Despite Management's Best Efforts, Argus Sees Failed Merger, Amazon Pressure Continuing To Squeeze Staples

Argus maintained its Hold rating on Staples, Inc. (NASDAQ: SPLS), as it expects the company to face intense competition and declining sales of core office supplies in an increasingly digital world.

Recent Performance And Justification

However, Argus believes management has been systematically adapting to this environment by reducing its brick-and-mortar square footage, improving e-commerce infrastructure and offering a wider product range.

That said, Argus noted profitability is under pressure. The adjusted gross margin ended FY16 at 26.2 percent, down from about 28 percent in FY05–08.

In May, a federal judge sided with the FTC and blocked Staples' attempt to acquire Office Depot Inc (NASDAQ: ODP), saying it would reduce competition and lead to higher prices for corporations that buy office supplies in bulk.

Related Link: Staples Launches New Trends For Back-To-School Supplies At The Lowest Prices

Staples had expected the merger to provide $1 billion in cost savings, which would have helped to offset declining sales and the increased competition from Amazon.com, Inc. (NASDAQ: AMZN) and other big-box retailers.

"Despite the Federal Trade Commission's opposition to the now terminated merger agreement with Office Depot, we continue to believe that there is too much capacity (too many sellers) and too much competition from the likes of Amazon, Wal-Mart Stores, Inc. (NYSE: WMT), Costco Wholesale Corporation (NASDAQ: COST), Best Buy Co Inc (NYSE: BBY) and a host of business-to-business sellers," analyst Christopher Graja wrote in a note.

Estimates Looking Forward

The analyst reiterated his FY17 earnings estimate of $0.89 per share, while management's guidance suggests declining sales and relatively flat earnings for the year. Graja's second quarter estimate is $0.11 per share, which comes in at the low end of management's guidance range of $0.11–$0.13. The consensus estimate for FY17 is $0.91 and the second-quarter estimate is $0.12.

"While we see value in Staples cash flow generation, 5 percent dividend yield, e-commerce presence, and commercial business, we would like to see tangible progress in improving return on capital," Graja highlighted.

"We believe that too much capital has been deployed to a sector whose profitability is being compressed by increasing competition and declining demand for paper and core office products," Graja added.

At time of writing, shares of Staples were down 0.99 percent on the day at $9.03.

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