Excerpted from Whitney Tilson’s email to investors

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Whitney TilsonPer my recent email, I’ve been finding it exceedingly difficult to find any stocks to buy, but I did find one recently and established a position in Staples (SPLS). I’m not pounding the table on it, but there’s a decent upside/downside equation I think in light of its low valuation (0.3x sales, <5x EBITDA) and a business that’s declining more slowly than I would have expected. As this chart shows, after a sharp decline from 2012-14, both revenue and operating income has nearly stabilized:

Below is a good write-up of it from ValueInvestorsClub.com (an excellent web site that I’ve been a member of for 15+ years). Here’s the opening:

 

On April 4th, the WSJ disclosed SPLS is in early stage talks with private equity firms to explore a sale of the company.  I believe there is a strong likelihood (75%) that the talks will lead to a deal as private equity takes advantage of the public markets’ misperception and mispricing of SPLS as a secularly challenged retailer.  In the event these early talks do not lead to a deal, the intrinsic value of the company supports 10% or less downside in the shares.

 

It has been a tumultuous and transformative past 12 months for Staples.  The ODP merger was blocked on antitrust grounds, fifteen months after signing.  SPLS’ CEO since 2002 stepped down and left the board.  A new CEO with 25 years of experience at the company (after 5 years at Bain Consulting) took the helm and wasted no time leaving her mark:  SPLS exited its unprofitable European operations, announced a $300mm 3-year cost-savings program (already achieved $100mm, beating $70mm guidance with “visibility” into another $100mm in 2017), began transitioning the small/mid B2B delivery business to a paid-membership model, and in Q4 2016 reclassified their operating segments by stripping all delivery business (staples.com) out of the retail segment and into their North American B2B segment.

 

The new segment disclosure shows SPLS generates 63% of segment EBITDA from its larger, growing N. American delivery business and only 37% of EBITDA from its smaller, shrinking retail business.  Combined segment EBITDA is unchanged for three years while the quality of the EBITDA improves as the mix shifts toward the contract and delivery business.  NA delivery business sales have been unchanged largely due to an underlying mix shift of its own:  sales of ink/paper/printers are in secular decline while SPLS has been growing “BOSS” (beyond office supplies) categories high single digit / low double digit percentage each quarter.

 

2) Following up on my last email, here’s a link to video of the forum last week featuring two of the greatest businessmen in the world today (and both among the people I most admire and respect), Warren Buffett and Jorge Paulo Lemann: www.youtube.com/watch?v=Co3GFCqQInw (63 min)

 

3) Speaking of Buffett, here’s some interesting history:

In the mid-1960s, the man who would become the most successful investor of all time dipped his toe into advertising. Berkshire Hathaway acquired major positions in two agencies, McCann-Erickson and Ogilvy & Mather. As Warren Buffett explained his strategy: “I like royalty-based businesses.” At that time, ad agencies were still compensated by commissions on media purchases.

4) An interesting article showing why it’s so hard for active managers to beat the indices:

The effect Heaton is referring to is the subject of a five-page paper he published in 2015 with colleagues Nicholas Polson and Jan Hendrik Witte; Hendrik Bessembinder of Arizona State University recently expanded their findings. In short: The distribution of returns in the stock market is bizarrely lopsided. Often, equity benchmarks are so reliant on gigantic gains in just a handful of stocks that missing them—as most managers do—consigns the majority to futility. “Your intuition is that you can randomly pick stocks and start at zero,” Heaton says. “But the empirical fact is if you randomly pick, you are starting behind zero.”

What Heaton and his colleagues didn’t realize when trying to solve the riddle of chronic underperformance is that someone already had done it, for the most part, in a 1998 study, “Why Active Managers Underperform the S&P 500: The Impact of Size and Skewness,” published in the inaugural issue of the Journal of Private Portfolio Management. One of the original authors of the study is Richard Shockley, an associate professor of finance at Indiana University. At the time of publication, Shockley and his colleagues were investigating their observation that the drag from manager fees and the cost of managing a portfolio didn’t explain the degree of consistent underperformance by mutual funds to their benchmarks. The culprit as they saw it: the concept known as positive skew.

The implication, like it or not, is that a concentration of outsize gains in a minority of index members is tantamount to a death sentence for anyone who gets paid for beating a benchmark. It’s a pattern of returns that virtually ensures everyone outside of an indexer owns mostly deadbeat stocks. “It gets very little attention,” says Rob Arnott, the Research Affiliates co-founder and smart-beta pioneer who’s no stranger to pontificating in the academic realm. “The focus is often on the random walk and the coin toss analogy, and the impact of skewness is overlooked.”

5) Krugman with some very interesting statistics and arguments:

Why does public discussion of job loss focus so intensely on mining and manufacturing, while virtually ignoring the big declines in some service sectors?

Over the weekend The Times Magazine published a photographic essay on the decline of traditional retailers in the face of internet competition. The pictures, contrasting “zombie malls” largely emptied of tenants with giant warehouses holding inventory for online sellers, were striking. The economic reality is pretty striking too.

Consider what has happened to department stores. Even as Mr. Trump was boasting about saving a few hundred jobs in manufacturing here and there, Macy’s announced plans to close 68 stores and lay off 10,000 workers. Sears, another iconic institution, has expressed “substantial doubt” about its ability to stay in business.

Overall, department stores employ a third fewer people now than they did in 2001. That’s half a million traditional jobs gone — about eighteen times as many jobs as were lost in coal mining over the same period.

And retailing isn’t the only service industry that has been hit hard by changing technology. Another prime example is newspaper publishing, where employment has declined by 270,000, almost two-thirds of the work force, since 2000.

So why aren’t promises to save service jobs as much a staple of political posturing as promises to save mining and manufacturing jobs?

6) A fascinating and troubling article and great piece of journalism. But of course Trump would shut down OSHA if given the opportunity…Sad! Inside Alabama’s Auto Jobs Boom: Cheap Wages, Little Training, Crushed Limbs, www.bloomberg.com/news/features/2017-03-23/inside-alabama-s-auto-jobs-boom-cheap-wages-little-training-crushed-limbs. Excerpt:

 

Alabama has been trying on the nickname “New Detroit.” Its burgeoning auto parts industry employs 26,000 workers, who last year earned $1.3 billion in wages. Georgia and Mississippi have similar, though smaller, auto parts sectors. This factory growth, after the long, painful demise of the region’s textile industry, would seem to be just the kind of manufacturing renaissance President Donald Trump and his supporters are looking for.

 

Except that it also epitomizes the global economy’s race to the bottom. Parts suppliers in the American South compete for low-margin orders against suppliers in Mexico and Asia. They promise delivery schedules they can’t possibly meet and face ruinous penalties if they fall short. Employees work ungodly hours, six or seven days a week, for months on end. Pay is low, turnover is high, training is scant, and safety is an afterthought, usually after someone is badly hurt. Many of the same woes that typify work conditions at contract manufacturers across Asia now bedevil parts plants in the South.

 

… The pressure inside parts plants is wreaking a different American carnage than the one Trump conjured up at his inauguration. OSHA records obtained by Bloomberg document burning flesh, crushed limbs, dismembered body parts, and a flailing fall into a vat of acid. The files read like Upton Sinclair, or even Dickens.

 

7) A good Q&A on Brexit (below):

  1. Didn’t Brexit already happen?

No. The June 2016 referendum, in which 52 percent of British voters chose to leave the European Union, was just the start of a lengthy proceeding. If May has her way, the actual split will occur around April 2019. Its contours are about to be negotiated.

  1. What does Brexit actually mean?

Britain is exiting the 28-country EU bloc, which it joined in 1973. Initially envisaged as a free-trade zone that now includes 500 million consumers, the EU is, in the eyes of many Britons, too bureaucratic, out of touch, expensive and an obstacle to clamping down on immigration. Free movement of citizens is a basic tenet of EU law.

Read more: Why Britain Is Saying ‘Adieu’ to the European Union

8) A very interesting article on Netflix:

Tara Flynn, a rising star at a TV production unit of 21st Century Fox, walked into her boss’s office last August and told him she was quitting and joining streaming-video giant Netflix Inc.

The news was not well-received.

“Netflix is public enemy No. 1,” said Bert Salke, the head of Fox 21 Television Studios, where Ms. Flynn was a vice president, according to a Netflix legal filing.

When Netflix finalized Ms. Flynn’s hire a few weeks later, Fox sued, accusing it of a “brazen campaign” to poach Fox executives. In response, Netflix argued Fox’s contracts are “unlawful and unenforceable.”

The ongoing legal battle is just one sign of the escalating tensions between Netflix and Hollywood as the streaming-video company moves from being an upstart dabbling in original programming to a big-spending entertainment powerhouse that will produce more than 70 shows this year.

It is expanding into new genres such as children’s fare, reality TV and stand-up comedy specials—including a $40 million deal for two shows by Chris Rock. The shift has unnerved some TV networks that had become used to Netflix’s original content being focused on scripted dramas and sitcoms.

Netflix’s spending on original and acquired programming this year is expected to be more than $6 billion, up from $5 billion last year, more than double what Time Warner Inc.’s HBO spends and five times as much as 21st Century Fox’s FX or CBS Corp.’s Showtime. It spent close to $10 million an episode on “The Crown,” a lavish period drama about a young Queen Elizabeth II.

Its shock-and-awe spending—combined with that of Amazon and other new players—is driving up costs industrywide and creating a scarcity of people and equipment.

“You just can’t compete with someone coming in with fresh money, low overhead and a lot less baggage than you,” said Darrell Miller, an entertainment lawyer at Fox Rothschild LLP. One veteran television executive likened Netflix’s onslaught to Genghis Khan’s.

9) I just finished reading (listening to) Dueling with Kings: High Stakes, Killer Sharks, and the Get-Rich Promise of Daily Fantasy Sports, which is a rollicking good tale with quite a few lessons for investors.

 

——————-

Staples SPLS

April 10, 2017 – 11:58pm EST by pfq783

2017   2018

Price:              9.70                EPS                 .89       0

Shares Out. (in M):               653                 P/E                 10.9    0

Market Cap (in M):               6,334              P/FCF             9.9       0

Net Debt (in M):                    0                      EBIT                895     0

TEV:                6,334              TEV/EBIT                   7.1       0

 

Description

 

On April 4th, the WSJ disclosed SPLS is in early stage talks with private equity firms to explore a sale of the company.  I believe there is a strong likelihood (75%) that the talks will lead to a deal as private equity takes advantage of the public markets’ misperception and mispricing of SPLS as a secularly challenged retailer.  In the event these early talks do not lead to a deal, the intrinsic value of the company supports 10% or less downside in the shares.

 

It has been a tumultuous and transformative past 12 months for Staples.  The ODP merger was blocked on antitrust grounds, fifteen months after signing.  SPLS’ CEO since 2002 stepped down and left the board.  A new CEO with 25 years of experience at the company (after 5 years at Bain Consulting) took the helm and wasted no time leaving her mark:  SPLS exited its unprofitable European operations, announced a $300mm 3-year cost-savings program (already achieved $100mm, beating $70mm guidance with “visibility” into another $100mm in 2017), began transitioning the small/mid B2B delivery business to a paid-membership model, and in Q4 2016 reclassified their operating segments by stripping all delivery business (staples.com) out of the retail segment and into their North American B2B segment.

 

The new segment disclosure shows SPLS generates 63% of segment EBITDA from its larger, growing N. American delivery business and only 37% of EBITDA from its smaller, shrinking retail business.  Combined segment EBITDA is unchanged for three years while the quality of the EBITDA improves as the mix shifts toward the contract and delivery business.  NA delivery business sales have been unchanged largely due to an underlying mix shift of its own:  sales of ink/paper/printers are in secular decline while SPLS has been growing “BOSS” (beyond office supplies) categories high single digit / low double digit percentage each quarter.

 

2014   2015   2016

 

  1. American Delivery sales                          10,664            10,731            10,636
  2. American Retail sales                             8,055  7,169  6,662

Other (various foreign locales)                  965     864     949

Total sales                                         19,684            18,764            18,247

% NA delivery                                  57%    60%    61%

% NA retail                           43%    40%    39%

 

EBITDA

NA Delivery                                       768     806     861

NA retail                                                        616     562     495

Other                                                 -2        12       10

Total biz unit EBITDA                                  1,382  1,380  1,366

% NA delivery                                  55%    59%    63%

% NA retail                           45%    41%    37%

 

Unallocated expense (stk comp, SERP)                 -64      -49      -73

 

New reclassified segments

NA delivery EBITDA margin                                   7.2%   7.5%   8.1%

NA retail EBITDA margin                            7.6%   7.8%   7.4%

 

Old segments

NA stores and online EBITDA margin                    6.7%   6.8%   Not avail.

NA commercial EBITDA margin                              8.6%   8.9%   Not avail.

 

A timeline of the past 2.5 years of distractions suggests the above operating results are probably under-achieving:

 

–                    Dec 2014, Starboard builds a 6% stake and goes activist, pushing for ODP merger.

–                    Feb 2015, SPLS/ODP merge.

–                    May 2016, deal blocked on antitrust grounds related to the office contract/supply business.

–                    May 2016, explores sale of unprofitable European operations

–                    June 2016, CEO since 2002 resigns.  Leaving board Jan 2017.  Interim CEO worked at SPLS since 1992; previously Bain.

–                    Sept 2016, interim CEO gets the job.

–                    Nov 2016, sells UK business to Hilco for $1.

–                    Dec 2016, sells European business to Cerberus for $50mm.

–                    March 2017, re-classifies operating segments.  Retail segment is now pure B&M.  Staples.com folded into NA Commercial.

–                    March 2017, sells Australia and NZ business to Platinum Equity.

 

SPLS trades today at a 10.1% free cash flow yield with no net debt despite the stability of the business, its market leadership, and its scale advantage.  The stock yields 5% with the dividend more than covered by the NA delivery alone.

 

Stock price     $9.70

Shares out      653

Market cap     6,330

Cash               1,015    Q4 balance, adjusted for euro ops sale, no credit for Q1 cash gen

Debt               1,048

EV                  6,363

 

LTM EBITDA  1,289

EV/EBITDA    4.9

 

EBITDA                      1,289    LTM, $63mm stk comp not excluded, no credit for restructuring program

Cash int income         10         $1B+ cash balance

Cash int expense       -36        Cash interest on bonds

Capex            -300      $255mm LTM, $380mm in prior year.  No mgmt guidance

Tax                 -323      33.5% non-GAAP effective tax rate, per mgmt guidance

Calculated FCF           640

% to equity    10.1%

% to EV                     10.1%

 

LTM FCF                    879       adjusted for after-tax ODP term fee and expenses but not $22mm litigation pmt

FCF yield                   13.9%          ^ Not adjusted for $102mm paid restructuring accruals [$56mm accrual remains at               YE 2016]

^^ Working capital benefit and deferred capex, per mgmt

 

On a recent conference call, SPLS unveiled an intriguing data point:  2/3rds of new mid-market (10 – 200 employees) customers are signing up for their $299 / year Premier membership package.  As AMZN/COST know, paying membership customers like to shop with you to get a “return” on their investment.  And they are relatively sticky.

 

These are the early results for total paid memberships, starting with Q1 2016:  21k, 26k, 38k, 61k.  Half are mid-market customers, half are small business.  SPLS thinks they have 2% penetration of an $80B market serving mid-market customers, which implies 16% of SPLS NA delivery sales today.  SPLS is ramping their sales force by 1000 people over the next 3 years to address the growth opportunity, paired with managing leads from staples.com.

 

It is probably best to explore this growth avenue out of the public market limelight.  The NA delivery business has already expanded EBITDA margins 90 bps on flat sales over 3 years with a distracted management (the segment reclass actually reset NA delivery margins lower… they would have been 9.x% this year in the old presentation).  Further public margin expansion brings to mind the Bezos Axiom: “your margin is my opportunity”.

 

Speaking of Amazon, I doubt they are being contacted as part of the sale process to private equity.  But they are a logical buyer of Staples, who already has purchasing and customer scale.  Perhaps down the road when the retail stores have mostly melted, or in a deal where Amazon buys NA Delivery and spin-merges SPLS retail with ODP.  Another exit could be private equity spinning retail into ODP.  Or IPO’ing the company after investing in paid membership growth.

 

Like all LBOs, the math is highly sensitive to input assumptions on leverage and growth.  One conservative possibility:  $11.50 deal price, with 4 turns of leverage would need a $2.3B equity check.  At 7% average pre-tax cost of debt, $300mm capex, no growth, no lower corporate tax rates, they have levered their equity up to 17% base return with $400mm FCF to de-lever or invest for growth.  I think all of these inputs have room to move much higher in a more realistic deal scenario (including the purchase price).

 

SPLS was trading at $8.70 before the WSJ piece, and I expect it would trade back to those levels without a deal.  As Barron’s observed (http://www.barrons.com/articles/lbo-or-not-staples-stock-looks-very-undervalued-1491413854), SPLS could tap their own balance sheet to create a public LBO with a $4 – 5 special dividend or share repurchase and perhaps it would trade with some optionality on this, but I suspect management will be content to keep their investment grade rating intact while they are a public company.

 

The new CEO has observed the distractions of the public market firsthand (Starboard activism, promoting a failed merger, paying a competitor $250mm, etc.) and I suspect would prefer to keep the financial benefits of a transition to a paid membership model out of the public realm.  I do not know if SPLS looked for buyers or if they received inbound interest, but half of the SPLS board is new and could be receptive to a premium on the last twelve month price history.  Interestingly, SPLS did not execute on a $100mm share repurchase authorization in 2H of 2016, despite the attractive share price, which makes it a bit easier to justify selling the company to private equity.

 

At a 75% chance of an $11.50 deal (trades $11.25) and a 25% chance of $8.70 on a break, I view the stock as 1.6 up / 1 down with the probabilities heavily weighted in our favor.  EV neutral is approximately $10.60 and I think I’m much more likely to be wrong being too conservative (on both the upside and downside estimates) than too aggressive.  I think this tees up to be a fantastic deal for private equity, and the deal price could certaintly come in higher.

 

The main risks are:  corporate tax reform that eliminates interest deduction w/o grandfathering, BAT, a sudden decline in SPLS business, or a big splash by AMZN into the space.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer’s securities.

 

Catalysts

 

–                    Signed deal

 

–                    No deal but share repurchases highly accretive to intrinsic value

 

–                    Growth initiatives gain traction