Why I Bought Office Depot

As stated in my previous post, I purchased stock in Office Depot (ODP/NYSE) at $15.00 per share last week.

Office Depot is a simple story. If this stock pick works out, the reasons will be simple. If it doesn’t, the reasons are likely to be simple as well.

Office Depot stock is beaten down. The shares traded as high as $41.06 in December 2006. The stock currently goes for less than 1.5 times stated book value, less than 10 times earnings and about one-quarter annual sales. The market capitalization is around $4 billion with almost 273 million shares outstanding. There is no dividend.

The company just announced lousy third quarter results, with the housing bust impacting certain key markets, most prominently California and Florida. And it expects further erosion in the fourth quarter. The fact is that it may be several quarters before Office Depot turns around -- but I’m patient and believe now is the time to establish a position.

Another reason investors are shunning the company is that office products are a mature market. Yet the big three -- Staples, Office Depot and OfficeMax -- account for only approximately 12% of US sales. Office Depot itself is less than 4%. The company has an opportunity to grow market share without the industry expanding, though competition may be fierce.

Steve Odland was named Chairman and CEO in 2005. Before that Office Depot had several different chief executives in a short period of time. He’s credited with realizing significant operational improvements including widespread cost-cutting measures. The management looks to remain intact -- but Odland’s contract is set to expire in March 2008. This isn’t a bet on a CEO, and I haven’t seen anything suggesting another shake-up is in the cards. Yet management stability would be a plus for investors going forward.

Simply stated, I believe Office Depot’s stock price is beaten down due to short-to-intermediate term challenges that the company will eventually overcome to the benefit of shareholders with a long-term horizon.

What could go wrong with this pick? That’s pretty simple as well. Primarily a sustained, worse-than-anticipated economic downturn drastically reducing business expenditures. A ruinous price war breaking out between the big three office suppliers wouldn't be a happy development, either. I think either of those would fit into the short-to-intermediate term problem category, but I could always be wrong.

Of the value investors I follow, Southeastern Asset Management bought more than 5% of Office Depot in the third quarter, and the company is the second-largest holding in their Longleaf Partners Small-Cap Fund (as of 9/30/07). Those facts and two bucks will buy you a Grande coffee at my local Starbucks, but there you go.

As I always say when reporting on stocks I’m buying, be sure and do you own due diligence before jumping in. There are some significant headwinds blowing against this company right now -- how long they continue blowing will be key to how long before the shares turn upward.

Comments

[Amit Chokshi]

Have you fully loaded your the ODP position? Did you leave enough room to average down into it if it goes down more?

[Ron Paulitan]

Terrible, terrible idea. Your explanation is worst. If you are a cigar butt kinda guy, then by all means get a cigar butt company. This is not even close. You can get companies with below book values. Financial without sub-prime mess is trading at less premium than this g-funk.

Just my opinion. I don't mean to sound rude. I am just so disgusted with this pick. I do love your Whirlpool pick though (missed it at $73 though).

[John]

Amit: Well, funny you should ask. ;-) I purchased it to be between 4% and 5% of the portfolio, which is a full position for me. But since it's sinking like a rock, I may buy more. I'll probably wait to seen what the next company report says.

Ron: As long as we can disagree without being disagreeable, no problem.

[Amit Chokshi]

I think ODP will work out fine in a few years, if it goes to $8 or so, who cares, if you're cost basis is around $12-15, in about 3 years this is likely to be around $24-$40, those annualized returns are going to be phenomenal. Lot of retail is looking cheap, basically confirming a recession and the sector may be dead money for a year but when the stocks will emerge well ahead of an economic recovery.

[Scott]

Why ODP not SPLS, pure valuation?

[John]

Scott: I think it's cheaper, but then again, it deserves to be. ;-)

[RandomWalker]

I had a good look at ODP recently and Im not a believer. Their margins are literally wafer thin and it looks like they could have liquidity issues. Its cheap but is there a margin of safety? If it went the Chapter 11 way how much of your capital can you expect to recover - given that the bond holders expected recovery rate is ~30%.

Have you noticed that Southeastern seems to have exited their position in ODP?