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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Friday, August 10, 2007

Office Depot Looks Cheap Relative to Peers

Office Depot Corporation (NYSE: ODP) has dropped to around $23 from a 2007 high of nearly $40. Analysts have been cutting back their earnings estimates amid worries of a softening economy as well as management announcing a reduction in planned new store openings. Pessimism surrounding ODP and the outlook for the retail sector presents a buying opportunity for Office Depot shares with significant upside potential.

According to Zacks, Office Depot is trading at about 11x ’07 EPS estimates of $2.07, and less than 10x ’08 EPS estimates of $2.37. Annual EPS growth for the next five years is expected to be 13.9% resulting in an attractive PEG ratio of .7. Average EPS growth for the past 5 years has been 19%.

On a relative basis, Staples (SPLS) and OfficeMax (OMX) both trade at approx 13x ’08 EPS and have PEG ratios of about 1.0. The S&P 500’s forward P/E multiple is currently 15.

Boosting Profit margins is management’s primary focus and they have been showing signs of success. Operating margins doubled from 2.4% (2005) to 4.8% (2006). ODP trimmed their projections for new stores from 150 to 125 in 2007 and 200 down to 150 in 2008 citing less operating visibility going forward. I believe this was a major factor behind downward revisions to EPS estimates.

There are a couple factors that should help support Office Depot’s earnings. I think that the strong focus on cost-cutting measures will continue to lift margins and boost earnings. Additionally, with the stock trading at such low multiples, management will be more inclined to boost share buy-backs. Since budgeted capital expenditures have decreased due to fewer store additions, management will have more cash to repurchase shares aggressively.

The domestic office products market is an estimated $320 billion of which ODP, SPLS, and OMX make up 10%. Thus, there is still abundant room for growth and industry consolidation. The industry is highly competitive but Office Depot is well entrenched and has a strong brand. ODP has plenty of room to expand internationally.

Office Depot is trading at too low of a multiple. If ODP were to trade at a multiple similar to it’s peers of 13x the stock should fetch more that $30 or 30% higher than current value. Taking next this years expected EPS and discounting by 9.5% minus a 3% normal growth rate would produce a value of $31.50. That is essentially the same as applying a 15 multiple equivalent to the overall market. My discounted cash flow models also confirm a fair value north of $30. There is significant evidence that ODP is worth more than what the current market perceives.


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