2023-11-03 21:07:47 ET
Summary
- ODP’s revenue has declined consistently at a (3)% rate, as the business transitions from the highly competitive B2C segment to B2B, with the consistent closure of its physical locations.
- We are struggling to see the compelling value proposition its Management is selling in the new iteration of this company. We do not see its growth trajectory changing any time.
- The business is facing headwinds, as remote working and heightened competition limit its value proposition. Even its expansion into new segments appears underwhelming and lacks transformational qualities.
- ODP’s recent performance has been difficult, with minimal margin improvement suggesting it has maximized the majority of the gains deliverable in the near term.
- ODP’s valuation is not sufficiently compelling for the outlook we see. The company is more expensive than its historical average on a FCF yield basis, which we struggle to reconcile.
Investment thesis
Our current investment thesis is:
- Efforts to modernize ODP fall flat in our view, as we struggle to see what has limited its share price decline to only ~20%. The business continues to face the same competitive threats it did when it was primarily focused on B2C, while also having additional headwinds associated with the work-from-home trend.
- We do not see any positives to yield going forward, with margin improvement likely maxed out and other divisions showing limited long-term qualities.
Company description
The ODP Corporation, Inc. ( ODP ) is a leading provider of business services, products, and digital workplace technology solutions. With a rich legacy and a commitment to innovation, ODP serves a diverse customer base ranging from small businesses to large enterprises. Their offerings include office supplies, technology products, business services, and digital solutions, making them a comprehensive partner for businesses' operational needs.
Share price
ODP’s share price performance during the last decade has been disappointing, losing over 20% of its value while the market has generated impressive returns. This is a reflection of changing industry dynamics and increased pressure on its business model.
Financial analysis
Presented above are ODP's financial results.
Revenue & Commercial Factors
ODP’s revenue has declined at a (3)% rate during the last decade, as Management has sought to respond to market trends and transition the business for the future.
Business Model
ODP maintains a substantial retail presence through brick-and-mortar stores and a robust online platform, although is aggressively transitioning from the traditional BAM approach by closing locations and cutting costs. This dual approach has allowed it to reach both traditional customers who prefer in-store shopping and the growing tech-savvy cohort of consumers who prefer online purchases.
This transition has been forced by the revolutionary changes within the market, with consumers increasingly seeking to shop online. This has coincided with the rise of global supply chains, allowing production costs to decline and shipping times to fall. Consumers can now compare hundreds of options and receive their products the next day, reducing the value proposition of an Office Depot location.
ODP has thus transitioned its focus to business-to-business (B2B) sales, offering a wide array of office supplies, technology products, and services tailored to corporate clients. This allows the business to exploit the competitive advantages it still has to drive revenue, namely the ability to support bulk sales, flexibility, optionality, and offer long-term partnerships with dependability.
In addition to its B2B and B2C segments, the company also operates two more divisions, “Veyer”, which provides services to internal customers of the B2B/B2C segments, and “Varis”, which is a B2B procurement platform. Management is bullish on both but we struggle to see the reason. Although Veyer is growing well, it has an OPM of 0.56%. Varis on the other hand has posted Q2’23 revenue of $1m. This leaves the business inherently dependent on its B2B/B2C businesses, at least in the medium term.
Despite its business model transition, both its B2B and B2C segments have struggled with organic growth. Store count is the largest driver but there is an inherent market underperformance, which we attribute to the following factors:
- Digital Transformation Challenges - The widespread adoption of digital communication and document management systems in particular have led to decreased demand for traditional office supplies. This is exaggerated by the desire to be more sustainable with business practices to meet carbon-neutral goals. This means less demand for printing paper, pens, etc.
- Online Retail Competition - The rise of online retail giants, particularly Amazon (AMZN), has intensified competition and essentially eradicated the value proposition of specialist retailers in mass-market goods. These platforms offer vast product selections, competitive pricing, expedited deliveries, and the ability to shop for numerous things concurrently.
- Pandemic Impact - The COVID-19 pandemic accelerated remote work trends, reducing the need for office supplies further. With businesses operating remotely, the demand for certain products will likely remain depressed. This business did see an initial rebound but we suspect a “new normal” is now in place, and will mean greater issues ahead.
Margins
ODP’s margins have incrementally softened during the last decade, although Management has looked to stem the bleeding somewhat through operational streamlining. GPM is currently 3ppts below its peak levels while S&A spending as a % of revenue is at a low of 18% (-5ppts since FY13).
Although we are supportive of seeking operational efficiency, rarely can a business cut its S&A spending by ~5% p.a. on average without compromising its business model, which we believe is the case here.
Importantly, despite the lean cost base, the company is still only fractionally profitable on a NIM basis, and has lost money at this level in 4 fiscal years during the last decade. We struggle to see this business generate attractive margins alongside achieving consistent growth.
Quarterly results
ODP’s recent performance has been more of the same, with top-line revenue growth of (1.7)%, (0.3)%, 3.1%, (3.2)%, and (6.2)% in its last five quarters. In conjunction with this, margins have remained stable.
ODP’s recent financial performance is a reflection of the wider macroeconomic environment, with heightened inflation and interest rates continuing to cause a financial strain on both consumers and businesses. This has been a compounding effect during the last 2 years, with inflation’s stubbornness restricting the ability to initiate expansionary policy.
ODP is not helped by its retreating store footprint, leading to a decline in sales that its marketing is insufficient to offset through increasing e-commerce sales. The business is experiencing a long-term decline that cannot be wholly attributed to macroeconomic pressures.
Key takeaways from its most recent quarter are:
- ODP’s revenue decline is largely driven by 68 fewer retail locations, as well as a broader decline in retail and online consumer traffic.
- The Veyer and Varis businesses are developing well but yet to offset the top-line weakness. Veyer continues to win new third-party business and remains on track to double external EBITDA in 2023. Further, Varis is onboarding customers and incorporating feedback into its platform.
- This Management team seems wholly focused on the idea of “operational excellence” and “prioritizing capital allocation”. We struggle to see how a business succeeds long-term without a focus on growth and we have not seen a single mention of this being a focus within Management’s quarterly release.
Balance sheet & Cash Flows
ODP is conservatively financed, with an ND/EBITDA ratio of 0.7x. This reduces any downside risks associated with profitability stagnation, even following EBITDA almost halving since FY15.
FCF has been mild but consistent, more so than NIM importantly. This has allowed the company to provide consistent distributions despite its declining position. We believe this is slightly deceiving, however, as the business has distributed in excess of its FCF generation. The current levels are not sustainable and are incrementally eating into its cash balance.
Outlook
Presented above is Wall Street's consensus view on the coming years.
Analysts are forecasting a continued decline in revenue, with a CAGR of (2)% in FY25F. In conjunction with this, margins are expected to remain broadly in line with their FY22 level.
We consider these assumptions to be reasonable. With a continuation of its physical closures and lack of material e-commerce development, we struggle to see growth returning. Further, “optimization” can only go so far, with GPM and S&A spending as a % of revenue stagnating in recent years.
Industry analysis
Presented above is a comparison of ODP's growth and profitability to the average of its industry, as defined by Seeking Alpha (20 companies).
ODP is performing poorly relative to its peers. The company’s growth is problematic, as we have already discussed in detail, although its profitability is not much better. ODP’s EBITDA-M is less than half that of its peers, allowing its peers to generate superior returns. The company does have a better FCF margin, but the lack of growth means this is not that impressive over any period of time.
Valuation
ODP is currently trading at 7x LTM EBITDA and 6x NTM EBITDA. This is broadly in line with its historical average.
A discount to its historical average is warranted in our view. The company’s profitability may appear slightly improved but its trajectory is downward, contributing to a decline in gross returns over time with no evidence to suggest a change in fortunes. We believe the business is priced heavily based on its near-term situation, which is unsustainable distributions and above-average FCF generation.
Further, ODP is trading at a ~41% discount to its peers on an LTM EBITDA basis and ~60% on a NTM P/E basis. This is insufficient in our view given the size of the growth delta. With a similar FCF margin and superior ROE, its peers will generate superior returns over time.
Key risks with our thesis
The risks to our current thesis are:
- Successful implementation of digital solutions.
- Transformation transition to Veyer and Varis.
Final thoughts
ODP is not a compelling business in our view. The company has attempted to transition its business model but is still facing the same issues, namely growth. We appreciate the optimization efforts as it downsizes but ODP has likely reached a crossroads, following an expansive distribution exercise.
We expect the company to struggle to generate meaningful improvements to profitability, with revenue continuing to decline and distributions also softening.
For further details see:
ODP Corporation: Uphill Battle For Any Meaningful Long-Term Gains