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.