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Why Shares of Office Depot Have a Favorable Risk/Reward Profile

Stocks in this article: ODP SPLS

NEW YORK (TheStreet) -- On the surface, Office Depot’s (ODP - Get Report) second quarter net loss of $190 million, or 36 cents per share, looks worse than it is. After adjusting for special charges, the company’s net loss was just 2 cents per share -- in line with analysts' estimates. Further, revenue matched expectations of approximately $3.81 billion.

The majority of these special charges include $103 million in merger-related expenses and $80 million in legal accruals related to a potential settlement arising from a 2009 lawsuit filed in California state court. These merger-related costs should come as no surprise to investors and analysts as the company expects to realize approximately $300 million in these costs for all of 2014.

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Halfway through the year, Office Depot has reported total merger-related expenses of $204 million. Therefore, it is estimated that these costs should start to taper off in the second half. Since total costs are expected to be around $400 million when all is said and done, that leaves two years to capture this last $100 million in expenses.

In its earnings announcement, management raised its operating income forecast for the full year from at least $160 million to at least $200 million. This upgraded outlook was aided primarily by an increase in the expected synergies the company expects to realize from the nearly 400 store closures planned by the end of 2016.

Although Office Depot reported year-over-year improvement in operating income on a pro-forma basis, adjusted sales came in lower in each of the company’s reporting segments. While Office Depot has been known to suffer from seasonality during this period as the second quarter is usually the company’s weakest before the back-to-school season begins, the underlying trend in sales has been consistent.

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Over the years –- and continuing in the second quarter -– both the North American Retail Division and the International Division accounted for a smaller percentage of the company’s overall revenue. At the same time, the North American Solutions Division has grown its percentage of total sales. For example, back in 2011, the Retail Division, Business Solutions Division, and International Division accounted for approximately 42%, 28%, and 29% of total sales. In the second quarter of 2014, these percentages had shifted to 38%, 39%, and 22%, respectively.

While the Retail Division has experienced consistent same store sales declines as a result of lower customer traffic and a decrease in technology sales –- as consumers have continued to transition from laptops and PCs to lower-priced tablets -– the International Division suffered primarily from competitive pressures and soft economic conditions in Europe. The Business Solutions Division, however, continued to grow -– helped primarily by online sales, growing education accounts, and increased state and local government contracts.

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