Thursday, May 19, 2011

Morningstar Research on Staples and on Staples’ Copy/Print Business

Morningstar Research (“MSR”) just moved Staples (SPLS) to a 5 star (MS’ highest) rating.

I’m a Morningstar subscriber, and I just finished reading the “updated” report that MSR’s analyst just put up on MSR about Staples.

Yesterday, after Staples released its Q1 earnings results and forward outlook the day before, Staples’ stock dropped like rock. And, articles I read on-line “said that” Staples stock dropped because of its lowered forward outlook.

Well, this morning, after Staples’ stock dropped like a rock yesterday, MSR issued an updated report on Staples, as I already mentioned.

In the updated report on Staples, MSR’s analyst said this:

“We expect Staples to add 30-40 new stores per year, but most of these will be smaller stores solely dedicated to copy and print services. These stores currently represent just 20 of the company's nearly 1,900 North American Retail stores, and we believe Staples has an opportunity to take share from local copy and print stores and large chains alike.

Staples is my favorite company in the “office supplies” market space, and based on Staples business model, I think Staples will continue to grow and be profitable well into the future. Staples execution of the “office supplies” business has been amazing.

But, I don’t agree with MSR’s analyst’s opinion that Staples will be very successful at taking “market share” away from local copy/print store and large chains, at least not in sufficient quantities/amounts to make Staples’ copy/print business highly successful. I don’t think that MSR’s analysts have a deep understanding of the copy/print business, nor do they have great insight into the severe “digitalization” headwind that all copy/print businesses (and reprographics businesses) are dealing with and will continue to have to deal with. Demand for “copies and prints” is on the decline. Talk to just about any copy/print center franchisee or independent copy/print center owner; it is highly likely that you will hear the same (sad) story from all. “Customers are finding ways to print less and less.” “Copy/print equipment manufacturers continue to release copy/print equipment at less expensive prices.” “More and more customers are copying and printing less and less.”

While Staples may, because of visibility and the number of its locations, be able to take “some” market share away from franchise copy/print centers, from independent copy/print centers, from Fedex Office (Kinko’s) and from reprographers, “overall demand” for copy/print services from copy/print centers has been declining, not growing, and this trend is expected to get worse, not better. The only saving grace, if there has been one, for copy/print centers and reprographers, has been growth in “color” copying/printing demand, but this growth has mostly been the result of, and at the expense of, copy/print centers seriously lowering, over the past year or so, prices for “color” copy/print services. (At my local UPS Store, 8 ½ x 11 color copies/prints are now priced at $.25 each.) It won’t be long before “color” copy print prices get down to around the $.12-$.15 range. (Some copy/print centers are already there for larger volume copy/print jobs.) As I pointed out in a recent previous post, the first Memjet-enabled very-fast (60 cpm/ppm) small-format, color-capable printer was just released, albeit in China. Hold your breath, but not too long, for an inexpensive Memjet-enbled color printer will likely show up in the U.S. in the not too distant future, and, when it does, it will have an impact – and adverse impact - on the prices copy/print centers charge for color copies/prints. It will also reduce demand for short-run color printing services offered by copy/print centers and reprographers, as consumers and businesses increasingly “insource” what they’ve been outsourcing.

By the way, Morningstar Research provided coverage on ARC from February 2006 up until September 2009. In September 2009, MSR stopped following and reporting on (“dropped coverage” of) ARC. At that time, MSR said this, We are no longer providing equity research on American Reprographics Company ARP. We provide broad coverage of more than 1,800 companies across 91 industry groups and adjust our coverage as necessary based on client demand and investor interest.” Perhaps MSR decided to stop coverage of ARC because MSR did not feel it knew enough about ARC’s business to provide meaningful insights about ARC’s opportunities? That would be my guess.

In a report on ARC on May 14, 2008, titled “Despite a slowdown in construction, we think American Reprographics is going to ride out this economic downturn,” MSR said this, “Given its clout, we think ARC can set a standard for charging for digital services. Its industry expertise and long-standing customer relationships should also provide a potent deterrent to new entrants. We would gladly buy ARC shares at an appropriate discount to our fair value estimate.”

And, in that same report, MSR said this, “We are maintaining our fair value estimate at $30 per share. We think internal sales growth will be in high single digits during the next five years as ARC continues to grow slightly ahead of the construction sector. We expect operating margins to reach the high teens as a result of positive leverage in general and administrative operations. However, some margin pressure could occur as the industry migrates to the digital medium, and printing volume declines. Despite this negative trend, returns on invested capital are projected to average 21%, exceeding ARC's 10.8% average cost of capital.”

To its credit, MSR also said this (under “Risk”), “Technological changes leading to a decline in print volume and an increase in free downloads are a major risk factor. Intense local competition, the cyclical nature of the construction industry, and the possibility of new entrants from the copy and printing industry are also areas of concern.”

In a previous report, dated January 29, 2008, titled “We think American Reprographics can weather an economic downturn,” MSR said this, “Internal growth will generally follow the construction industry, which is expected to expand at 8%-9% annually.”

Later on, in a report dated May 2009, titled “American Reprographics is not immune to a slowdown in the construction industry”, MSR said this, “We are lowering our fair value estimate to $13 per share from $30 and raising our uncertainty rating to high after revisiting our growth and profitability assumptions in light of the current economic slowdown. In our model, we project revenue will decrease 4% annually over the next four years, mainly driven by a 20% revenue decline in 2009 as a result of the difficult conditions in the construction industry.”

Again, to MSR’s credit, MSR did mention these (which are basically risk factors) in its very first report on ARC in February 2006:

Bears Say

A trend toward free document downloading could undermine ARC's operating model unless the firm manages to monetize its digital services.

A slowdown in the nonresidential construction sector would negatively impact ARC's earnings.

Competition is likely to intensify, as more companies enter the market and existing players consolidate.

ARC heavily relies on California's economy, where it derives 40% of its revenues.

I enjoyed reading MSR’s coverage (reports) on ARC, and I was sad that MSR stopped its coverage of ARC. I think that MSR’s analysts (the ones who researched and wrote reports on ARC) had excellent “finance” knowledge, but, just to the opposite, were slow to catch on to the headwinds ARC (and all reprographers) were facing. This is one of the reasons – and the main reason - why I don’t think any financial analysts (at MSR or elsewhere) really, truly understand the headwinds that copy/print center businesses (and reprographers) are facing, going forward.

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