SPLS reported its Q2 results this morning. The overall business trends are still disappointing, especially in the traditional brick-and-mortar retail business. Management is in a race against time, trying to close stores at minimal cost to prevent further cash flow bleed and stem the ongoing losses from reduced store traffic (4% decline year-over-year) as sales continue to migrate online and overall paper consumption continues to decline.
Expectations for the quarter were very low (reflected in the stock’s valuation near book value, which was the main part of our thesis). The North American commercial business grew 3% and the online business grew 8%, offsetting some of the weakness in traditional retail. However, management recognizes the importance of resizing the retail chain to reflect reduced demand, as noted in the press release:
“We’re accelerating growth in our delivery businesses as customers turn to Staples for more products beyond office supplies,” said Ron Sargent, Staples’ chairman and chief executive officer. “At the same time, we have more work to do to stabilize our retail business, and we’re taking action to improve customer traffic, reduce expenses and close underperforming stores.”
Management is clearly still in restructuring mode. Executives noted on the call that the office supply market remains in overcapacity, suggesting possibly deeper cuts in the retail business. They are focusing on growing online, with increasing investments and management hires.
We initiated a new position in SPLS in late June, with the following rationale:
The cheap valuation in SPLS combined with a kitchen sink type of quarter in May has led to a low expectation situation with limited potential downside given the overall business prospects and diversification (especially online) at Staples. While the environment is still poor, the stock may offer a nice turnaround opportunity before the business actually improves. Short interest is still around 15% and the stock is down nearly 30% on the year, so we know where sentiment stands.Meanwhile, options prices are quite cheap relative to history, with implied volatility near multiyear lows, along with the rest of the market.TRADE: SPLS ($11.23) Bought Jan15 12 Call for $0.59
While it’s a tough situation, there are some reasons for optimism. I entered the SPLS long call position in late June for 3 main fundamental reasons:
1) Valuation on a price/book basis was near an all-time low, at around 1.2x book, comparable to other distressed peers even though SPLS is in a better financial and business position
2) SPLS has limited debt (due in 2018 and 2023) and positive free cash flow despite the declining sales over the past 3 years, in sharp contrast to most other distressed retailers
3) The business comprises the commercial and online segments as well as the legacy retail business, giving Staples some “outs” as it tries to stabilize the decline in traditional retail.
Technically, SPLS had held above its mid-2012 low of $10.57, so that was the thought behind the timing on the entry in late June. In addition, the bad May earnings report reset expectations significantly lower, so that today’s weak guidance does not elicit quite the same negative reaction (though the stock is still red this morning).
None of this guarantees that SPLS is going higher over the next 4 months, but it does at least suggest that the risk/reward is skewed in my favor, especially since the call options were relatively cheap for a distressed stock. The main risk in my view is that SPLS remains close to unchanged in the coming months, leading to the loss in the time value of my Jan15 12 call options.
At the moment, SPLS is trading down about 3%, around $11.30, close to the price where I initially bought the Jan15 12 calls for $0.59. The calls are currently indicated $0.40 bid / $0.50 offer. Given that the positives I noted above are still in place, I am going to continue to hold my Jan15 12 calls. After management’s indication that the restructuring might take longer than expected, I might be quicker on the exit on a move above $12 in the coming months.