Staples Equity Valuation and Analysis

David Lecky Chad Loudermilk Bennett Matkins Kara Reynolds Amanda Rhodes

David.Lecky@ttu.edu Chad.loudermilk@ttu.edu Bennett.Matkins@ttu.edu Karereyddd@yahoo.com Amanda.b.Rhodes@ttu.edu

Table of Contents
Executive Summary……………………………………………………….. 2 Overview of Staples and the Industry………………………………... 7 Five Forces Model……………………………………………………………………….. 9 Rivalry among Existing Firms……………………………………………………….. 9 Threat of New Entrants……………………………………………………………….. 15 Threat of Substitute Products………………………………………………………. 17 Bargaining Power of Buyers………………………………………………………... 17 Bargaining Power of Suppliers…………………………………………………..... 18 Classifying the Industry………………………………………………………………. 18 Key Success Factors……………………………………………………………………. 19 Competitive Advantage Analysis………………………………………………….. 19 Accounting Analysis………………………………………………………. 25 Key Accounting Policies………………………………………………………………. 25 Accounting Flexibility………………………………………………………………….. 26 Evaluation of Actual Accounting Strategy……………………………………… 29 Quality of Disclosure…………………………………………………………………… 30 Screening Ratio Analysis….…………………………………………………………. 33 Revenue Diagnostics………………………………………………………………….. 34 Expense Diagnostics…………………………………………………………………… 37 Potential “Red Flags”………………………………………………………………….. 39 Undo Accounting Distortions……………………………………………………….. 41 Ratio Analysis………………………………………………………………. 44 Liquidity Ratio……………………………………………………………………………. 44 Profitability Ratio……………………………………………………………………….. 56 Capital Structure Ratio……………………………………………………………….. 66 SGR & IGR………………………………………………………………………………… 71 Financial Statement Forecasting……………………………………… 72 Income Statement……………………………………………………………………… 72 Balance Sheet……………………………………………………………………………. 77 Statement of Cash Flows……………………………………………………………. 80 Analysis of Evaluations………………………………………………….. 83 Cost of Capital………………………………………………………………………….. 83 Method of Comparables…………………………………………………………….. 86 Intrinsic Valuation Models………………………………………………………….. 89 Altman Z-Score…………………………………………………………………………. 96 Appendices: Appendix 1: Screening Ratios…………………………………………………….. 98 Appendix 2: Core Financial Ratios………………………………………………. 99 Appendix 3: Regression Analysis……………………………………………….. 100 Appendix 4: Valuation Models……………………………………………………. 105 Works Cited………..................................................................... 110

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Executive Summary

Investment Recommendation: Slightly Overvalued: Hold
SPLS - Nasdaq $25.84 52 week range $21.08 - $28.00 Revenue (2006) $18,160,789 Market Capitalization $18.19 Billion Shares Outstanding 717,000,000 Dividend Yield .29 (1.1%) 3-month Avg Daily Trading Vol. 6,120,780 Percent Institutional Ownership 84.60% Book Value Per Share (mrq) $6.99 ROE 22% ROA 12.68% Est. 5 year EPS Growth Rate 13.95% Cost of Capital Est. R2 Beta Ke Estimated 5-year 0.230 1.146 1-year 0.231 1.150 10-year 0.230 1.146 3-month 0.232 1.152 Published 1.52 Kd 5.547% WACC 9.2292% Altman Z-Score 6.88

04/01/07

EPS Forecast FYE 4/1 2006 (A) 2007 (E) 2008 (E) 2009 (E) EPS $1.32 $1.55 $1.77 $2.01 Ratio Comparison Trailing P/E Forward P/E M/B SPLS ODP OMX $41.29 $55.99 $37.22 $19.50 $26.44 $17.58 $19.78 $26.72 $72.96

Ke 10.24% 10.04% 10.19% 9.97% 10.24% Intrinsic Valuations Discounted Dividends $3.38 Free Cash Flows $20.13 Residual Income $17.07 LR ROE $12.61 Abnormal Earnings Growth $15.26

Valuation Estimates Actual Price (as of 4/1/07) $25.84 Ratio Based Valuations P/E Trailing $19.56 P/E Forward $15.05 Enterprise Value $29.12 M/B $3.68

Staples stock is traded on the NASDAQ market and the ticker symbol is: SPLS. The Company had its Initial Public Offering (I.P.O.) on April 27, 1989. 3,250,000 shares sold at $19.00 per share ($0.74 after adjusting for stock splits). Since 2002, Staples’ stock prices have almost doubled. Their stock prices have also been fairly consistent with that of its competitors for the past two years.

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Two Year Stock Performance Between Staples, Office Depot, and Office Max

Five Year Stock Performance Between Staples, Office Depot, and Office Max

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Industry and Company Overview Staples Inc. is the world’s largest supplier of office products, headquartered in Framingham, Massachusetts. Staples competes in the worldwide office supply superstore industry, with physical locations and an internet website. Its two main competitors are Office Depot and Office Max. Staples originated the office products superstore in Brighton, Massachusetts in 1986. They offer a wide variety of office supply products including supplies, furniture, small business machines, computers, peripherals, and various business services. Staples has many key success factors that attribute to its every day success. One of these main success factors is Staples ability to differentiate itself form the rest of the competition. Ever since the first Staples opened, the company has been continuously looking for ways to differentiate itself. One example of differentiation in the industry that Staples effectively prosecutes is its ability to offer several different sales channels. These sales channels include retail stores, catalog, internet, fax, and telephone. Offering all of these sales channels provides Staples with the capability to reach all of their target market. In addition, these sales channels also provide customers with an easy and overall positive shopping experience. Adding to the differentiation concept, Staples efficiently provides their own brand name items; ultimately giving the company an extra step ahead of the competition. By providing their own brand name products, Staples is able to offer a much lower price than the rest of the products they sell, giving them a competitive advantage. Another competitive advantage instilled in the Staples Corporation, is the “Easy Service Model” that was created in 2005. This model introduced the “easy button,” which helped increase the Staples brand awareness. Additionally this model helped increase the staples market share from 35% in 2004 to 41% in 2005. This model not only increased the company’s market share, it also significantly increased their brand awareness by providing customers with a more positive shopping experience.

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Accounting Analysis Staples’ annual 10-K contains information regarding their key accounting policies and accounting flexibility which can be used to evaluate their accounting strategies and identify potential red flags. During the process we were able to conclude that Staples quality of disclosure was superior to its competitors. During the accounting analysis we were able to relate Staples’ key success factors to their key accounting policies and identify potential red flags. For example, Staples finances the majority of their properties with operating leases rather than capital leases which causes the assets and liabilities to be understated. Also, since the implementation of SFAS No. 142, Staples has acquired six different businesses worldwide and has failed to write off any goodwill causing the assets on the balance sheet to be overstated and the expenses on the income statement to be understated by a significant amount. After we discovered these accounting distortions we were able to adjust their accounting methods to represent true values. We were able to adjust the lease problem by finding the present value of Staples’ future payments on its operating leases, and increase the assets and liabilities on the balance sheet by that amount. Also, we amortized the current value of goodwill over the next ten years down to zero to make up for Staples failure of not writing off goodwill. After undoing these accounting distortions, Staples’ true value will be revealed. Financial Ratio Analysis The financial statements for a firm provide significant information that must be evaluated to analyze their overall performance compared to other firms in the industry. This analysis provides you with a way to relate different line items of the financial statements and then assess those relationships. There are three main groups of ratios: liquidity, profitability, and capital structure. Liquidity ratios, which determine a firm’s ability to meet current obligations with liquid assets, include the current ratio, quick asset ratio, accounts receivable turnover 5

and days supply, inventory turnover and days supply, and working capital turnover. Profitability Ratios, which measure how successful a firm is at generating a profit, include the gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets, and return on equity. Lastly, Capital Structure Ratios determine the sources of financing used to acquire assets and they include the debt to equity ratio, times interest earned, and debt service margin. In conclusion, the financial ratio analysis measures the overall performance of a firm compared to other competitors in an industry. Intrinsic Valuations After finding the intrinsic values for each of the discount dividends, discounted free cash flows, residual income, abnormal earnings growth, and long run residual income perpetuity models, we discovered that Staples is overvalued. The discount dividends model had a calculated intrinsic value of $3.38, which we believe to be insignificant because future dividends are relatively difficult to accurately predict. Next, the discounted free cash flows model resulted in an intrinsic value of $20.13, implying Staples is slightly overvalued. The long run residual income perpetuity model had an intrinsic value of $10.78 which is well below the observed price of $25.84 at April 1, 2007. As mentioned earlier we placed the most emphasis on the residual income and abnormal earnings growth models; we did this because of the link between residual income and abnormal earnings growth and the significant explanatory power of the residual income model. The residual income model calculated an intrinsic value of $19.90, ultimately implying that Staples is again slightly overvalued by $5.94. Lastly, the abnormal earnings growth model computed an intrinsic value of $22.52, stating that Staples is slightly overvalued by $3.32. Since, we placed a major emphasis on the residual income and abnormal earnings growth models, we believe it is safe to say Staples is a slightly overvalued firm. In addition, the Altman Z-Score turned out to be 6.88, implying that Staples has a low probability of bankruptcy.

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The WACC was calculated to be 9.29%, with a cost of equity of 10.237% and a cost of debt of 5.547%. Business and Industry Analysis Company Overview Staples, Inc. introduced the first office products superstore in Brighton, Massachusetts in 1986. Launched to serve the needs of small businesses, Staples, Inc. is a specialty retailer offering a wide array of office supply products including supplies, furniture, small business machines, computers, and peripherals. They also offer business services such as color and self-service copying, printing services, faxing, and pack and ship services. Staples has 1,522 superstores found in 47 states, the District of Columbia, and 11 Canadian provinces at the fiscal year end of 2005. In addition, 258 stores are found in 19 countries in Europe, South America, and Asia. Staples is continuing to grow with an average of 119.8 store openings per year over the past 5 years. The company is headquartered in Framingham, Massachusetts. It also does business via the Internet, through its own website. Staples concentrates on superior customer services to differentiate itself from competitors offering low prices and innovative services. In 2003, Staples launched its new brand promise: “We make buying office products easy.” Activating a new customer service model to its employees, offering expanded product lines, speedy check-outs, in-stock guarantees, and redesigning their website to make it more customer-friendly are some of the new features Staples offers to cater to its customers. It currently leads the industry in market capitalization at 18.6 billion dollars.

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Staples Sales & Assets
SPLS Sales
$20,000,000

SPLS Assets

$ in Thousands

$15,000,000 $10,000,000 $5,000,000 $0 SPLS Sales

2002

2003

2004

2005

2006

$10,744,373 $11,596,075 $12,967,022 $14,448,378 $16,078,852

SPLS Assets $4,093,035 $5,721,388 $6,503,046 $7,071,448 $7,676,589

Year

The office products industry as a whole has been continuously growing over the past four years. Office Max’s sales have declined in response to Office Depot and Staples’ sales rapidly increasing. The industry also shows an increase in individual company assets.

Staples Competitors Sales and Assets (Office Depot & Office Max)
$16,000,000 $14,000,000

ODP Sales ODP Assets OMX Sales OMX Assets

$ in Thousands

$12,000,000 $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $0 ODP Sales ODP Assets OMX Sales OMX Assets 2002 $11,356,633 $4,765,812 $7,412,330 $1,295,750 2003 $12,358,566 $6,145,242 $8,245,146 $7,376,159 2004 $13,564,699 $6,794,338 $13,270,196 $7,542,999 2005

$14,278,944 $6,098,525 $9,157,660 $6,272,142

Year

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Five Forces Model The five forces model includes five factors by which to classify the industry in which a firm is competing. It allows the ability to define the industry structure and profitability. These five factors include: Rivalry Among Existing Firms, Threat of New Entrants, Threat of Substitute Products, Bargaining Power of Buyers, Bargaining Power of Suppliers. Office Supplies Retail Industry Rivalry Among Existing Firms Moderate Threat of New Entrants Low Threat of Substitute Products High Bargaining Power of Buyers Moderate Bargaining Power of Suppliers Low

Rivalry Among Existing Firms Rivalry among existing firms in an industry influences the average level of profitability. Competition between existing firms in an industry is determined by the following factors: industry growth, concentration, differentiation, switching costs, scale/learning economies, fixed-variable costs, excess capacity, and exit barriers. The analysis of these factors pertaining to the office products retail industry shows a high level of competition among existing firms. The intensity of competition between existing players in an industry influences the level of profitability. The office products retail industry is highly competitive among its key competitors of Office Depot, Office Max, and Staples. These competitors also compete with virtually any company who also offer office supplies and services, business machines and related products, computers and related products, and office furniture. These companies include mass merchants, warehouse clubs, computer and electronics superstores, mail order firms, contract stationers business, electronic commerce distributors, local dealers, and direct manufacturers. The office supply superstore industry is very

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competitive because the key competitors also have to compete against any company that sells office products.

Industry Growth Rate
An industry’s growth rate determines if firms need to take market share away from their competitors in order to grow. The office products industry has experienced significant growth since 1986 as the industry has expanded to include a variety of retailers, dealers, and distributors. Each key competitor in the office products retail industry have seen sales, numbers of stores and employees, and international business grow significantly in the past years. For example, during 2006 Office Depot planned to open 100 new retail stores, OfficeMax planned to open 70, and Staples planned to open 110 new stores. The industry is growing steadily and competing firms are not required to take their competitors’ market shares in order to grow. The graphs below display the office supply superstore industry’s sales growth as a whole and as individual competitors.

Industry Sales Growth (in thousands)
50000000 40000000
Total Sales

30000000 20000000 10000000 0 2002 2003 2004
Year

Office Supply Industry

2005

2006

10

SPLS, ODP, OMX Sales (in thousands)
20000000 15000000
Sales

10000000 5000000 0 2002 2003 2004
Year

Staples Office Depot Office Max

2005

2006

Concentration and Balance of Competitors
The degree of concentration and the balance of the competitors in an industry determine the amount of competition based upon price within the industry. The office products retail industry’s main competitors are Office Depot, Office Max, and Staples, but office products are also sold by various firms such as Wal-Mart, Costco, Best Buy, and Dell. In order to compete with these firms, office supply superstores have to keep their prices competitive, rely on superior customer service, broader selection of office products, and convenient store locations. Since Office Depot, OfficeMax, and Staples are the only main competitors in the office products retail industry they often cooperate among themselves to avoid destructive price competition. In conclusion, the office products retail industry is highly centralized among Office Depot, OfficeMax, and Staples. The graphs below display the market shares of these competitors in the office supply superstore industry for the past five years.

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Market Shares: 2002

24% 39%

Staples Office Depot Office Max

37%

For 2002, Staples is the leader owning 39 percent of the office supply superstore industry. Office Depot is running a close second with 37 percent and coming in last is OfficeMax with a much lower 24 percent.

Market Shares: 2003

25% 38%

Staples Office Depot Office Max

37%

In 2003, Staples remained the leader by a narrow margin of one percent (38% of industry market share). Following close behind was Office Depot with 37 percent and once again OfficeMax was lagging behind with 25 percent.

Market Shares: 2004

32%

35%

Staples Office Depot Office Max

33%

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In 2004, OfficeMax took a considerable amount of the market share from its competitors from previous years but remained in last with 32 percent. Again Staples was the leader in the industry with a lower 35 percent and Office Depot followed closely with 33 percent.

Market Shares: 2005

23%
Staples

41%

Office Depot Office Max

36%

For 2005, Staples raised the bar and increased their market share by 6 percent to 41 percent. Office Depot stayed in second with a market share of 36 percent and OfficeMax fell drastically behind to 23 percent.

Market Shares: 2006

21%
Staples

43%

Office Depot Office Max

36%

In 2006, Staples further increased their market share by 2 percent to a total of 43 percent. Office Depot remained the same at 36 percent, while OfficeMax fell further behind to 21 percent. The above graphs show Staples has remained the office supply superstore industry’s leader for the past five years. We believe that much of this success is derived from Staples’ ability to differentiate itself from competitors while maintaining a low price strategy.

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Degree of Differentiation and Switching Costs
Firms in any industry must differentiate their products and services in order to avoid excessive competition. Firms in the office products retail industry mainly carry identical products or close substitutes to their competitors. In addition, Office Depot, OfficeMax, and Staples offer similar websites and in-store copy and print services. Since the products the firms sell and the services they offer carry a low degree of differentiation, switching costs for customer are very low. Since, the office products retail industry offers minimal product differentiation and low switching costs, customers are allowed to switch retailers purely on the basis of price.

Scale/Learning Economies and the Ratio of Fixed to Variable Costs
If there are any types of scale or learning economies in an industry, firm sizes become an important factor. When economies of scale exist in an industry, new firms must be willing and able to invest large amounts of capital in order to grab market share and compete with industry leaders. In the office products retail industry there are only three main competitors and large economies of scale exist making it difficult for new entrants in the industry to compete. Office Depot, OfficeMax, and Staples therefore compete aggressively for market share. A firm in any industry must minimize its variable costs in order to maintain profits. Firms in the office products retail industry are able to obtain low variable costs by purchasing supplies in bulk from vendors. Also, Staples is able to further reduce their variable costs by selling their own branded products which cost 10-15% less than national brands. Firms in the office supply superstore industry are able to reduce their variable costs allowing them to maintain profits.

Excess Capacity and Exit Barriers
If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill capacity (Palepu 2-3). High levels of inventories associated with the office products retail industry create an excess 14

capacity because it creates more supply than demand. The excess capacity can require firms to cut prices to fill capacity. Exit barriers make it difficult and costly for firms to exit the industry. The office products retail industry typically does not have specialized assets or legal barriers. Therefore the exit barriers to the industry are not costly. Threat of New Entrants

Economies of Scale
Economies of scale exist within an industry when companies expand the scope of their operations, resulting in a subsequent decrease in costs for companies competing within that industry. When economies of scale exist, new entrants must be willing to invest large amounts of capital in order to compete with the industry’s leading companies. It is important for a company to recognize where economies of scale exist because they help the company understand where its resources should be allocated in order to improve market share and increase profits. Leading companies within the office product retail industry, such as Staples and Office Depot, specialize in selling a wide variety of products in-store. In 2005, Staples’ merchandise inventories were 40% of the company’s total current assets. A company entering the office products segment of the specialty retail industry must possess bargaining power with suppliers and enough capital to acquire, and maintain, a large in-store merchandise inventory, or the company will not survive in the industry. Another barrier to new entrants is their limited access to markets. Larger companies have greater access to markets and can operate with larger geographic reach. Office Depot, for example, operates 1,016 stores in 49 different states and plans to continue to open new locations. Staples and its competitors benefit from economies of scale in advertising as well. In 2005, Staples unveiled the Easy marketing message which enhanced Staple’s brand promise to make buying office products easy. Because of increased buying power, market accessibility, and efficient

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advertising, large economies of scale exist within the office products segment of the retail industry.

First Mover Advantage
In an industry where price competition and switching costs are minimal, a company must create a first mover advantage in other aspects of the business. For example, according to finance.yahoo.com, Office Max recently announced that it plans on installing the newest, state-of-the art Xerox systems that will allow customers to produce their work faster and with greater quality. In this industry, companies create a first mover advantage by introducing innovative customer service techniques, providing new services to customers first, introducing new product lines, and expanding into untapped markets globally, which can be quite costly; therefore, first mover advantage is of moderate risk.

Access to Channels of Distribution and Relationships
Companies in the office supplies retail industry differentiate themselves by offering superior product variety. To achieve this, it is critical for companies in this industry to implement efficient inventory methods in order to maintain onshelf products. Companies, such as Staples and Office Depot, receive efficient inventory volumes through retail distribution centers that purchase products directly from manufacturers. Many of the products sold in these stores come from competing manufacturers which adversely affects manufacturer relations. The result of this adverse affect could be that vendors reduce product offerings in leading office supplies retail companies. Also, many companies in this industry sell products sourced from a wide variety of third-party vendors, including international manufacturers. This is a risk factor because leading companies in this industry cannot control the availability of the raw materials used to make their products or the stability of foreign supply chains; therefore, companies in the office supplies retail industry face a high risk of new entrants because of competition between manufacturers and uncontrollable third-party vendors. 16

Legal Barriers
In this specialized segment of the retail industry prospective entrants do not face many legal barriers to entry. Licensing regulations, patents, and copyrights are non-existent within this industry. The only legal barrier to entry is if a prospective entrant might want to begin Internet operations. There are laws and regulations that must be followed when conducting business transactions on the Internet. Because of the absence of extensive legal barriers to entry, this industry faces a high risk of entrants into the market. Threat of Substitute Products The threat of substitutes depends on the relative price and performance of competing products or services and the customers’ willingness to substitute (Palepu 2-4). The office products retail industry competes mainly on the basis of pricing, product selection, convenient locations, and customer service. Competitors in the industry offer identical products and services and close substitutes. For example, Office Depot, OfficeMax, and Staples all sell similar office supplies, technology products, and furniture to consumers. Therefore, the threat of substitute products among firms in the industry is very high. Bargaining Power of Buyers Competitors in the office products superstore industry do compete on the basis of price. Office products superstores sell office supplies and services to a large assortment of customers including individual consumers, small, medium, and large businesses, and government offices. Switching costs for the industry are low because buyers can find identical products and services or close substitutes among competitors. Since the products and services have a low level of differentiation, the bargaining power of buyers increases. Staples is the world’s leading office products company so they can maintain an effective bargaining position with vendors. Staples purchases in high volumes and has centralized distribution facilities allowing them to obtain favorable pricing from 17

their carefully selected suppliers. This in turn helps them offer low price products in the price sensitive office products industry. In conclusion, Staples has a moderate bargaining power with its buyers. Bargaining Power of Suppliers Suppliers retain bargaining power when they are able to extend enough pressure on a company to affect its inventory volumes and margins. Understanding whether or not suppliers exhibit bargaining power within an industry is important because it aids in analyzing many important factors of the industry, including selling prices and costs of inventories. The suppliers of the office supplies retail industry exhibit weak bargaining power for many reasons. One main reason the bargaining power of suppliers in this industry is weak is because leading companies, namely Staples, Office Depot, and Office Max, provide their customers with a wide variety of similar products that come from competing suppliers. In other words, there is a high concentration of suppliers selling to small number of leading office supply retail chains. Because Staples, Office Depot, and Office Max aggregately control most of the industry’s market share, to maintain high profits from sells of high volume purchase orders, suppliers must compete with one another to ensure their product is on the shelves of one of these leading companies. Any one of these three companies could sustain their bottom line profits if one supplier pulled its products; therefore, the threat of suppliers bargaining power within this industry is low. Competitive Advantage Analysis

Classifying the Industry
The office supplies retail industry is a highly competitive industry with Staples, Office Depot, and Office Max leading the way. It is important for us to analyze the industry as a whole in order to establish a better understanding of how Staples creates its own value. Firms in this industry compete on the basis of offering everyday low prices and high product selection, but each firm must 18

differentiate itself from the competition in order to maintain, or possibly increase, market share. In the following sections, we will discuss the key success factors of the office supplies retail industry, as well as explain how Staples implements business techniques on the basis of these factors.

Key Success Factors of the Industry
The year 1986 marked a revolutionary change to the office products industry with the introduction of Staples and Office Depot. Before the opening of these two companies, the office products industry contained a very small amount of companies and was not a very attractive or competitive industry. Today, this industry is a very competitive one with many different innovations and company tactics. This industry has experienced continual growth since 1986 as it has acquired many different retailers, dealers, and office supplies distributors. Leading this dominant industry, Staples currently has over 69,000 employees operating around 1,800 stores world wide. Office Depot comes in a distant second with approximately 1,400 stores and 50,000 employees around the world. The third largest company in the office products industry is OfficeMax with nearly 1,000 stores and 40,000+ associates. These three prestigious players “account for annual sales of roughly $30 billion in a North American and European sales valued at more than $200 billion, (Findarticles.com).” In such a competitive industry, corporate strategies play a significant role in the success and survival of a firm. One major focus that is pursued by companies in this industry is that of differentiation. Differentiation is the act or process of differentiating oneself from the competition to attract customers. One way that these three leading companies differentiate themselves from the rest of the competition is that they all offer several different sales channels including retail stores, catalog, internet, fax, and telephone. These different sales channels create a competitive advantage for Staples, Office Depot, and OfficeMax by permitting them to reach all or most of their target markets as well as providing 19

a much more convenient way of shopping for their customers. Offering all of these sales channels also helps the firms to obtain a more efficient production process, which in turn ultimately cuts down production costs. Another very good example of product differentiation in the industry is the 2005 change in the availability of Staples’ products. The office supply leader “and Ahold announced, in March of 2005, a joint collaboration in which all Stop & Shop Supermarkets and Giant Food Stores throughout the Northeast will have a Staples branded store-within-store section that will sell traditional school and home office products in addition to copy and photo paper, ink cartridges, and technology products. In August 2006, Ahold announced the addition of the Staples section to all Tops Friendly Markets locations as well, (en.wikipedia.org).” The next value adding corporate strategy that is a key component of industrial survival is customer value. Customer value is obtained by offering products or services that retain the most benefits at the most reasonable price in the eyes of the customer. A very strong competitive advantage that the large office supply company’s have is their ability to maintain their own brand name items. Operating in this industry for many years, these companies have a much larger collection of knowledge about the needs of their customers and they can better meet these needs by customizing, producing, and offering their own product. In addition, these firms can sell their product at a much lower price than the rest of the products on their shelf, such as “Staples’ brand products are priced 10-15 percent lower than the national average,” giving them a better opportunity to achieve a higher customer value, (edgarscan.pwcglobal.com). A recently new trend of major companies in the office products industry is the transition of competing in multiple industries as opposed to only one. For instance, Office Depot and Staples have both began to offer services in the multi-billion dollar copy and print market. By offering these various services, including high-speed, color and self-service copying, faxing, and pack and ship capabilities, these two empires create a much larger target market and greatly increase their opportunities for potential growth. An additional opportunity to 20

increase growth in the office products industry that begun in the late 1990’s among the larger firms was the expansion to foreign markets. Many of the larger firms were and still are looking to expand their horizons by entering into foreign markets, most popular being Europe and China. One of the first companies in this industry to obtain access to international markets was Office Depot. In 1998, “Office Depot received government antitrust clearance for its $2.6 billion acquisition of Viking Office Products,” (Findarticles.com). The wholly-owned subsidiary operated in 11 countries at the time of acquisition and currently operates in over 16 countries. Additionally, this attainment significantly increased the purchasing power for Office Depot, giving them a much stronger ability to expand and invest in their brand image. This is evidence that expanding into foreign markets will ultimately ensure growth and create a powerful competitive advantage over the rest of the industry. To this day, the office products industry continues to grow at a very rapid pace. In order to compete with the competition, firms are forced to develop many different techniques in there day to day promotions and activities. The three main firms in this industry, Staples, Office Depot, and OfficeMax, work very hard everyday to maintain their market share by differentiating their product as well as promoting their brand image. Unfortunately, to survive in this industry there are many other key components that must be considered including being the low cost leader, providing quality in their products as well as their customer service, and achieving efficient production. Without the majority of these concepts entrusted in to your company strategy, your chances of survival are slim to none. Staples’ Competitive Advantages Staples retains competitive advantages over top industry firms on a differentiation and cost leadership basis. In the following paragraphs, we will explain how Staples utilizes its core strengths to achieve these competitive

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advantages that ultimately create value for the firm and help to sustain market share.

Customer Service
In 2003, Staples conducted extensive research in order to pinpoint what it was that customers really wanted when shopping for office products. The results of the research showed that customers placed significant value on an easy shopping experience. Staples aims to provide such a shopping experience for their customers through a number of different business techniques. To promote an easy shopping atmosphere, Staples rearranged all of its North American stores to a customer-friendly layout, also known as the Dover format. This layout opened the interior of the store to give the customer a better view of Staples’ extensive product array. In addition to this layout change, the company increased the number of sales associates in the furniture, business machines, and technology sections of the store because customers often need assistance in these areas. In 2005, Staples created an “Easy service model” which helped to increase the knowledge of sales associates and encouraged them to engage customers in a more effective manner. Staples also provides many services to its customers which help to increase customer service. Recently, Staples unveiled its new EasyTech service. As of January 30, 2007, every Staples store in the U.S. will have an “in-store technician that provides customers with assistance in computer installations, data protection and security, and repair and troubleshooting”. (finance.yahoo.com) In addition, every Staples retail location offers customers copy, fax, and pack and ship services. When it comes to customer service, Staples utilizes this value additive factor extremely well. By providing its customers with an easy-to-shop atmosphere, friendly sales associates, and numerous services, Staples retains a high percentage of customers which ultimately helps the company to maintain a competitive advantage over its competitors. 22

Brand Image
Exceptional brand images are instantly evoked, positive, and almost always unique among competitive brands. Brand image can be reinforced by brand communications, such as packaging, advertising, promotion, customer service, word-of-mouth and other aspects of the brand experience. Staples’ brand image is one of the key ingredients to the success of the company; it is exclusively centered on the brand promise “we make buying office products easy”, which was established in 2003. One way Staples preserves this brand image is through its broad array of sales channels, which includes retail stores, catalog, and Internet. These sales channels offer customers the ability to conveniently purchase Staples’ merchandise in the comfort of their home or at well-planned retail locations. By offering customers numerous ways to purchase products, Staples presents customers with an easy shopping experience while at the same time increasing awareness of its name. Increasing brand awareness provides Staples with the opportunity to establish a positive brand image among new customers, which could ultimately increase market share. The success of the new brand image repositioning is evident in the numbers. In 2005, two years after the “easy” corporate image unveiling, Staples’ market share, when compared with Office Depot and Office Max, was 40.7%. Office Depot’s market share that year was considerably lower than Staples’, and Office Max’s market share actually dropped that year to 23%.

Input Costs
In the year 2000, California experienced an electricity crisis in which the demand for electricity was rising so rapidly that it eventually began to break price records across the state. In response to this crisis, Staples, Inc. teamed up with the energy consulting firm Energy Logic, Inc. in order to figure out a way to help lower their record breaking electricity cost. With funding from the California 23

Energy Commission, they devised a plan to install wireless control technology that would allow them to reduce the lighting and HVAC loads at most of their California locations. Staples associates could send electronic pages from the internet to reduce the electricity consumption at selected stores. In addition, Staples also had modem-enabled utility meters installed at each of the stores in order to verify the load reductions. “Staples now has the ability to curtail up to 2.8 MW of demand within minutes from their Massachusetts headquarters without affecting customer comfort. This not only leads to significant savings in demand charges during peak periods, but also strengthens the reliability of regional electricity supplies in the event of a Stage 2 or Stage 3 emergency,” (energy.ca.gov). This program not only significantly lowered Staples from the possibility of a blackout; it also saved the company large amounts of money, as well as made them allegeable to participate in a California Independent System Operator program. This program offered incentives for each kW reduced during peak demand times. All in all, Staples was able to take advantage of real-time pricing by creating a system that could wirelessly reduce electricity demand at 119 different locations with the “touch of a button.” In addition, this design gave Staples the ability to considerably lower their input cost as well as track the electricity demand patterns for review to make further efficiency improvements. (Baseline vs. Curtailed Graph;.energy.ca.gov)

Conclusion
Staples is able to utilize its competitive advantages over its competitors because of many different successful business strategies. Staples is capable of retaining customers due to its provision of superior customer service and brand image. It also takes a cost leadership position through techniques to lower its input costs, which increase profit margins. These competitive advantages are the key contributions to Staples’ increased market share in the office supplies retail industry.

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Accounting Analysis
“The purpose of the accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality,” (Business Analysis and Valuation). Reviewing a firms accounting policies and looking for areas with accounting flexibility allow analyst to assess the extent of distortion in a company’s accounting numbers. The analyst must then follow with the next step in the accounting analysis which is to undo any of these distortions. This is done by recasting the firm’s accounting numbers ultimately producing unbiased accounting data. Key Accounting Policies The key accounting policies of a firm are extremely important because they relate directly to the firm’s key success factors. In our analysis of Staples’ competitive advantages, we determined that the firm creates its competitive advantages by utilizing both a low cost strategy and a strategy of differentiation. Staples is in the office supplies retail industry, which facilitates growth and profitability by increasing its number of stores, entering into economies of scale by acquiring competition, and investing in the firm’s brand image. The types of leases used to increase operations, the creation of goodwill, and the advertising/marketing expenses incurred to invest in brand image must be examined when implementing the firm’s key accounting policies. To utilize its key success factor of increasing operations, Staples must continue to increase its number of retail stores and distribution centers. According to the firm’s most recent 10-K, Staples leases almost all of their new stores and distribution centers. While Staples does acquire some of these new locations by way of capital leases, a majority of them are leased by way of operating leases. Accounting policies related to these leases are important to examine because they affect important items on the firm’s balance sheet. 25

In order to compete on a low cost basis, Staples must decrease competition within the industry by entering into economies of scale. The firm does this by acquiring other companies. The accounting policies associated with these events involve the addition of goodwill to the balance sheet. “Goodwill is the excess purchase price over the fair value of an acquisition.” (2005 10-k, C13) Goodwill is recorded on the balance sheet as an intangible asset and should be evaluated annually for impairment by the firm. In 2003, Staples completely changed their brand image. It was at this time that the “Easy” marketing strategy was created; one of the most dominant key success factors for Staples. When people see the “Easy button”, they immediately correlate it to the Staples name, whether it is positive or negative. This costly investment in the Staples brand image allows the firm to compete on a differentiation strategy; another major key success factor for the office supply company. Advertising expenses are involved in accounting for this investment in brand image. Staples has spent millions of dollars over the past few years developing new techniques to increase customer awareness in the Staples’ brand image. The accounting for these advertising expenses is a key accounting policy because it deals directly with one of Staples’ most important key success factors, investment in brand image. Accounting Flexibility Accounting flexibility allows management to manipulate and control their reported numbers on their financial statements and reports. Staples is allowed various amounts of accounting flexibility in their key accounting policies and estimates when disclosing financial information. Staples’ key accounting policies relate to their key success factors included in their mixture of cost leadership and differentiation strategies. Many of Staples’ key success factors fall under the differentiation category. For example, Staples is able to provide more flexible delivery and brand image through their various sales channels including retail, catalog, 26

internet, fax, and telephone methods. Furthermore, Staples normally expenses advertising costs, with the exception of their catalog costs which are capitalized and amortized over the life of the catalog giving the firm a form of accounting flexibility. Another way Staples is able to differentiate themselves is by creating customer value and additional brand image by offering numerous services while competing in multiple industries. For example, Staples offers high-speed, color, and self-service copying, faxing, and packaging and shipping services to customers. Also, Staples is expanding globally into foreign markets. Since Staples adopted the Statement of Financial Accounting Standard No. 142 on February 3, 2002, they have acquired six businesses world wide: Officenet, Pressel Versand International, Malling Beck, Globus Office World, Guilbert, and Medical Arts Press. The businesses Staples acquired since the change in accounting policy, included goodwill. SFAS No. 142 requires firms to no longer amortize goodwill and intangibles with indefinite lives. Instead management of firms is permitted to estimate these assets’ impairments and they are allowed to determine how much goodwill to write-off. “Staples uses the fourth quarter to complete its annual goodwill impairment tests, and as a result management has determined no impairment charges have been required toward goodwill since they adopted SFAS No. 142” (Staples’ 10-K). Since this change in accounting policy, Staples’ management has been offered greater accounting flexibility when deciding if goodwill and intangibles with indefinite lives should be written off. The following chart shows the steady increases in goodwill since the adoption of SFAS No. 142 on February 3, 2002.

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Staples, Inc: Goodwill (in thousands) February 3, 2002 North American Retail North American Delivery International 140,832 Operations Total Goodwill $223,718 $1,207,824 $1,202,007 $1,321,464 $1,378,752 781,436 776,154 889,320 910,272 45,777 389,279 388,744 395,035 431,371 $37,109 February 1, 2003 $37,109 January 31, January 29, January 28, 2004 $37,109 2005 $37,109 2006 $37,109

The treatment of Staples’ goodwill most likely overstates their assets and will be further discussed in the “Undo Accounting Distortions” section.
Instead of recording capital leases, firms are able to structure their leases into operating leases. If a company treats leases as operating leases their balance sheet will omit important assets and liabilities. Staples specifically states they finance the majority of their retail stores, support facilities, and equipment with operating leases. The following chart show the amounts of capital and operating leases held by Staples at January 28, 2006, the date of their most recent 10-K filing. Staples, Inc: Leases at January 28, 2006 (in thousands) Total Outstanding Obligations Capital Leases and Notes Payable Operating Leases $12803 $5,246,874

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Staples’ also attempts to differentiate themselves from their competitors by offering an “easy” shopping experience. In order to do so Staples rearranged all of their North American stores to a customer friendly layout, called the dover format. The layout opened the interior of the store to give the customer a better view of Staples’ extensive product array. To account for these improvements, Staples capitalizes and amortizes these costs in the leasehold improvements account. Staples has an ample amount of accounting flexibility when accounting for advertising costs, goodwill, and leases. The accounting flexibility they have help management manipulate and manage their reported numbers on their financial statements and reports. Evaluation of Actual Accounting Strategy When evaluating the actual accounting strategy of a firm, it is important to analyze the accounting policies relative to other leading competitors within the same industry. It is also critical to relate these accounting strategies to a firm’s key success factors, which are the most apparent value additives to a firm. Because Staples, Office Depot, and Office Max possess many similar key success factors, they do, for the most part, implement similar accounting strategies. In the following paragraphs, we will identify Staples’ actual accounting strategies of its key success factors as well as relate them to the accounting strategies of other leading firms within the industry Staples’ management has chosen to establish a mixture of aggressive and conservative accounting policies. For example, Staples’, Office Depot, and Office Max normally expense advertising costs, but each company has chosen to capitalize the costs of catalog production, which totaled $28.4 million in 2005 and $30.8 million in 2006. This is an aggressive accounting practice because it hides advertising expenses in the company’s assets which ultimately increase net income.

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Staples and Office Max both take an aggressive stance when it comes to goodwill impairment. Neither company has recognized an impairment expense since 2001 which raises a red flag because the assets of both companies might be overstated. “Managers can use their reporting judgment to delay write downs on the balance sheet and avoid showing impairment charges in the income statement” (Palepu, 4-8). The affect of not impairing goodwill each year increase Staples’ assets by billions of dollars. At the beginning of 2003, Staples had $1,207,824,000 worth of goodwill. This goodwill was not impaired at the end of the year, therefore; the assets were overstated and expenses were understated by a significant amount. All of the competitors in the office supply superstore industry tend to avoid capital leases and, instead, expense them as operating leases. For example, on January 28, 2006 Staples recorded total outstanding lease obligations amounting to $12,803,000 of capital leases and notes payable, and $5,246,874,000 of operating leases. This type of aggressive accounting policy excludes vital lease assets and liabilities from the balance sheet, understating assets and liabilities. Overall, the office supplies superstore industry is one that uses moderately aggressive accounting policies. While Staples does employ some conservative practices, for the most part, its accounting policies lean more towards the aggressive side of the spectrum. When compared to Office Depot and Office Max, however, Staples has accounting policies that are slightly more conservative than the industry norm. Quality of Disclosure The quality of disclosure accounts for the manager’s ability to accurately disclose information which tells the true story of what is going on in their firm. In looking at the qualitative disclosure, we will analyze the managers of Staples’ discussion on their business strategy, footnotes explaining accounting policies, its current performance, and its segment disclosure. We will also conduct a 30

quantitative disclosure using ratios to analyze the firm’s trends and trends within the industry to see if the firm is overvaluing or undervaluing numbers to make certain aspects of its business look better than it might actually be. The quality of disclosure in regards to the business strategy is normally found in the letter to the shareholders. The business strategy should convey current industry conditions, the company’s competitive positions, and management’s plans for the future. Staples provided a letter to the shareholders along with a business strategy section in the beginning of the 10-k. The letter to the shareholders informed the readers of Staples’ increase in sales, earnings per share increase, and an all time high operating margin. It focused mainly on what it had done over the past year in regards to sales, growth, customer services, brand development, and supply chain improvements. It did not look at the future, not did it really give a good analysis of its competitive position. However, the business strategy section of the 10-k did explain to the shareholders the company’s competitive position and plans for the future. The footnotes for a company should explain key accounting policies and the logic behind them. If any of the policies are different from industry norms, they need to be explained in the footnotes so that outsiders may have an explanation of why the balance of numbers might be off. When looking at Staples’ Footnotes it is apparent that they have adequately explained their key accounting policies and assumptions. Staples includes information on where they derived their numbers to formulate their financial statements. The adequacy with which management discusses its current performance is a chance for management to relay why certain events took place over the year or why certain numbers changed in relation to the past. In analyzing their discussion, we found that Staples did explain why certain numbers changed. For example, interest income increased to $56.8 million from $39.9 million in the previous year. In the management’s discussion, they explained that this increase was due in part to “an increase in interest rates, partially offset by a reduction in

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outstanding borrowings. Interest expense was also impacted by our November 2004 repayment of 150 million Euro Notes.”(Staples, 10-k) The Quality of segment disclosure should provide information about how the firm is divided into product segments and geographic segments. The information that Staples has disclosed in their segment report gives us details about their performance. “Staples has three reportable segments: North American Retail, North American Delivery and International Operations.” (Staples, 10-k)The information about each segment is broken down into how the performance is measured by each one. Financial statements are also included to compare each segments significant accounts and balances. These consolidated financial statements provide sufficient information to assess staples overall performance in comparison to their main accounting policies. Screen Ratio Analysis will be discussed in the following paragraphs. The ratios in the table below are core sales and expense diagnostics which help analysts to see if a company is manipulating its accounting numbers. The following ratios were not found and will not be discussed due to inadequate amounts of information: sales/unearned revenues, sales/warranty liabilities, total accruals/change in sales, pension expense/selling, general, and administrative costs(SG&A), and other employment expenses/SG&A.

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Screen Ratio Analysis
2002 Staples sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa 0.99 31.73 7.36 2.62 0.31 0.18 1.19 31.82 7.45 2.02 0.30 0.16 0.99 31.6 8.85 1.99 1.27 0.18 0.99 29.78 9.02 2.04 1.04 0.17 0.99 27.88 9.42 2.09 0.94 0.17 2003 2004 2005 2006

Office Depot sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa

2002 1.001 14.71 8.69 2.38 1.40 0.14

2003 1.002 11.1 9.24 2.01 1.38 0.10

2004 0.98 10.4 9.62 1.99 1.21 0.09

2005 1.0003 11.58 10.49 2.34 1.82 0.10

2006 0.99 10.14 9.62 2.28 1.12 0.12

Office Max sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa

2002

2003 1.002

2004 1.03 20.63 11.66 1.76 (0.69) (0.06)

2005 0.99 15.26 8.22 1.46 (0.27) (0.01)

2006 no data provided

17.51 10.34 1.5 0.25 0.06

22.03 5.12 1.12 0.69 0.05

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Revenue Diagnostics Sales/ Cash From Sales

1.4 1.2 1 O U 0.8 T P 0.6 U T 0.4 0.2 0 2002

Staples Office Depot Office Max

2003

2004 Year

2005

2006

Over the past five years, Staples ratio of cash to cash from sales has lingered right around 1 with .99 being a common ratio outcome. This means that Staples is collecting roughly $0.99 in cash from every sale. Their ratio shot above the rest of the industry in 2003, but has stabilized in the past three years to average out with the rest of the industry. Office Depot and Office Max also have sales to cash from sales ratio at 1. This indicates that the industry as a whole is collecting cash from sales at relatively the same rate. This would lead us to believe that the majority of sales in the office supply industry are cash sales.

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Sales/ Net Accounts Receivable
35 30 25 Output 20 15 10 5 0 2002 2003 2004 Year 2005 2006 Staples Office Depot Office Max

The ratio that divides sales by net accounts receivables has dropped over the past five years indicating Staples is not collecting their cash receivables. It is currently at its lowest point from the last five years at 27.88. Although its receivable turnover is higher than the other two competitors, we still question why the receivables turnover is decreasing. These two ratios, cash divided by cash from sales and cash divided by net accounts receivable, should move in the same direction. However, our ratio of cash divided by cash from sales is stabilizing while cash divided by net accounts receivables is declining. This would possibly raise a red flag, but Staples can account for this difference in its 10-K notes to consolidated financial statements. Staples receivables consist of trade and non-trade receivables. Trade receivables are receivables from the sale of goods or services on credit. Trade receivables make up for the majority of account receivables at $444.8 million. “Concentrations of credit risk with respect to trade receivables are limited due to Staples large number of customers and their dispersion across many industries and geographic regions.” (Staples, 10-k) This indicates that their majority sales are collectable which is why the cash to cash from sales ratio are at .99. The reason the receivables turnover ratio is 35

declining is because of the non-trade receivables which are increasing and currently account for $148.3 million. Non-trade receivables are receivables from things other than sale of services or goods. Staples includes this to be “vendors under various incentive and promotional programs”. (Staples,10-k) This increase in receivables overall is why the ratio has declined.

Sales/ Inventory
14 12 10 Output 8 6 4 2 0 2002 2003 2004 Year 2005 2006 Staples Office Depot Office Max

Sales divided by inventory is a ratio that has been increasing for Staples over the past five years. This tells us that Staples has been able to keep its inventory supply on track with its sales. In doing so, they are keeping costs low by not having too much inventory on hand. Therefore, revenues from their sales are going to other business needs and not being spend on holding inventory. This also tells us that Staples is aware of their customer’s needs by being able to manage inventory to create sales. In comparison to the industry, Staples and Office Depot have both been increasing their inventory turnover ratios, whereas Office Max has been unstable over the last four years with its inventory ratio turnover. Since Office Depot and Staples have a higher market capitalization, we feel that Staples inventory turnover is in a good position relative to the industry.

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Expense Diagnostics

Sales/ Assets
3 2.5 Output 2 1.5 1 0.5 0 2002 2003 2004 Year 2005 2006 Staples Office Depot Office Max

The asset turnover ratio, sales divided by assets, describes the efficiency to which the company utilizes its assets to generate sales. Staples’ asset turnover ratio has remained at roughly 2. Most recently it is at 2.09. This indicates that Staples was able to generate $2.09 dollars in sales for every dollar of asset for this past year. This shows that Staples is utilizing its assets very well. In comparison to the industry, once again Office Depot is using its assets well too at an average of $2.18 for the past five years. Office Depot though currently leads the big three competitors in its asset utilization. Office Max, which generates less sells, averages at $1.16 for the past five years. We feel that Staples’ asset turnover is accurate in comparison to the industry.

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CFFO/ OI
2 1.5 1 Output 0.5 0 -0.5 -1 Year 2002 2003 2004 2005 2006 Staples Office Depot Office Max

The cash flow from operations (cffo) to operating income (oi) ratio for Staples has fluctuated around 1 for the past three years. Staples had operating income as a line item on its income statements filed for 2006, 2005, and 2004. However, it did not have it as a line item for the reports filed in 2003 and 2002. This is why the ratio jumps from 0.30 to 1.27 in the filing of 2004. We had to compute operating income for the 2003 and 2002 filings. Staples ratio for the past three years is a better comparison to Office Depot, its main competitor, because we did not have to compute their operating income either. Staples last filing in 2006 tells us that $0.94 of every dollar of cash flow from operations results in operating income. Office Depot has remained along 0.2 and Office Max has been very unstable in its cash flow from operations to operating income ratios. The graph shows that the companies in the office supply industry have been inconsistent in their cash flow from operations to operating income. It also tells us that the industry as a whole is not generating enough operating income to support cash flows. Noting that we can compare Staples past three years with the Office Depot, we see that their ratios were very similar in 2004, and in 2005 and 2006 Office Depot has been declining in its ratios and Staples has been inconsistent. We would need a few more years to see if the industry is just trying

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to stabilize itself or if there are actual real problems for this industry in profiting from its operations.

CFFO/ NOA
0.2 0.15 0.1 Output 0.05 0 -0.05 -0.1 Year 2002 2003 2004 2005 2006 Staples Office Depot Office Max

Cash flow from operations divided by net operating assets tells us how well a company utilizes its assets to generate cash flows. Once again Staples’ ratio has remained stable over the last five years at roughly .172. It leads the industry since Office Depot’s ratio has been at about .11, and Office Max has been unstable in this ratio as well. This shows that Staples is utilizing its operating assets more effectively than its two main competitors and is able to generate cash flows from them. Identifying Potential “Red Flags” When reviewing a firm’s financial statements it is important to be aware of abnormal and suspicious behavior and information. These “red flags” arise though a firm’s accounting strategies within their flexibility limitations. They highlight the need to re-examine accounting procedures and outcomes to determine if the company overvalued or undervalued its numbers to make the shareholders believe the company is doing better than it actually is. We believe 39

that the ratios including sales divided by cash from sales, sales divided by net account receivables, sales divide by inventory, sales divided by assets, cash flow from operations (cffo), and cash flow from operations divided by net operating assets (noa) do not raise any potential red flags for Staples. The treatment of goodwill by firms has significantly changed since the implementation of SFAS No. 142. Since Staples adopted the accounting policy on February 3, 2002 they have acquired six businesses globally including a total increase in goodwill of $1,155,034,000. The problem is, since the change in accounting policy, Staples has not accounted for any impairment charges nor written off any goodwill. This aggressive accounting behavior leads to an overstatement of intangible assets and an understatement of impairment expenses. Staples also uses aggressive accounting strategies with advertising costs. Staples normally expenses advertising costs, but capitalizes and amortizes catalog costs over the life of the catalog. While the amounts of catalog costs are relatively low, they still raise concerns over Staples’ accounting strategy, because they are assuming all these catalogs are assets and will provide future economic benefits. Capitalized catalog costs amounted to $30,800,000 at January 29, 2005 and $28,400,000 at January 28, 2006. We conclude, these distortions are not significant enough to be undone due to their low relative magnitude, but they still raise concern and should have been recognized as an expense. Treatment of leases plays a significant role on firms’ financial statements. Staples structures their leases as mainly operating leases to finance their retail stores, support facilities, and equipment, while using capital leases for the remainder. Staples’ capital leases at January 28, 2006 totaled $12,803,000 while their operating leases total $5,246,874,000. Treating leases as operating leases greatly understates lease asses and lease liabilities, thus having a detrimental impact on the balance sheet.

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We did not find any “red flags” associated with our ratio analysis. This may be a result of Staples’ use of aggressive accounting strategies and number manipulations. Undo Accounting Distortions The red flags stated in the “Potential Red Flags” section of this document skewed numerical figures to make the firm appear more profitable. It is important when valuing Staples to undo these accounting distortions in order to truthfully state the firm’s financial position. As stated previously, Staples leases a majority of its new properties by way of operating leases. Staples’ Operating Lease Obligations: Operating Leases Year 1 2 3 4 5 6 7 8 9 10 FV $617,021 $593,176 $558,355 $526,981 $491,310 $492,006 $492,006 $492,006 $492,006 $492,006 i = 7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 PV $576,655.14 $518,102.89 $455,784.00 $402,031.28 $350,297.24 $327,844.37 $306,396.61 $286,351.97 $267,618.66 $250,110.90 $3,741,193.07

The table above shows the present value of Staples’ future payments on its operating leases. We used ten years because when assuming a 20 year maturity, the payments decreased from year 5 to years 6-20 by about $300 million dollars. By assuming a ten year maturity, we kept the remaining payments (Years 5 – 10) fairly close to the payments in the first 5 years. This effect is somewhat of a tradeoff between having a drastic decrease in payments

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after 5 years which would be hard to justify in the financial statements and paying off the leases much faster due to large payments. We assumed a 7% discount rate because that is about the industry standard. From the table, it can be determined that Staples is hiding about $3.7 billion worth of liabilities. To undo this distortion, Staples should increase it leased assets and lease liabilities by $3.7 billion. Staples should also recognize a depreciation expense each year of roughly $374 million ($3741193.07/10 years). The affect of this large expense recognition would ultimately decrease net income, but accurately state Staples’ assets and liabilities. Assets: Leased Assets (Land and Buildings): +$3.7 billion Liabilities: Lease Liabilities (Capital Leases): +$3.7 billion Staples’ also distorted accounting policies when dealing with its impairment of goodwill. As stated previously, Staples has not evaluated goodwill for impairment since 2001. By not doing so, the company is overstating its assets considerably. Even though goodwill is not amortized, we believe an accurate assumption would be to amortize it over 10 years. This amortization expense should be similar to the amount that should have been impaired by Staples’ management at the end of each year. In doing so, Staples would decrease its assets to portray a truthful figure. Since total goodwill equals $1,378,752,000, we believe it is fair to amortize this amount over 10 years at a rate of $137,875,200 per year. This will decrease the current value of goodwill to zero over ten years because we believe the goodwill already acquired will have lost its value.

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Ratio Analysis and Forecasting Financials Financial Analysis Financial Analysis is a very important part of valuing a firm. We use the company’s balance sheets, income statements, and statements of cash flows to analyze the company’s plans and the performance of the firms and corporate managers. We do this analysis through the use of ratios in which we compute for Staples and its competitors. This allows us to make comparisons and note trends. Ratio Analysis In valuing a firm, you must perform a ratio analysis. This provides you with a way to relate different line items of the financial statements and then assess those relationships. A cross-sectional comparison allows you to examine the ratios of your company to its competitors. There are three main groups of ratios: liquidity, profitability, and capital structure. We will analyze these ratios for Staples, Office Depot, and Office Max and compare them against each other. Trend (Time Series) Analysis/ Cross Sectional Analysis We will begin with the liquidity ratios. These ratios include the current ratio, quick-asset ratio, inventory turnover, days inventory turnover, receivables turnover, days receivables turnover, and working capital turnover. Liquidity ratios look at the amount of cash-equivalence in a company’s assets and its ability to turn assets into cash to meet financial obligations. After computing the ratios for Staples and its competitors, we will now analyze these ratios and identify any trends within Staples as well as within the industry. We will begin with the current ratio which is found by dividing current assets by current liabilities.

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Liquidity Ratios Current Assets: Current Assets/Current Liabilities 2001 Staples Office Depot Office Max 1.51 1.61 1.23 2002 1.25 1.57 1.31 2003 1.64 1.51 1.75 2004 1.72 1.43 1.22 2005 1.67 1.16 1.37 2006 1.59

The current ratio is an analysis of the amount of current assets a company has to cover its current liabilities. Current assets consist of cash and cash equivalents, short term investments, net receivables, net merchandise inventories, deferred income tax assets, and prepaid expenses. Current liabilities consist of accounts payable, accrued expenses and other current liabilities, and debt maturing within one year. When reading this ratio, you would state that for every dollar of current liabilities, the company has an amount of current assets to cover those liabilities. Staples, for example, had a current ratio in 2006 that shows that for every dollar of current liabilities, they had $1.59 in current assets to cover those liabilities. A ratio over one suggests that the company has the ability to pay its short term liabilities with its current assets. A ratio under one does not necessarily mean the company will go bankrupt, it just shows that company is not in good financial health. The higher the ratio is, the more liquid its current assets and therefore it has a better ability to meet short term obligations. However, if the current ratio is too high, that tells us that the firm is not utilizing its assets efficiently.

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Current Asset Ratio
1.8 1.7 1.6 output 1.5 1.4 1.3 1.2 1.1 1 2001 2002 2003 years 2004 2005

Staples Office Depot Office Max Industry Avg.

Staples has an average over the past six years of 1.56 with its high being at 1.72 and its low at 1.25. These tell us that Staples is using its assets efficiently and has the ability to cover its short term debt. Its current assets have been steadily increasing at roughly 80% to 90% and its current liabilities have not been increasing as consistently. This is why its current ratio has varied over the past six years. Office Depot and Office Max are also both utilizing their assets efficiently and have the ability to cover their short term debt. The quick asset ratio is a measure of how easily a company can be liquidated. This tells us how credit-worthy a company is. Then companies are rated as being strong or weak by financial institutions.

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Quick Asset Ratio: cash + securities + A/R / Current Liabilities 2001 Staples Office Depot Office Max Industry Average 0.46 0.83 0.46 0.58 2002 0.44 0.88 0.35 0.56 2003 0.41 0.86 1.02 0.76 2004 0.67 0.78 0.42 0.63 2005 0.63 0.56 0.55 0.58 2006 0.62

The quick asset ratio gives us a better idea of if a company has the ability to cover its short term obligations. This is because it does not include inventory like the current ratio does. Inventory is hard to guarantee that it will be liquid because you can not be sure that you can sell your inventory at the market price at any given time. A low quick ratio indicates an efficient use of current assets. Staples has been operating fairly efficiently based on the given ratios. However, over the past three years the ratios have increased. This is just due to an increase in quick assets.
Quick Asset Ratio
1.20 1.00 0.80 output 0.60 0.40 0.20 0.00 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

In comparison with its competitors, Staples has fallen below the industry average until 2004. This also shows that Staples has been the most efficient in

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the use of its assets until 2005. Office Depot has been the most inefficient with its quick asset ratio staying above industry average until recently in 2005. Office Max has been very inconsistent in using its assets efficiently. Staples ability to keep a low quick asset ratio consistently shows that management has been effectively utilizing their assets. Inventory Turnover: Cost of Goods Sold/Inventory 2001 Staples Office Depot Office Max Industry Average 5.60 6.14 8.36 6.70 2002 5.56 6.35 4.12 5.34 2003 6.46 6.61 8.99 7.35 2004 6.45 7.27 6.11 6.61 2005 6.74 6.63 6.09 6.49 2006 6.75

Inventory turnover is a measure of how many times a firm sells and replaces its inventory over a given time period. It is found by taking cost of goods sold and dividing it by inventory. A low turnover rate may indicate overstocking, problems in the marketing effort or product line, or a decline in interest by the consumers for that product. A high turnover rate may indicate inadequate inventory levels. The appropriate inventory level depends on the business that the firm is within. According to www.retailowner.com, Staples inventory should be about 6 to 7 turns. Staples inventory turnover rate averages at about 6 turns. This tells us that Staples is selling its stock of inventory and restocking on average six times a year. Staples, therefore, is generating high profits.

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Inventory Turnover
10 9 8 output 7 6 5 4 3 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

As you can see from the graph, Staples’ inventory turnover seems to be on the same track as the industry average, sometimes dipping just a little below or above the average. Office Depot seems to be following that trend as well. These are the two main competitors in this industry, so it leads us to believe that Staples’ inventory levels are in line with customer demand and that the product line is effective. Office Max’s inventory turnover is inconsistent due to their sales and inventory rates. In 2004, their sales spiked unexpectedly, and therefore they overstocked for 2005. This caused their irregular ratios. Staples increasing inventory turnover can be linked to their marketing efforts. They launched the easy brand promise in 2003 and “the easy button” in 2005. With both of these efforts, they increased their sales which increased their supply of inventory and therefore their inventory turnover ratio. Staples continues to grow and management has done a good job at keeping inventory levels in sync with their sales.

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Days Supply Inventory Turnover: 365/Inventory Turnover 2001 Staples Office Depot Office Max Industry Average 65.19 59.4 43.67 56.09 2002 65.6 57.49 88.62 70.57 2003 56.51 55.24 40.59 50.78 2004 56.55 50.22 59.74 55.50 2005 54.19 55.05 59.90 56.38 2006 54.04

Days supply inventory turnover ratio tells us how many days it takes for a firm to turnover its inventory. It is found by dividing 365 days by the inventory turnover rate. A low days supply of inventory turnover is desirable because it means that the company is not holding inventory in storage for long periods of time. Staples has been decreasing its days supply inventory turnover over the past six years. This indicates that Staples’ is managing its inventory in relation to its sales more effectively. They are not only turning over their inventory at a faster rate, but they are also turning over their days supply inventory at a faster rate. This shows that Staples is generating higher profits, getting inventory out of its stores faster, and managing their inventory levels better.
Days Supply Inventory Turnover
100 90 80 ouput 70 60 50 40 30 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

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Compared to its main competitors, Staples seems to be aligning with the industry. Office Depot leads the industry with consistently having a lower days supply inventory turnover rate. Office Max once again is inconsistent with its ratios. Staples declining days supply inventory ratio tells us several things. It says that they are able to better use their assets. We know this because the lower the days supply turnover rate, the less amount of days that inventory is actually staying in storage. This means that Staples is spending less money on their holdings of inventory which means they are utilizing their assets better. Their turnover rate also tells us that they have significant relations with their suppliers. This would imply that due to their decreasing days supply turnover rate and increasing brand recognition that Staples holds bargaining power over its suppliers. This is beneficial to Staples’ sales and cost of goods sold which are apart of their inventory turnover ratio. This is also important to their key success factors in which they compete on cost. By hold bargaining power over their suppliers they are able to buy their products at a lower cost, thus in turn able to sell it a lower price. Receivables Turnover: Sales/Accounts Receivable 2001 Staples Office Depot Office Max Industry Average 31.73 10.40 17.48 19.87 2002 31.82 7.63 14.36 17.94 2003 31.6 7.14 20.63 19.79 2004 29.78 8.02 15.26 17.69 2005 27.88 10.14 15.94 17.99 2006 25.2

Accounts receivables turnover is found by dividing sales by accounts receivables. “This ratio tells us the number of times accounts receivables are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables and the more cash the client generally has on hand (www.missouribusiness.net).” It measures a firm’s effectiveness in extending credit and collecting debt. Staples has an average 50

turnover rate at 29.67 turns. This indicates to us that Staples is effective in collecting its accounts receivables and probably operates on a cash basis. We can confirm this when looking at the balance sheets for Staples. Over the past six years, Staples cash account is a lot higher compared to its accounts receivables.
Receivables Turnover
35 30 25 output 20 15 10 5 0 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

As you can see from the graph, Staples leads the industry in receivables turnover. This shows us that Staples is managing its accounts receivables better than the other two companies. Office Depot has the lowest receivables turnover rates from 2001 to 2005 which means that they are not collecting on their receivables in relation to their sales rates. Office Max stays right about the industry average indicating that they are collecting on their receivables with enough efficiency. Staples recent decline in their ratios is due to an increase in accounts receivables.

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Days Sales Outstanding: 365/Receivables Turnover Ratio 2001 Staples Office Depot Office Max Industry Average 11.50 24.08 20.88 18.82 2002 11.47 32.85 25.42 23.25 2003 11.55 35.09 17.69 18.11 2004 12.26 31.50 23.92 22.56 2005 13.09 36.00 22.9 24.00 2006 14.49

Days Sales Outstanding tells us how many days it takes the firm to collect their accounts receivables. A lower ratio is preferable because it indicates that the company is collecting their receivables at a fast rate. Staples ratio averages at 12.39 days for the past six years. This means that on average they collected their accounts receivables 12 days after the purchase date. This is a very good rate for Staples.

Days Sales Outstanding
40 35 30 output 25 20 15 10 5 0 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

Staples, as you can see from the graph, leads the industry with the lowest days sales outstanding ratios. This, once again, is indicative that they are taking the least amount of days to collect cash from their accounts receivables. Office Depot has the highest days sales outstanding ratios. This, which correlates with

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their receivables turnover ratio, further proves that Office Depot is struggling to collect cash on their accounts receivables. Their receivables account is increasing and they are taking longer to cash in on the account. Office Max seems to stay within the industry average just like the receivables turnover ratio. Both their cash and receivables have increased over the years, however their sales have not been as steady. In most recent years their sales have declined. This is why Office Max’s ratios have not been consistent. According to Staples annual 10-k report in 2006, the reason that they are able to collect on their accounts is because they have a high customer base spread out internationally and within different industries. We agree with this statement as well as from the ratios we see that Staples has a lot of cash basis transactions. Working Capital: sales/working capital 2001 Staples Office Depot Office Max Industry Average 13.31 9.33 30.61 17.75 2002 21.39 9.51 13.5 14.80 2003 9.57 10.24 9.59 9.80 2004 9.12 13.45 25.89 16.15 2005 9.66 30.94 15.79 18.80 2006 11.05

Working capital is a ratio that measures how many dollars of working capital generate sales. It is found by dividing sales by working capital. Working capital is found by subtracting current liabilities from current assets. A higher working capital turnover is preferred because it means you are generating sales from your working capital. Staples working capital has decreased and has been inconsistent over the past six years. Its high was in 2002 at 21.39. It declined from 2003 to 2005, and has increased again for this past annual report. The reason behind the decline was due to an increasing working capital that did not match the increase in sales. They were both increasing, but working capital was increasing at a faster rate. For this last annual report, Staples working capital ratio is at 11.05 which is an increase from 2005. This means that for 2006, 53

Staples generated $11.05 in sales off of every dollar in working capital. As compared with Office Depot, who in its last annual report for 2005 was generating $30.94 in sales off of every working capital dollar. Staples’ managers will need to change their use of assets considering that Office Depot makes over double off of their working capital dollars than Staples.

Working Capital
35 30 25 output 20 15 10 5 0 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Avg.

As you can see from the graph, none of these companies have been very stable in their working capital ratios. This tells us that the companies are struggling to utilize their assets effieciently and generate profits off of them in a consistent manner. Office Depot has the best working capital ratios. They are increasing with each year. This is due to a decrease in their working capital and increase in sales. Office Max has once again been inconsistent in managing its assets. Staples decline in compared to the industry means that its managers are not utilizing its working capital assets as effectively as compared to its competitors.

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Liquidity Analysis 2001 Current Ratio Quick Asset Ratio Inventory Turnover Days Supply Inventory Turnover Receivables Turnover Days Sales Outstanding Working Capital Turnover After computing the liquidity ratios, we found that overall Staples liquidity is positive. Our current and quick asset ratio tells us that Staples has enough liquid assets to meet its short-term obligations. Our inventory turnover and receivables turnover shows our liquidity in that we are collecting on our receivables at a reasonable rate in comparison to the industry. Our working capital turnover is the only ratio that is slightly negative. Overall, we found Staples’ liquidity to be positive. 13.31 21.39 9.57 9.12 9.66 11.05 Slightly Negative 11.50 11.47 11.55 12.26 13.09 14.49 Positive 31.73 31.82 31.60 29.78 27.88 25.20 Positive 65.19 65.60 56.51 56.55 54.19 54.04 Positive 5.60 5.56 6.46 6.45 6.74 6.75 Positive 0.46 0.44 0.41 0.67 0.63 0.62 Positive 1.51 2002 1.25 2003 1.64 2004 1.72 2005 1.67 2006 1.59 Opinion Steady

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Profitability Ratios Gross Profit Margin (%): Gross Profit/Sales 2001 Staples Office Depot Office Max Industry Average 23.92 29.36 19.04 24.11 2002 25.38 31.35 19.65 25.46 2003 26.98 31.38 22.88 27.08 2004 28.41 30.76 25.64 28.27 2005 28.52 31.10 27.18 28.93 2006 28.60

Gross Profit Margin tells us how efficiently a company uses its materials and labor in the production process. It is a measure of the amount of profit left over after cost of goods sold. A high gross profit ratio is favorable because it means that the company is generating profits after cost of goods sold is subtracted out. Over the past six years, the gross profit margin for Staples has increased from 23.92 to 28.60. This tells us that Staples has become more efficient over the past six years in their production process. This efficiency has come from several different factors. “Gross profit as a percentage of sales was 28.6% for fiscal 2006, 28.5% for fiscal 2005, and 28.4% for fiscal 2004 (Staples 10-k).” Gross profit on its own has been increasing in relation to sales. General and administrative and operating and selling expenses also have both declined in relation to sales. All of these things add up to the increase in gross profit margin over the past couple years.

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Gross Profit Margin
32 30 28 output 26 24 22 20 18 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Avg

Office Depot leads the three competitors with the highest gross profit margin. This indicates that they are generating the most in profits off of their sales after cost of goods sold has been subtracted out. Staples stays right with the industry average. Most recently, Staples profits 28.6% off of every dollar in gross profits. Office Max has the lowest gross profit margins, but they have been increasing over the past five years. Operating Expense Ratio (%): Selling & Administrative Expenses/Sales 2001 Staples Office Depot Office Max Industry Average 18.91 24.87 12.68 18.82 2002 19.40 27.40 13.44 20.08 2003 20.76 27.21 15.14 21.04 2004 20.56 27.39 23.89 23.95 2005 20.27 26.30 23.91 23.50 2006 20.46

The operating expense ratio tells us the efficiency of management of operating expenses in relation to net sales. This ratio should be lower indicating that the firm is reducing expenses to increase profits. Staples operating expense

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ratios are low with an average of 20.06% for the past six years. This shows that management is doing a good job of keeping their operating expenses low while still increasing profits.

Operating Expenses 30 25 output 20 15 10 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Average

Office Depot leads the industry in operating expense ratios averaging at 26.63%. This means that they are not managing their operating expenses very well. Their expenses are high in relation to sales, so they are profiting less from those sales. Staples’ operating expense ratios align with the industry average until 2004 where they fall below the industry average. This means that Staples is continuously working on keeping their expenses low and increasing revenues. Falling below industry average is actually a good thing, meaning that they are becoming the leaders of the industry since a lower operating expense ratio is preferable. Management of Staples is continuously working on keeping their expenses low and in comparison with the rest of the competition they appear to be ahead of the game. Office Max was leading the industry with the lowest ratios until 2004 where it spiked up really high. This is due to a decrease in sales from previous years.

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Net Profit Margin (%): Net Income/Sales 2001 Staples Office Depot Office Max Industry Average 2.47 2.74 0.15 1.79 2002 3.85 2.21 0.10 2.05 2003 3.78 2.47 1.30 2.52 2004 4.90 1.92 -0.81 2.00 2005 5.19 3.44 1.02 3.22 2006 5.36

Net profit margin measures how much of every dollar is actually retained as earnings. A higher net profit margin is preferred meaning that the firm is profitable and that it has very good cost control. Staples’ net profit margin has increased over the past six years. This indicates that they are controlling costs and able to hold on to more of every dollar generated in sales. This would also be another indicator of Staples’ ability to hold bargaining power over their suppliers. When holding power over their suppliers, they are able to buy their products from their suppliers at lower costs which is why we see an increase in their net profit margin. We came to this conclusion because their net income and sales are increasing together. In the fiscal year of 2006, Staples was collecting roughly $0.05 on every sales dollar in comparison to 2001 when they collected roughly $0.02 on every sales dollar.

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Net Profit Margin
6 5 4 output 3 2 1 0 -1 -2 2001 2002 2003 years 2004 2005 Staples Office Depot Office Max Industry Average

As you can see from the graph, Staples leads the industry in net profit margin ratios. Office Depot tends to stay right with the industry average, but more recently has began to increase. This could be due to cost leadership or their increase in sales. This indicates that the office products industry is growing and that relationships between buyers and suppliers are being established. Office Max is inconsistent with their ratios. This tells us that they are having trouble controlling their costs as well as they have had a recent decline in sales. The industry as a whole has low net profit margin ratios. This is due to the pricing strategy of this industry. The office products industry competes on low prices and the majority of their products are high volume sales. Their main products are office products such as pens, staplers, copy paper, and printer ink. These are all products that will be sold in high volume amounts. In selling high volume products at low costs, your net profit margins will be lower because of the lower sales price associated with the costs.

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Asset Turnover 2001 2002 2003 2004 2005 2006 Staples Office Depot OfficeMax Industry Average 2.63 2.03 1.99 2.04 2.09 2.16 2.38 2.01 2.1 2.34 2.28 1.49 1.12 1.73 1.46 1.44 2.17 1.72 1.94 1.95 1.94 2.16

The table above displays the asset turnover ratio over the past five years for Staples and its competitors. Asset turnover is calculated by taking the sales of a firm and dividing it by its total assets. This will show us how efficient Staples is at using its assets to generate sales. With an average of 2.16 over the past five years, we can see that Staples has a fairly neutral profit margin. Since Staples owns so many retail stores and also has to keep an extremely large amount of inventory on hand due to their high demand internet based business, in turn this inflates the asset denominator. The reason why their ratio was larger in 2002 and then decreased a somewhat significant amount in 2003 was because their current assets were high in relevance to their amount of revenue for the subsequent years. When looking at the Industry average for the past five years it is clear the Staples and Office Depot are in the lead, while OfficeMax is once again trailing. For the entire industry the revenue seems to be strong with a slowly but steadily increasing ratio.

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Asset Turnover
3

2.5

2 Staples Output 1.5 Office Depot OfficeMax Industry Average 1

0.5

0 2001 2002 2003 Year 2004 2005 2006

Return on Assets 2002 Staples Office Depot OfficeMax Industry Average 10.90% 0.06 0.01 3.66 2003 8.57% 0.05 0.01 2.88 2004 0.04 0.02 3.65 2005 0.08 0 3.96 12.68 2006 10.89% 11.80% 12.68%

When calculating Return on Assets we used the company’s Net Income for the year we were trying to find and then divided it by the preceding year’s Total current liabilities. This is a marker of how profitable a company is comparative to its total assets invested. Staples has a very positive Return on Asset ratio average totaling 10.97%. Their yearly percentage has been increasing since 2003. Staples is effectively converting the money it has to invest into net income by allocating its resources.

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When looking at the Return on Assets Ratio table we can see that Staples competitors fall extremely far behind. Both Office Depot and OfficeMax’s net income is far less than their total assets which give them such poor ROA ratios. This is due to a very low number of investments. The industry average is far off from all three companies but stays fairly consistent.
Return on Assets
14 12 10 Output 8 6 4 2 0 2002 2003 2004 Year 2005 2006 Staples Office Depot OfficeMax Industry Average

Return on Equity 2002 Staples Office Depot OfficeMax Industry Average 21.72 0.11 0.05 7.29 2003 18.44 0.12 -0.02 6.18 2004 19.34 0.09 0.07 6.50 2005 20.28 0.19 0.01 6.83 22.00 2006 22

When calculating Return on Equity the Net Income is divided by the total equity of the firm for the previous year. This indicates how much profit the firm will generate with the money shareholders invested. Looking at Staples ROE from the years shown in the table above we can see that they have not produced a steady trend but they are at the highest they have been in five year with a ratio of 22% for the year 2006.

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Once again Staples competitors have fallen behind because of such a low Net Income as the numerator to a inflated shareholder’s equity. From just looking at these ratios Office Depot and OfficeMax does not appear to be very profitable.

Return on Equity
25 20 15 O u tp u t 10 5 0 -5 2002 2003 2004 Year 2005 2006 Staples Office Depot OfficeMax Industry Average

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Profitability Analysis 2001 Gross Profit Margin Operating 18.91 Expense Ratio Net Profit Margin Asset Turnover Return on Assets Return on Equity Our overall profitability analysis for Staples is positive. The gross profit margin tells us that Staples is able to generate profits after cost of good sold is taken out; this is a positive factor for Staples. The operating expense ratio is positive for Staples with low ratios indicating that management is reducing expenses. The net profit margin is also positive because our profits are increasing in relation to our expenses. Their asset turnover is good in that we are able to generate sales from their assets. Staples return on assets is another positive ratio indicating their ability to make a profit off of invested assets. Their return on equity is positive because they were able to generate profits off of their shareholders investments. Overall, we found that Staples profitability prove to be positive. N/A 21.72% 18.44% 19.34% 20.28% 22% Positive N/A 10.9% 8.57% 10.89% 11.8% 12.98% Positive 2.63 2.03 1.99 2.04 2.09 2.16 Neutral 2.47 3.85 3.78 4.90 5.19 5.36 Positive 19.40 20.76 20.56 20.27 20.46 Positive 23.92 2002 25.38 2003 26.98 2004 28.41 2005 28.52 2006 28.60 Opinion Slightly Positive

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Capital Structure Ratios The optimal capital structure for a firm is determined by the risk that it takes which is entailed within its liabilities. Part of a company’s short and longterm debt is considered when analyzing capital structure. The capital structure ratios include the Debt to Equity Ratio, the Time Interest Earned Ratio, and the Debt Service Margin Ratio. Debt to Equity Ratio Year Staples Office Depot OfficeMax 2001 0.91 1.07 2.53 1.50 2002 1.03 1.19 2.17 1.46 2003 1.23 1.11 1.93 1.42 2004 2005 2006 1.25 1.28 1.23 1.52 2.61 2.13 1.70 1.64 1.42 1.42

Industry Average

A company’s debt to equity ratio is what provides and indication of how many dollars of debt financing the firm is using for each dollar invested by its shareholders. Staples average amount for every dollar they have invested n equity over the past five years is $1.19. This tells us that Staples does not average a large amount of debt. We can see that their debt to equity has been slightly increasing over the past five years. This could be because Staples has been growing by opening new stores as well as their Internet based clientele; therefore inquiring more and more debt. Compared to Staples competitors, they have the lowest debt to equity ratio. This tells us that even though they are growing they are not doing so in such a way that would inquire a large amount of risk. Office Depot is not far behind which makes them their strongest competitor while OfficeMax is trailing by over a dollar more. Even though OfficeMax is decreasing their debt it might not be a good thing. Office Max might be reducing their number of stores which only puts Staples at an advantage.

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Debt to Equity Ratio 3.00 2.50 O u u tp u t 2.00 1.50 1.00 0.50 0.00 2001 2002 2003 Year 2004 2005 2006 Staples Office Depot OfficeMax Industry Average Average

Times Interest Earned
Year Staples Office Depot OfficeMax Industry Average 2001 16.83 10.37 0.01 9.07 2002 33.12 8.04 0.37 13.84 2003 25.28 7.55 2.49 11.77 2004 28.23 11.16 0.29 13.23 2005 23.13 17.81 1.39 14.11 30.60 2006 30.6

To calculate the Time Interest Earned Ratio we take the earnings before interest and taxes (EBIT) and then divide it by the interest expense. This indicates how many times Staples can cover its interest charges on a pretax basis. A ratio of one means that the firm is barely covering its interest expense through its operating activities; which puts the firm at risk. The larger the ratio the more room it has to pay their interest expense. The average times interest earned ratio for Staples over the pas six year equals 26.13. With a ratio that high, Staples is not putting their firm at risk.

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When comparing Staples to its competitors we have found that they are ahead of the game. Office depot’s average times interest earned equals 10.98, which is far less than half of Staples. OfficeMax’s interest earned is no competition with an average of 0.91.

Times Interest Earned
35 30 25 Output 20 15 10 5 0 2001 2002 2003 Year 2004 2005 2006 Staples Office Depot OfficeMax Industry Average

Debt Service Margin Year Staples Office Depot OfficeMax Industry Average 2001 154.71 17.18 14.66 62.18 2002 2.79 13.45 -0.66 5.19 2003 5.36 1.11 -4.17 0.77 2004 0.79 3.68 2005 1.7 2.22

947.92 427.32

317.46 143.75

Taking the operating cash flow and dividing it by the current amount of notes payable the Debt Service Margin is obtained. This ratio indicates the 68

dollars of cash generated by operations for each dollar of required notes payable. The wider the margin is the more coverage Staples has to meet its obligations to pay its notes. There is no way to see a trend by looking at the margin over the past five years for Staples. Its highest margin is 947 compared to its lowest at almost 3. With a difference of 944, we do not see a steady development. Although Staples competitors have lower, more consistent ratios, it is not possible to predict anything within the future nor make a comparison.

Debt Service Margin
1000 800 600 O utput 400 200 0 -200 2001 2002 2003 Year 2004 2005 Staples Office Depot OfficeMax Industry Average

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Capital Structure Analysis 2001 Debt to Equity Ratio Times Interest Earned Debt Service Margin Our overall capital structure analysis for Staples is slightly positive. Their debt to equity ratio is steady in that they are able to keep their debt at a relative low level. Staples’ times interest earned ratio is positive showing that they have the ability to cover their interest on a pretax basis. Their debt service margin is slightly negative due to Staples’ inconsistency with their ability to cover their notes payable. In general, we find their capital structure to be slightly positive. 154.71 2.79 5.36 947.92 427.32 Slightly Negative 16.83 33.12 25.28 28.23 23.13 30.6 Positive .91 2002 1.03 2003 1.23 2004 1.25 2005 1.28 2006 1.42 Opinion Steady

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Sustainable Growth Rate and Internal Growth Rate SGR & IGR Ratios Staples SGR IGR Office Depot SGR IGR OfficeMax SGR IGR 2003 -4.24% 28 2003 -0.01% 0.06 2003 0.01% -0.01 2004 5.06% 22.5 2004 -0.01% 0.05 2004 -0.01% 0.02 2005 8.07% 28.7 2005 -0.01% 0.04 2005 0.03% -0.02 2006 8.59% 32.4 2006 -0.04% 0.08 2006 -0.01% 0.01

The above table shows the sustainable growth rate for Staples and its competitors over the past five years. The sustainable growth rate is a measure of how Staples can grow without borrowing money. Staples has room to grow in the future at about 8.6% with without having to make any changes to its operating and financial policies. Staples does not start paying dividends until the year 2005. Since they have only been paying dividends for two years it is not possible to forecast a realistic growth rate for the future. The average SGR for Staples is 4.37%. Staples management must have anticipated the growth of the company around 2005 enabling them to start paying dividends. Staples SGR has grown at a fairly reasonable pace while its competitors seem to be slowly dwindling.

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Financial Statement Forecast Methodology Income Statement

While constructing the common size income statement we decided to compute a five year total average and a relevant average, which included the past values we believed to be significant in order to accurately forecast the income statement.
Since our competitors are beginning to offer identical or close substitutes to Staples’ products and services, our industry is becoming less differentiated. Therefore, we chose to use a smaller sales growth than our average from the past 5 years because we believe our industry will soon become very diluted with similar products and services from our competitors making it more difficult to increase sales. In conclusion we chose to use a 11% growth from 2007-2011 and 8.5% from 2012-2016, because we believe Staples will remain the industry leader in the short-run, but will eventually fall near the industry average sales growth as the market becomes less differentiated in the long-run. Cost of goods sold was calculated as the difference between sales and gross profit, and we expect, on average, for cost of goods sold to be 70.85% of sales. Gross profit was forecasted at an increasing rate of 0.10% per year. We derived this estimate from the increasing common size gross profit percentage over the past three years. Industry Sales Growth: 2002-2006 Staples 2002 2003 2004 2005 2006 Sales Growth 7.93% 11.82% 11.42% 11.28% 12.95%

Average

11.08%

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Office Depot 2002 2003 2004 2005 2006 2.48% 8.82% 9.76% 5.27% 5.13%

Average
OfficeMax 2002 2003 2004 2005 2006

6.29%
-0.13% 11.23% 60.95% -30.99% -2.10%

Average Industry Average

7.79% 8.39%

Operating and selling expenses were forecasted using a decreasing rate of 0.05% per year. This rate was computed using the decreasing rate of operating and selling expenses with respect to sales over the relevant past three years. We believe our general and administrative expenses will remain near 4.25% of sales, a slight increase from previous years. This increase is due to the costs we believe will be associated with Staples entering new domestic and foreign markets including the 110 new stores they plan to open in 2007. We avoided increasing the amortization of intangibles from the most recent year at 0.08%. This is due to a potential red flag observed earlier that rises from Staples’ failure to recognize the impairment of goodwill and indefinite lived intangible assets since the adoption of SFAS No. 142 on February 3, 2002. Since that date, Staples has acquired numerous businesses worldwide. Total operating expenses were calculated as the sum of operating and selling expenses, general and

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administrative expenses, and the amortization of intangibles and operating income was calculated as the difference between gross profit and total operating expenses. Interest income and interest expense were forecasted using constant rates of 0.28% and 0.26% respectively using recent their recent trends. Miscellaneous income (expense) was forecasted using the 5 year average of 0.01%. The sum of interest income, interest expense, and miscellaneous interest (expense) equals interest and other expenses, which is added to operating income to obtain income before taxes. Finally, forecasted net income is derived using an increasing rate of 0.15% per year, which is smaller than the average increase, because net income is increasing at a decreasing rate, and income tax expense is calculated by the difference between income before taxes and net income.

74

Staples Income Statements (in thousands) Actual Financial Statements 2002 Sales Cost of goods sold and occupancy costs Gross profit Operating and other expenses: Operating and selling Pre-opening General and administrative Amortization of intangibles Total operating expenses Operating income Other income (expense): Interest income Interest expense Miscellaneous income (expense) Interest and other expense, net Income before income taxes and minority interest Income tax expense Income before minority interests Minority interest Net Income $446100 -$20609 $662063 $215963 $10135 -$31575 $1264 -$20176 $287901 $490211 $ $490211 $31042 -$39888 -$1455 -$10301 $407184 $708388 $ $708388 $59937 -$56773 -$1945 $1219 $479792 $834707 $298 $834409 $58839 -$47810 -$2770 $8259 $497972 $973356 -$321 $973677 $1111019 $1266795 $1443399 $1643526 $1870217 $2078990 $2309743 $2564702 $2846317 $3157276 $56444 -$52412 -$1955 $2077 $545515 $62653 -$58177 -$2016 $2459 $605828 $69544 -$64577 -$2119 $2848 $672708 $77194 -$71680 -$2008 $3506 $2390920 $747394 $85686 -$79565 -$2412 $3708 $2699458 $829240 $92969 -$86328 -$2734 $3907 $2978484 $899493 $100871 -$93666 -$3056 $4149 $3285514 $975771 $109445 -$101628 -$3201 $4617 $3623643 $1058941 $118748 -$110266 -$3428 $5054 $128842 -$119639 -$3688 $5515 $1795428 $2167764 $2359551 $2617958 $2946249 $8746 $454501 $2135 $682672 $524094 $7986 $610568 $8743 $641296 $13008 $770268 $14415 $856735 $16127 $950976 $17901 $1055583 $19870 $1171698 $22055 $5611228 $2383909 $1300584 $24482 $6213162 $2692042 $1411134 $26563 $6724679 $2970670 $1531080 $28820 $7278264 $3277215 $1661222 $31270 $7877373 $3614410 $1802426 $1955632 $33928 $36812 $8525744 $9227425 $3985250 $4393018 $3260257 $3607697 $3992126 $4417475 $4888096 $5286983 $5718363 $6184880 $6689390 $7234981 2003 2004 2005 2006 2003/01/31 2004/01/28 2005/01/28 2006/01/28 2007/02/03 $11596075 $12967022 $14448378 $16078852 $18160789 11% Growth/Year $20158476 $22375908 $24837258 $27569356 $30601986 8.5% Growth/Year $33203154 $36025423 $39087583 $42410028 $46014880 $8652593 $9468890 $10343643 $11493310 $12966788 $2943482 $3498132 $4104735 $4585542 $5194001 $14372976 $15931628 $17659269 $19574220 $21696782 $5785500 $6444280 $7177989 $7995137 $8905204 $23507805 $25469943 $27595801 $29899034 $32394437 $9695349 $10555479 $11491783 $12510994 $13620443 ASSUME 2007 Forecasted Financial Statements 2008 2009 2010 2011 ASSUME 2012 2013 2014 2015 2016

$2260810 $2699844 $2978862 $3272262 $3730932 $798288 $1125873 $1313280 $1463069

$4133119 $4576574 $5067579 $1652380 $1867706 $2110410

$778112 $1115572 $1314499 $1471328

$1656534 $1872624 $2116106

$3995358 $4404049 $1149041 $1246772 .

75

Common Size Income Statement - SPLS Forecasted Financial Statements Actual Financial Statements 5 Year Average Relevant Average ASSUME 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2003/01/31 2004/01/28 2005/01/28 2006/01/28 2007/02/03 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 74.62% 73.02% 71.59% 71.48% 71.40% 72.42% 71.49% Calculated 71.30% 71.20% 71.10% 71.00% 70.90% 70.80% 70.70% 70.60% 70.50% 70.40% 25.38% 26.98% 28.41% 28.52% 28.60% 27.58% 28.51% Increasing 0.10%/Year 28.70% 28.80% 28.90% 29.00% 29.10% 29.20% 29.30% 29.40% 29.50% 29.60% 15.48% 0.08% 3.92% 0.02% 19.50% 5.89% 0.00% 0.00% 0.00% -0.18% 5.71% 1.86% 0.00% 0.00% 3.85% 16.72% 0.00% 4.04% 0.06% 20.82% 6.16% 0.08% -0.24% 0.01% -0.16% 6.00% 2.22% 3.78% 0.00% 3.78% 16.33% 0.00% 4.23% 0.06% 20.62% 7.79% 0.21% -0.28% -0.01% -0.07% 7.72% 2.82% 4.90% 0.00% 4.90% 16.28% 0.00% 3.99% 0.08% 20.35% 8.17% 0.37% -0.35% -0.01% 0.01% 8.18% 2.98% 5.19% 0.00% 5.19% 16.22% 0.00% 4.24% 0.08% 20.54% 8.06% 0.32% -0.26% -0.02% 0.05% 8.10% 2.74% 5.36% 0.00% 5.36% 16.21% 0.02% 4.08% 0.06% 20.37% 7.21% 0.20% -0.23% -0.01% -0.03% 7.14% 2.53% 3.85% 0.00% 4.62% 16.28% Decreasing 0.05%/Year 16.17% 16.12% 16.07% 16.02% 15.97% 15.92% 15.87% 15.82% 15.77% 15.72% 4.08% 0.06% 20.58% 8.01% 0.30% -0.28% -0.01% 0.01% 8.03% 2.85% 4.25% 0.08% Calculated Calculated 0.28% -0.26% -0.01% Calculated Calculated Calculated 4.25% 0.08% 20.50% 8.20% 0.28% -0.26% -0.01% 0.01% 8.22% 2.71% 4.25% 0.08% 20.45% 8.35% 0.28% -0.26% -0.01% 0.01% 8.37% 2.71% 4.25% 0.08% 20.40% 8.50% 0.28% -0.26% -0.01% 0.01% 8.52% 2.71% 4.25% 0.08% 20.35% 8.65% 0.28% -0.26% -0.01% 0.01% 8.67% 2.71% 4.25% 0.08% 20.30% 8.80% 0.28% -0.26% -0.01% 0.01% 8.82% 2.71% 4.25% 0.08% 20.25% 8.95% 0.28% -0.26% -0.01% 0.01% 8.97% 2.71% 4.25% 0.08% 20.20% 9.10% 0.28% -0.26% -0.01% 0.01% 9.12% 2.71% 4.25% 0.08% 20.15% 9.25% 0.28% -0.26% -0.01% 0.01% 9.27% 2.71% 4.25% 0.08% 20.10% 9.40% 0.28% -0.26% -0.01% 0.01% 9.42% 2.71% 4.25% 0.08% 20.05% 9.55% 0.28% -0.26% -0.01% 0.01% 9.57% 2.71%

Sales Cost of goods sold and occupancy costs Gross profit Operating and other expenses: Operating and selling Pre-opening General and administrative Amortization of intangibles Total operating expenses Operating income Other income (expense): Interest income Interest expense Miscellaneous income (expense) Interest and other expense, net Income before income taxes and minority interest Income tax expense Income before minority interests Minority interest Net Income

5.15% Increasing 0.15%/Year 5.51% 5.66% 5.81% 5.96% 6.11% 6.26% 6.41% 6.56% 6.71% 6.86%

76

Balance Sheet To forecast the balance sheet of Staples, we began by taking an average of the percentage of total assets to sales in each of the previous five years. In doing so, we found that total assets are, on average, 48.5% of sales. We ultimately decided to use 45% because in recent years, Staples’ sales have increased greater compared to its total assets. We then multiplied this percentage with each year’s forecasted sales values to arrive at a forecasted value for total assets. Once we had forecasted values for the firm’s total assets we could begin to forecast all the assets of the firm. In most cases, we took an average percentage of total assets for the previous five years to arrive at our forecasted asset values. While this proved to work with many of the asset categories, in some cases, the average was not an accurate forecast index to use. For example, on average, accounts receivable were 7.32% of total assets in the previous five years. However, we used 9% given the recent three year upward trend of the receivables to total assets percentage. The ten year forecasts of Staples’ liabilities and stockholder’s equity were obtained using the same technique. We found an average percentage of each line item to total assets. We found current liabilities to be 32% of total assets and total liabilities to be 42% of total assets, both averaged over the previous five years. We found stockholder’s equity to be an average of 58% of total assets over the previous five years.

77

Balance Sheets - SPLS (in thousands) Actual Financial Statements 2002 2003 2004 2003/01/31 2004/01/28 2005/01/28 Assets Current assets: Cash and cash equivalents Short-term investments Receivables, net Merchandise inventories, net Deferred income tax asset Prepaid expenses and other current assets Total current assets Property and equipment: Land and buildings Leasehold improvements Equipment Furniture and fixtures Total property and equipment Less accumulated depreciation and amortization Net property and equipment Lease acquisition costs, net of accumulated amortization Intangible assets, net of accumulated amortization Goodwill defferred income taxes Other assets Total assets Liabilities Current liabilities: Accounts payable Accrued expenses and other current liabilities Debt maturing within one year Total current liabilities Long-term debt Deferred income tax liability Other long-term obligations Minority interest Total liabilities Adjusted total Liabilities Stockholders Equity: Common stock Additional paid-in capital Cumulative foreign currency translation adjustments Retained earnings Less: treasury stock Total stockholders equity Adjusted total Retained Earnings Adjusted total equity Total liabilities and stockholders equity Total Assets Forecasted DPS Forecasted Total Dividends ∆ Adjusted Total Equity ASSUME 2005 2006/01/28 2006 2007/02/03 2007 2008 2009 2010 Forecasted Financial Statements 2011 2012 2013 2014 2015 2016

$596064 $100175 $364419 $1555205 $96229 $105559 $2717476 $524730 $621713 $951439 $472935 $2570817 $1123065 $1447752 $51450 $216391 $1207824 $80495 $5721388

$457465 $934275 $410330 $1465989 $96247 $114598 $3478904 $601063 $692837 $1045605 $533104 $2872609 $1367308 $1505301 $44227 $209541 $1202007 $63066 $6503046

$997310 $472231 $485126 $1602530 $86041 $138374 $3781612 $649175 $762946 $1140234 $597293 $3149648 $1548774 $1600874 $38400 $222520 $1321464 $106578 $7071448

$977822 $593082 $576672 $1706372 $149257 $141339 $4144544 $705978 $884853 $1330181 $672931 $3593943 $1835549 $1758394 $34885 $240395 $1378752 $119619 $7676589

$1017671 $457759 $720797 $1919714 $141108 $174314 $4431363 $791264 $996434 $1539617 $757408 $4084723 $2110602 $1974121 $33579 $232383 $1455113 $270706 $8397265 45% of sales

$1088558 $598707 $816418 $2120373

$1208299 $664564 $906224 $2265561

$1341212 $737667 $1005909 $2514772

$1488745 $818810 $1116559 $2791397

$1652507 $908879 $1239380 $3098451

$1792970 $986134 $1344728 $3361819

$1945373 $1069955 $1459030 $3647574

$2110730 $1160901 $1583047 $3957618

$2290142 $1259578 $1717606 $4294015

$2484804 $1366642 $1863603 $4659007

$4807796 $907131 $1088558 $1700871 $816418 $4399587 -$2358542 $2177115 $27214

$5336654 $1006916 $1208299 $1887967 $906224 $4883542 -$2617981 $2416598 $30207

$5923686 $1117677 $1341212 $2095644 $1005909 $5420732 -$2905959 $2682424 $33530

$6575292 $1240621 $1488745 $2326164 $1116559 $6017012 -$3225615 $2977490 $37219

$7298574 $1377089 $1652507 $2582043 $1239380 $6678883 -$3580432 $3305014 $41313

$7918952 $1494142 $1792970 $2801516 $1344728 $7246588 -$3884769 $3585941 $44824

$8592063 $1621144 $1945373 $3039645 $1459030 $7862548 -$4214974 $3890746 $48634

$9322389 $10114792 $10974549 $1758941 $2110730 $3298015 $1583047 $8530865 -$4573247 $4221459 $52768 $1908451 $2070670 $2290142 $2484804 $3578346 $3882506 $1863603 $1717606 $9255989 $10042748 -$4961973 $4580283 $57254 -$5383741 $4969607 $62120

$9071314

$10069159

$11176766

$12406210

$13770894

$14941419

$16211440 $17589413 $19084513 $20706696

$1092172 $755483 $327671 $2175326 $732041 $50267 $104862 $3062496

$1110631 $822453 $190150 $2123234 $567433 $7563 $141916 $2840146

$1241433 $954184 $1244 $2196861 $557927 $23314 $178150 $2956252

$1435815 $1041200 $2891 $2479906 $527606 $5845 $233426 $4335 $3251118

$1486188 $1101018 $201177 $2788383 32% of TA $316465 $8986 $252657 $9109 $3375600 42% of TA

$1610158 $1197413 $2902821 $453566 $244925 $3809952 $3151758

$1787276 $1329129 $3222131 $503458 $271867 $4229047 $3101264

$1983876 $1475333 $3576565 $558838 $301773 $4694242 $2989391

$2202102 $1637620 $3969987 $620311 $334968 $5210608 $2804825

$2444334 $1817758 $4406686 $688545 $371814 $5783775 $2534544

$2652102 $1972267 $4781254 $747071 $403418 $6275396 $3946205

$2877531 $2139910 $5187661 $810572 $437709 $6808805 $3384399

$3122121 $2321802 $5628612 $879471 $474914 $7387553 $2705971

$3387501 $2519156 $6107044 $954226 $515282 $8015495 $1896045

$3675439 $2733284 $6626143 $1035335 $559081 $8696812 $938079

$299 $1484833 $11481 $1719091 -$556812 $2658892

$316 $1933379 $81002 $2209302 -$561099 $3662900

$488 $2254947 $114427 $2818163 -$1072829 $4115196

$498 $2544692 $87085 $3529170 -$1735974 $4425471

$510 $3338412 $189115 $4005424 -$2511796 $5021665

$4172804 $5261362 $4903315 $5919556 $9071314

$4631813 $5840112 $5951654 $6967895 $10069159

$5141312 $6482524 $7171134 $8187375 $11176766

$5706857 $7195602 $8585145 $9601386 $12406210

$6334611 $7987118 $10220108 $11236349 $13770894

$6873053 $8666023 $9978973 $10995214 $14941419

$7457262

$8091130

$8778876

$9525080

$9402635 $10201859 $11069017 $12009884 $11810800 $13867201 $16172227 $18752376 $12827041 $14883442 $17188468 $19768617 $16211440 $17589413 $19084513 $20706696

$5721388

$6503046

$7071448

$7676589

$8397265

717

$9071314 $10069159 $11176766 $12406210 $13770894 $14941419 $16211440 $17589413 $19084513 $20706696 $0.30 $0.30 $0.31 $0.32 $0.33 $0.34 $0.34 $0.35 $0.36 $0.37 $213128 $218456 $223918 $229516 $235254 $241135 $247163 $253343 $259676 $266168 17.71% 17.50% 17.27% 17.03% -2.15% 16.66% 16.03% 15.49% 15.01% N/A

78

Common Size Balance Sheet - SPLS Actual Financial Statements 2002 2003 2004 2005 2006 2003/02/01 2004/01/31 2005/01/28 2006/01/28 2007/02/03 Assets Current assets: Cash and cash equivalents Short-term investments Receivables, net Merchandise inventories, net Deferred income tax asset Prepaid expenses and other current assets Total current assets Property and equipment: Land and buildings Leasehold improvements Equipment Furniture and fixtures Total property and equipment Less accumulated depreciation and amortization Net property and equipment Lease acquisition costs, net of accumulated amortization Intangible assets, net of accumulated amortization Goodwill defferred income taxes Other assets Total assets Liabilities Current liabilities: Accounts payable Accrued expenses and other current liabilities Debt maturing within one year Total current liabilities Long-term debt Deferred income tax liability Other long-term obligations Minority interest Total liabilities Stockholders Equity: Common stock Additional paid-in capital Cumulative foreign currency translation adjustments Retained earnings Less: treasury stock Total stockholders equity Total Liabilities and Stockholders Equity AVG ASSUME 2007 2008 2009 Forecasted Financial Statements 2010 2011 2012 2013 2014 2015 2016

10.42% 1.75% 6.37% 27.18% 1.68% 1.84% 47.50% 9.17% 10.87% 16.63% 8.27% 44.93% 19.63% 25.30% 0.90% 3.78% 21.11% 0.00% 1.41% 100.00%

7.03% 14.37% 6.31% 22.54% 1.48% 1.76% 53.50% 9.24% 10.65% 16.08% 8.20% 44.17% 21.03% 23.15% 0.68% 3.22% 18.48% 0.00% 0.97% 100.00%

14.10% 6.68% 6.86% 22.66% 1.22% 1.96% 53.48% 9.18% 10.79% 16.12% 8.45% 44.54% 21.90% 22.64% 0.54% 3.15% 18.69% 0.00% 1.51% 100.00%

12.74% 7.73% 7.51% 22.23% 1.94% 1.84% 53.99% 9.20% 11.53% 17.33% 8.77% 46.82% 23.91% 22.91% 0.45% 3.13% 17.96% 0.00% 1.56% 100.00%

12.12% 5.45% 8.58% 22.86% 1.68% 2.08% 52.77% 9.42% 11.87% 18.33% 9.02% 48.64% 25.13% 23.51% 0.40% 2.77% 17.33% 0.00% 3.22% 100.00%

6.62% 7.32% 22.57%

12% 6.60% 9% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

12.00% 6.60% 9.00% 22.50%

53.43%

53% 10% 12% 18.75% 9% 48.50% 26% 24% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

53.00% 10.00% 12.00% 18.75% 9.00% 48.50% -26.00% 24.00% 0.30%

46.67%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

19.09% 13.20% 5.73% 38.02% 12.79% 0.88% 1.83% 0.00% 53.53%

17.08% 12.65% 2.92% 32.65% 8.73% 0.12% 2.18% 0.00% 43.67%

17.56% 13.49% 0.02% 31.07% 7.89% 0.33% 2.52% 0.00% 41.81%

18.70% 13.56% 0.04% 32.30% 6.87% 0.08% 3.04% 0.06% 42.35%

17.70% 13.11% 2.40% 33.21% 3.77% 0.11% 3.01% 0.11% 40.20%

17.76% 13.20%

17.75% 13.20% 32% of TA 5% 2.70%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

17.75% 13.20% 32.00% 5.00% 2.70% 42.00%

8.01% 2.69%

42.01% 42% of TA

0.01% 25.95% 0.20% 30.05% -9.73% 46.47% 100.00%

0.00% 29.73% 1.25% 33.97% -8.63% 56.33% 100.00%

0.01% 31.89% 1.62% 39.85% -15.17% 58.19% 100.00%

0.01% 33.15% 1.13% 45.97% -22.61% 57.65% 100.00%

0.01% 39.76% 2.25% 47.70% -29.91% 59.80% 100.00%

33.63%

0.01% 35%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

0.01% 35.00%

44.51% 57.99% 100.00%

46% 58%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

46.00% 58.00%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

79

Cash Flows Statement When forecasting the statement of cash flows, we first created a common size cash flow statement to get an idea of the percentage of cash flows from operations. This helped us analyze each line item to determine whether or not there was a growth pattern present. If a pattern is in fact present, then the line item is further analyzed and the first steps of forecasting begin. For the forecasting of net income we used the same growth percentages as net sales; for years 2006 – 2011 the growth rate is 11% and for 2012 – 2016 the growth rate is 8.5%. To better explain, the net income for 2005 is 973,677,000, taking this number and multiplying it by 11% gives you the forecasted net income for 2006: 1,080,781,470. The same method used for net income was also used for depreciation and amortization. A different method was used in the forecasting of net cash provided by operating activities. This forecast was computed by obtaining the growth percentage from years 2002 to 2004 and taking the average of these three percentages. This average is then continuously multiplied each year by the previous year’s cash from operating activities, ultimately giving you the forecasted cash from operating activities. In addition, we also took the average over the past five years of many line items to assist us in the forecasting of the cash flows statement. Lastly, we were unable to forecast many items due to the fact that there were no apparent trends in the numbers.

80

Consolidated Statement of Cash Flows - SPLS (in thousands) 2002 2003/02/01 Operating Activities: Net Income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Deferred income tax (benefit) expense Excess tax benefits from stock-based compensation arrangements Other Change in assets and liabilities, net of companies acquired: Increase in receivables Increase in merchandise inventories Increase in prepaid expenses and other assets Increase in accounts payable Increase in accrued expenses and other current liabilities Increase in other long-term obligations Net cash provided by operating activities Investing activities: Acquisition of property and equipment Acquisition of businesses, net of cash acquired Investment in joint venture, net of cash acquired Proceeds from the sale of short-term investments Purchase of short-term investments Acquisition of lease rights Net cash used in investing activities Free Cash Flows to the Firm Financing activities: Proceeds from the sale of capital stock Proceeds from the exercise of stock options and the sale of stock under Proceeds from borrowings Payments on borrowings Repayments under receivables securitization agreement Cash dividends paid Excess tax benefits from stock-based compensation arrangements Purchase of treasury stock, net Net cash used in financing activities Effect of exchange rate changes on cash Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period CFFO/NI CFFO/OI $446100 Actual Financial Statements 2003 2004 2005 2004/01/31 2005/01/29 2006/01/28 $490211 $664575 $784117 ASSUME 2006 2007/02/03 $973677 2007 Forecasted Financial Statements 2008 2009 2010 ASSUME 2011 2012 2013 2014 2015 2016

Growth Rate = 11% $1080781 $1199667 $1331631 $1478110 $1640702

Growth Rate = 8.5% $1780162 $1931476 $2095651 $2273782 $2467053

$267209 $226 $35767 -$62460 $15781 -$3574 $49396 $63630 $8917 $914350 11.53% -$264692 -$1171187 $265996 -$366171 -$347 -$1536401

$282811 -$13725 $36434 $4218 -$147130 -$34 -$27266 $95549 $12840 $1019732 11.60% -$277793 -$2910 $8180025 -$9014125 -$1114803

$278845 $114861 $15307 -$41205 $12516 -$49786 -$63747 -$8736 $82355 $76103 $56915 $1138003 5.33% -$335435 -$111657 -$29330 $10708696 -$10246652 -$14378

$303900 $129806 -$96189 -$36748 -$6513 -$80166 -$97538 -$15646 $187402 $105274 $20922 $1198621 -$456103 -$40560 -$16636 $8097199 -$8218049 -$634149

$339299 $168736 -$65401 -$36069 -$365

Growth Rate = 11% $376622 $418050 $464036 $515080 $571739

Growth Rate = 8.5% $620336 $673065 $730275

$792349

$859698

-$128010 -$191957 -$44298 $34379 $93175 $21823 $1164989 Growth Rate=9.483% $1275465 $1396417 $1528839 $1673819 $1832548 Growth Rate=9.483% $2006328 $2196588 $2404891 $2632946 $2882629 -$528475 -$29654 -$2096 $8358384 $8223063 -$424904 -$468987 -$520576 -$577839 -$641401 $1275465 $927430 $1008264 $1095981 $1191147 -$550147 -$596910 -$647647 -$702697 -$762426 $1456181 $1599679 $1757244 $1930249 $2120202

$78895 $730897 -$95235

$252972 $136821 -$325235 -$25000

$206934 -$235081 -$99527 $41205 -$511730 -$598739 $14959 $539845 $457465 $997310 58.40% $1.01

$181997 $535 -$16735 -$123402 $36748 -$663145 -$584002 $42 -$19488 $997310 $977822 65.42% $0.91

$195263 -$5191 -$160883 $36069 -$775822 -$710564 $10328 $39849 $977822 $1017671 83.58% $0.80

-$474 $714083 $9033 $101065 $394824 $495889 48.79% $1.34

-$4287 $35271 $21376 -$38424 $495889 $457465 48.07% $1.28

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Common Size Statement of Cash Flows - SPLS Actual FinancialStatements 5 Year Average Relevant Average 2002 2003 2004 2005 2006 2003/02/01 2004/01/31 2005/01/29 2006/01/28 2007/02/03 Operating Activities: Net Income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Deferred income tax (benefit) expense Excess tax benefits from stock-based compensation arrangements Other Change in assets and liabilities, net of companies acquired: Increase in receivables Increase in merchandise inventories Increase in prepaid expenses and other assets Increase in accounts payable Increase in accrued expenses and other current liabilities Increase in other long-term obligations Net cash provided by operating activities 48.789% 48.073% 58.398% 65.418% 83.578% 60.85% 2007 2008 2009 Forecast Financial Statements 2010 2011 2012 2013 2014 2015 2016

60.85% 84.74% 85.91% 87.10% 88.31% 89.53% 88.73% 87.93% 87.14% 86.36% 85.58%

29.224% 27.734% 24.503% 25.354% 29.125% 10.093% 10.830% 14.484% 0.025% -1.346% 1.345% -8.025% -5.614% -3.621% 1.100% -3.066% -0.543% -3.096% -0.031%

27.19% -2.72%

27.19% 29.53% 29.94% 30.35% 30.77% 31.20% 30.92% 30.64% 30.37% 30.09% 29.82% 11.80% -6.82% -3.26% 0.18% -7.35% -11.16% -1.96% 8.61% 7.96% 1.81% 100%

3.912%

3.573%

1.60% -5.69% -8.58% -1.25% 5.71% 7.959% 2.171% 100%

-6.831% 0.414% 1.726% -14.428% -0.391% -0.003% 5.402% -2.674% 6.959% 9.370% 0.975% 1.259% 100% 100%

-4.375% -6.688% -10.988% -5.602% -8.138% -16.477% -0.768% -1.305% -3.802% 7.237% 15.635% 2.951% 6.687% 8.783% 7.998% 5.001% 1.746% 1.873% 100% 100% 100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

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Analysis of Valuations Cost of Capital The cost of capital is an important factor for analysts to consider because it is “the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm” (investopedia.com). It is computed as a weighted average of the value of debt and equity to the firm. Cost of Equity To estimate the cost of equity, we use the CAPM model. To do this, we first had to obtain market prices for Staples, S&P 500 monthly returns, and government risk-free rates. We used the 10 year, 7 year, 5 year, 1 year, and 3 month treasury bill rates. We obtained a market risk premium for each treasury rate by subtracting it from the market, or S&P 500, returns. From there, we ran a regression for 2, 3, 4, 5, and 6 years. From the regression results, we were able to obtain a beta of 1.15. We concluded this because the R^2 value, 23.15%, was the largest of all the regression models. With the attainment of a beta value, we could now estimate the cost of equity using the CAPM model. The cost of equity is important because it is the required rate of return for investors. In other words, it is the minimum rate of return that will induce an investor to buy. Our CAPM model is: Ke = 0.0313 + 1.15(.0617)

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GS10 Summary
24 month 36 month 48 month 60 month 72 month Beta R^2 0.35528 -0.03938 0.68603 0.00395 0.62676 0.01572 1.16314 0.20306 1.14619 0.22953 RF = 0.0472 KE 0.06347 0.07862 0.07591 0.10047 0.09970 24 month 36 month 48 month 60 month 72 month

GS7 Summary
Beta R^2 0.36017 -0.03922 0.68862 0.00414 0.62677 0.01583 1.16301 0.20311 1.14573 0.22949 RF = 0.0453 KE 0.06248 0.07815 0.07520 0.10078 0.09995

GS5 Summary
24 month 36 month 48 month 60 month 72 month Beta R^2 0.36502 -0.03905 0.69114 0.00431 0.62677 0.01597 1.16327 0.20316 1.14607 0.22962 RF = 0.0426 KE 0.06100 0.07743 0.07419 0.10123 0.10036 24 month 36 month 48 month 60 month 72 month

GS1 Summary
Beta R^2 0.39384 -0.03806 0.70952 0.00578 0.63336 0.01715 1.16773 0.20414 1.15041 0.23094 RF = 0.0336 KE 0.05699 0.07575 0.07122 0.10296 0.10193

GS 3 MONTH Summary
24 month 36 month 48 month 60 month 72 month Beta R^2 0.40605 -0.03762 0.71746 0.00649 0.63857 0.01770 1.17050 0.20492 1.15183 0.23153 RF = 0.0313 KE 0.05635 0.07557 0.07070 0.10352 0.10237

We obtained the risk-free rate by taking an average of the yearly returns for each risk-free rate series. We ultimately used the 3 month average risk-free return because it correlated with the highest R^2 value. In addition, we concluded the market return was 0.093. We obtained this value by taking an average of the S&P 500 monthly returns. The market risk premium, 0.0617, was calculated by subtracting the risk-free rate from the average S&P 500 monthly returns (0.093 – 0.0313). Solving the CAPM equation, we were able to calculate a cost of equity of 10.237%.

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Cost of Debt The cost of debt is calculated using current and long-term liabilities from the balance sheet. The different interest rates associated with the debt were found directly in Staples’ 10-K, on the St. Louis Federal Reserve website, or were reasonably estimated using available data for Staples, Office Depot, and OfficeMax. The interest rates for accounts payable and accrued expenses and liabilities are set equal to the one month commercial paper rate of 5.24%. The interest rate for debt maturing within one year is given in Staples’ 10-K as 4.25%. The estimated interest rate for long-term liabilities was calculated using an average of all available interest rates for long-term liabilities found in Staples’ 10-K. The interest rate for long-term debt was directly stated in the 10-K at a rate of 7.33%, and the deferred income tax liabilities are set equal to the risk free rate of a one month treasury bill found on the St. Louis Federal Reserve’s website. The line items contained within current and long-term liabilities on the balance sheet are weighted using total liabilities. The sum of each line item’s interest rate multiplied by its weight equals the total cost of debt of 5.547%. Weighted Average Cost of Capital To compute the after tax weighted average cost of capital we use the value of debt, value of equity, cost of debt, cost of equity, and the tax rate. To compute WACC, we used the following formula: WACC = [Vd/(Vd+Ve)]rd(1-T) + [Ve/(Vd+Ve)]re To find the market value of the equity we simply found the difference between the market capitalization, the total value of the company, and the value of the debt. This is represented by the following formula: VF=VD+VE

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The value of the firm (market capitalization) equals $22,337,993, the value of debt equals $3,366,491,000, and therefore the market value of equity equals $18,971,502. Plugging these values along with the cost of debt of 5.547%, the cost of equity of 10.237%, and a tax rate of 36% into the after-tax WACC formula we end up with a weighted average cost of capital of 9.23%.The following table shows our calculations for the after tax weighted average cost of capital.
LIABILITIES AND SHAREHOLDER'S EQUITY Current Liabilities Accounts Payable Accrued Expenses and Liabilities Debt maturing within one year Total Current Liabilities Long-term liabilities long-term debt Deferred Income Tax Liability Total Liabilities Vd = 3366491 Kd = 0.05547 Ke = 0.10237 Ve = 18971502 T= 0.36 Vf = 22337993 WACC 0.092292 Source Fed Fed 10-K Est. 10-K Fed Interest Weight 0.0524 0.4415 0.0524 0.3271 0.0425 0.0598 0.075 0.0733 0.0518 0.0751 0.0940 0.0027 Value 1,486,188 1,101,018 201,177 2,788,383 252,657 316,465 8,986 3,366,491

0.02313 0.01714 0.00254 0.00563 0.00689 0.00014 0.05547

Method of Comparables STAPLES OFFICE DEPOT OFIICE MAX PPS EPS 25.84 1.32 34.90 1.79 51.30 1.19 BPS 6.99 9.44 DPS 1.34
Does not pay dividends

25.78 1.22

Trailing Price/Earnings: Undervalued STAPLES OFFICE DEPOT OFIICE MAX 19.56 19.46 43.11 Industry 31.28 SPLS 1.32 EPS EST $41.29 Share Price

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The Trailing P/E estimates the share price for Staples to be at $41.29. This makes Staples undervalued at $25.84. We found the estimated share price by taking the industry average and multiplying it by Staples’ earnings per share (EPS). Forward Price/Earnings: Overvalued STAPLES OFFICE DEPOT OFIICE MAX 15.05 12.93 16.60 Industry 14.77 SPLS 1.32 EPS $19.50 EST Share Price

The Forward P/E estimates the share price for Staples at $19.50. This makes Staples overvalued at a current PPS (price per share) of $25.84. We found the estimated share price at $19.50 by taking the industry average and multiplying it by Staples’ EPS. Market/Book: Overvalued STAPLES OFFICE DEPOT OFIICE MAX 3.68 3.69 1.98 Industry 2.83 SPLS 6.99 BPS EST $19.78 Share Price

The Market/Book ratio gives Staples an estimated share price of 19.78. This makes Staples overvalued at $25.84. The estimated share price is found by taking the industry average and multiplying it by Staples’ BPS (book value per share).

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Dividend/Price: STAPLES OFFICE DEPOT OFIICE MAX
Does not pay dividends

1.34

Industry SPLS DPS EST Share Price

1.34 $

1.22

The estimated share price for the Dividends/Price ratio could not be computed because Office Depot does not pay dividends. PEG Ratio: STAPLES OFFICE DEPOT OFIICE MAX .99 1.05 1.18 Industry SPLS EPS Growth Rate EST Share Price 1.11 1.32 9.75 $1.32

Using the PEG ratio, Staples has an estimated share price of $1.32. This would severely overvalue the firm with its current PPS of $25.84. The estimated share price is found by taking the industry average and multiplying it by 1 minus the growth rate. You then multiply that number by Staples’ EPS. The industry as a whole has very low PEG ratios which is why the estimated share price is so low.

Enterprise Value Enterprise Value Staples Office Depot Office Max $20,877,929,090 $13,436,439,000 $ 7,798,334,000

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The enterprise value tells us the theoretical takeover price. It is computed by adding together the market value of equity and the book value of liabilities and then subtracting cash and cash equivalents. Currently, Staples leads the industry with the highest buy out price. Staples has the most stable buyout price too because of their increasing assets and low levels of debt.

Intrinsic Valuation Models Given our previous forecasts and estimates we can derive an intrinsic value using different valuation models. These models include the discount dividends, discounted free cash flows, residual income, abnormal earnings growth, and long run return on equity models. It is known that the residual income model has the largest explanatory power, while the discount dividends model has the lowest. Furthermore, Staples’ most recent 10-K was released on March 1, 2007 and our valuation date is April 1, 2007. Therefore, we found the future value of our estimated intrinsic value at March 1, 2007 to derive our implied value at the valuation date for each model. Again, Staples’ stock price at April 1, 2007, the valuation date, was $25.84. Discount Dividends Model Staples began paying dividends on April 22, 2004 and has given one annually for the past four years. Currently our dividends are increasing at an average rate of 29.61% , but we do not believe this dividend growth rate will sustain in the future because it will result in significantly higher dividend payouts. Therefore, we chose to use a 2.5% dividend growth rate due to our future expectations and lack of historical dividends.

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Staples Dividend History

Date March 28, 2007 March 29, 2006 March 23, 2005 April 22, 2004 Average

Dividend $0.29 $0.22 $0.16667 $0.13333 $0.2025

Change 31.82% 32.00% 25.01% N/A 29.61

After forecasting our expected future dividends for the next ten years, we discounted each one back using the appropriate present value factor using our estimated cost of equity. Furthermore, we expect Staples to pay dividends for the foreseeable future in the form of a perpetuity beginning in 2017. For the value of the perpetuity beginning in 2017 we used the same value as the expected dividend in 2016 of $0.37, because we want to avoid excessively increasing the dividend growth rate. Next, we also discounted the value of the perpetuity back using the present value factor from the previous years.
Sensitivity Analysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $5.02 $3.86 $3.38 $2.63 $2.26 0.025 $6.52 $4.54 $3.82 $2.83 $2.38 0.05 $11.78 $6.05 $4.69 $3.16 $2.57 0.075 ($35.51) $12.61 $7.14 $3.78 $2.88 0.1 ($3.98) ($13.63) $61.39 $5.45 $3.50 0.2 $0.87 $0.68 $0.56 $0.21 ($0.21)

The above chart shows the sensitivity analysis for calculating different intrinsic values when altering the cost of equity and growth rate. Given our estimated cost of equity of 10.237%, the closest intrinsic value we can obtain to our observed price is $7.14 with a growth rate of 7.5%. This means our closest estimate has Staples’ overvalued by $18.70 per share. It is known that the Discount Dividends Model has the lowest amount of explanatory power among the different valuation models. Therefore, we expect our calculated intrinsic 90

values using this model to contain significant error, because future dividends are relatively difficult to accurately predict. Discounted Free Cash Flows The weighted average cost of capital is the discount rate used in the discounted free cash flows model. For Staples, the WACC is 9.23%. The free cash flows are calculated by taking the cash flows from operations and subtracting the cash flows from investing activities. This difference is carried out for nine of the forecasted years and is discounted each year by the discount rate. The discount rate is computed using the formula 1/(1+WACC)t, t being the year number in the forecast. Multiplying the free cash flows by the discount rate gives you the present value of free cash flows. Next, we computed the perpetuity by taking the average growth rate of the free cash flows for the forecasted years and multiplying it by the free cash flows in the year 2015. Finally, we took the total present value of annual cash flows and added the present value of the terminal value to get the value of the firm. We looked at Staples’ 10-K to find the value of debt and also discovered that they do not offer any preferred stock at this point. After getting the book value of debt, we subtracted it from the value of the firm to get the value of equity. We then divided the value of equity by the number of shares outstanding to get the estimated value per share. In our estimated value per share computations, a month is missing due to fact that the release date for Staples’ 10-K is on March 1 and we based everything off of April 1 numbers. We simply just computed the implied value to make up for the missing month.

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WACC

0.09 0.1 0.11 0.12 0.13 0.14

Sensitivity Analysis g 0 0.01 0.03 $20.13 $21.91 $27.17 $17.83 $19.24 $23.25 $15.35 $16.41 $19.33 $13.30 $14.12 $16.30 $11.59 $12.23 $13.89 $10.15 $10.65 $11.94

0.05 $37.40 $30.49 $24.19 $19.72 $16.38 $13.80

The sensitivity analysis above shows that the higher the WACC is the lower the computed share price will be. Also, as the growth rate increases and the WACC is held constant the computed price increases. The price that is closest to the Staples’ observed price of $25.84 on April 1, 2007 appears in the sensitivity analysis when the WACC is at 11% and the growth rate is between 5% and 6%. Overall, with the discounted free cash flow model we decided that the firm is overvalued in that the implied value is $20.13 and the actual price is $25.84. Residual Income We placed the most emphasis for the valuation of Staples on the residual income model because it has the largest explanatory power of the models. The model takes the beginning book value of equity (the previous year’s ending book value of equity), adds the annual net income, and subtracts dividends to arrive at the ending book value of equity. Normal income (benchmark income), which is the income you earn if you maintain value at the cost of equity, is then computed annually by multiplying the cost of equity and the beginning book value of equity each year. Finally, each year’s residual income is calculated by finding the difference between the year’s net income and normal income. Beginning in 2017 we implemented a perpetuity valued at $1,106,315, the same value as the residual income in the previous year. We then discounted back each year’s residual income value and the perpetuity with the appropriate present value discount factor including the cost of equity.

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Sensitivity Analysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $22.50 $20.67 $19.90 $18.72 $18.14 -0.1 $17.57 $17.24 $17.07 $16.75 $16.57 -0.2 $16.30 $16.17 $16.11 $15.98 $15.90 -0.3 $15.71 $15.66 $15.62 $15.56 $15.52 -0.4 $15.38 $15.35 $15.33 $15.30 $15.29 -0.5 $15.16 $15.15 $15.14 $15.13 $15.12

The above chart shows the sensitivity analysis for calculating different intrinsic values when altering the cost of equity and growth rate. Given our estimated cost of equity of 10.237%, the closest intrinsic value we can obtain to our observed price is $19.90 with a growth rate of 0%. This valuation implies Staples is slightly overvalued by $5.94. We used negative growth rates because our return on equity is significantly higher than our cost of equity, and in the long run you ultimately earn the cost of equity. In conclusion, we found the calculated intrinsic share price increases as the cost of equity decreases and/or the growth rate increases. Abnormal Earnings Growth The abnormal earnings growth model is another significant model because it is closely linked the residual income model. For example, the abnormal earnings growth for year two equals the difference between residual income in year two and residual income in year one. We have a lot of confidence in our residual income and abnormal earning growth models because they demonstrated this correlation with very little error, amounting to fractions of a cent. When valuing Staples with the abnormal earnings growth model, we began by multiplying our forecasted dividends by our cost of equity of 10.237% and then adding that amount to Staples’ annual earnings to get cum-dividend earnings. We then calculated our normal income, which again is the income you earn if you maintain value at the cost of equity. To calculate normal income for the abnormal earnings growth model we simply follow the formula: 93

Normal Income = (1+KE)(Earningst-1) Finally, to calculate each year’s abnormal earnings growth you find the difference between cum-dividend earnings and normal earnings to determine value has been created (positive value), maintained (constant value), or destroyed (negative value). Beginning in 2017 we implemented a perpetuity valued at $47,000,000, a slight increase relative to the previous year. Then, we discounted each year’s abnormal earnings growth and the perpetuity with the appropriate present value discount factor including the cost of equity.
Sensitivity Anlaysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $43.86 $28.40 $22.52 $14.37 $10.83 -0.1 $39.55 $26.43 $21.23 $13.80 $10.50 -0.2 $38.44 $25.81 $20.79 $13.58 $10.35 -0.3 $37.93 $25.51 $20.57 $13.46 $10.27 -0.4 $37.63 $25.34 $20.43 $13.38 $10.22 -0.5 $37.44 $25.22 $20.35 $13.33 $10.19

The above chart shows the sensitivity analysis for calculating different intrinsic values when altering the cost of equity and growth rate. Given our estimated cost of equity of 10.237%, the closest intrinsic value we can obtain to our observed price is $22.52 with a growth rate of 0%. This valuation also implies Staples is slightly overvalued by $5.94. Again, we used negative growth rates because you ultimately have to earn the cost of equity and maintain value by having abnormal earnings growth of $0. In conclusion, we placed the most emphasis for valuing Staples on the residual income and abnormal earnings growth model because of the link between the two models and the explanatory power of the residual income model. Long Run ROE Perpetuity The last model we used to derive an intrinsic value for Staples was the long-run ROE perpetuity model. This model is different from the other models in

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that it is a simple mathematical equation and not a summation of calculations over time. The formula for this model is as follows: P=BVE0 + BVE0 [(ROE – Ke)/(Ke – g)] In order to obtain an intrinsic value, we first had to find the return-onequity for each forecasted year by simply dividing EPS for that year by the ending BVE from the previous year. We also had to estimate a growth rate for the book value of equity to be used in the model. We did this by taking the difference between the average growth in the book value of equity, 16.4%, and the cost of equity we obtained in the capital asset pricing model, 10.24%; therefore, we used a growth rate of -6.2%. A negative growth rate was used because growth will increase at a decreasing rate in order to level out at a point equivalent to the cost of equity.

-10% Ke 0.07 0.09 0.10237 0.13 0.15 $11.97 $10.73 $10.08 $8.89 $8.19

Sensitivity Analysis g -6.2% 0 5% $13.39 $11.65 $10.78 $9.25 $8.39 $19.01 $14.81 $13.03 $10.29 $8.93 $48.94 $24.51 $18.74 $12.29 $9.85

10% ($20.89) ($62.77) $265.08 $20.98 $12.61

The above sensitivity analysis chart shows the different intrinsic values calculated when altering the growth rate and the cost of equity. When using the growth rate of -6.2% and a cost of equity of .10237, an intrinsic value of $10.78 was obtained. When adding a BVE0 of $7.00 to the resulting intrinsic value, we obtained a final intrinsic value of $17.78. In a manner parallel to the other valuation models, the long run ROE perpetuity model results in a slightly overvalued market price for Staples.

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Altman’s Z-Score/Creditworthiness When firms obtain loans from lending companies, the lenders analyze the firm’s creditworthiness. As valuation analysts, we too must analyze the firm’s creditworthiness in order to gain an understanding of how firms obtain the interest rates they receive on loans. We did this by using the Altman Z-Score equation. This equation is a fixed weighted equation that ultimately gives a score to a company based on numbers found in financial statements. The Zscore equation is as follows: Z-score = 1.2(Working Capital/Total Assets)+1.4(Retained Earnings/Total Assets)+3.3(Earnings Before Interest and Taxes/Total Assets)+0.6(Market Value of Equity/Book Value of Liabilities)+1.0(Sales/Total Assets) The equation gives weights to each underlying ratio with an emphasis on a company’s current earnings (EBIT/Total Assets). The lowest weight is given to the market’s perception of the firm. A Z-Score of 1.8 or lower implies that a firm has a high level of default risk, while a Z-score of 2.7 or higher implies a low level of default risk. Staples’ Z-scores for the previous five years are shown in the table below: 2002 Z-score 2.34 2003 4.89 2004 5.77 2005 6.22 2006 6.88

From the table above, we concluded that Staples had some credit problems in 2002, but has increased its Z-score each year which implies Staples is extremely creditworthy when it come to its default risk. This is important because Staples can borrow loans with low interest premiums.

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Valuation Conclusion After finding the intrinsic values for each of the discount dividends, discounted free cash flows, residual income, abnormal earnings growth, and long run residual income perpetuity models, we found Staples’ to be overvalued. The discount dividends model had a calculated intrinsic value of $3.38, which we believe to be insignificant because future dividends are relatively difficult to accurately predict. Next, the discounted free cash flows model resulted in an intrinsic value of $20.13, implying Staples is slightly overvalued. The long run residual income perpetuity model had an intrinsic value of $10.78 which is well below the observed price of $25.84 at April 1, 2007. As mentioned earlier we placed the most emphasis on the residual income and abnormal earnings growth models; we did this because of the link between residual income and abnormal earnings growth and the significant explanatory power of the residual income model. The residual income model calculated an intrinsic value of $19.90, ultimately implying that Staples is again slightly overvalued by $5.94. Lastly, the abnormal earnings growth model computed an intrinsic value of $22.52, stating that Staples is slightly overvalued by $3.32. Since, we placed a major emphasis on the residual income and abnormal earnings growth models, we believe it is safe to say Staples is a slightly overvalued firm.

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Appendix 1 – Screening Ratios Screening Ratios
2002 Staples sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa 0.99 31.73 7.36 2.62 0.31 0.18 1.19 31.82 7.45 2.02 0.30 0.16 0.99 31.6 8.85 1.99 1.27 0.18 0.99 29.78 9.02 2.04 1.04 0.17 0.99 27.88 9.42 2.09 0.94 0.17 2003 2004 2005 2006

Office Depot sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa

2002 1.001 14.71 8.69 2.38 1.40 0.14

2003 1.002 11.1 9.24 2.01 1.38 0.10

2004 0.98 10.4 9.62 1.99 1.21 0.09

2005 1.0003 11.58 10.49 2.34 1.82 0.10

2006 0.99 10.14 9.62 2.28 1.12 0.12

Office Max sales/cash from sales sales/net accounts receivable sales/inventory sales/assets cffo/oi cffo/noa

2002

2003 1.002

2004 1.03 20.63 11.66 1.76 (0.69) (0.06)

2005 0.99 15.26 8.22 1.46 (0.27) (0.01)

2006 no data provided

17.51 10.34 1.5 0.25 0.06

22.03 5.12 1.12 0.69 0.05

98

Appendix 2 – Core Financial Ratios Core Financial Ratios
SPLS ODP OMX 2001 1.51 1.61 1.23 2002 1.25 1.57 1.31 Current Ratio 2003 2004 1.64 1.72 1.51 1.43 1.75 1.22 2005 1.67 1.16 1.37 2006 1.59 SPLS ODP OMX 2001 0.46 0.83 0.46 2002 0.44 0.88 0.35 Quick Asset Ratio 2003 2004 0.41 0.67 0.86 0.78 1.02 0.42 2005 0.63 0.56 0.55 2006 0.62

SPLS ODP OMX AVG.

2001 5.6 6.14 8.36 6.7

Inventory Turnover 2002 2003 2004 5.56 6.46 6.45 6.35 6.61 7.27 4.12 8.99 6.11 5.34 7.35 6.61 Receivables Turnover 2002 2003 2004 31.82 31.6 29.78 7.63 7.14 8.02 14.36 20.63 15.26 17.94 19.79 17.69 Working Capital Turnover 2002 2003 2004 21.39 9.57 9.12 9.51 10.24 13.45 13.5 9.59 25.89 14.8 9.8 16.15 Operating Expense Ratio 2002 2003 2004 19.4 20.76 20.56 27.4 27.21 27.39 13.44 15.14 23.89 20.08 21.04 23.95 Asset Turnover 2003 1.99 2.1 1.73 1.94

2005 6.74 6.63 6.09 6.49

2006 6.75

SPLS ODP OMX AVG.

2001 65.19 59.4 43.67 56.09

Days Supply of Inventory 2002 2003 2004 65.6 56.51 56.55 57.49 55.24 50.22 88.62 40.59 59.74 70.57 50.78 55.5 Days Sales Outstanding 2002 2003 2004 11.47 11.55 12.26 32.85 35.09 31.5 25.42 17.69 23.92 23.25 18.11 22.56 Gross Profit Margin 2002 2003 2004 25.38 26.98 28.41 31.35 31.38 30.76 19.65 22.88 25.64 25.46 27.08 28.27 Net Profit Margin 2003 2004 3.78 4.9 2.47 1.92 1.3 -0.81 2.52 2

2005 54.19 55.05 59.9 56.38

2006 54

SPLS ODP OMX AVG.

2001 31.73 10.4 17.48 19.87

2005 27.88 10.14 15.94 17.99

2006 25.2

SPLS ODP OMX AVG.

2001 11.5 24.08 20.88 18.82

2005 13.09 36 22.9 24

2006 14.5

SPLS ODP OMX AVG.

2001 13.31 9.33 30.61 17.75

2005 9.66 30.94 15.79 18.8

2006 11.1

SPLS ODP OMX AVG

2001 23.92 29.36 19.04 24.11

2005 28.52 31.1 27.18 28.93

2006 28.6

SPLS ODP OMX AVG.

2001 18.91 24.87 12.68 18.82

2005 20.27 26.3 23.91 23.5

2006 20.5

SPLS ODP OMX AVG.

2001 2.47 2.74 0.15 1.79

2002 3.85 2.21 0.1 2.05

2005 5.19 3.44 1.02 3.22

2006 5.36

SPLS ODP OMX AVG.

2001 2.63 2.38 1.49 2.17

2002 2.03 2.01 1.12 1.72

2004 2.04 2.34 1.46 1.95

2005 2.09 2.28 1.44 1.94

2006 2.16

2.16

SPLS ODP OMX AVG.

2002 10.90% 0.06 0.01 3.66

Return on Assets 2003 2004 8.57% 10.89% 0.05 0.04 0.01 0.02 2.88 3.65 Return on Equity 2003 2004 18.44 19.34 0.12 0.09 -0.02 0.07 6.18 6.5 Debt Service Margin 2002 2003 2.79 5.36 13.45 1.11 -0.66 -4.17 5.19 0.77 IGR Ratios 2004 22.5 0.05 0.02

2005 11.80% 0.08 0 3.96

2006 12.68%

12.68

Year SPLS ODP OMX AVG.

2001 0.91 1.07 2.53 1.5

Debt to Equity Ratio 2002 2003 2004 1.03 1.23 1.25 1.19 1.11 1.23 2.17 1.93 2.61 1.46 1.42 1.7 Times Interest Earned 2002 2003 2004 33.12 25.28 28.23 8.04 7.55 11.16 0.37 2.49 0.29 13.84 11.77 13.23 SGR Ratios 2004 5.06% 0.01% 0.01%

2005 1.28 1.52 2.13 1.64

2006 1.42

1.42

SPLS ODP OMX AVG.

2002 21.72 0.11 0.05 7.29

2005 20.28 0.19 0.01 6.83

2006 22

22

Year SPLS ODP OMX AVG.

2001 16.83 10.37 0.01 9.07

2005 23.13 17.81 1.39 14.11

2006 30.6

30.6

Year SPLS ODP OMX AVG.

2001 154.71 17.18 14.66 62.18

2004 947.92 0.79 3.68 317.46

2005 427.32 1.7 2.22 143.75

SPLS ODP OMX

2003 4.24% 0.01% 0.01%

2005 8.07% 0.01% 0.03%

2006 8.59% 0.04% 0.01% SPLS ODP OMX

2003 28 0.06 -0.01

2005 28.7 0.04 -0.02

2006 32.4 0.08 0.01

99

Appendix 3 – Regression Analysis
GS3 MONTH Regression Analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.086553745 R Square 0.007491551 Adjusted R Square -0.03762247 Standard Error 0.092325231 Observations 24 ANOVA df Regression Residual Total 1 22 23 SS 0.001415471 0.187526863 0.188942334 MS 0.001415471 0.008523948 F 0.166058152 Significance F 0.687577208 24 month regression

Intercept X Variable 1

Coefficients Standard Error 0.029791382 0.019106708 0.406045495 0.996424957

t Stat 1.559210589 0.407502333

P-value 0.133217031 0.687577208

Lower 95% -0.009833506 -1.660413379

Upper 95% Lower 95.0% Upper 95.0% 0.06941627 -0.009833506 0.06941627 2.472504369 -1.660413379 2.472504369

SUMMARY OUTPUT Regression Statistics Multiple R 0.186739174 R Square 0.034871519 Adjusted R Square 0.006485387 Standard Error 0.077365594 Observations 36 ANOVA df Regression Residual Total 1 34 35

36 month regression

SS 0.007352929 0.203504797 0.210857726

MS 0.007352929 0.005985435

F 1.228470274

Significance F 0.275483845

Intercept X Variable 1

Coefficients Standard Error 0.024425418 0.013051181 0.717464538 0.647318642

t Stat 1.871510182 1.108363782

P-value 0.069899103 0.275483845

Lower 95% -0.002097773 -0.59804521

Upper 95% Lower 95.0% Upper 95.0% 0.050948608 -0.002097773 0.050948608 2.032974286 -0.59804521 2.032974286

SUMMARY OUTPUT Regression Statistics Multiple R 0.196459453 R Square 0.038596317 Adjusted R Square 0.017696237 Standard Error 0.076691357 Observations 48 ANOVA df Regression Residual Total 1 46 47

48 month regression

SS 0.010861524 0.270551952 0.281413475

MS 0.010861524 0.005881564

F 1.846706639

Significance F 0.180793019

Intercept X Variable 1

Coefficients Standard Error 0.023837195 0.011803222 0.638566462 0.469901845

t Stat 2.019549793 1.358935848

P-value 0.049278223 0.180793019

Lower 95% 7.85413E-05 -0.307296879

Upper 95% Lower 95.0% Upper 95.0% 0.047595848 7.85413E-05 0.047595848 1.584429803 -0.307296879 1.584429803

SUMMARY OUTPUT Regression Statistics Multiple R 0.467326457 R Square 0.218394017 Adjusted R Square 0.204918052 Standard Error 0.079540534 Observations 60 ANOVA df Regression Residual Total 1 58 59

60 month regression

SS 0.102531631 0.366948404 0.469480035

MS 0.102531631 0.006326697

F 16.20618734

Significance F 0.000166895

Intercept X Variable 1

Coefficients Standard Error 0.019855646 0.010294828 1.170498834 0.290757253

t Stat 1.92870113 4.025690915

P-value 0.058666738 0.000166895

Lower 95% -0.000751691 0.58848496

Upper 95% Lower 95.0% Upper 95.0% 0.040462982 -0.000751691 0.040462982 1.752512707 0.58848496 1.752512707

SUMMARY OUTPUT Regression Statistics Multiple R 0.492290627 R Square 0.242350061 Adjusted R Square 0.231526491 Standard Error 0.078594115 Observations 72 ANOVA df Regression Residual Total 1 70 71

72 month regression

SS 0.1383097 0.432392446 0.570702146

MS 0.1383097 0.006177035

F 22.39095316

Significance F 1.12157E-05

Intercept X Variable 1

Coefficients Standard Error 0.023249409 0.009262733 1.151832192 0.24341813

t Stat 2.509994381 4.731907983

P-value 0.014388184 1.12157E-05

Lower 95% 0.00477547 0.666350046

Upper 95% Lower 95.0% Upper 95.0% 0.041723348 0.00477547 0.041723348 1.637314337 0.666350046 1.637314337

100

GS1 Regression Analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.084091248 R Square 0.007071338 Adjusted R Square -0.038061783 Standard Error 0.092344774 Observations 24 ANOVA df Regression Residual Total 1 22 23 SS 0.001336075 0.187606259 0.188942334 MS 0.001336075 0.008527557 F 0.156677353 Significance F 0.696046749 24 month regression

Intercept X Variable 1

Coefficients Standard Error 0.029895163 0.019083489 0.39383803 0.994980426

t Stat 1.566546007 0.395824902

P-value 0.131492778 0.696046749

Lower 95% -0.00968157 -1.66962507

Upper 95% Lower 95.0% Upper 95.0% 0.069471895 -0.00968157 0.069471895 2.457301129 -1.66962507 2.457301129

SUMMARY OUTPUT Regression Statistics Multiple R 0.184898701 R Square 0.03418753 Adjusted R Square 0.00578128 Standard Error 0.077393004 Observations 36 ANOVA df Regression Residual Total 1 34 35

36 month regression

SS 0.007208705 0.203649021 0.210857726

MS 0.007208705 0.005989677

F 1.20352143

Significance F 0.280328315

Intercept X Variable 1

Coefficients Standard Error 0.024630357 0.013031071 0.70951884 0.646750864

t Stat 1.890125285 1.097051243

P-value 0.067290732 0.280328315

Lower 95% -0.001851966 -0.604837045

Upper 95% Lower 95.0% Upper 95.0% 0.051112679 -0.001851966 0.051112679 2.023874725 -0.604837045 2.023874725

Regression Statistics Multiple R 0.195096916 R Square 0.038062806 Adjusted R Square 0.017151128 Standard Error 0.076712633 Observations 48 ANOVA df Regression Residual Total 1 46 47 SS 0.010711387 0.270702088 0.281413475 MS 0.010711387 0.005884828 F 1.82016987 Significance F 0.183896798

Intercept X Variable 1

Coefficients Standard Error 0.024035393 0.011765963 0.633364215 0.469458884

t Stat 2.042790072 1.349136713

P-value 0.046827764 0.183896798

Lower 95% 0.000351738 -0.311607491

Upper 95% Lower 95.0% Upper 95.0% 0.047719048 0.000351738 0.047719048 1.578335921 -0.311607491 1.578335921

SUMMARY OUTPUT Regression Statistics Multiple R 0.466503455 R Square 0.217625473 Adjusted R Square 0.204136257 Standard Error 0.07957963 Observations 60 ANOVA df Regression Residual Total 1 58 59

60 month regression

SS 0.102170815 0.36730922 0.469480035

MS 0.102170815 0.006332918

F 16.13329298

Significance F 0.000171986

Intercept X Variable 1

Coefficients Standard Error 0.020148895 0.010295024 1.167727698 0.290723455

t Stat 1.957148877 4.016627065

P-value 0.055148603 0.000171986

Lower 95% -0.000458835 0.58578148

Upper 95% Lower 95.0% Upper 95.0% 0.040756625 -0.000458835 0.040756625 1.749673916 0.58578148 1.749673916

SUMMARY OUTPUT Regression Statistics Multiple R 0.491706948 R Square 0.241775723 Adjusted R Square 0.230943947 Standard Error 0.078623899 Observations 72 ANOVA df Regression Residual Total 1 70 71

72 month regression

SS 0.137981924 0.432720222 0.570702146

MS 0.137981924 0.006181717

F 22.32096899

Significance F 1.15295E-05

Intercept X Variable 1

Coefficients Standard Error 0.023510172 0.009265944 1.150406012 0.243497564

t Stat 2.537266859 4.724507274

P-value 0.013402679 1.15295E-05

Lower 95% 0.00502983 0.66476544

Upper 95% Lower 95.0% Upper 95.0% 0.041990513 0.00502983 0.041990513 1.636046584 0.66476544 1.636046584

101

GS5 Regression Analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.078240898 R Square 0.006121638 Adjusted R Square -0.039054651 Standard Error 0.092388925 Observations 24 ANOVA df Regression Residual Total 1 22 23 SS 0.001156637 0.187785698 0.188942334 MS 0.001156637 0.008535714 F 0.135505554 Significance F 0.716308786 24 month regression

Intercept X Variable 1

Coefficients Standard Error 0.029989514 0.019087403 0.365018108 0.991598502

t Stat 1.571167905 0.36811079

P-value 0.130415889 0.716308786

Lower 95% -0.009595336 -1.691431309

Upper 95% Lower 95.0% Upper 95.0% 0.069574364 -0.009595336 0.069574364 2.421467525 -1.691431309 2.421467525

SUMMARY OUTPUT Regression Statistics Multiple R 0.180995283 R Square 0.032759293 Adjusted R Square 0.004311037 Standard Error 0.077450207 Observations 36 ANOVA df Regression Residual Total 1 34 35

36 month regression

SS 0.00690755 0.203950176 0.210857726

MS 0.00690755 0.005998535

F 1.151539572

Significance F 0.290784669

Intercept X Variable 1

Coefficients Standard Error 0.02495544 0.013005939 0.691137673 0.644058228

t Stat 1.918772645 1.073098118

P-value 0.063440204 0.290784669

Lower 95% -0.001475808 -0.617746117

Upper 95% Lower 95.0% Upper 95.0% 0.051386688 -0.001475808 0.051386688 2.000021462 -0.617746117 2.000021462

SUMMARY OUTPUT Regression Statistics Multiple R 0.192104667 R Square 0.036904203 Adjusted R Square 0.015967338 Standard Error 0.076758817 Observations 48 ANOVA df Regression Residual Total 1 46 47

48 month regression

SS 0.01038534 0.271028135 0.281413475

MS 0.01038534 0.005891916

F 1.762642259

Significance F 0.190846455

Intercept X Variable 1

Coefficients Standard Error 0.024506308 0.011677304 0.626770273 0.472091631

t Stat 2.098627214 1.327645381

P-value 0.04136892 0.190846455

Lower 95% 0.001001114 -0.323500878

Upper 95% Lower 95.0% Upper 95.0% 0.048011501 0.001001114 0.048011501 1.577041424 -0.323500878 1.577041424

SUMMARY OUTPUT Regression Statistics Multiple R 0.465478647 R Square 0.216670371 Adjusted R Square 0.203164687 Standard Error 0.07962819 Observations 60 ANOVA df Regression Residual Total 1 58 59

60 month regression

SS 0.101722413 0.367757622 0.469480035

MS 0.101722413 0.006340649

F 16.04290329

Significance F 0.000178525

Intercept X Variable 1

Coefficients Standard Error 0.021111325 0.010288698 1.163265806 0.290427328

t Stat 2.051894647 4.005359321

P-value 0.044703476 0.000178525

Lower 95% 0.000516258 0.58191235

Upper 95% Lower 95.0% Upper 95.0% 0.041706392 0.000516258 0.041706392 1.744619261 0.58191235 1.744619261

SUMMARY OUTPUT Regression Statistics Multiple R 0.490376394 R Square 0.240469008 Adjusted R Square 0.229618565 Standard Error 0.078691619 Observations 72 ANOVA df Regression Residual Total 1 70 71

72 month regression

SS 0.137236179 0.433465967 0.570702146

MS 0.137236179 0.006192371

F 22.16213784

Significance F 1.22758E-05

Intercept X Variable 1

Coefficients Standard Error 0.024515644 0.009275855 1.146067639 0.243446998

t Stat 2.642952503 4.707667983

P-value 0.010133685 1.22758E-05

Lower 95% 0.006015535 0.660527917

Upper 95% Lower 95.0% Upper 95.0% 0.043015753 0.006015535 0.043015753 1.631607361 0.660527917 1.631607361

102

GS 7 Regression Analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.07724672 R Square 0.005967056 Adjusted R Square -0.03921626 Standard Error 0.09239611 Observations 24 ANOVA df Regression Residual Total 1 22 23 SS 0.001127429 0.187814905 0.188942334 MS 0.001127429 0.008537041 F 0.132063254 Significance F 0.719770993 24 month regression

Intercept X Variable 1

Coefficients Standard Error 0.030015554 0.019083709 0.360166888 0.991089299

t Stat 1.572836467 0.363405083

P-value 0.13002892 0.719770993

Lower 95% -0.009561637 -1.695226506

Upper 95% Lower 95.0% Upper 95.0% 0.069592744 -0.009561637 0.069592744 2.415560283 -1.695226506 2.415560283

SUMMARY OUTPUT Regression Statistics Multiple R 0.180522947 R Square 0.032588534 Adjusted R Square 0.004135256 Standard Error 0.077457043 Observations 36 ANOVA df Regression Residual Total 1 34 35

36 month regression

SS 0.006871544 0.203986182 0.210857726

MS 0.006871544 0.005999594

F 1.145334958

Significance F 0.292066719

Intercept X Variable 1

Coefficients Standard Error 0.025051071 0.012996946 0.68862421 0.643451813

t Stat 1.927458297 1.070203232

P-value 0.062310959 0.292066719

Lower 95% -0.001361901 -0.619027196

Upper 95% Lower 95.0% Upper 95.0% 0.051464042 -0.001361901 0.051464042 1.996275616 -0.619027196 1.996275616

SUMMARY OUTPUT Regression Statistics Multiple R 0.19176517 R Square 0.03677388 Adjusted R Square 0.015834182 Standard Error 0.07676401 Observations 48 ANOVA df Regression Residual Total 1 46 47

48 month regression

SS 0.010348665 0.27106481 0.281413475

MS 0.010348665 0.005892713

F 1.756180052

Significance F 0.191646605

Intercept X Variable 1

Coefficients Standard Error 0.02463916 0.011648824 0.626771553 0.472960375

t Stat 2.115162905 1.325209437

P-value 0.039862961 0.191646605

Lower 95% 0.001191294 -0.32524829

Upper 95% Lower 95.0% Upper 95.0% 0.048087026 0.001191294 0.048087026 1.578791395 -0.32524829 1.578791395

SUMMARY OUTPUT Regression Statistics Multiple R 0.465417422 R Square 0.216613377 Adjusted R Square 0.203106711 Standard Error 0.079631087 Observations 60 ANOVA df Regression Residual Total 1 58 59

60 month regression

SS 0.101695656 0.367784379 0.469480035

MS 0.101695656 0.00634111

F 16.03751645

Significance F 0.000178922

Intercept X Variable 1

Coefficients Standard Error 0.021407622 0.010286291 1.163008089 0.290411746

t Stat 2.081180003 4.00468681

P-value 0.04184229 0.000178922

Lower 95% 0.000817375 0.581685824

Upper 95% Lower 95.0% Upper 95.0% 0.04199787 0.000817375 0.04199787 1.744330353 0.581685824 1.744330353

SUMMARY OUTPUT Regression Statistics Multiple R 0.490249418 R Square 0.240344492 Adjusted R Square 0.229492271 Standard Error 0.078698069 Observations 72 ANOVA df Regression Residual Total 1 70 71

72 month regression

SS 0.137165117 0.433537029 0.570702146

MS 0.137165117 0.006193386

F 22.14703149

Significance F 1.23493E-05

Intercept X Variable 1

Coefficients Standard Error 0.024815209 0.009278143 1.145733221 0.24345895

t Stat 2.674587924 4.706063269

P-value 0.009306893 1.23493E-05

Lower 95% 0.006310537 0.660169663

Upper 95% Lower 95.0% Upper 95.0% 0.043319881 0.006310537 0.043319881 1.631296779 0.660169663 1.631296779

103

GS10 Regression Analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.076222945 R Square 0.005809937 Adjusted R Square -0.03938052 Standard Error 0.092403412 Observations 24 ANOVA df Regression Residual Total 1 22 23 SS 0.001097743 0.187844591 0.188942334 MS 0.001097743 0.008538391 F 0.128565578 Significance F 0.723341865

24 month regression

Intercept X Variable 1

Coefficients Standard Error 0.030050521 0.019076393 0.355276889 0.990842446

t Stat 1.575272716 0.358560425

P-value 0.129465622 0.723341865

Lower 95% -0.009511496 -1.699604566

Upper 95% Lower 95.0% Upper 95.0% 0.069612538 -0.009511496 0.069612538 2.410158343 -1.699604566 2.410158343

SUMMARY OUTPUT Regression Statistics Multiple R 0.180010444 R Square 0.03240376 Adjusted R Square 0.003945047 Standard Error 0.07746444 Observations 36 ANOVA df Regression Residual Total 1 34 35

36 month regression

SS 0.006832583 0.204025143 0.210857726

MS 0.006832583 0.006000739

F 1.138623525

Significance F 0.293461887

Intercept X Variable 1

Coefficients Standard Error 0.025152428 0.012987996 0.686026775 0.642911197

t Stat 1.936590369 1.067063037

P-value 0.061142443 0.293461887

Lower 95% -0.001242355 -0.620525968

Upper 95% Lower 95.0% Upper 95.0% 0.051547211 -0.001242355 0.051547211 1.992579518 -0.620525968 1.992579518

SUMMARY OUTPUT Regression Statistics Multiple R 0.191480243 R Square 0.036664683 Adjusted R Square 0.015722611 Standard Error 0.076768361 Observations 48 ANOVA df Regression Residual Total 1 46 47

48 month regression

SS 0.010317936 0.271095539 0.281413475

MS 0.010317936 0.005893381

F 1.750766745

Significance F 0.192319978

Intercept X Variable 1

Coefficients Standard Error 0.024769844 0.011620988 0.62675715 0.473680114

t Stat 2.131474954 1.323165426

P-value 0.038424656 0.192319978

Lower 95% 0.00137801 -0.326711452

Upper 95% Lower 95.0% Upper 95.0% 0.048161678 0.00137801 0.048161678 1.580225752 -0.326711452 1.580225752

SUMMARY OUTPUT Regression Statistics Multiple R 0.465371651 R Square 0.216570774 Adjusted R Square 0.203063373 Standard Error 0.079633252 Observations 60 ANOVA df Regression Residual Total 1 58 59

60 month regression

SS 0.101675654 0.36780438 0.469480035

MS 0.101675654 0.006341455

F 16.03349026

Significance F 0.00017922

Intercept X Variable 1

Coefficients Standard Error 0.021668041 0.010284563 1.163137511 0.290480528

t Stat 2.106851008 4.004184094

P-value 0.039466386 0.00017922

Lower 95% 0.001081252 0.581677563

Upper 95% Lower 95.0% Upper 95.0% 0.04225483 0.001081252 0.04225483 1.744597459 0.581677563 1.744597459

SUMMARY OUTPUT Regression Statistics Multiple R 0.49028316 R Square 0.240377577 Adjusted R Square 0.229525828 Standard Error 0.078696356 Observations 72 ANOVA df Regression Residual Total 1 70 71

72 month regression

SS 0.137183999 0.433518147 0.570702146

MS 0.137183999 0.006193116

F 22.15104488

Significance F 1.23297E-05

Intercept X Variable 1

Coefficients Standard Error 0.025057661 0.009279495 1.146191504 0.243534266

t Stat 2.700325913 4.706489656

P-value 0.008680112 1.23297E-05

Lower 95% 0.006550292 0.660477732

Upper 95% Lower 95.0% Upper 95.0% 0.04356503 0.006550292 0.04356503 1.631905276 0.660477732 1.631905276

104

Appendix 4 – Valuation Models Discount Dividends
Staples - Discount Dividends Valuation
Years from valuation date 1-Mar-07 2006 $0.29 1 2007 $0.30 0.907 $0.27 2 2008 $0.30 0.823 $0.25 3 2009 $0.31 0.746 $0.23 4 2010 $0.32 0.677 $0.22 5 6 Forecast Years 2011 2012 $0.33 $0.34 0.614 0.557 $0.20 $0.19 7 2013 $0.34 0.505 $0.17 8 2014 $0.35 0.459 $0.16 9 2015 $0.36 0.416 $0.15 10 PERP 2016 $0.37 0.377 $0.14 $0.37

Dividends per share PV Factor PV of Future Dividends Total PV of Forecast Future Dividends Continuing (Terminal) Value (assume no growth) PV of Continuing (Terminal) Value Estimated Value at March 1, 2007 Implied value for end of March 2007 Observed Value at 1 April, 2007 Difference Ke g Actual Price per share Total Outstanding Shares

$1.99 $3.61 $1.36 $3.35 $3.38 $25.84 ($22.46) 0.10237 0 $25.84 717,000

$3.61 Sensitivity Analysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $5.02 $3.86 $3.38 $2.63 $2.26 0.025 $6.52 $4.54 $3.82 $2.83 $2.38 0.05 $11.78 $6.05 $4.69 $3.16 $2.57 0.075 ($35.51) $12.61 $7.14 $3.78 $2.88 0.1 ($3.98) ($13.63) $61.39 $5.45 $3.50 0.2 $0.87 $0.68 $0.56 $0.21 ($0.21)

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Discounted Free Cash Flows
Staples - Discounted Free Cash Flows
1 1-Mar-07 Cash Flow from Operations Cash Provided (Used) by Investing Activities Free Cash Flow (to firm) Discount Rate (9% WACC) Present Value of Free Cash Flows Total Present Value of Annual Cash Flows Continuing (Terminal) Value (assume no growth) Present Value of Continuing (Terminal) Value Value of the Firm (end of 2006) Book Value of Debt Value of Equity (end of 2006) Estimated Value per Share at March 1, 2007 Implied value for end of March 2007 Actual Price per share Difference WACC g Actual Price per share Total Outstanding Shares 2007 $1,275,464,907 ($440,000,000) $835,464,907 0.916 $764,873,227 2 2008 $1,396,417,244 ($468,986,939) $927,430,305 0.838 $777,327,043 3 2009 $1,528,839,491 ($520,575,503) $1,008,263,989 0.767 $773,673,992 4 2010 $1,673,819,340 ($577,838,808) $1,095,980,532 0.702 $769,923,948 5 Forecasted Years 2011 $1,832,547,628 ($641,401,077) $1,191,146,552 0.643 $766,075,253 6 2012 $2,006,328,120 ($550,147,196) $1,456,180,924 0.589 $857,398,699 7 2013 $2,196,588,215 ($596,909,708) $1,599,678,507 0.539 $862,306,063 8 2014 $2,404,890,676 ($647,647,033) $1,757,243,643 0.494 $867,205,369 9 PERP 2015 $2,632,946,459 ($702,697,031) $1,930,249,428 0.452 $872,096,727

$2,123,274,371

$7,310,880,321 $23,006,050,046 $10,394,253,020 $17,705,133,341 $3,375,600,000 $14,329,533,341 19.99 20.13 $25.84 ($5.71) 0.09 0.00 $25.84 717000 $23,006,050,046 Sensitivity Analysis g WACC 0.09 0.1 0.11 0.12 0.13 0.14 0 $20.13 $17.83 $15.35 $13.30 $11.59 $10.15 0.01 $21.91 $19.24 $16.41 $14.12 $12.23 $10.65 0.03 $27.17 $23.25 $19.33 $16.30 $13.89 $11.94 0.05 $37.40 $30.49 $24.19 $19.72 $16.38 $13.80

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Residual Income
Staples-Residual Income
Years from valuation date 1-Mar-07 2006 Beginning BE Earnings Dividends Ending BE Ke "Normal" Income Residual Income (RI) Discount Factor Present Value of RI ∆ Residual Income ROE ROE Growth BV Equity (per share) 2006 Total PV of RI (end 2006) Continuation (Terminal) Value PV of Terminal Value (end 2006) Estimated Value at March 1, 2007 Implied value for end of March 2007 Observed Value at 1 April, 2007 Difference Ke Growth Actual Price per share Total Outstanding Shares 0 1 2007 $5,021,665 $1,111,019 $213,128 $5,919,556 $514,068 $596,951 0.907 $541,516.15 22.12% $7.00 $7.05 $15.07 $5.69 $19.74 $19.90 $25.84 ($5.94) 0.10237 0 $25.84 717000 2 2008 $5,919,556 $1,266,795 $218,456 $6,967,894 $605,985 $660,810 0.823 $543,778.32 $63,858.92 21.40% -3.3% 3 Forecast Years 2009 $6,967,894 $1,443,399 $223,918 $8,187,375 $713,303 $730,096 0.746 $545,001.39 $69,285.58 20.71% -3.2% 2010 $8,187,375 $1,643,526 $229,516 $9,601,386 $838,142 $805,384 0.677 $545,373 $75,289 20.07% -3.1% 2011 $9,601,386 $1,870,217 $235,254 $11,236,349 $982,894 $887,323 0.614 $545,061 $81,939 19.48% -3.0% 2012 $11,236,349 $2,078,990 $241,135 $13,074,204 $1,150,265 $928,725 0.557 $517,515 $41,402 18.50% -5.0% 2013 $13,074,204 $2,309,743 $247,163 $15,136,783 $1,338,406 $971,337 0.505 $490,996 $42,612 17.67% -4.5% 2014 $15,136,783 $2,564,702 $253,343 $17,448,143 $1,549,553 $1,015,149 0.459 $465,491 $43,813 16.94% -4.1% 2015 $17,448,143 $2,846,317 $259,676 $20,034,784 $1,786,166 $1,060,151 0.416 $440,982 $45,001 16.31% -3.7% 2016 $20,034,784 $3,157,276 $266,168 $22,925,892 $2,050,961 $1,106,315 4 5 6 7 8 9 10 PERP

$5,021,665 0.10237

$1,106,315

0.377 $417,451 $46,165 18.90% 15.76% Avg. ROE -3.4% Avg. ROE Growth -3.7%

$10,807,025.29 Sensitivity Analysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $22.50 $20.67 $19.90 $18.72 $18.14 -0.1 $17.57 $17.24 $17.07 $16.75 $16.57 -0.2 $16.30 $16.17 $16.11 $15.98 $15.90 -0.3 $15.71 $15.66 $15.62 $15.56 $15.52 -0.4 $15.38 $15.35 $15.33 $15.30 $15.29 -0.5 $15.16 $15.15 $15.14 $15.13 $15.12

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Abnormal Earnings Growth
Staples - Abnormal Earnings Growth
Years from valuation date 1-Mar-07 2006 Earnings Dividends Dividends invested at 10.237% (Drip) Cum-Dividend Earnings Normal Earnings Abnormal Earning Growth (AEG) PV Factor PV of AEG Residual Income Difference Error Core EPS Total PV of AEG Continuing (Terminal) Value PV of Terminal Value Total PV of AEG Total Average EPS Perp (t+1) Capitalization Rate (perpetuity) Estimated Value at March 1, 2007 Implied Value for end of March 2007 Observed Value at 1 April, 2007 Difference Ke g Actual Price per share Total Outstanding Shares 0.10237 0 $25.84 717000 0 2007 $1,111,019 $213,128 1 2008 $1,266,795 $218,456 $21,818 $1,288,613 $1,224,754 $63,859 0.91 $57,929 $63,858.92 $0.00 2 2009 $1,443,399 $223,918 $22,363 $1,465,762 $1,396,477 $69,286 0.82 $57,015 $69,285.58 $0.00 3 Forecast Years 2010 $1,643,526 $229,516 $22,922 $1,666,448 $1,591,160 $75,289 0.75 $56,201 $75,288.72 $0.00 4 2011 $1,870,217 $235,254 $23,496 $1,893,713 $1,811,774 $81,939 0.68 $55,486 $81,938.78 $0.00 5 2012 $2,078,990 $241,135 $24,083 $2,103,073 $2,061,671 $41,402 0.61 $25,432 $41,401.81 $0.00 6 2013 $2,309,743 $247,163 $24,685 $2,334,428 $2,291,816 $42,612 0.56 $23,745 $42,611.79 $0.00 7 2014 $2,564,702 $253,343 $25,302 $2,590,004 $2,546,191 $43,813 0.51 $22,147 $43,812.73 $0.00 8 2015 $2,846,317 $259,676 $25,935 $2,872,252 $2,827,251 $45,001 0.46 $20,635 $45,001.13 $0.00 9 PERP 2016 $3,157,276 $266,168 $26,583 $3,183,859 $3,137,694 $46,165 0.42 $19,203 $46,164.57 $0.00

$47,000

$1.55 $0.47 $0.07 $0.27 $0.74 $2.29 0.10237 $22.34 $22.52 $25.84 ($3.32)

$459,119 Sensitivity Anlaysis g Ke 0.07 0.09 0.10237 0.13 0.15 0 $43.86 $28.40 $22.52 $14.37 $10.83 -0.1 $39.55 $26.43 $21.23 $13.80 $10.50 -0.2 $38.44 $25.81 $20.79 $13.58 $10.35 -0.3 $37.93 $25.51 $20.57 $13.46 $10.27 -0.4 $37.63 $25.34 $20.43 $13.38 $10.22 -0.5 $37.44 $25.22 $20.35 $13.33 $10.19

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Long Run Residual Income Perpetuity

Staples - Long Run Residual Income Perpetuity
Years from valuation date 0 1-Mar-07 2006 1 2007 $7.00 $1.55 $0.30 $8.26 22.12% 17.88% 18.90% 16.40% $ 10.69 $ 10.78 $ 25.84 ($15.06) 0.10237 -6.2% $ 25.84 717000 2 2008 $8.26 $1.77 $0.30 $9.72 21.40% 17.71% 3 2009 $9.72 $2.01 $0.31 $11.42 20.71% 17.50% 4 5 Forecast Years 2010 2011 $11.42 $13.39 $2.29 $2.61 $0.32 $0.33 $13.39 $15.67 20.07% 17.27% 19.48% 17.03% 6 2012 $15.67 $2.90 $0.34 $18.23 18.50% 16.36% 7 2013 $18.23 $3.22 $0.34 $21.11 17.67% 15.78% 8 2014 $21.11 $3.58 $0.35 $24.33 16.94% 15.27% 9 2015 $24.33 $3.97 $0.36 $27.94 16.31% 14.82% 10 PERP 2016 $27.94 $4.40 $0.37 $31.97 15.76% 14.43%

Beginning BE Earnings Dividends Ending BE ROE Growth in BE Average ROE Average growth in BPS LR RI Perpetuity Value Implied value for end of March 2007 Actual Price Difference Ke g Actual Price Total Outstanding Shares

$7.00

Ke

0.07 0.09 0.10237 0.13 0.15

-10% $11.97 $10.73 $10.08 $8.89 $8.19

Sensitivity Analysis g -6.2% 0 5% $13.39 $19.01 $48.94 $11.65 $14.81 $24.51 $10.78 $13.03 $18.74 $9.25 $10.29 $12.29 $8.39 $8.93 $9.85

10% ($20.89) ($62.77) $265.08 $20.98 $12.61

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Work Cited

1.) Staples’ Website: 2.) Office Depot’s Website: 3.) OfficeMax’s Website: 4.) Yahoo Finance: 5.) Google Finance: 6.) Edgar Scan, PWC: 7.) St. Louis Federal Reserve: 8.) Find Articles: 8.) Wikipedia Encyclopedia: 9.) California Energy Commission: 10.) Retail Owner’s Institute: 2004)

www.Staples.com www.officedepot.com www.officemax.com www.finance.yahoo.com www.finance.google.com http://edgarscan.pwcglobal.com http://stlouisfed.org http://findarticles.com http://en.wikipedia.com http://energy.ca.gov http://retailowner.com

11.) Palepu, Healy and Bernard, Business Analysis and Valuation (3rd Edition

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