US economy batters Office Depot


Office Depot suffered a dramatic slump in its share price last month after it announced it was expecting a fall-back in earnings from last year’s revenues.
Shares for the Delray Beach-based company fell as much as ten percent at one stage as the big-box retailer reduced its third and fourth quarter forecasts.
The company blamed the year-on-year dip on reduced spending from small- business customers in response to the US housing slowdown. The revised sales prediction triggered the company’s slide on the stock market.
"Our small-business customers have changed their buying habits as a result of this environment, and traffic remains slower than normal in our retail stores," Depot’s CFO Patricia McKay announced at a Goldman Sachs retail conference in New York at the beginning of last month.
McKay revealed that EPS for the third quarter will likely fall by double-digits. "If small-business spending in the US remains soft in the fourth quarter, it could be affected similarly as in the third quarter," McKay added.
The unexpected warning triggered a sharp response from analysts including Goldman Sachs, William Blair & Co and Credit Suisse, who all cut their earnings estimates. Goldman Sachs also reduced its 12-month price target on the stock by $3.
"The macro[economic] backdrop is no doubt presenting some headwinds, though given ongoing industrial production and GDP growth, we are surprised by the magnitude of spill-over to the office products retail segment," Goldman Sachs analyst Matthew Fassler wrote in a research note to clients. "Office Depot seems to be bearing more than its fair share of the fallout," he said.
At the Goldman Sachs conference, McKay revealed the trading downturn had caused Depot to re-examine its current expansion strategy. She said the retailer had subsequently shaved its plans for new store openings and now expects to open 100 stores by the end of 2007, down from an earlier 150. For 2008, it now expects to open between 125 and 150 stores, down from the 200 originally planned.
The company also said the tough competitive environment during the back-to-school shopping season would likely damage third-quarter operating profit margins in its retail division.
"We have seen a tremendous amount of promotion from Wal-Mart, Target, mass (merchants), drugs, supermarkets and everybody chasing back-to-school," said chairman and CEO Steve Odland.
"So we had to risk losing market share by trying to become more promotional in this quarter."
In July, Odland expressed his frustration that a run of eight straight quarters of double-digit EPS growth had ended.
"We knew we were facing significant headwinds as we entered the second quarter this year, a quarter which also is seasonally our lowest point for sales. While we are frustrated that we weren’t able to grow earnings at the same rate as in the previous two years, we are pleased that in this challenging sales environment we delivered earnings per share consistent with the prior year and were able to invest in our global business for the future.
"In North America we maintained our focus on pursuing only those sales which would yield profitable growth. This approach allowed us to somewhat mitigate the effects of a softening economy in North America while continuing to position ourselves for margin expansion when economic conditions improve. We remain positive on the long-term growth and margin expansion opportunities for Office Depot."
The company blamed weak consumer spending as a main reason for its underperforming retail stores.
But according to analyst Jack Murphy of William Blair & Company, the short-term future continues to looks bleak for Depot.
He commented: "Office Depot can expect soft fundamental results for the remainder of the year due to the macroeconomic conditions cited by the company’s management."
In the fourth quarter of 2006, Office Depot made significant investments in its US retail stores, which are historically more lucrative than its US delivery and international businesses.
However, "the investment yielded disappointing results," said analyst Bradley Thomas of Lehman Brothers, who accordingly lowered his rest-of-the-year earnings’ estimates.
"For longer-term investors, we have confidence in the longer-term outlook for the business and valuation is compelling. But on a shorter horizon we continue to recommend taking a cautious approach to the stock," he wrote.
Thomas, who favours Staples over Office Depot due to faster growth and potential earnings, believes that several macroeconomic factors are currently affecting the industry as a whole.
And Bill Sims, retail hardlines analyst at Citigroup, agrees, adding: "Management indicated that both its North American retail and delivery businesses were suffering from increasing small-business spending weakness and pressure from a softening housing market."
And Depot’s warning was in sharp contract to that of rival Staples. Chief executive Ron Sargent said he had identified market weakness from the tightening housing market in retail consumers but had not seen this on the small-business side.