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

NEW YORK (TheStreet) -- On the surface, Office Depot’s (ODP) 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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Meanwhile, Office Depot looks to further expand its margins through the aforementioned cost savings from the OfficeMax merger. Already the company has realized some of these benefits in the first and second quarters of 2014, but it should be noted that Office Depot has managed to expand its gross margin in five of the last six years, and is even higher on average over the past decade than its nearest competitor Staples (SPLS) at 29.0% vs. 27.4%.

Ultimately, Office Depot is facing more tailwinds than headwinds as the company is expected to continue to realize the benefits from its merger with OfficeMax, especially heading into the back-to-school season. Further, the company’s significant cash position of $768 million provides a considerable margin of safety as it represents nearly 28% of the company’s current market cap.

At the time of publication the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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TheStreet Ratings team rates OFFICE DEPOT INC as a Hold with a ratings score of C-. TheStreet Ratings Team has this to say about their recommendation:

"We rate OFFICE DEPOT INC (ODP) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, good cash flow from operations and solid stock price performance. However, as a counter to these strengths, we also find weaknesses including unimpressive growth in net income and poor profit margins."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • ODP's very impressive revenue growth greatly exceeded the industry average of 0.5%. Since the same quarter one year prior, revenues leaped by 60.2%. This growth in revenue does not appear to have trickled down to the company's bottom line, displayed by a decline in earnings per share.
  • Net operating cash flow has increased to -$74.00 million or 21.22% when compared to the same quarter last year. The firm also exceeded the industry average cash flow growth rate of -3.20%.
  • Compared to where it was a year ago today, the stock is now trading at a higher level, regardless of the company's weak earnings results. Despite the fact that it has already risen in the past year, there is currently no conclusive evidence that warrants the purchase or sale of this stock.
  • The gross profit margin for OFFICE DEPOT INC is currently lower than what is desirable, coming in at 25.08%. It has decreased from the same quarter the previous year. Along with this, the net profit margin of -2.50% trails that of the industry average.
  • The company, on the basis of change in net income from the same quarter one year ago, has significantly underperformed when compared to that of the S&P 500 and the Specialty Retail industry. The net income has significantly decreased by 1537.9% when compared to the same quarter one year ago, falling from -$6.66 million to -$109.00 million.

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