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- 1. Johns Hopkins University – Carey Student Research Financial Sector, Retailing Industry Nasdaq Staples Inc. Date: 01/30/2015 Current Price: USD17.05 Recommendation: Sell (18.4% downside) Ticker: SPLS Target Price: USD13.45 SPLS:Lighting the way We issue a SELL recommendation on Staples Inc.(SPLS) with a target price of USD 13.45 using the Discounted Free Cash Flow to Firm method. This offers a 21.1% downside from its closing price of USD 17.05 on January 30, 2015. Business Description Co-founded by Leo Kahn and Thomas G. Stemberg in 1986, Staple is a major United States-base office supply chain store with more than 2000 stores in 26 countries. Headquartered in Framingham, Massachusetts, Staples has offices in North America, South America, Europe, Asia, Australia and New Zealand. Company strategies GrowingbeyondOfficeSupplies Since consumers’ needs are shifting away from office supplies in recent years, Staples is rapidly expanding its offering in new areas, including break- room supplies, copy and print, and furniture. Today, approximately half of Staples’ sales are from categories other than office supplies. StabilizingEurope In 2004, Staples has made a progress in increasing profitability by stabling sales and controlling costs in Europe. In addition, Staples improves its online platform to enhance its customer experience. ReducingExpenses Staples achieved more than $250 million gross cost savings in 2014 by challenging the conventional way employees work, increasing productivity, and refining customer service. OfficeDepotAcquisition In early 2015, Staples announced its acquisition of Office Depot. It believes that this acquisition will enable it to better compete with a wide range of competitors in scopes that beyond office supplies. Shareholder Structure Institutional shareholders hold 95.3% of Staples’ stocks, and mutual funds hold 53% of all shares. 1.1% of shares are hold by insiders. In terms of concentration, the
- 2. largest 10 institutional shareholders hold 41.1% of shares, and the largest 50 hold 70.3%. In terms of style, 28.3% of institutional shares is index and 13.8% is GARP. The top three stockholders are: The Vanguard Group, Inc.(7.7%), Fidelity Management & Research Company (5.3%), and State Street Global Advisors (4.7%). Corporate Governance Staples’ board is consists of 11 directors with an average age of 59.4. 10 directors are independent. The separation of CEO and chairman does not exist in Staples, as Ronald Sargent is in charge of both roles. An independent lead director does exist though. All directors are elected annually, and the independence of board is reviewed annually as well. There exist five committees, including an independent audit committee, an independent nominating and corporate governance committee, an independent compensation committee, an executive committee, and an independence finance committee. Shareholders of Staples have the right to act by majority written consent and to call special meetings. The compensation of executives is performance-based, and the company is able to claw-back incentive compensation. Industry Overviewand Competitive Positioning US Economic Performance The United States is the largest national economy in the world, making up 22% of nominal global GDP. As of Q4 2014, the GDP of United States was approximately $17.7 trillion. The United States has the world’s most influential financial market as well as the largest consumer market. In 2013, consumer spending comprises 71% of the economy in US. Beginning in 2009, the US economy gradually recovers from the financial crisis of 2007-08. By February 2015, unemployment has declined from 20% to 5.5%. US retail industry According to the report study conducted by PricewaterhouseCoopers LLP, retail is the largest private employer in US. It provides 42 million jobs, $1.6 trillion of labor income, and $2.6 million to annual GDP. An estimated two-thirds of the U.S. gross domestic product comes from retail consumption. Wal-mart is the undisputed- leader in this industry. Competitive Position IndustryRivalry (High) Even consumer confidence is growing in office supply stores, annual growth is negative (-4.4%) because of the fragmented market and intense competition. The top two players, Office Depot and Staples account for approximately 76.9% of total revenue. Threatof NewEntrants (Medium)
- 3. Since there is no licensing requirement and the capital cost of establishing a new store is minimal, the barrier to entry is limited. Nonetheless, brand awareness and intense competition can deter some potential new entrants. Threatof Substitutes (High) With the changing landscape of high technology, traditional stores of office supply are under the pressure of competing with online stores. In addition, they face fierce competition from external retailers, including supercenters, discount stores, and warehouse clubs. BargainingPower ofBuyers(Medium) Even though customers have little bargaining power individually, collectively they can demand fair prices and high-quality products. BargainingPowerofSuppliers (Medium) There exist many supplies for the retail industry, including Xerox, Apple, International Paper, and Microsoft. Because of the large number of industry players, suppliers, and products, the bargaining power between retailers and suppliers is balanced. Investment Summary I issue a SELL recommendation on Staples (SPLS) with a target price of USD13.45 using the Discounted Cash Flow to Firm Model. This offers a 18.4% downside from its closing price of USD17.05 on January 30, 2015. Along with the ever-changing landscape of the digital market, conventional retailing stores such as Staples have long been under the pressure, as many consumers are shifting away towards online stores. Also, since the initial outlay to establish a new store is not hard to overcome, Staples also faces competition from potential new entrants. Furthermore, even though Staples is one of the industry leaders, its bargaining power with its suppliers is not extremely high due to the diversity of its product and suppliers. http://www.investopedia.com/features/industryhandbook/retail.aspIn addition, Staples announces its takeover of Office Depot in the beginning of 2015. It is reasonable to expect that as the acquirer, Staples’ stock will decline in value. Valuation The discounted free cash flow to firm (DCFF) methods indicates that Staples’ equity value is USD 8614.43 million and the share price is USD 13.45. The base case for this model is based on historical financial statements of 2010 to 2015 and an assumed long-term growth rate of 2%. According to the Crystal Ball analysis, the DCFF model is most sensitive to the following factors: WeightedAverageRateof Capital (-41.9%) The cost of debt is calculated by dividing interest expense by total amount of debt in the recent three years. The cost of equity is calculated by using the Gordon Growth Model. WACC calculated by Gordon Growth Model is 16.67%. There are two reasons that I choose this number as the estimated WACC:
- 4. first, since the dividend growth rate of Staples is fairly stable and predictable, the result yielded by the Gordon Growth Model should be reliable; second, the result given by Gordon Growth Model is between those given by the classic CAPM and tax-adjusted CAPM, which are 9.08% and 18%, respectively. For the CAPM and tax-adjusted CAPM models, the equity beta is 1.48, which is calculated by using the S&P 500 returns and SPLS price returns. Selling,General &AdministrativeExpense (33.4%) The SGA expense is estimated by using historical data from between year 2011 to 2015. The minimum, maximum, and expected value of SGA as a percentage of sales is 18.5%, 21%, and 21.4%, respectively. Since SGA has been fairly stable, it is expected to stay at 21% for the next five years. CostofGoodSold(12%) COGS is estimated by using historical data from between year 2011 to 2015. The minimum, maximum, and expected value of SGA as a percentage of sales is 71.3% 73.1%, and 72.1%, respectively. Since the fluctuation of COGS is small over the past few years, I expect it to remain constant at its historical average, 72.1%, for the next five years. IncomeTax(9%) Income tax has been fluctuating dramatically over the past five years. Without considering the outlier in year 2013 (160.6%), it is estimated that income tax will fluctuate between 33% and 60%, with an expected value of 50% which is close to the value of year 2015. Long-termFCFF GrowthRate (3.5%) There is a big fluctuation in the forecasted FCFF of Staples between year 2011 and 2015 with a negative average value. The projected long-term growth rate FCFF used is 2%. Sales/RevenueGrowth Overthe past fouryears, Staples’ sale growth rate is -2.56%, 5.21%, and -2.68%, respectively. Therefore,for the future five years, the projected sale growth rate will be approximately 3%. -41.9% 33.4% 12.0% 9.0% 3.5% 0.2% -100.0% -50.0% 0.0% 50.0% 100.0% Estimated WACC SGA expense COGS IncomeTax Long-term FCFF growth rate Sales/Revenuegrowth Sensitivity: Estimated Share Value
- 5. Financial Analysis Gross margin and net profit margin tend to stop decreasing and remain constant in the future, as Staples launches its cost reduction strategies. Current Ratio is likely to drop in 2016, as the acquisition of Office Depot takes place, and then gradually improve. Debt-to Equity ratio will decreases in the future because of the tax expenses associated with debt financing. There will not be much fluctuation in asset turnover and return on asset. Return on equity will remain low due to the intense competition retail industry faces.