. If by the end of next year, Office Depot were to use half of its budget for repurchases at an average of $15 a share, net income of $400 million would work out to $1.33 in earnings per share -- a 20% jump. No question, without a permanent CEO, Office Depot's future is hard to see. My bet is that the lights will be coming back on soon.

By Robert Barker


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