Best Buy (NYSE: BBY) has been one of the toughest retailers to own over the past few years -- but investors who bought BBY when there was "blood in the streets" are still up over 100%.
For instance, consider office-supply giant Staples (Nasdaq: SPLS), which, like Best Buy, is down about 25% this year. Staples' problems have been twofold: The rise of e-commerce competition and the lingering economic downturn have both weighed on its sales.
Staples missed fiscal first-quarter earnings expectations by 14%, which drove its stock down further. But after being beaten up for the past couple of years, Staples could be a turnaround story trading in deep value territory.
Shares of Best Buy went on a tear last year after the company announced a number of initiatives to transform it into an omni-channel (retail and online) leader. Trouble is, Best Buy has yet to live up to its turnaround promise and has continued to lack a strong e-commerce presence. As a result, Best Buy's stock crumbled at the end of 2013.
The difference between Staples and Best Buy is that we are starting to see the early signs of improvement at Staples -- not just hearing about plans for improvement.
The rise of e-commerce has really put pressure on the brick-and-mortar retailers. However, unlike Best Buy, Staples has a robust online presence. The third largest e-commerce company by revenue (behind only Amazon.com (Nasdaq: AMZN) and Apple (Nasdaq: AAPL)), Staples had over $10 billion in online sales last year, accounting for around 45% of its total revenue. In comparison, Best Buy's Web sales were roughly $3 billion, just under 8% of its total revenue.
Last year, Staples decided to accelerate its plan to expand its e-commerce presence. It will be opening a development center later this year to help focus on boosting personalization to increase conversions in online sales. Staples also revamped its website last year, its largest Web makeover in nearly a decade, and increased the number of products it offered online from 100,000 to 500,000.
Staples' cost-reduction program -- focusing on improving its supply chain, downsizing its workforce and accelerating its store closure plan -- is already producing results. Staples closed 16 stores during the first quarter and expects to close 80 more next quarter. The company expects to save $250 million in costs this year and $500 million annually by 2015.
Staples expects to generate free cash flow of $0.90 a share this year, which would amount to a robust free cash flow yield of 8%. For comparison, Wal-Mart's (NYSE: WMT) free cash flow yield is only 4%. Staples also has a strong balance sheet, with a debt-to-equity ratio of only 20%, well below the industry average of close to 40%.
Staples' dividend also makes SPLS an income story. It has increased its annual dividend payment in each of the past four years. Its dividend yield is an enticing 4.4%, which compares favorably with Best Buy's 2.4% yield and the industry average of 1.8%.
As far as valuation goes, the specialty retailer industry trades at an average price-to-earnings (P/E) ratio of 16. Staples is trading at a P/E ratio of just over 13. Once investors start to see signs that Staples' sales and margins are improving, the stock should be rewarded with higher multiples.
Staples should also get a boost from a rebounding U.S. economy, which should increase the demand for office products. In the meantime, Staples generates around 17% of revenues from outside of North America, which should help offset the weakness in U.S. office supply sales.
Risks to Consider: Staples might fail to see a rebound in the demand for office supplies, due to increasing competition and the shift toward digital. This could lead Staples to rely more on lower-margin non-office supply products, which would lead to further margin compression and reduced profits.
Action to Take --> Staples is a long-term turnaround play. Once the business shows signs of stabilizing, SPLS should trade more in line with its specialty retail peers. My target price of $15.50 represents 40% upside and is based on the assumption that Staples should trade at a P/E of 16 on expected fiscal 2016 earnings of $0.97 a share.