Is Staples headed for a buzzsaw?

August 8, 2012: 2:14 PM ET

The office retailer has $1.3 billion on hand -- but its business model is about to come under serious pressure.

By Jack Hidary, contributor

staples_storeFORTUNE -- Staples may be heading for a steep decline in value. Office Depot (ODP) and Office Max (OMX) have already plunged in the last few years to sub-$500 million market caps. There is ample evidence that Staples could also lose substantial value in the mid-term.

First, let's consider its core business: office supplies. The recession and the rise of digital platforms have led to a 24% decrease in the use of paper across the US in the last three years. Many other office items depend on the paper chain: folders, binders, clips, file cabinets, etc. Despite taking market share from its competitors, Staples (SPLS) has only been able to eke out a 1.5% revenue growth rate this past year. Compare that with same-store sales growth of 2.6% for Wal-Mart (WMT) stores on a base that is more than ten times the size of Staples.

The mission of Staples is to be the best office supply company in the world. That is a misguided goal in today's times. Instead, Staples should immediately leverage its corporate business and transition to services and value-added products in the way that IBM (IBM) did. When IBM realized that its hardware was commoditized, it transformed itself into a services company under the leadership of Lou Gerstner. By shedding its PC division to China's Lenovo, IBM was able to refocus on a higher-margin service business. IBM now commands a $230 billion market cap and a core position in business tech services.

(A Staples spokesperson did not respond to request for comment for this piece.)

The one service area that Staples does offer -- photocopying and print services -- has long been commoditized by Kinkos (FDX) and now online suppliers such as Vistaprint and Mimeo. Staples has also recently tried to copy Best Buy's (BBY) Geek Squad model with its EasyTech PC upgrade and repair offering. The problem is that the services it offers do not climb far enough up the value chain to generate substantial margin. Most of the work is limited to simple fixes and installation of inexpensive memory chips. Staples will have to move very quickly to save itself from this double barrel shotgun of commoditization and competition.

Next, let's break down the revenue streams at Staples:

  1. North American Delivery: This division supplies office material to large companies on contract and in bulk volume. While this unit avoids the cost of retail outlets it will be increasingly squeezed on margin and will suffer declines in core product categories as digitization continues to take hold. Staples commercial customers are looking for savings wherever they can find them. For example, many companies are now implementing forced limits on computer printing.
  2. North American Retail: With an extensive store footprint across the US, Staples is a sitting duck for e-commerce. True, it is making a valiant attempt to capture some of those e-commerce dollars with its own site, but this is outweighed by the massive infrastructure of running a multi-thousand SKU retail operation.

Amazon (AMZN) and other pure-play e-commerce sites will continue to gain market share. With Amazon's prime service of free shipping, what advantage is there to buying supplies at Staples? Amazon now plans to wipe out the last remaining benefit of offline retail -- the ability to have the item at the time of purchase -- by building out local distribution centers that will deliver frequently ordered goods the very same day.

Furthermore, Amazon just bought one of the last hopes for Staples to gain efficiency in its distribution centers: Kiva Systems. Kiva makes the robots that bring 200% to 400% efficiency gains to pick-pack and ship operations. Now that Amazon owns Kiva, it can control pricing of these robots and limit their upside impact at Staples. Here is a testimonial from Staples itself.

Amazon will probably not make any immediate move on this front to squeeze Staples. Yet, it surely will keep the best distribution center technology for itself even as Staples will now pay Amazon for last year's models.

  1. International Operations: This unit has swung to a loss over the last year. International operations in retail businesses are notoriously difficult to manage. You open yourself up to a myriad of local competitors and do not have the fungibility of a global services organization to reposition assets quickly. Inventory can become a nightmare overnight. Furthermore, some countries are now heading into the digital age with even faster adoption rates than the US. Mobile adoption in Brazil, as an example, has obviated the need for many traditional desktop computing and printing supplies.

Finally, let's look at the financial picture: Staples has $1.3 billion on hand which gives it a far bigger cushion than its direct competitors. But even this reserve will not be able to withstand the pressure on its business model in the coming years.

If Staples takes aggressive moves to shed retail outlets and move into value-added services it may be able to create a higher-margin business. This will require a clear conversation with the Street, which, while difficult in the short-term, will save the company from stagnation. Given the quarterly pressure on management teams today, however, will Staples have the stomach Jeff Bezos has for implementing long-range plans in the face of short-term challenges? For shareholders' sake let's hope so.

Jack Hidary is a startup investor and co-founder and former CEO of Dice.com (DHX). Send Jack comments @jackhidary.

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