2023-08-29 14:38:44 ET
Summary
- We had rated ODP a Buy in our previous coverage due to its lean cost structure model, earnings momentum, and improving return to office trends.
- It reported a mixed Q2 with a significant deterioration in its retail division while robust operational performance and lean cost structure model de-escalated bottom line risks.
- We downgrade ODP to neutral given intensifying macro pressures as a result of anticipated increases in unemployment rates and lack of valuation comfort at current levels.
Investment Thesis
In continuation with our coverage of ODP Corporation ( ODP ), we rated ODP as a Buy driven by its lean cost structure model, strong earnings momentum, improving return to office trends and dirt cheap valuation. The stock is up ~18% since the publication back in June compared to almost 0% for the broad indices.
Seeking Alpha
It continued with steady execution amidst a tough macroeconomic backdrop relying on its lean cost structure model delivering a beat on operating margins. Its retail business reported an 8% comp store decline, significantly higher than 2% average decline over 5 years which compelled them to revise its guidance downwards. We believe while the execution has been spot on amidst a tough environment, macro headwinds will continue to intensify and weigh more heavily on ODP given further expectations of rising unemployment. We downgrade it to Neutral post the recent run up in its price.
Mixed Earnings
ODP reported a 6% YoY decline in revenues for Q2 at $1,900 mn compared to consensus expectation at $1,981 mn. Business Solutions division sales were largely flattish as improvement in return to office trends and pricing strategy were largely offset by higher unemployment levels and other macro issues. Its retail division continue to be pressured with sales tumbling 13% (8% comp sales decline) YoY driven by fewer retail stores and lower traffic as a result of a soft consumer demand environment. Office Depot closed 7 retail stores (21 stores closed in Q1) for the quarter ending at 952 stores (vs 1,020 stores last year). Its supply chain business, Veyer, saw continued growth in Q2 with sales from external customers coming in ahead of the plan at $10 mn along with a healthy $3 mn in EBITDA (up from $7 mn revenues and $2 mn in EBITDA in Q1). Its continued traction positions it perfectly well to achieve its long term target of $25 mn in EBITDA by third party customers by FY25. Varis growth slowed as difficulty in tech stacks limited its ability to onboard new customers.
Adjusted EBITDA margin came in largely flat as a decline in revenues were largely offset by an improvement in gross margins as a result of its lean cost structure model. Business Solutions division reported a strong 4.5% Operating margin, up 100 bps and reaching to its pre-pandemic levels. Office depot however reported a 90 bps decline in operating margins to 4% as a result of decline in sales and sticky inflationary costs. It reported an Adj. EPS of $0.99 beating analyst consensus at $0.77 largely due to repurchase of shares as the company repurchased 8.3 mn shares since the launch of its repurchase program in November 2022.
Its balance sheet position continues to remain flexible with a net cash position. It ended with liquidity of $1.1 bn that include $335 mn in cash and undrawn facility of over $800 mn. Total debt outstanding remains just $181 mn providing sufficient headroom for continuing its share repurchase program ($615 mn still available in authorization).
ODP revised its revenue guidance downwards at $8 bn compared to $8.2 bn at the midpoint in the previous quarter (consensus estimates at $8.15 bn) as a result of weakening macro trends within Office Depot. However, it reiterated its EBITDA guidance of $400 - $430 mn continuing to rely on its lean cost structure model while it expects EPS to increase to $5.15 at midpoint from $4.80 previously as a result of continuing stock repurchases.
Valuation
ODP continues to trade relatively cheaply compared to peers at 5.9x Fwd EV/ EBITDA, however, post the run-up, it trades marginally higher than its 5-year average at 5.6x. Additionally, it has a relatively smaller scale and profitability compared to its peers which necessitates a discount. We believe given the weakening outlook and intensifying macro headwinds, even while ODP has shown operational excellence with strong execution, there are potential downside risks to the topline. Post the spike in share price which has not been followed through in earnings, we downgrade our rating to Neutral. We ascribe a target price of $46 at 5.6x EV/ Fwd EBITDA (in line with its historical average).
Risks to Rating
Risks to rating include:
1) Any improvement in the consumer environment which can lead to an improvement in discretionary spending within its retail sector. However, any further deterioration could lead to a significant impact on its already struggling retail segment.
2) Any surprise in unemployment data can significantly impact the overall macro environment and have an outsized impact on ODP's ability to generate sales.
3) ODP had tech stack issues at Varis limiting its ability to onboard customers and it has been loss making with $14 mn in operating losses in Q2 2023. Its continuing inability to ramp up customers as a result of technology issues can significantly hurt margins.
Final Takeaways
ODP has shown significant promise as a result of its lean cost structure model and improving return to office trends. Its store optimization strategy has largely impacted its decline in its Office Depot business, however, an 8% comp store decline is significantly higher, demonstrating the outsized impact of macro headwinds which may not be able to be offset by its robust operational execution. We believe given the company is at the end of its store optimization plan of 800 - 900 stores (current store footprint of ~950), sales uptick in existing stores due to store closures elsewhere may also limit topline growth. We downgrade the ratings to Neutral with target price of $46 post the ~20% jump in share price since our last release.
For further details see:
ODP Corporation: Macro Headwinds Intensify, Downgrade To Neutral