Buy Low, Sell High, with This Cyclical Stock
This 5-star stock offers 20%-plus expected returns.
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Moat: None | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 23.5%
What It Does: Staples (SPLS) is the world's largest supplier of office products and related services to consumers and businesses. The company operates about 1,900 office-supply superstores and also sells products through catalogs, Web sites, and a direct salesforce. Staples operates in 21 countries.
What Gives It an Edge: Given that it competes in a commodity business, Morningstar analyst John Gabriel does not think Staples possesses a structural competitive advantage that warrants an economic moat. That said, Gabriel still believes Staples is the clear industry leader with the lowest cost structure and most efficient capital base relative to its office superstore rivals, Office Depot (ODP) and OfficeMax (OMX). For instance, despite operating nearly identical businesses, over the past five years Staples' operating margin has averaged 7.6% versus 3.5% and 1.7% for Office Depot and OfficeMax, respectively. Staples also trounces its rivals in terms of return on equity; over the past five years Staples' average return on equity was 18.5% compared with 12.8% at Office Depot and 3.8% at OfficeMax.
What the Risks Are: The primary risk facing Staples is the aggressive turnaround efforts at its two main competitors, Office Depot and OfficeMax. If those companies are able to execute successful turnarounds sooner than expected, there is potential for increased pricing pressure amid a heightened battle for market share. This would make it more challenging for Staples to be the third entrant in new markets where rivals currently have a stronghold. Price competition is an ongoing concern and could pressure Staples' operating profits.
What the Market Is Missing: Gabriel believes Staples' stock has a taken a hit after it became clear that the uncertain macroeconomic climate in the U.S. would cause consumers and small-business customers to cut back spending. While Gabriel acknowledges that this weak climate should persist into 2009, Gabriel thinks the market is focusing too much on this near-term outlook and ignoring Staples' long-term growth opportunities. In the U.S., Staples has adapted to the ever-changing demands in the marketplace by implementing its EasyTech service (similar to Best Buy's (BBY) Geek Squad) and enhancing the service offerings at its copy and print centers. Though likely a tough year in the U.S., Gabriel is confident that actions like these will allow Staples to capture market share from weaker rivals. Also, in recent years, Staples has actively expanded its footprint in international markets, including building operations in China and India, two of the world's fastest-growing markets for office supplies. While still a small part of total revenues, Gabriel contends that Staples' international presence puts the firm in a better position to weather the current U.S. downturn.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, May 9, 2008.
Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.