Will Staples Close Its Doors to the Public?

On Thursday, Fortune magazine published a report that several private equity sponsors may be interested in taking  Staples private, citing unnamed sources. We consider this transaction to be a low-probability outcome, since Staples' lofty size (roughly $8.2 billion market capitalization and $9 billion enterprise value at current market prices) would make it difficult to acquire the necessary financing, and financial backers may be reluctant to put that much capital at risk in a company that will probably experience significant structural headwinds as a result of increased competition from  Amazon.com (AMZN) and other nontraditional office distributors. 

Still, we would not be surprised to hear that large private equity firms are carrying out preliminary work on this name. Staples continues to generate a great deal of free cash flow (roughly $1.2 billion in 2011), and acquirers could be enticed by the potential to expand the delivery business, which has historically benefited from a large network of fairly sticky middle-market customers, while redirecting capital away from low-return investments such as the struggling international operations. Assuming $8 billion-$9 billion in debt is issued (approximately 4 times fiscal 2011 EBITDA), low-single-digit top-line growth and operating margins stabilize around 6% over the next decade (more aggressive assumptions than we've committed to in our base-case assumptions), an internal rate of return in the high teens for private equity suitors, and an enterprise/EBITDA exit multiple of 6 times, we arrive at a theoretical leveraged buyout takeover price around $17 per share.

However, this rumor does not change our negative long-term outlook on office supply distribution. We have lowered our fair value estimate for Staples to $11 per share (which values the firm as a stand-alone entity using a long-term discounted cash flow analysis) to incorporate more pessimistic assumptions regarding the defensibility of Staples' economic returns in North America. The crux of our valuation assumptions are driven by Staples' lack of an economic moat, the result of operating in a commodified category like office supplies where customers (including Staples' profitable middle-market delivery customers) tend to gravitate to the low-cost producer. While Staples historically enjoyed a significant cost advantage over direct rivals  OfficeMax and  Office Depot (ODP), we believe its primary competitors in the future will be nontraditional office distributors like Amazon and  Costco (COST), which benefit from the same scale advantages and are willing to consistently undercut Staples' prices in order to maintain their image among consumers as the low-cost provider. If our prediction holds true, the return on invested capital implications for Staples' North American operations (currently in the high teens) would be quite severe.

Given uncertainty over timing and pace of competitive headwinds as well as potential volatility surrounding a possible private equity takeover, we have raised our fair value uncertainty rating. If Staples could preserve its current returns on capital for the next five years, the shares would be quite cheap, in our view, but investors should approach this viewpoint with a high degree of caution. Similar to the developments in the consumer electronics and book retail categories, price competition and the subsequent margin contraction accelerated very rapidly after a long period of relative stability because of aggressive moves initiated by various competing players. Similarly, we are concerned that Staples' outlook depends largely on how aggressively Amazon and other nontraditional office distributors decide to pursue the market. In our opinion, aggressive pricing is an effective way to gain share in this market, which creates a fragile pricing environment and opens opportunistic windows for entrants that can be content with lower margins. As a result, performance could very easily deteriorate faster than investor expectations.

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