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Author: howardroark Big red star, 1000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 20226  
Subject: Re: SPLS Date: 5/20/2012 4:47 PM
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Hard not to sympathize with you here, GM. I'm waiting for George Gilder to jump in and remind you that everyone once thought Pluto would always be a planet. This is like that game Taboo where everyone is forced to debate Staples but isn't allowed to mention paper, office supplies, distribution networks, EasyTech, or toner.

Surely we can all agree that the internet is a huge threat to many retailers, (even if some of us have no idea what it means to say that no retailers are competing). In fact, we would have agreed about this back in 1999 while we perused the Borders magazine rack and scanned every other cover article from the likes of Red Herring and Business 2.0 proclaiming as much. You know, back when investors were starting to ask David Simon how many of his malls were licensed for laser tag. The harder questions are who, when, and how bad?

Staples is arguably the world's second biggest online retailer. It generates more profits through its North American delivery business than its 1900 or so NA retail stores. In 2012 it is on pace to generate maybe $900-$950m in mostly fully allocated operating income in this segement. It is at least as much a wholesale distribution business as it is a traditional retail business. More like Sysco or McLane or Tree House foods than Radio Shack. And its showroom and point of interaction in this segment are already largely online. Delivery is about 66 North American distribution centeres, scale, and customer relationships, with maybe a little cost benefit from having a reliable private label brand thrown in.

The general internet threat to retail is worth separating into its two primary components. One is really about digitization; specifically, the digitization of the stuff that a particular retailer sells. This is a terrible threat to manufacturers, but also a threat to retailers who have sunk a lot of capital into brands, systems and locations tailored to a particular product. Barnes and Noble can try to switch space from books to wildly overpriced jigsaw puzzles and Vera Bradley branded diaries, but it's not a great situation to find yourself in. This is different than the more direct threat from online retail competition, the kind offered by Amazon and Netflix and Etoys and Pets.com and Webvan. Many defunct retailers like Borders, Blockbuster and Tower records, were hit by both threats at once.

All of Staples businesses are subject to the first threat. Paper demand is in apparent decline (including at Staples); it would be suprising if it wasn't. Plenty of other stuff, like toner and ink and paper-related accessories and boxed software, are also showing signs of decline that make sense. Staples can try to replace this kind of stuff, but often the replacement products are more commodotized, more competitive and don't offer higher margin private label opportunities: things like mobile phones and tablets. On the other hand, some replacement categories already show genuine promise. In both segments but especially in the delivery business, Staples is having a ton of success with break room and janitorial type supplies: paper towels, coffee, etc. which are not at much risk from digitization. And some are in limbo between promising and at risk, like the managed print services and imitation Geek Squad businesses that have gotten some traction. How acute the declines will be relative to how they affect Staples overall business is a hard question, and why it's so easy to blithely proclaim that Staples is dead or Staples is safe. So far it has been very tame...it might not stay that way for long. I think the RIM analogy is a weak attempt to think deeply about this, and the idea that Staples has a significant chance of being a zero in a couple years seems way, way off to me -- but I guess significant is as significant does. Some obviously inexorable digitzation trends take an awfully long time (landlines??), some retailers successfully operate to create tons of value despite partial digitization (Toys R US), and some don't (Ritz, Musicland), but I can't see how RIM even ranks as a useful analogy here.

Though both businesses are subject to product threat, really only the retail business is facing the second threat...aka the Amazon threat. It's a serious threat. It might accelerate. Of course, unlike many other victims, Staples is actually the online category leader so they will suffer a little less pain for every dollar that switches online than a typical B&M retailer. And they have the most productive stores, so they have some buffer from competitor closures. Still, retail has a chance to get ugly over time, given both threats. But note that Staples' minimum rent commitment in North America in 2016 is less than half of what it is in 2012...giving them some potential room to react aggressively. Whether they will is admittedly a toss up, but there is some reason to hope that Ron Sargent would be objective and economic at the expense of the retail empire if the paper hits the fan.

The Delivery business doesn't really have the Amazon threat. I mean, it does, but it is competing on even ground, give or take sales taxes. Having a new competitor is bad, and having a new competitor named Amazon is worse (though of course they are not new, just maybe focused more on office supplies, but even there they seem to be targeting other supplies like MRO more than office supplies), but this is totally different than internet substitution. As mentioned, the delivery business is already online and actually has some advantages over online competitors with less category scale, helping it to secure huge market share in its distribution business both in the big enterprise (66 of Fortune 100 are customers) and small business market. BTW, 98% of Staples delivery customers already get free shipping, and that's without paying $79 a year.

The problem with Staples is that you don't really get to bet on whether it has a significant chance to be dead in a few years (unless someone in this thread wants to put up some $$). I mean, you can buy the Jan 2014 debt for a 1.5% YTM or sell 2yr CDS for 90bps that implies a ~3% chance of default -- not exactly what I would have in mind (cf. GPS spreads implies 3.8% or BBY spreads implying 13-14% chance of default within two years). Instead, you have to pay 9X earnings for the stock, which could work out pretty badly even if Staples doesn't come anywhere near insta-death by internet over the next few years. There's a lot of room between 8% and zero and between 1900 and zero. I guess I could imagine a world in which the effects of competition and substitution accelerate on the industry (not near RIM-esque rates, though) while Staples stubbornly doubles down enough such that a healthy but still pressured Delivery business isn't enough to float the ship by 2015. But I can imagine the Jets winning the Super Bowl too. Peter Thiel and Marc Andresson can get away with platitudes but I think GM is right that us pikers can do better than vague obsoletion analogies or retail-is-dead theories.
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