Not the Time for Office Depot

So that brings me to the financial nitty gritty. Is the valuation cheap enough to merit a long-term investment, or is it still time to stay away from a falling knife? Although net income is still up year-to-date, cash from operations is down -- and that dichotomy is often a warning sign.

The difference has been working-capital investments. Inventory on hand has crept up to 54 days from 52 last year, but receivables are down a bit. It looks as though the timing of tax payments was the main culprit, and that makes me a little less concerned about the decline.

Even in the face of the downturn, the company has generated $636 million in cash from operations over the last 12 months. The pressure is expected to continue into the third quarter but should start to ease next year, if only because the comparisons will be easier. It used up nearly $450 million on capital expenditures and is expected to continue spending about $500 million annually -- mostly on store openings and remodels.

Of that $500 million, I estimate that about $200 million is going to new stores, and the rest toward required maintenance. Since the new stores are presumably expected to boost future cash flows, the "no-growth" free cash flow stands at about $325 million per year, a 5.8% free-cash-flow yield on the current enterprise value. It doesn't take much growth from there to get to an enticing total return.

What's more, if this worst-case scenario does unfold, the company has shown that it has the discipline to act on it. Office Depot has already reduced planned store openings to 100 this year (from an initial plan of 150) and 125-150 next year (from initial plans of 200).

Office Depot has also been buying back shares (although in retrospect, the company was paying too much for them). The share count is down nearly 6% from one year ago, and further buybacks will help soften the EPS blow during the downturn, as well as provide leverage to the recovery.

All that said, an investment in Office Depot will require patience and possibly a strong stomach, as things are likely to get worse before they get better. It looks like a stock that will pay off in the end, but there are probably some names that will pay off sooner.

---

At the time of publication, Trent had no positions in the stocks mentioned, although positions may change at any time.

William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback; click here to send him an email.