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Staples Has Its Papers in Order

By Yogeesh Wagle Office-products retailer Staples (SPLS) has gained a competitive edge over its rivals in part by returning to its roots. Through its ongoing "Back to Brighton" initiatives (the title refers to the Massachusetts town where the first Staples opened in 1986), it has tried to improve its customer service -- and thus, its profitability. Staples has also benefited from strong growth in its delivery business and a key international acquisition.

Standard & Poor's believes Staples has strengthened its market-leading position and is likely to reap the most benefit from any business-spending rebound. The stock carries S&P's highest investment recommendation of 5 STARS (buy).

SAME-STORE TURNAROUND. The estimated $325 billion U.S. school- and office-products market, which is expected to grow 4% to 5% annually over the next several years, remains fragmented. The industry's "Big Three" retailers -- Staples, Office Depot (ODP), and OfficeMax (OMX) -- have a combined market share of less than 8%, leaving them ample opportunity to increase their presence. Furthermore, Staples and its peers have opportunities to expand in the fast-growing, increasingly homogenized $150 billion European market.

A key factor in Staples' resurgent sales and climbing earnings has been the turnaround in same-store sales of its North American segment, its largest in terms of sales and profits. The figure increased 3% in the fourth quarter of fiscal 2003 (ending January), after a 1% gain in the third quarter and declines earlier in the year.

What contributed to the rebound? For one, the accelerated conversion to its customer-centric "Dover" format (named for the New Hampshire town where the new design's prototype was unveiled in spring, 2001.) Also, Staples has shifted its merchandise mix to target small businesses and "power users" -- individuals who spend more than $500 a year on office supplies and electronics -- over casual customers. Furthermore, it boosted the number of higher-margin Staples-branded products it sells. A shift in Staples' store culture -- from one based on tasks and transactions to a customer-oriented one -- has helped as well.

BETTER LAYOUT. We believe the Dover format, with its focus on making shopping easier, has provided Staples with a key point of differentiation over its competitors. A typical Dover store has a more efficient, slightly smaller layout and features lower sightlines and signage hanging from the ceiling to improve navigability.

Staples ended fiscal 2003 with 1,300 stores in North America. A slower store-expansion pace has allowed it to focus more on productivity improvements and operational execution. After adding over 330 stores in the prior two-year period, Staples opened only 75 in fiscal 2003 and is expected to unveil 75 to 90 units in fiscal 2004. The new stores are likely to have the Dover format, and with 50 additional remodels, about 30% of all Staples shops should be operating in this format by the end of fiscal 2004.

With the integration of Medical Arts Press, a direct marketer of office products for medical practices, Staples' North American delivery business is poised for another strong year. Including the July, 2002, acquisition, this segment's income increased an industry-leading 30% in fiscal 2003. The unit recorded gains in all three of its arms: Staples Business Delivery, which includes its direct-mail catalog business and; Quill, a direct-mail catalog business acquired in 1998, which targets midsize U.S. businesses with specialized products; and the contract-stationer business, which provides customized services to midsize and large businesses and includes

PROFITABLE FOCUS. By increasing its focus on the higher-margin delivery business, Staples has been able to improve overall operating margins. We expect further margin expansion in North American delivery in fiscal 2004, as Staples reaps the benefits of continued supply-chain improvements, consolidation of fulfillment centers in some areas, key investments in the sales force, and leveraging of Medical Arts Press's printing capabilities in other business-delivery operations.

Those activities have been boosted by significant investments in information technology. E-commerce sales reached $1.6 billion for fiscal 2003, accounting for 53% of overall North American delivery volume, vs. 45% a year ago.

Europe remains a growth area for Staples and its largest rival, Office Depot. With the August, 2002, acquisition of French stationer Guilbert's mail-order business, Staples gained access to four new countries: Belgium, France, Spain, and Italy. The deal also strengthened its competitive position in Britain. We believe that the acquired business, renamed Staples European Catalogue, provides a strategic platform for continued penetration of the Continent's fast-growing mail-order market. The region is expected to be a key driver of long-term growth.

WEAKNESS IN GERMANY. Staples' European retail operations had 188 stores at the end of the 2003 fiscal year, concentrated in Britain, Germany, the Netherlands, and Portugal. Fourth-quarter same-store sales were down 3% in Europe mainly because of a weak performance in Germany. In fiscal 2004, Staples plans to add 15 new stores on the Continent.

Overall, S&P projects high single-digit sales growth in fiscal 2004, aided by 2002's delivery-business acquisitions, continued international penetration, store additions in North America and Europe, and modest gains in retail traffic and same-store sales. Gross margins should widen, as Staples benefits from a growing private-label business, a merchandise shift toward small-business customers, recent supply-chain initiatives, and better buying.

We see selling, general, and administrative costs remaining well controlled, despite sales-force and payroll expenses rising. With slightly higher interest expense and taxes at 37%, we project fiscal 2004 EPS at $1.05, up 19% from fiscal 2003's 88 cents (excluding a one-time tax benefit of 6 cents).

CONSERVATIVE ASSUMPTIONS. We do have some mild earnings-quality concerns. Our estimate of S&P's core earnings per share for fiscal 2003 is 87 cents, which is 7.5% below reported EPS of 94 cents. This modest difference is related to the costs of unexpensed stock options. For fiscal 2004, we estimate S&P core earnings of 97 cents a share, shaving 7.3% off projected EPS of $1.05 because of unexpensed stock options.


discounted cash-flow (DCF) valuation suggests an intrinsic value of $24 for the stock, some 28% above the recent price. In our DCF model for fiscal 2004 we estimate free cash flows of $519 million, 20% below fiscal 2003's level, after capital spending of $325 million (compared to $265 million in fiscal 2003).

We assume free cash flows growing at a compounded annual rate of 11% over the next four years, before tapering off to 4% in subsequently. We believe that these assumptions are conservative, considering that free cash flows climbed at a compounded annual rate of about 30% over the past five years.

POTENTIAL DRAWBACKS. Based on our stock-valuation model, which takes into account the shares' volatility, debt-to-equity ratio, cost of debt, first-year free cash flow, and growth rate in subsequent years, we calculated a target price range of $21 to $27 in 6 to 12 months. The stock has recently been trading at just under $19.

Our earnings forecasts and share price target have risks. Among them: Possible ongoing economic weakness and low consumer confidence, which could decrease business spending; aggressive price-cutting by rivals; negative foreign-currency fluctuations, and the potential for problems in U.S. relations with certain European countries leading to a backlash against U.S.-based companies and products. Other possible risks include problems in integrating recent acquisitions and geopolitical risks and uncertainties, including the impact of terrorist threats and actions. Analyst Wagle covers retailing stocks for Standard & Poor's

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