2024-01-16 00:56:00 ET
Summary
- ODP Corporation is a value stock trading at just 4.3x forward EV/EBITDA.
- AREX Capital Management's recent letter argues for spinning off the retail business, divesting Varis, and increasing leverage to buyback shares.
- I view ODP is likely to engage with AREX's proposal to some extent even if it does not embrace all parts of the proposal.
- ODP's aggressive share repurchase program represents an additional positive catalyst.
- I believe ODP is undervalued and am initiating coverage with a buy rating.
The ODP Corporation ( ODP ) is a very cheap stock based on most key metrics. ODP trades at 9x consensus FY 2024 EPS and at a forward EV/ EBITDA multiple of just 4.3x.
While there are many stocks trading at cheap valuations, particularly in the retail sector, ODP stands out as having a number of catalysts that I believe have the potential to send shares higher.
Key catalysts include the recently released open letter from AREX Capital Management, an aggressive share repurchase program, and potential interest from Staples in acquiring ODP's retail business.
Letter From AREX Capital Management
On December 18, 2023, AREX Capital Management issued an open letter to ODP's Board of Directors. In its letter, AREX argued that ODP should spin off its brick-and-mortar retail business into a NewCo and consider divesting all or a part of its Varis business. Furthermore, AREX suggests that ODP should consider increasing its debt levels to fund an additional $875 million of share repurchases.
AREX argues that the fair value for ODP shares under its plan is $75-$81 (if the buybacks are not pursued) and $88 to $98 per share (assuming $875 million of shares are repurchased at $55 per share.) AREX believes that a separation of ODP's business will result in the NewCo trading at ~3x FY 2024 EV/EBITDA while the remaining company will trade at ~6.6x FY 2024 EV/EBITDA. Moreover, AREX suggests the remaining company equity value will be ~$569 million higher than the EV due to cash on the balance sheet, other assets, and proceeds from a complete sale of Varis.
One thing to note is that a significant part of the value creation appears to be coming from the increase in EBITDA due to the Varis sale. AREX estimates combined total FY 2024 EBITDA of $473 million which compares to current consensus estimates of $401 million. Through Q3 2023, Varis has delivered a year-to-date operating loss of $48 million. Thus, I believe a significant driver of the higher EBITDA used in AREX's analysis is related to the removal of losses from Varis.
I am supportive of each part of AREX's proposal and believe even partial adoption would be a positive for the stock. For example, I believe the stock would react positively to the sale of Varis or increasing leverage to pursue an increased repurchase program even if the company does not embrace a spin-off of the brick-and-mortar business, though I am highly supportive of that as well.
Prior to the release of the letter, ODP shares were trading at ~$53 per share and moved higher in the days following the news. However, shares have recently moved lower and are now below where they were trading prior to the release of the letter.
On December 19, 2023, ODP released the below response to the letter:
We thank AREX for its input, as we welcome all shareholders’ views on the Company and the most effective way for it to realize value for our investors. The Board regularly and actively evaluates the Company’s strategic plan - including its approach to capital allocation and any potential alternatives for its businesses - and will continue to do so, informed by, among other things, the views expressed by AREX or other shareholders
Just days before the letter was released, ODP CFO Anthony Scaglione told Seeking Alpha that he believes the retail business should trade at an EV/EBITDA multiple of 3x-4x while the B2B business should trade at a high-single digits multiple. Scaglione also suggested that ODP's current valuation does not make sense given the value of these two businesses. Based on these comments, and the fact the ODP had previously planned to spin off its retail business before abandoning plans due to market conditions , I believe there is a reasonable probability that ODP management will be open to embracing some parts of the AREX plan. Market conditions have clearly improved since ODP abandoned its previous plan as ODP shares have risen by ~71% while the S&P 500 has risen by ~30%.
Moreover, if the company does not embrace AREX's plan I believe it may face a challenge from the activist investor.
While AREX holds just ~1% of ODP shares it also has the support of Greenlight Capital which owns ~4.3% of outstanding shares. Moreover, hedge fund HG Vora is a large owner of the stock with ~8% of outstanding shares. While HG Vora has not commented on the letter, its cooperation agreement with the company recently ended and a partner at HG Vora recently stepped down from the ODP Board of Directors.
If AREX is able to get support from Greenlight and HG Vora (or other large holders), I believe it may be able to successfully mount a board challenge to pressure the company to take action.
Aggressive Share Repurchase Program
Over the past three years, ODP has been an aggressive repurchaser of its own stock. As shown by the chart below, ODP has decreased its share count by ~30% over this time period.
During Q3 2023, ODP repurchased 659,000 shares for $32 million implying an average repurchase price of $48.55 per share. After the end of the quarter, the company repurchased an additional 249,000 shares for $11 million at an average price of $44.18 per share. As of September 30, 2023, $583 million remained under the company's current repurchase authorization. After adjusting for the $11 million repurchased after quarter end ~$572 million remains under the authorization. Based on the current share price, this authorization represents ~30% of the total market cap of the company.
I view this aggressive repurchase program, in terms of size and pace, as a substantial positive. On the Q3 2023 earnings call , ODP CFO Anthony Scaglione added commentary on the repurchase program:
We continue to believe that buying back our stock at these levels is one of the best investments we can make to create additional shareholder value.
Based on this comment and the company's large remaining repurchase authorization, I expect ODP to continue to be aggressive in terms of repurchasing shares over the next few quarters. I believe high level of repurchases should serve as support for the stock moving forward regardless of the outcome of the recently launched activist campaign though further increases in the repurchase program would be a welcomed development.
Staples May Re-Emerge As A Bidder For ODP's Retail Business
Staples, which is owned by the private equity firm Sycamore Partners, has a long history of trying to acquire ODP. In January 2021, Sycamore sought to acquire ODP for more than $2 billion or $40 per share. While ODP rejected that bid, it signed openness to different types of transactions including selling its retail business to Staples or agreeing to a joint venture. ODP and Sycamore engaged in further discussions around a potential deal for Staples to acquire the retail assets of ODP but a deal was not reached.
Given the recent development related to AREX's open letter to the company, I believe that Staples may take another shot at acquiring the retail assets of ODP. I believe such a transaction has the potential to be value-additive for both Staples and ODP due to potential cost synergies and a reduction of competition.
Additional Valuation Perspectives
While I find AREX's low-end valuation argument of $75 reasonable if changes are implemented, I also believe an argument can be made that ODP deserves to trade at that valuation even if it does not implement the proposed changes.
One additional method that can be used to value ODP is a DCF. Using very conservative assumptions, as shown by table below, I find that ODP is worth ~$72 per share. Key assumptions in my analysis include a levered beta of 0.72x, FY 2024 free cash flow of $215 million (which is in line with the company's FY 2023 free cash flow guidance), 0% free cash flow growth for FY 2025-2028, and a -1% terminal free cash flow rate.
At its core, ODP is a mix between a distribution company and retail company. The retail business accounts for ~60% of segment operating income with the distribution business accounting for most of the company's remaining income. Thus, I believe taking a look at both retail comps and distribution comps is helpful to establish a view on fair value for ODP.
As shown by the chart below, ODP is currently trading at a significant discount to other retailers such as Foot Locker ( FL ), DICK'S Sporting Goods ( DKS ), Signet Jewelers ( SIG ), and Petco ( WOOF ). While each of these businesses is somewhat different than ODP I view them as relevant benchmarks given the lack of public comps for ODP. Historically, ODP has traded in line with DKS, FL, and SIG but is now trading at a 1x forward EV/EBITDA discount which I do not view as warranted given similarly muted long-term growth prospects.
Distribution-focused peers such as Global Industrial Company ( GIC ), W.W. Grainger ( GWW ), and Fastenal ( FAST ) trade at substantially higher multiples than ODP. While these businesses have better growth prospects than ODP, I believe it suggests that ODP's distribution business should trade at a somewhat higher multiple than its retail business.
Overall, I believe a conservative comps-based valuation suggests that ODP is worth at least 5.5x EV/EBITDA which implies a share price of ~$65 per share. This level represents the low end of retail peer valuations which i view as conservative given the distribution business should receive a higher valuation.
Risks To Consider
I believe the biggest risk to my bullish view is that ODP faces additional headwinds in its brick-and-mortar retail business. During Q3 2023, same-store sales for the retail business declined by 6% from the same period a year ago while operating profit fell by ~20%. The weakness was driven by cautious consumer spending during the back-to-school season. While I believe the retail environment sales will continue to be challenging in 2024, I expect the company to continue closing underperforming stores which should help to stabilize or even modestly improve margins.
Continued weakness in the retail business may actually serve as a catalyst to encourage management to explore strategic alternatives for that business including a spin-off or potential sale to Staples. That said, if the company decides not to explore strategic alternatives for the retail business, further deterioration of this segment will weigh on the overall financial performance of the company.
Conclusion
ODP is a value stock with catalysts. Based on an intrinsic valuation, I believe the stock is conservatively worth $72 per share.
I believe the recently released letter from AREX Capital Management may result in the company taking actions that would unlock value for shareholders. Even a partial implementation of ideas proposed by AREX is likely to send ODP shares higher. ODP's massive stock repurchase program is another catalyst that I believe can help drive shares higher from current levels.
Given the recent release of AREX's letter, I would not be surprised to see Staples re-emerge as a potential bidder for ODP's retail business. Furthermore, I believe there is a deal to be reached that could be beneficial for both ODP and Staples due to potential synergies.
I am initiating ODP with a buy rating.
For further details see:
ODP: A Value Play With Catalysts