Too High A Price For Black Ink

All that copier paper. All those yellow pads, file folders, pencils, and pens (72 Foray-brand retractable ballpoints now on sale at Office Depot (ODP ) for just $14.99). The desk chairs, cell phones, laptops. Printer ink cartridges priced like caviar. How much can the value of retailing this stuff of daily commerce change in a year?

If you believe the stock market, a lot. Back in October, 2004, when this column last examined Office Depot, the stock struck me as way undervalued. Back then, it was changing hands near 14 a share. Today, with the shares above 31, I have to wonder: In a mere 15 months, are Office Depot's prospects truly 120% better? Doubtful.

I say that not because Office Depot is headed for a wreck. On the contrary, the company remains financially strong -- it has more in cash and short-term investments than it owes in debt -- and its operations are being intelligently streamlined. For example, two domestic catalog units that it had run separately, one under the Viking brand, are being consolidated into a single Office Depot-branded offering. This and other common-sense efficiencies at its retail outlets are the work of Steve Odland. He joined as chief executive last March following four successful years leading car parts retailer AutoZone (AZO ). I didn't reach Odland, but his chief financial officer, Patricia McKay, told me they're pleased by the stock's gains. She added, "We've got the growth priorities to drive [further] improvement in shareholder value."

JUST THE SAME, it looks as if the stock market already has discounted much of what Odland, McKay & Co. might do in the foreseeable future. On Feb. 22 the Delray Beach (Fla.) company is set to unveil full-year 2005 results. Wall Street's consensus guess is for revenues of nearly $14.2 billion and earnings per share of $1.36, a sizable leap from $1.06 in the previous year. In 2006 analysts are forecasting profits of $1.56 a share, a further gain of almost 15%.

Where would that come from? Some from higher profits on fewer shares, since Office Depot remains an aggressive repurchaser of its stock. More would come from cutting costs and reorganizing operations, particularly in Europe, to expand profit margins. McKay noted that more aggressive selling by telephone, more private labeling of such higher-margin goods as furniture and paper shredders, plus the opening of 100 new stores this year, are all set to boost sales growth and widen margins. How fast might sales grow over the next few years? How much might margins widen? On those key issues for investors, McKay is vague.

Assume, however, that Office Depot stays on a roll and that growth in earnings keeps moving at a good clip. It's still far from clear that Office Depot is the best buy in this end of the market. According to Capital IQ, a unit of Standard & Poor's (MHP ), Office Depot's operating profit margin came to 3.8% over the last twelve months. Staples' (SPLS ) was 8%. Through last year's first nine months, the average Office Depot store in North America produced about $198,000 in operating profit, vs. $354,000 or so at the average Staples. McKay told me "there's nothing structurally different" between the rivals that would bar Office Depot from enjoying margins like Staples'. That will mean cutting costs further, expanding revenues, and improving its mix of merchandise to include more high-margin items. Yet today an investor pays a higher multiple for Office Depot's earnings than for Staples'.

Michael Souers is an S&P equity analyst who thinks Office Depot is on the right track, and is impressed by Odland's record. Yet when he considers the office-supply industry's growth rate of perhaps 3% a year and sees Office Depot trading at 20 times estimated earnings, he balks. "I just think the shares have gotten ahead of themselves," he told me, suggesting they're worth something closer to 26. Almost makes computer printer ink look like a bargain.

By Robert Barker

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