The office supply business has sustained more than its share of paper cuts this past year.
Despite healthy consumer spending, analysts agree the $200 billion industry is oversaturated. The three big players in the market — Office Depot, Inc. (NYSE: ODP), Staples, Inc. (Nasdaq: SPLS) and OfficeMax, Inc. (NYSE: OMX) — have suffered from competition on all fronts. Retail giants such as Wal-Mart Stores, Inc. (NYSE: WMT) and Costco Wholesale Corp. (Nasdaq: COST) push low-priced pencils and legal pads, while Best Buy Co., Inc. (NYSE: BBY) and Circuit City Group (NYSE: CC) entice consumers with inexpensive modems and computers.
Intensifying price pressures have further depressed margins, which have already been squeezed by aggressive expansion campaigns. Add to that pressures from the Internet, and it’s little wonder that office supplier stock prices have tumbled by as much as two-thirds since spring.
“The industry is struggling with overcapacity and with an increasingly competitive landscape,” said David Strasser, vice president of equity research at Salomon Smith Barney in New York. “I still think it’s an open question as to who will come out on top.”
Given the chaos and questions, analysts say this might be just the time for investors to sharpen their pencils and take a new look at the industry.
“These are stocks that should be on the radar screen for the value investors out there,” said Jeff Stinson, an equity research analyst with Midwest Research in Cleveland. “Store saturation is a big concern, and that is something that will need to be addressed before investors can become comfortable with the sector.”
Analysts agree that the top three office retailers, which accounted for $24 billion in sales last year, or roughly 13 percent of the entire industry, have built too many North American stores. Between OfficeMax, Office Depot and Staples, the number is 3,000 — and growing.
Retail analyst Danielle Fox with J.P. Morgan Securities in New York said that growth is slowing, though. She feels 2001 will be a “critical year” from a growth perspective.
“We’re in the eighth or ninth inning in terms of rollout potential,” Fox explained. “What this industry really needs is for there to be [store] closings. The growth across all three companies is slowing, and the saturation point may be moving closer.”
That saturation point typically ripens the environment for mergers and consolidation, but it’s unlikely that federal regulators will allow any of the top players to swallow one another. Strasser points out that the Federal Trade Commission nixed such a merger in 1995, further cramping potential consolidation strategies.
“This is an industry that would be more attractive to investors if you only had two players,” Stinson said.
He said that the Internet has not had a cannibalizing effect on retail sales at this point. All three players have a Web presence, which Stinson called a “logical extension” of their current business plans. The absence of a pure-play Internet site means that Web sales, which were $1.3 billion last year, belong to the Big 3.
“The purchasing power that they have excludes someone else from coming into the Internet and taking market share,” he said.
Too much uncertainty about future prospects leaves analysts a little cool on office supply stocks. J.P. Morgan’s Fox said that pricing pressures, domestic market saturation and an increasingly competitive market “don’t add up to healthy industry dynamics.”
“You have return on capital coming under pressure from all three companies,” she said.
Salomon Smith Barney’s Strasser rates Office Depot, Staples and OfficeMax as neutral, and was hard-pressed to name the top retailer among the three.
Stinson also rated all three stocks as neutral, though he said that Staples and Office Depot had better business models than OfficeMax.
OfficeMax, which posted $4.8 billion in sales last year, is the smallest of the three, with more than 946 superstores in 370 markets in the United States, Puerto Rico and the U.S. Virgin Islands. The stock hit a 52-week low of $2 in early October and had rebounded slightly by mid-Novmber, but was still down substantially from its 52-week high of $7.63 in February.
The company faces a spate of shareholder lawsuits over alleged misrepresentations by OfficeMax management. Investors charge that OfficeMax executives made fraudulent performance claims that artificially inflated the company’s stock.
OfficeMax is also launching a new distribution network, installing a new management information system and introducing a Gateway computer store-within-a-store model — and that makes for a more-than-full plate, according to Midwest Research’s Stinson. The company recently announced that the second half of 2000 would see lower-than-expected results.
Glenn Curtis, an equity analyst at WorldlyInvestor.com, called OfficeMax a “solid company” despite its earnings surprise to Wall Street.
“You want to get back into these stocks when it seems like all the bad news has been factored in,” Curtis said. “OfficeMax has time after time disappointed, and I think it will be tied up with its shareholders for some time.”
He’s more bullish on OfficeDepot, the industry leader that operates more than 829 stores across the United States and Canada. It posted sales of about $10 billion last year. Its stock has dropped from a 52-week high of $14.88 in February to about $7 per share earlier this month.
“Office Depot is one of those cheap stocks it’s hard to ignore right now,” Curtis said. “I consider it a buy. It’s a value play that’s hard to ignore. It’s turning out earnings, unlike other high-tech companies.”
Stinson called Staples the “best player” in the industry right now. The Massachusetts-based company operates more than 1,000 retail stores and continues to open more. Stinson said Staples plans to open 150 new stores next year, compared with fewer than 50 by OfficeMax.
Staples posted sales of $8.9 billion last year, putting it solidly in second place. The company has a track record for meeting or beating analyst expectations. Its stock was trading at a 52-week high of $28.75 in January, but was trading at about $12 per share in mid-November.
“Staples is clearly the most consistent performer of the three, but they’re not immune to some of the trends in the industry,” Stinson said.
