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Equity Valuation and Analysis

Equity Valuation and Analysis Report

December 6th, 2007

Analysis Group

Andrew Readinger rareadinger@yahoo.com

Edward Willman edward.m.willman@ttu.edu

Matt Wilson msw1185@gmail.com

Steven Kratzer stkratzer@hotmail.com

Zac Holly Zachary.s.holly@ttu.edu

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Table of Contents

Executive Summary 3

Business & Industry Analysis 8

Company Overview 9

Industry Overview 11

Five Forces Model 14

Rivalry Among Existing Firms 15

Threat of New Entrants 23

Threat of Substitute Products 27

Bargaining Power of Buyers 29

Bargaining Power of Suppliers 29

Key Success Factors for Value Creation 31

Competitive Advantage Analysis 33

Accounting Analysis 38

Key Accounting Policies 39

Potential Accounting Flexibility 41

Actual Accounting Strategy 44

Quality of Disclosure 47

Qualitative Analysis of Disclosure 47

Quantitative Analysis of Disclosure 49

Sales Manipulation Diagnostics 50

Expense Manipulation Diagnostics 55

Potential Red Flags 62

Accounting Distortions Coming Undone 62

Financial Analysis, Forecast Financials, Cost of Capital Estimation 64

Financial Analysis 64

Liquidity Analysis 65

Profitability Analysis 82

Capital Structure Analysis 100

IGR/SGR Analysis 105

Financial Statement Forecasting 107

Income Statement 108

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Balance Sheet 111

Cash Flows Statement 115

Analysis of Valuations 119

Cost of Equity 120

Cost of Debt 122

Weighted Average Cost of Capital 122

Method of Comparables 123

Intrinsic Valuations 132

Discount Dividend Model 132

Free Cash Flows Model 133

Long Run Residual Income Model 134

Residual Income Model 135

Abnormal Earnings Growth Model 136

Credit Analysis 137

Revised Free Cash Flows Model 139

Revised Residual Income Model 140

Revised Long-Run Residual Income Model 141

Revised Abnormal Earnings Growth Model 142

Appendices 144

References 178

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Executive Summary

Recommendation – Overvalued - SELL

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Industry Analysis

Office Depot is a major supplier of office and paper supplies to individual and

business consumers around the world. Founded in 1986, it has grown to be the second

largest company in its industry in terms of total sales and total assets. In 2006, Office

Depot recorded its best year of sales in its history, reaching sales in excess of 15 billion.

With 1158 stores in North America alone, along with customers in 42 countries, Office

Depot has established itself as a main stay in its industry. Its headquarters are located

in Delray Beach, Florida.

Office Depots main competitors are Staples and Office Max. These three firms

combined accounted for 42 billion in retail sales alone in 2006. Staples has established

itself as the industry leader due to its ability to increase total sales and net income while

at the same time decreasing its operating expenses over the past four years. Office

Depot is just as solid of a company as Staples but is not the industry leader because it

does not display the efficiency that Staples does. Office Max, on the other hand, has

been experiencing difficulties producing positive results, but did take a large amount of

market share during 2003 only to lose it the next few years.

Due to the nature of the products that are sold in this industry, in order to be

profitable, firms must have a cost leadership mentality while utilizing economies of

scale. According to the five forces model, rivalry among firms and the threat of

substitute products are currently at a moderate level and threats of new entrants and

the bargaining power of suppliers are relatively low and is expected to be this way for

the coming years. Office Depot plans to have 150 new store openings in 2007 and 200

new store opening in 2008. The retail office supplies industry is healthy and continues

to grow but has slowed over the past few years.

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Accounting Analysis

An accounting analysis was conducted to examine where Office Depot has

accounting flexibility and if they have utilized this flexibility by manipulating its financial

statements. A series of revenue and expense diagnostic ratios were calculated and

evaluated which led to a better picture of Office Depot as a firm.

After the analysis we determined that Office Depot has been aggressive in its

accounting practices of operating leases. After calculating the present value of all future

operating lease obligations we determined that Office Depot, though accounting

flexibility, is understating is assets and liabilities by roughly 2.7 billion dollars due to

these contractual obligations.

The diagnostic ratios that were calculated for Office Depot demonstrate, for the

most past, acceptable behavior and we believe that Office Depot has not manipulated

its financial reports with respect to these ratios.

To fix these accounting disorders, we recast Office Depots previous financial

statement and included all their operating leases as an asset and liability because

operating leases do have economic value. These recasted financial statements provided

a much better outlook of Office Depots and its overall financial position.

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Financial Analysis, Forecasts, and Cost of Capital Estimation

After conducting an accounting analysis a financial analysis was performed to

access the overall health of Office Depot. In order to do this we computed several

series of ratios for Office Depot and its competitors and then calculated the industry

average. By calculating the industry average we were able to benchmark Office Depots

results to see if they were in line with the industry average. Office Depot and Staples

performed quite well in their financial analysis. These two firms have been able to

consistently generate cash and sales from its assets and have also been able to

turnover its inventory at a respectable rate. Office Max, though, had erratic

performance for some of its ratio, which indicates that Office Max is having difficulties

producing consistent, positive results.

After the financial analysis was conducted we proceeded to forecast the next ten

years for Office Depot. These forecasts allow investors and the likes to visually see

estimated profitability, expenses, and liabilities among other things for Office Depot in

the future. These forecasts are then used to produce valuations of Office Depot and will

indicate whether or not Office Depot is fairly, under, or overvalued. With an estimated

growth rate for sales of 6.29%, though, Office Depot seems to have a solid future

barring any unforeseen economic issues. We also added back capital lease expenses,

obligations, and right and then forecasted Office Depot’s revised financial statement for

the next ten years.

The costs of debt and equity estimates were also calculated and these numbers

were used to produce the valuation models of Office Depot at the end of this report.

We calculated the Office Depots Ke is 11.04% and Kd is 4.8% while WACCbt was

calculated as 5.1% and WACCat was 4.42.

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Valuations

The last objective of this report is to value Office Depot using method of

comparable models and intrinsic valuation models. According to the method of

comparable models Office Depot is currently undervalued. Intrinsic valuation modes,

though, indicated that Office Depot is overvalued taking into effect the forecasted

results that were used to produce these valuations.

The method of comparable models that were calculated were trailing price to

earnings, forward price to earnings, price to book, dividend yield, P.E.G., price over

EBITDA, price over free cash flows, and enterprise value over EBITDA. All method of

comparables indicated that Office Depot is undervalued, with the exception of forward

price to earnings, which indicated that Office Depot is fairly valued. These models

indicated that Office Depot is undervalued by as little as $.40 and as much as $11.00.

The intrinsic valuation models that were calculated indicated a different picture.

According to these models, Office Depot is overvalued when taking it account the

forecasted earnings for the following ten years. If Ke changed the sensitivity analysis

indicates that Office Depot could be fairly valued and even undervalued, but at Office

Depots current Ke it is considered to be overvalued.

The intrinsic valuation models were also calculated for the revised forecasts that

included capital lease corrections. When these models were calculated they once again

indicate the Office Depot is a overvalued company.

With all this in mind we came to the conclusion that Office Depot is overvalued

and the recommendation for this stock would be to SELL.

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Business & Industry Analysis

To begin, we will discuss and analyze Office Depot as a company and then

analyze its industry. First, a company overview of Office Depot will be presented to

discuss different aspects of the firm with an emphasis on sales volume, main

competitors, asset value, stock performance and market capitalization. Secondly, a

detailed industry overview and analysis will be performed utilizing the five forces model.

In order to interpret the industry, many factors will be discussed including but not

limited to rivalry among existing firms, threat of new entrants, threat of substitute

products, and the bargaining power of buyers and suppliers. These aspects will dictate

industry profitability and sustainability. After identifying what creates value in the retail

office supply industry, an analysis of key success factors of the industry will be

presented. From these key success factors, what Office Depot specifically does well in

order to create competitive advantages within the industry will be defined. Finally,

Office Depot will be analyzed in order to understand how effective their

implementations of these key success factors are on a historical, current, and future

perspective.

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Company Overview

Office Depot, Inc. is a global supplier of office supplies and services. The first

store was opened in Fort Lauderdale, FL in 1986 and currently their corporate

headquarters are located in Delray Beach, Florida. Since 1986, Office Depot’s North

American Retail Division currently operates 1,158 office supply superstores throughout

the United States and Canada. In addition to the North American Division, they also sell

to customers in 42 different countries around the world. “Their sales are processed

through a number of different ways including: stores, a contract sales force, internet

sites, direct marketing catalogs and call centers all supported by networks of

crossdocks, warehouses and delivery operations” (www.officedepot.com). Office

Depot’s sales consist of brand name and private brand name office supplies, computers,

computer software, office furniture, and a wide variety of other business supplies. “Most

stores also contain a design, print, and shipping center offering graphic design, printing,

reproduction, mailing, shipping, and other services” (Office Depot 10-K).

Office Depot competes in the specialty retail office supplies industry. Its major

competitors are Staples (SPLS) and OfficeMax (OMX). Office Depot has a market

capitalization of $5.05 billion and last year reported sales in excess of $15 billion dollars.

Key statistics of the last five years for Office Depot are as follows:

Office Depot has plans to open approximately 150 new retail stores in 2007 and

200 additional stores in 2008. It strives to optimize its visual presentation, product

placement, shelf capacity, in-stock positions, inventory turnover, distribution capacity,

and handling costs.

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ww.moneycental.msn.com

Office Depot’s stock price has been moderately volatile over the past few years.

On January 3, 2002 Office Depot’s stock price closed at $18.54 and on May 11, 2006 it

peaked at $44.46. Since May of 2006, though, Office Depot’s stock price has been on a

steady decline, closing at $19.15 on September 14, 2007.

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Industry Overview

Office Depot and its competitors compete in the retail industry with a specialty

focus on office supply distribution. The retail industry generates $3.8 trillion dollars in

annual sales and is a vital component of the health of the U.S. economy. The “retail

industry” title is a broad term used to describe a vast industry comprised of firms selling

goods and products to consumers. The retail industry can be broken into several, more

focused segments which serve to facilitate the analysis of particular types of products or

target consumers.

Because of the nature of Office Depot’s business, they are classified into the

“retail office product and paper distribution industry” (firstresearch.com). This industry

generates roughly $55 billion in annual sales and serves clientele across the globe.

Firms in the retail office supply industry sell its products not only to individual

consumers but also to many small and large businesses. These firms compete through

wholesale/retail sales, contract sales and electronic and mail ordering sales through

online stores and catalogs. The industry is highly concentrated and highly competitive

with “the 50 largest wholesalers hold[ing] about 70 percent of the market”

(firstresearch.com). The three largest retail firms in this industry include Office Depot,

Office Max, and Staples. The following chart shows that Staples leads the industry in

market share with Office Depot trailing moderately behind and Office Max far off pace.

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*Market share calculated by net sales reported from Staples, Office Depot, and Office Max.

Industry Leader Comparisons

After analyzing the previous graph and taking into account the fact that Staples

has been the only firm in its industry to consistently increase its sales and net income

while decreasing its operating cost percentages over the past five years, we conclude

that Staples is the leader of its industry. Office Depot trails behind Staples but is still a

main player in its industry due to the respectable, operating results they have posted

over the past five years. It is also important to note that in 2001, Office Depot was the

industry leader in terms of sales, but since then Staples has been able to reclaim that

market share over the past five years. Office Max is the industry laggard and has had a

very hard time producing positive results for the past five years, with the exception of

2004, in which Office Max grabbed a large share of the market only to lose it the

following years.

The retail office supplies industry deals in supplying commodities and is therefore

highly competitive. These firms compete mainly on customer base rather than price.

Inter-firm price competition would detrimentally affect each firm’s respective

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profitability. Rather, these firms maintain competitive prices to the end that they reduce

outside competition and entry. Commodity based industries are inherently highly

competitive due to the difficulty in effectively differentiating your products from the

competition. Central to firms’ success strategies in this industry are cost minimization,

supply chain management, merchandizing, and customer service. For example, Office

Depot is in the process of renovating hundreds of stores to feature a new store layout

dubbed, “M2.” Office Depot believes this new format will reduce operating costs while

at the same time enhance line of sight and improving complementary product

proximity. Because the profitable differentiation of office products is largely

unattainable, Office Depot is seeking to draw increased sales from a more efficient and

inviting shopping experience. Achieving this goal will facilitate more efficient customer

traffic flow inside the store and create a positive experience for the consumer which in

turn encourages return business.

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Five Forces Model

In order to evaluate Office Depot, its industry, and the profitability of this

industry, a structured analysis and classification of the industry must be conducted. One

method in finding this very important information about Office Depot’s industry is the

utilization of the five forces model. The five forces model is used in the business world

to help financial analysts assess the competitiveness of an industry as well as its

strengths and weaknesses. The five forces model breaks down an industry into two

very broad categories: the degree of actual and potential competition and the

bargaining power of input and output markets. To determine the degree of actual and

potential competition of an industry, three important topics must be evaluated. These

three topics are rivalry among existing firms, threats of new entrants, and threats of

substitute products. In order to determine the bargaining power of input and output

markets of an industry two other important topics must be evaluated. These topics are

the bargaining power of buyers and the bargaining power of suppliers. The following is

the utilization of the five forces model for the retail office supplies industry. The

following information is extremely important because it is a stepping stone in the

valuation process of Office Depot.

Retail Industry - Specialty

(Office Supply and Paper Distribution)

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Rivalry Among Existing Firms

In order to evaluate the profitability of a particular industry it is very important to

look closely at the rivalry among existing firms in that industry. If an industry is not

highly concentrated one can expect that rivalries between existing firms will be high. If

rivalries in an industry are relatively high then competitive strategies such as price wars

will be conducted and the overall profitability of that industry will decrease. The

following is the evaluation of how high rivalries among existing firms are for the retail

office supplies industry.

Industry Growth

In order to accurately value a firm the first step that must be taken is to evaluate

the industry the firm resides in. If an industry is experiencing high growth during a

certain period of time then the majority of firms in that industry will also experience

some sort of growth. As an industry begins leveling off or declining, the level of rivalry

among existing firms will increase because in order for firms to continue growing they

must step up competition with each other in order to increase their market share and

profitability. The retail office supplies industry experienced a considerably large amount

of growth from 2001-2004. Since the end of 2004, though, growth of the retail office

supply industry has flat lined, with negative growth performances in 2005 followed by

slightly moderate growth in 2006. The following graph displays the percentage growth

of the retail office supply industry over the last five years.

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Although growth in the retail office and supplies industry has slowed over the

past two years in comparison to the previous three years before that, net sales of

Staples and Office Depot has increased moderately, regaining the market share they

lost to Office Max in 2004. The following graph shows sales revenues for Office Depot,

Staples, and Office Max over the last six years.

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Since the retail office supplies industry has not experienced considerable growth

over the last few years it is expected that rivalry among firms in this industry will

increase moderately in an attempt to increase their market share and profitability.

Concentrations and Balance of Competitors

The concentration and balance of competitors in an industry is a very important

metric to evaluate because it is one main determinant on whether an industry is

considered to be highly competitive, moderately competitive, or not competitive at all.

The majority of the time, the larger number of firms in an industry the more

competitive that industry is. In this case, the retail office supplies industry is not

considered to be an industry that is fragmented because the majority of market share in

this industry is held by three main firms. With this in mind, the retail office supply

industry is not considered to be highly competitive. The reason being is that due to a

low number of firms in this industry, if they competed fiercely with each other nothing

would be accomplished and would only lead to a decrease in revenue for all firms due

to destructive, competitive strategies such as price wars. Instead, prices are relatively

the same at each firm because they carry a majority of the same products. Since 2002,

Staples has led the industry in market share and has been the industry leader every

since with Office Depot trailing slightly behind and Office Max a distant third. The

following graph shows the market share for the retail office supply industry since 2001.

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*Market share calculated by net sales reported from Staples, Office Depot, and Office Max.

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Degree of Differentiation and Switching Costs

If the products sold in a specific industry are very similar then the degree of

differentiation is relatively low in that industry and firms will have to compete with each

other primarily on cost. On the other hand, if firms in an industry are able to

differentiate its products and services from others then competition on price will not be

as high. As with switching costs, if firms in an industry sell products that have low

switching costs, then those firms will have to compete against each other in terms of

price as well as customer service. Likewise, if switching costs are relatively high, firms

in that industry will not have to compete as much on price due to the fact that if

customers do decided to switch from one firm’s products to another they will be the

ones that will end up eating the cost of switching, which is less likely to occur. In

regards to the retail office supplies industry, differentiation is relatively low and firms

have to price their products competitively against other firms products because if they

don’t they will end up losing customers and market share due to the commodity type

products this industry sells. Switching costs are also relatively low in the retail office

supplies industry because the majority of products sold in this industry are consumer

goods and switching costs with consumer goods is virtually zero. To conclude, the

degree of differentiation and switching costs are very low in the retail office supplies

industry and firms in this industry will have to compete on low cost strategies as well as

superior, customer service in order to gain customers and market share.

Economies of Scale

It is very important to evaluate the economies of scale of firms in a particular

industry in order to determine the possibility of firms in that industry of increasing its

revenues and gaining market share. In most industries, firms that have large economies

of scale have a greater chance of increasing their operating revenues and gaining

market share. In the retail office supplies industry, economies of scale are very

important to a firm’s success because the larger the firm’s operations the greater

chance it has at reducing product costs by having the ability to make large purchases

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and receive quantity discounts. These quantity discounts on their products not only

allow the firm to reap a larger profit compared to a smaller firm but also allows the firm

the ability to better respond to pricing threats from others in its industry. The following

table shows the total assets of the three major firms in the retail office supplies industry

for the past four years.

Firm 2003 2004 2005 2006 Office Depot 6.20 6.80 6.10 6.57 Staples 6.50 7.07 7.73 8.40 Office Max 7.38 7.34 6.27 6.22 *in billions

It is easy to see that all three firms have roughly the same amount of total

assets. This indicates that all three firms, although they do not have the same market

share as indicated above, have roughly the same size operations and all have the ability

and capacity to compete against each other in terms of price and customer service.

Ratio of Fixed to Variable Costs

In order for any firm to be successful it must be able to manage its fixed and

variable costs. If a firm is able to keep these costs low it will be able to increase its

profitability and likelihood of success. The retail office supplies industry is no exception

to this rule. All three major firms in this industry are constantly looking for new ways to

keep these costs down and when they succeed in doing so not only does their market

share increase but their overall profitability as a firm increases as well. As mentioned

above, when a firm’s economies of scale are high it is able to make large bulk

purchases and receive quantity discounts for their purchase commitments as well as

retain the personnel needed to provide superior customer service to its customers. This

is one example of how firms such as Office Depot work to reduce its variable costs so

that overall profit will increase. Another way Office Depot has attempted to reduce its

variable cost is by developing and manufacturing its own brand name products and

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offering these products to its customers for a reduced cost in comparison to its other

brand name competitors.

Excess Capacity

If firms in an industry supply more than what is demanded from its customers

then excess capacity has been created. If excess capacity has been created in an

industry, firms that reside in that industry will have incentive to cut prices in an attempt

to stimulate more demand. In the retail office supplies industry there is slight excess

capacity due to the fact that firms in this industry are expected by its customers to

supply such a variety of products at any given time. If a store location of a firm in the

retail office supplies industries has trouble selling the excess capacity that has been

created, it is very easy for the firm to close that store location and redirect inventories

to a location with higher demand. With this in mind, although there is slight excess

capacity in this industry, with such ease to move products and close store locations with

low demand the incentive to lower prices to move products are not considered to be

high.

Exit Barriers

Exit barriers are any type of force that prevents a firm in any given industry from

exiting that industry. For some industries, exit barriers are so strong and costly that

firms do not consider exiting because they would lose, for example, a large portion of

its assets or their liabilities will increase dramatically. In the retail office supplies

industry, exit barriers are not very significant due to the nature of the products the

firms in this industry sell.

Conclusion: Rivalry Among Existing Firms

The retail office supplies industry experienced a large amount of growth three to

five years ago. Since then, however, the industry has not grown considerably and firms

that reside in the industry are now being forced to find better ways to increase market

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share and profitability. Concentration in this industry is considered to be high which is

why competitive strategies such as price wars are not common in the industry. The

retail office supplies industry is also not very differentiated, so although price wars are

not common, firm still have to keep their prices competitive because switching costs are

virtually zero for the industries customers. The industry has only three major firms that

account for the majority of market share and the economies of scale between these

firms are considered to be close to equal. In order for these firms to increase its

profitability their main focus is to continue the reduction of their variable costs by using

methods such as bulk ordering and private brand name development. The industry does

experience slight excess capacity but due to the nature of the industries products, it is

able to sustain this excess capacity because its exit barriers are minimal. In conclusion,

rivalry among firms in the retail office supplies industry is considered to be moderate.

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Threat of New Entrants

If an industry is able to make abnormally high profits from the sale of its

products there is more incentive for new entrants to enter that industry. Some barriers,

though, will limit who will have the ability to enter that industry, such as economies of

scale, distribution access, and legal barriers, among others. The following is an

examination of the retail office supplies industry and the evaluation of the threat of new

entrants in the industry.

Economies of Scale

Economies of scale usually will limit the number of firms with the ability to enter

a new industry and be successful. As in most industries, the firms with the largest

amount of market share are also the firms with the largest economies of scale. The size

alone of these industry leaders enable them not only to influence pricing of particular

products in their industry, most also have brand name recognition that will attract new

customers to their business locations over their smaller competitor locations. In the

retail office supplies industry the same is true. The three major firms that hold the

majority of market share are also consequently the firms with the largest economies of

scale. The following is a chart that shows that the most successful firms in the retail

office supplies industry are also the firms with the largest market capitalization.

These firms have the ability to influence the price of any product sold in their

industry and also have brand name recognition that will attract new customers that are

in need of their particular selection of products. In a small survey that was conducted

on September 8th of 2007 by analyst Edward Willman, when asked where they would go

to purchase ink cartridges for their printer, 85% of participants said they would go to

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either Office Depot or Staples because they have a large selection as well as convenient

locations. This demonstrates the fact that in the retail office supplies industry, brand

name recognition and economies of scale are a significant factor. So significant in fact

that it would be nearly impossible for a new firm to enter this industry and compete

with the like of Office Depot, Staples, and Office Max and be successful without having

the same economies of scale as these three firms. So the threat of new entrants in the

retail office supplies industry is considered to be low when considering economies of

scale.

First Movers Advantage

The threat of new entrants in an industry is also influenced by the first mover

advantage. The firm(s) that enter an industry first have an advantage over their

respective laggards because they will be able to set industry standards and

expectations, create relationships with supplies to lock in low costs for their products,

and locate its business operations in prime areas that are in need of its products. In the

retail office supplies industry, the first mover advantage has already been utilized by its

three major firms. Industry standards have already been set and the industries three

major firms have created relationships with its suppliers that enable them to receive the

lowest costs for their products. Firms that wish to enter this industry will have to

conform to the industry standards that have already been set. Also, since suppliers to

this industry have already created good relationships with three major customers

(Office Depot, Staples, and Office Max) it is highly likely that suppliers will not offer

excellent prices to its customers competitors because not only will order sizes be

smaller, suppliers will not want to disturb the business it already has with firms such as

Office Depot, Staples, and Office Max. With this in mind, first mover advantage has

already been utilized in this industry which leads to a decrease in the possibility of the

threat of new entrants.

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Access to Channels of Distribution and Relationships

As mentioned above, when firms in an industry have created long-lasting

relationships with their suppliers due to first mover advantage, it is much more difficult

for new entrants to receive the same benefits and prices as its competing firms. This is

very important because even if a new entrant wishes to enter an industry, access to

channels of distribution might be very limited so that suppliers do not disturb the long-

lasting relationships it already created with its current customers. The three major firms

in the retail office supplies industry have created long-lasting relationships with its

suppliers and these relationships that have been created limits the possibility of new

entrants. Also, since this industry is not growing at a significantly fast pace, suppliers

have less incentive to supply to new entrants because this will only create a heightened

sense of competition between firms in the industry and overall revenue and profitability

will essentially remain unchanged for the supplier’s financial outlook. It would take

years for a new entrant in this industry to receive the same pricing structures and

benefits that suppliers have already granted to Office Depot, Staples, and Office Max.

Legal Barriers

Although there are many threats of new entrants to an industry, one of the most

significant is the legal barriers to enter an industry. Some industries, such as the

pharmaceuticals industry, have many legal barriers that a new firm would have to

overcome in order to begin conducting business. On the other hand, the retail office

supplies industry has minimal legal barriers if any (excluding the normal legalities of

conducting business, for example, articles of incorporation, ect.) to enter the industry.

The only significant legal barriers that new firms would face in this industry would be

international barriers if the new firm(s) wished to conduct business internationally.

Conclusion: Threat of New Entrants

The retail office supplies industry is an industry in which market share leaders

dictate not only industry standards but also have the ability to influence price structures

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of products in the industry. Since this industry is highly concentrated, economies of

scale are a major factor for new entrants. If new entrants do not have the same

economies of scale as Office Depot, Staples, and Office Max they will not be able to

compete against these firms and take market share away from them. The first mover

advantage has also been utilized in this industry which once again limits the threat of

new entrant into the industry. Access to channels of distribution is also limited in this

particular industry because suppliers to this industry have already created long-lasting,

successful relationships with its customers and will not want to disturb the business it

already has with these customers. Lastly, legal barriers are virtually zero to enter this

industry, but with all the other limitations to enter this industry, threats of new entrants

in this industry are considered to be very low.

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Threat of Substitute Products

The threat of substitute products is an important factor to gauge when

evaluating an industry. If there are many substitutes to products of a particular

industry, competition for market share can actually be created not only between firms

in a single industry, but also between two or more competing industries. If there are

incentives to switch from one product to a substitute product, customers are more likely

to switch in order to receive either a better price for the product or better customer

service. The following is an evaluation of the threat of substitute products and the

willingness of customers to switch to these substitutes for the retail office supplies

industry.

Relative Price and Performance

If two certain products have the same relative prices and they both have the

same level of performance there is a good possibility that customers will switch from

one product to the other. This is very important in the retail office supplies industry

because with the advancements of technology this industry is more susceptible to the

switching of substitute products from its customers. One example would be the trend of

“going green” and being “paperless.” With paper and ink cartridges for printers being

two of the industry’s most highly sold products, it faces a moderately high level of

substitution of products from its customers because its customers are now going

“paperless.” One way to combat this substitute, though, is to offer its customers a

larger selection of media storage, because if customers no longer use paper products

for information storage they then must be using some sort of digital media storage.

Now substitutes in this industry are considered to be moderate because although some

of the industries products face the possibility of substitute products, a majority of the

industries products cannot be substituted, for example, computer software such as

operating systems and school supplies.

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Buyers Willingness to Switch

If buyers in an industry are more willing to switch from one product to the next

then the threat level of product substitution is something that should be a concern for

the industry. One of the main determining factors for a customer to switch products is

the switching costs that will be involved. In the retail office supplies industry, for some

products, buyers stand willing to switch products to receive the best performing product

for the cheapest price available. Some products, though, do involve a high level of

switching costs, for example, computer software and office furniture. Other products,

though, have a much lower switching cost like the type of pens one wishes to use. And

lastly, other products have no switching costs, like printer paper. With this in mind,

buyer’s willingness to switch from one product to the next is considered to be

moderately high in this industry.

Conclusion: Threat of Substitute Products

In the retail office supplies industry some products face a high level of substitute

products being purchased. Other products, although they might offer better

performance and a better price than another product, involve a high level of switching

cost which limits the possibility of customers switching to that substitute product. The

retail office supplies industry is considered to be moderately affected by the threat of

substitute products because technology continues to advance and buyer’s willingness to

switch products in this industry are moderately high for some product but some are

moderately low when high switching costs are involved.

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Bargaining Power of Buyers (Customers)

The bargaining power of buyers (customers) is how much power the customer

holds over the industry to either keep a low or high price on the goods sold in that

industry. In the world of office supply superstores the object of the game is to sell as

much product as possible to make the most profit. Switching costs and differentiation

are relatively low because someone can find identical products at relatively the same

prices at any other office supply superstore. This gives the buyer a greater share of the

bargaining power. One way to keep costs down is to concentrate on selling large

amounts of volume to the public and to private companies. When a company does this,

it equates into the price of one individual product to be fragment of the original cost for

one individual product. This means that the overall cost is lower for the consumer. With

this in mind, consumers have a moderate level of bargaining power over Office Depot.

Bargaining Power of Suppliers

The bargaining power of suppliers means how much power the supplier has over

the company that is doing the selling. The supplier gets more bargaining power when

they can supply a unique product, but since the products that Office Depot sells are

undifferentiated there is minimal bargaining power for the supplier. This is because

many suppliers keep Office Depot and many other office supply superstores shelves

stocked. Many of the suppliers for Office Depot has been supplying to them for many

years and do not want to put that relationship in danger so they will work with each

other on prices. The way that both the suppliers and buyer (Office Depot) get ahead in

this relationship is to sell a large volume of merchandise. “Many of our[Office Depot’s]

vendor agreements provide that we pay higher per unit costs prior to reaching a

predetermined milestone, at which time the vendor rebates the per unit differential on

past purchases, and also applies the lower cost to future purchases until the next

milestone is reached” (Office Depot 10-K). Their predetermined agreements keep each

other not worrying so much on prices but on keeping the stores stocked. This gives the

suppliers a moderate to low bargaining power over the industry.

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Conclusion: Bargaining Power of Buyers/Suppliers

The bargaining power of the buyers and the bargaining power of the suppliers

can make a firm both profitable and successful. If a firm cannot gain an edge over the

buyers or suppliers it deals with then it would be very hard for them to be successful.

In the retail office supplies industry, the buyers (customers) have a moderate level of

power over which store they choose to shop at because they can find what they need

at any of Office Depot’s competitors stores. What keeps Office Depot and its major

competitors in such high demand, though, is by keeping their stores fully supplied with

a high array of products and by satisfying its customers by offering a price that is

competitive and acceptable. Since the suppliers are producing mass volumes of

products they are keeping their own stakeholders happy. Office Depot thus keeps the

suppliers bargaining power low and its competitors also do the same.

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Key Success Factors

The key success factors of the moderately, competitive retail office supplies

industry are:

• Economies of Scale

• Lower Input Costs

• Superior Product Variety.

Focusing on these key success factors will play a vital role in obtaining long term

profitability as well as achieving a competitive advantage for any company within this

industry. Currently, there are an extremely large number of office supply retailers in

the United States and the best way to maximize market share is to focus on a cost

leadership strategy.

Economies of Scale

The retail office supplies industry began its growth in 1986 with the introduction

of the two largest office supply retail chains in the United States, Office Depot and

Staples. Prior to these companies rapidly expanding across the country, the retail office

supplies industry was very small and uncompetitive. Now that these companies are

generating billions of dollars a year, it is important to differentiate themselves from one

another.

One way to do this is by using economies of scale, a key success factor to the

company’s advantage. In such a large industry new entrants will have to either invest

in a larger capacity then desired or enter with less than their optimum capacity. Neither

is desirable to new entrants because either way they will potentially lose revenue in

competing with existing firms. Another factor to take into account is that many early

entrants to an industry already have a large loyal customer base; therefore a new firm

has to spend money on brand advertising when an existing company may not. For

instance, as of June 30, 2007 Office Depot had 1,186 locations in the United States

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alone, not to mention 136 stores in other countries. It would be rather difficult for a

brand new company to compete with an entity that has such a presence. New stores

are also unable to price their products equivalently with established companies due to a

high startup capital. If a new firm were to lower prices to the level of existing

companies, it would take them many years to recover and gain any market share.

Lower Input Costs

Another key success factor relevant to the retail office supplies industry is

obtaining lower input costs. The two highest grossing office product suppliers are

Office Depot and Staples. If both of these companies are selling similar products at

comparable prices, spending less on the cost of inputs will dramatically increase

profitability.

Superior Product Variety

The last major key success factor for the retail office supplies industry is to focus

on using superior product variety to their advantage. This can include offering a higher

quality of product or even packaging the product in a manner that is more attractive to

the consumer. Additionally, a firm could initiate selling a new product or service that

was not previously offered. In this particular industry the most successful companies

have begun to offer services in the rather successful print and copy market. This will

allow these companies to increase potential growth opportunities and to expand their

marketability.

Focusing on these key success factors of the retail office supplies industry is a

priority in order to gain market share and profitability. Since this industry is not

growing at such a rapid pace as a few years ago losing sight of these factors could

result in a company not surviving amongst its competitors. Maintaining an efficient cost

leadership strategy and implementing the industry’s key success factors will give a firm

the opportunity to be the most successful in its field.

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Competitive Advantage Analysis

As previously discussed, Office Depot is a leading participant in both the national

and global retail office supply industry. This moderately growing market is dominated

by three major firms with Office Depot being accompanied by Staples and OfficeMax to

strategically gain as much market share as possible. In a market with homogeneous

products and services, a firm must differentiate itself through cost leadership and a

variety of other strategic implementations. When analyzing the competitive advantage

of a firm, it is important not only to look at the current competitive strategy of the firm,

but also its historical and future perspective. In other words, Office Depot needs to

attest to three strategic inquisitions: 1.) Where are we? 2.) Where are we going? 3.)

How do we get there? In order to acquire the greatest share of a potential $850 billion

global office supply market place (ODP 2006 Annual Report), Office Depot has begun to

focus mainly on three distinct strategic opportunities. The first and most lucrative

competitive advantage Office Depot has aimed to achieve is its drive to accomplish

superior economies of scale in expanding and dominating an ever growing global

marketplace. Secondly, Office Depot aims to gain a competitive advantage internally

through economies of scope and innovation by increasing product offerings and internal

efficiency. Lastly, in order to compete in a commodity based market Office Depot has

aimed to arm itself with a “one of a kind management team” focused towards

innovation and originality.

Office Depot encountered great change with optimism in 2005 when Steve

Odland, regarded as one of the top tier retail managers in the world, took over as

Chairman and CEO of Office Depot. On the cusp of their 20th Anniversary, Office Depot

and Odland recognized vast opportunity in a growing global marketplace. Odland made

it obvious his goal would be to become the outright leader in the global retail office

supply industry. In two short years, Office Depot has become the leader in the global

market by producing top international sales of over $3.6B in 42 countries. The graph

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below illustrates an international sales comparison with Office Depot’s largest

competitor, Staples, over the past five years.

With domestic sales between Office Depot and Staples being very similar, Office

Depot’s international edge becomes even more important. Although numbers can

reflect success, one must know how they were achieved in order to appreciate them. In

2006 alone, Office Depot erected 55 new international retail outlets that provide all the

same innovative product and service offerings as domestic outlets. In addition to a

physical global presence Office Depot has, “added new leaders to our senior

management team; launching marketing campaigns to heighten awareness of our

private brands; and applying our shared leadership discipline, operational protocols and

best practices across our international operations.” (ODP 2006 Annual Report). Another

way in which Office Depot has claimed itself as the global retail office supply leader is

its recent international firm acquisitions. Office Depot recently acquired a controlling

interest in AsiaEC, one of China’s largest retail office supply firms. Office Depot further

explored possibilities in the Asian market by acquiring another controlling interest in

Best Office Co., Ltd, a large firm in the South Korean retail office supply industry.

Without ignoring the European Market, Office Depot also fully acquired Papirius, one of

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the largest B2B retail office products suppliers in Eastern Europe. This aggressive global

expansion strategy has undoubtedly stamped Office Depot as the outright leader in

global retail office supply industry. These tactics will produce future financial benefits

and a competitive advantage in one of the most important markets yet fully established.

With so much effort being focused on global expansion, Office Depot has

definitely not neglected its domestic interests where its greatest sales are derived. In

the fiscal year 2006, Office Depot focused on taking leaps and bounds above direct

competitors. In order to sustain market share, one must not derive away from core

competencies and continued improvement. In order to separate itself from its

competitors, Office Depot has expanded its presence in existing markets. Going far and

above direct competition, Office Depot has opened 115 domestic stores and remodeled

176. This growth and restructuring is head and shoulders above both Staples and

OfficeMax. In addition, Office Depot has incorporated the M2 store layout format to

make shopping faster, easier, and thus more profitable. The most noted addition to the

new M2 format is Office Depot’s launch of their new Design, Print & Shipping Depot.

Through cross-promotion, now that Office Depot can offer its customers shipping,

design, and printing services they have increased the possibility of attracting customers

with these service needs to their retail. In addition to this new service offering, Office

Depot has aimed to utilize new affordable private brands including the Office Depot

brand, Ativa, Christopher Lowell, Foray and Break Escapes. The final outlet where Office

Depot intends to corner the retail office supply market is through e-commerce, and

currently Office Depot is the outright leader in on-line sales compared to direct

competitors.

In such a vast industry with corporate giants leading the way, large generalized

corporations at times need to focus on the little things to achieve and sustain a

competitive advantage over rivals. Office Depot achieves this on two fronts. The first is

Office Depot’s industry leading customer rewards program called Worklife Rewards.

This new program reaches far and above Office Depot’s competitors by offering

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superior discounts for both individual competitors as well as B2B networks. Secondly,

with Office Depot’s multiple acquisitions and an average 1.5 million dollars of online

transactions per month, a new cost effective inventory and accounts receivable system

needed to be implemented. Fully completed in 2006, this new automated system has

significantly decreased transactions costs and streamlined Office Depot’s current

holdings with their new acquisitions. Jan Gallagher, director of customer account

operations with Office Depot, has been on record stating this new system is so far

superior to the competition that she “viewed this project as an opportunity to gain a

competitive advantage…” (Cygnus Business Media 2006). Another key addition to Office

Depot is its new found relationship with www.where2getit.com. This new relationship

will assist customers in finding Office Depot locations and products throughout the

country and world. Staples and OfficeMax have failed to initiate any similar type of

relationship, once again placing Office Depot ahead of the pack.

As evidence illustrates above, Office Depot is the fastest growing, most

innovative retail office supply corporation in the world in terms of its international

business activities. Although Office Depot displays distinct attributes that contribute to

their industry competitive advantage, sustainability of this competitive advantage is

extremely important. Office Depot’s ability to sustain their competitive advantage is

secure due to three main factors: 1.) strong brand awareness, 2.) global reach, and 3.)

innovative leadership. Office Depot currently has brand name recognition that is second

to none in the international retail office supply industry. This brand equity will assist in

the sustainability of Office Depot’s expansion and will develop brand loyalty and

customer retention. Secondly, with Office Depot leading the way in this industry’s global

market place, their competitive advantage in this arena is sure to be secured. Lastly,

with one of the most highly regarded five-star CEOs Steve Odland currently in control of

Office Depot, one must be secure in knowing that Office Depot’s competitive

advantages will be continually adapting and improving over time. It is hard to value the

effect of a great leader, but because the stock price of Office Depot has nearly doubled

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in his first two years in office, this firm appears to be in great hands. The following

graphical depiction shows the monthly closing prices of Office Depot’s stock directly

after the acquisition of Chairman and CEO Steve Odland and the two years following.

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Accounting Analysis

The next step involved in valuing a firm is to conduct an accounting analysis of

the firm and its competitors by examining the annual reports (10-K) these firms filed

with the Security Exchange Commission (SEC). The main reason an accounting analysis

must be conducted is to ascertain whether the firm and its competitors’ accounting

policies accurately depict the actual financial position of the firms at a given point in

time. Since managers and top level executives might have, for example, bonus

compensation tied to reported net income (earnings management), the critical analyst

must consider possible distortions of the firm’s financial position through managers

utilizing accounting flexibility. With an accounting analysis, those accounting policies

that could be considered flexible will be examined and possibly restated to come to a

more accurate view of the firm’s financial position. When conducting an accounting

analysis, six major steps must be followed. This iterative process includes: identifying

key accounting policies, assessing accounting flexibility, evaluating accounting

strategies, evaluating quality of disclosures, identifying potential red flags and, finally,

undo any accounting distortions that may have been created.

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Identify Key Accounting Policies

The first step that must be taken in accounting analysis is to identify these

competing firms’ key success factors. This is important because their key accounting

policies are often tied very closely to these key success factors. In order for firms in the

retail office supplies industry to be successful, they must continually strive to be the

cost leader. This can be done by increasing their economies of scale, lowering input

costs, and maximizing operating efficiency.

We must identify a few significant accounting policies relating to Office Depot’s

key success factor of increasing its economies of scale. In order to increase its

economies of scale, Office Depot must continue to open new stores as well as decrease

competition by acquiring competing firms. In order to open new stores a firm either

needs to purchase the location at which the new store will be located or lease the

property from another company. According to Office Depot’s 2006 10-K, most of their

retail locations are leased properties. Although most of these properties are acquired

using an operating lease, approximately 38% are acquired by capital leases. The

method in which Office Depot estimates their capital leases’ reported value is a critical

accounting decision we must consider.

In an attempt to increase its economies of scale, Office Depot acquired a few

firms at a price in excess of fair market value. When a firm purchases another firm for

greater than market value, the purchasing firm will have to determine how to declare

and write off the asset of goodwill as well as restructure its assets, liabilities, and equity

components of its balance sheet. These accounting policies are also very significant

when analyzing the reported financial position of the firm.

Another key success factor is the ability to minimize input costs. In order to

achieve this, Office Depot has made arrangements with vendors that enable them to

receive benefits such as partial refunds on merchandise previously purchased, as well

as the utilization of a major rebate program for its products. Estimates that are tied to

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these particular vendor agreements are a major accounting policy to evaluate when

conducting an accounting analysis.

A final key accounting policy in this analysis involves policies relating to

estimating the firm’s pension liability. There is a high level of estimation involved in

even determining the values of the components necessary to estimate pension liability.

In addition, the firm must choose a discount rate to apply to the equation. Applying

higher or lower discount rates can have significant effects to the expense and net

income columns of the balance sheet as well as liabilities and owner’s equity on the

income statement. The potential for distortion in these areas warrants a closer

investigation into the firm’s activities relative to the competition.

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Potential Accounting Flexibility

The Generally Accepted Accounting Principles (GAAP) sets forth financial

reporting standards with which companies must comply. Although it mandates certain

actions be followed, it also allows for managerial freedom in other aspects of

accounting policy. Some of these aspects could potentially distort a firm’s financial

picture in such a way that there is a meaningful difference between the “true value”

and “portrayed value” of the company. Many variables, such as the relative weight of a

figure to the company’s assets, determine the extent of potential distortion.

Determining the significance of these potential data “skews” requires a critical eye and

careful analysis of the firm’s financial statements. Office Depot’s aforementioned key

accounting policies relate to their key success factors such as cost leadership. The

ability to manipulate costs and expenses provides obvious incentive to firms competing

on cost leadership.

Operating & Capital Leases

The accounting treatment of facility leases plays a significant role in reporting

expenses and ultimately profitability. Put simply, an operating lease states that your

total expense is reflected in your annual payment (rent). Because the firm does not

“own” the facility, potentially significant financial data is omitted in the net reporting of

assets, key liabilities, retained earnings, and net income- all of which are effected as a

function of each other. Capital leases report the facility as being under the ownership of

the firm and create additional expenses avoided by an operational lease. Such expenses

would include depreciation and interest on the facility’s note. These expenses are

realized in the short term; far more significant to financial data than any long term

potential appreciation on the real estate, for example. Because operational leases avoid

reporting interest and depreciation expense, their net expenses are comparatively lower

to a firm reporting the same facility as a capital lease. Understated expenses create

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overstated net income and retained earnings. Capital leases are reported under assets

(the facility) and liabilities (tax liability, interest) as well as expenses (depreciation).

Office Depot carries just under $4.4 billion in operational leases compared to only $456

million in capital leases. The almost 10:1 disparity is of some significance considering

that Office Depot’s total assets for 2006 were only $6.5 billion. This is not an anomaly

in this industry however. Staples, the industry leader and closest competitor to Office

Depot, reported roughly $5.25 billion in operational leases with total assets at $8.4

billion. The ratio of operating lease expense to total assets for Office Depot and Staples

are 68% and 63%, respectively. From a competitive standpoint, the extent of

demonstrated accounting flexibility is not concerning although it suggests both firms

have much higher financial commitments and risks than is represented in the financial

statements.

Pension Liability

Pensions are post-retirement programs designed to provide income for

employees after retirement either through defined benefit or defined contribution plans.

These are represented as long term liabilities for the company. The method for

determining the firm’s liability can be a key accounting policy to examine. Forecasting

pension liability in defined benefit plans is comprised of several unknowable

components (such as retirement date, death, etc) and must be estimated by managers

on an aggregate scale applied to the employee base. Aside from the uncertainty

mentioned already, managers must decide an appropriate discount rate to apply and

discount these distant cash outflows back to present day. Due to the time scale

involved, even relatively small changes in the applied discount rate can create

significantly different pension liability figures. Using an inflated discount rate has the

effect of lowering the present value of the future cash outflow thereby reducing

liabilities and having the net effect of increasing assets. Office Depot applied a discount

rate of 4.85% in 2006 compared to the 5.8% rate used by Office Max. Staples do not

disclose their applied discount rate. From this relative measure, we can say that Office

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Depot has fair amount of upside flexibility in estimating pension expense while still

remaining within a reasonable range of its competition.

Goodwill

In the pursuit of cost minimization through increasing economies of scale, Office

Depot acquired four companies and increased their investment stake in others during

2006. Goodwill is an intangible asset defined as the difference between purchase price

and fair value of an asset. Often the inflated selling price can be attributed to future

earnings potential in addition to fair value or a takeover situation where stock is

purchased above market as a condition of board approval. In accordance with SFAS no.

142, “goodwill must be tested for impairment annually and written down if carrying

value exceeds fair value.” (fasb.org) Because goodwill is reported as an asset but has

no meaningful revenue producing capacity, it is worthwhile to investigate the portion of

total assets it comprises relative to the competition as well as the frequency and size of

any write-downs. Office Depot accumulated $249 million in goodwill for 2006 while

writing down $41 million in the first quarter of 2006 relating to fiscal year 2005. Office

Depot had not yet determined 2006 goodwill impairment charges. Office Depot reports

goodwill on its balance sheet being valued at approximately $1.2 billion. Staples

reported a goodwill value of $1.45 billion while Office Max reported a value of $1.2

billion. The percentages of total assets comprised of goodwill for these firms are 18.4%,

17.2%, and 19.4%, respectively. These ratios represent that Office Depot has a

reasonable proportion of goodwill to assets relative to the industry leaders. The

potential for further flexibility in this key accounting policy is unsubstantial.

Conclusion

Although several key accounting policies have shown to manipulate various

determinants of Office Depot’s financial health, the degree to which these decisions

impacted each area falls in line with the competition and reiterates the cost leadership

mentality of the industry.

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Actual Accounting Strategy Evaluation

Assessing Degrees of Disclosure

Through methods previously discussed and some level of accounting flexibility,

firms can attempt to angle their financial reports to aggressively record revenues, hide

expenses, or dilute liabilities in the short term. Operating within the GAAP and FASB

standards, there is nothing illegal about “creative” accounting but it requires a critical

analyst to sort out the truth to appropriately compare firms to each other. Firms may

also choose to conservatively report figures often with the result of lower earnings and

higher expense and liabilities levels. These two approaches, or any mix thereof, can be

utilized to either portray a transparent window into the firm’s activities or to create a

façade intended to communicate something in particular to investors and competitors.

Operating and Capital Leases

As with Office Depot’s competitors and other large retailers, operational leases comprise

the vast majority of the financing methods for Office Depot’s leases. Because such a

high proportion of their leased assets are recorded as operational leases, the firm’s true

financial commitment and risk are vastly understated by keeping them off of the

balance sheet. This practice would suggest an aggressive approach to asset recognition

from an absolute standpoint. The industry and competition has very similar reporting on

their books as well. From this view, Office Depot is neither aggressive nor conservative

but merely competitive with its accounting. With respect to the degree of disclosure,

Office Depot lists both operational and capital leases as items under “contractual

obligations.” They categorize these cash obligations according to maturity and project

the future values of these cash flows to represent accurate expense estimates. They

also list the present value of 2006 lease expenses on the balance sheet.

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Pension Liability Estimation

The pension liability estimation is another strategic accounting consideration. The

ability to directly influence expenses, liabilities, and net income give managers a

powerful tool to manipulate aspects of the firm’s financial picture. One of the most

direct ways to influence pension liability is through the discount rate. Office Depot has

pursued a seemingly conservative to neutral approach in this area by reducing the

applied discount rate each year for the last three years. This has had the effect of

increasing pension expense in the current year and long term liabilities. This decline in

applied rates matches increasing inflation levels over the same period. Higher inflation

represents a lower future value of a cash flow. The increase in pension liability

expenses seems to have been subsidized in part by a decline in salary increases.

Office Depot uses a slightly more conservative figure for their discount rate than

does Office Max but is close enough to remain competitive in the industry in this regard.

Staples do not disclose their discount rate. With respect to the degree of disclosure

given by Office Depot, we can see that they make almost every aspect of their pension

program transparent in the 10-K. The historical trends of applied discount rates and

salary increases are given as well as the allocation of assets across different security

sectors with their respective relative weights. This information is particularly useful if

one wanted to analyze the effect of a market event, such as the sub-prime collapse, on

the pension investment plan. That information is clearly available and is given as 1%

invested in real estate. This is characteristic of a high level of intended disclosure in this

area.

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Goodwill

Office Depot has been actively acquiring and investing in other firms recently and

has accumulated a substantial amount of goodwill as a result. Goodwill allows the

purchase price of an asset or firm in excess of fair market value to be incorporated as

an asset on the acquiring company’s balance sheet. A high percentage of goodwill to

assets relative to the competition would suggest either atypical levels of expansion and

acquisitions for that particular firm/industry or that management was delaying or failing

to write down goodwill impairments to inflate asset balances. The top three firms in this

industry have very similar ratios of goodwill to total assets and have demonstrated

appropriate annual impairment charges. From an absolute standpoint, Office Depot

could be seen as pursuing aggressive accounting in this area due to the large balance

of goodwill relative to the asset balance. However, when viewed in comparison to the

industry and competition, Office Depot again remains competitive with the norm of the

environment in which it operates. The level of disclosure in this area is fairly high. The

firm delineates acquisition activities on a per-occurrence basis and quantifies the

goodwill incurred with each. It discloses past write down activity but stops short of

estimating impairment write downs for 2006. The impairment charges on goodwill for

2005 and 2004 were insignificant relative to the accumulated goodwill balance for that

year. One can forecast that, although 2006 goodwill impairment is not estimated or

available yet, it will not be a significant figure to impact the firm’s financials in a

meaningful way.

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Qualitative Analysis of Disclosure

Every year publicly traded firms are required to make public their financial

documents for the SEC, stakeholders, and any interested investors. Management is

required to show how their respected firms have performed in the past year by

explaining this in the annual report (10-K). The quality of disclosure means how clear

(transparent) they disclose their accounting policies and managements decisions. In the

next two sections we will discuss qualitative and quantitative disclosure.

Office Depot’s 10-K does like many others in raving of how the past year has

been a year of growth and success: “we have exceeded $15 billion in sales for the first

time by increasing sales levels in each of our operating Divisions…” (Office Depot 10-K,

2006) Since Office Depot is in the cost leadership sector they do need to be

concentrating on economies of scale and moving more products. It seems that they are

making the point that they are growing and selling more than ever. In each of the

company’s divisions: North American Retail Division, North American Business Solutions

Division, and the International Division, they do a good job in stating sales and that of

the division’s operating profit. Especially in regards to how they have improved in all

channels and the impact of acquisitions in foreign countries. Office Depot states how

they recognize goodwill and other intangible assets. The increase in goodwill of $249

million reflects all the acquisitions that were made in the past year.

They also state that they use operating leases and that they are a major portion

of the contractual obligations. And the use of operating leases is a way to understate

expenses which overstates net income, in turn makes the bottom line look a lot more

attractive. These leases total $4.39 billion through the years 2032, which is amortized

over the years. Although this is disclosed and seems to be an industry standard it does

need to be noted.

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One potential “red flag” that is raised when looking at the 10-K is that it

mentioned “Charges”. It states “During 2006, we refined our measure of Division

operating profit to include general and administrative expenses directly or closely

attributable to each reportable segment and to exclude charges related to programs

initially identified in 2005 following a Company-wide review of operations, processes

and commitments (the “Charges”). (Office Depot 10-K, 2006) These “charges” are

continually brought back up throughout the operating results section. Why did they

include general and administrative expenses to the Division operating profit? It seems

that they expensed them on to the Division operating profit. It definitely adds a little

confusion to what they actually mean by “charges.”

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Quantitative Analysis of Disclosure

When analyzing financial statements it is very important to examine a few certain

ratios that will help exploit the possibility that a firms financial statements might have

been manipulated. There are many reasons why a firms financial statements might

have been manipulated, which include but are not limited to: when a firms

management has certain “quotas” to meet in order to receive certain bonuses, when a

firm might have certain restrictions by their lenders to maintain certain ratios, and when

a firm might be planning to incur debt and wants to make its financial statements more

presentable in order to receive a lower interest rate. If any of these ratios change by a

significant amount, questions should be asked and a further investigation into the firm’s

financial statements should be conducted.

The first set of ratios that need to be calculated are the sales manipulation

diagnostic ratios. In years that a firm’s performance was sub-par, the firm’s

management might decide to inflate its net sales to make its performance not look so

bad. In years that a firm’s performance was excellent, the firm’s management might

decide to deflate its sales number just to “save some for a rainy day.” These are

excellent reasons why the ratios net sales/cash from sales, net sale/net accounts

receivable, and net sales/net inventory among others should be calculated and

examined to determine whether or not a firm has manipulated its sales.

The second set of ratios that need to be calculated are the expense manipulation

diagnostic ratios. These ratios help to indicate whether or not a firm might have

inaccurately reported its financial statements by understating or overstating things such

as assets and liabilities. These ratios can also help an analyst determine how effective

the company is in terms of generating sales from assets. Once all ratios are examined a

better picture of these companies will be drawn.

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Sales Manipulation Diagnostic Ratios

Net Sales/Cash From Sales

In order to calculate net sales/cash from sales, one must first calculate net sales

less the change in account receivables and then divide net sales by that number. This

ratio is good to examine because it indicates the amount of cash that is received

compared to the actual sales that a particular firm makes. The optimal ratio is 1:1. If a

firm is able to produce a net sales/cash from sales ratio that is equal to 1 over a certain

period of time, it indicates that the firms reported sales are supported by cash. The

above graph indicates the net sales/cash from sales ratio for the three major firms in

the retail office supplies industry. Office Depot has successfully kept its net sales/cash

from sales ratio within two basis points of the optimum 1:1 ratio, which indicates that

Office Depot’s sales have constantly been supported by cash over the past five years.

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Net Sales/Net Accounts Receivable

After examining the above graph, it is determined that only a small percentage

of sales within this industry are supported by accounts receivable and/or credit sales.

Office Depot is the industry leader in terms of having its sales supported by credit sales,

but still, its ratio is very minimal compared to its total sales. The important thing to

point out is that throughout the previous five years, Office Depots and its competitors

have maintained a consistent level of sales supported by accounts receivable over the

past five years which demonstrates stability.

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Net Sales/Inventory

The ratio net sales/inventory helps to examine how well a company uses it

inventory to create revenue. A spike in the above graph could indicate that the firm has

manipulated its reported sales. When analyzing all three firms, Office Max raises some

suspicion on whether it might have manipulated its reported sales in previous years.

Office Depot experiences a spike in 2005, and although very minimal, this could be the

direct effect of sales being manipulated that year. Over the years though, Office Depot

and Staples ratios have increase steadily over the years and, with the exclusion of

Office Max, would be considered the industry norm.

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Net Sales/Unearned Revenue

Since all three major firms in the retail office supplies industry do not perform

any services that are prepaid for, the ratio net sales/unearned revenue could not be

calculated.

Net Sales/Warranty Liabilities

Since all three firms in the retail office supplies industry do not directly provide

any warranty services for the products they sell, net sales/warranty liabilities could not

be calculated.

Conclusion to Sales Manipulation Diagnostics

After conducting a sales manipulation diagnostics test on the three major firms in

the retail office supplies industry, we only found one ratio that could lead us to believe

that Office Depot might have possibly manipulated its reported sales over the past five

years. However, due to the fact that the spike in the ratio is so small, we do not believe

that Office Depot has manipulated their reported sales. We also believe that Staples has

been a very consistent performer over the past five years and we come to the same

conclusions with them as we did with Office Depot. Office Max, on the other hand, has

displayed behavior in their sales manipulation diagnostic ratios that would lead us to

believe that Office Max could have manipulated it sales over the past five years and a

further investigation in this matter would have to be taken in order to formulate a

conclusion to the matter.

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The following table contains the exact ratios that were used to compose the graphs located above.

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Expense Manipulation Diagnostics

The following section presents ratio’s that will help in the examination of whether

a firm in the retail office supplies industry, particularly Office Depot, has manipulated its

financial reports over the last five years. Unlike the previous section where revenue

diagnostics were preformed, here we will perform expense diagnostics and determine if

one of these firms might have manipulated things such as assets and liabilities over the

past five years. After examining these ratios an educated determination can be made in

regards to the quality of these firms’ financial statements and accounting policies.

Asset Turnover

The asset turnover ratio indicates how well a firm is able to generate sales from

its assets. The asset turnover ratio for the two main firms in the retail office supplies

industry has remained relatively consistent over the past four years. Office Max, on the

other hand, has experienced difficulties keeping its asset turnover ratio constant. This

could be a direct effect of Office Max manipulating its total assets. If the asset turnover

ratio experiences a spikes this would indicate that the company may have manipulated

its assets. After reviewing the above graph we believe that the behavior of Office

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Depots asset turnover ratio do not raise any red flags in terms of them possibly

manipulating their assets.

Cash Flows From Operating Activities/Operating Income

The ratio cash flows from operating activities/operating income should preferably

be a number that is small. If the number of the ratio is small this indicates that the

majority of a firm’s cash flow was created from its operating activities and not it’s

investing or financing activities. It is a good indicator of the health of a company.

According to the above graph, both Office Depot and Staples have had a consistently

low ratio of cash flows from operating activities/operating income. This is preferable as

mentioned above because it indicates that over the past five years both these firms

have been successful at generating cash flows from its operating activities. The slight

increase from 2004-2005 for Office Depot is due to a decrease in their operating income

for 2005, and due to the fact that the industry was experiencing a decline in sales

during that period there is no level of concern for this particular type of behavior.

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Cash Flows From Operating Activities/Net Operating Assets

The ratio cash flows from operating activities/net operating assets indicate the

amount of cash from operations that was generated by the firms tangible assets. It also

determines if a firm is utilizing its fixed assets constructively. A high ratio is preferred

and indicates that a firm is utilizing its assets to create cash flow. The following graph

indicates that Staples is the industry leader for utilizing its fixed assets due to the

amount of cash from operations that are generated from them. If there is a spike in the

ratio it indicates that a firm could have overstated its assets. When evaluating Office

Max’s ratio, we believe that Office Max could have enhanced their financial reports.

Office Depot, although not as impressive as Staples, has had a very consistent ratio

over the past five years. This consistency indicates that they have generated roughly

the same amount of cash from operations from their fixed assets over the past five

years and do not raise any flags in terms them possible enhancing their reported

financial results.

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Total Accruals/Change In Sales

Total accruals/change in sales indicates how a firm conducts its business. If the

ratio is high, the majority of sales for a firm is on credit and placed in the accounts

receivables section of the balance sheet. This ratio also takes into account other accrual

factors such as accounts payable and goodwill. A low ratio is not necessarily preferred

all the time, but in the retail office supplies industry it is. That is because in the retail

industry it is good to have the majority of sales as cash transactions because credit

sales put firms such as Office Depot into more risk than otherwise is not needed. Also,

if there is a spike in this ratio it could be because a firm manipulated its financial

statements such. With a steady ratio for Office Depot and Staples over the past five

years, no suspicions of manipulated financial data are raised. Office Max once again

performed erratically in this ratio leading to some suspicion of their financial

statements.

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Pension Expense/SG&A

The pension expense/SG&A ratio indicates the percentage of SG&A expenses

that are pension related. By calculating this ratio we can analyze and form a conclusion

as to whether a firm spends too much money on its retired workers. A forward

conclusion can also be drawn as to how much obligation Office Depot can expect to

incur over the years due to the pensions that it offers it employees. Office Depot has

had a very consistent ratio over the past five years and recently is very close to Office

Max in terms of its pension expense. With Office Depot’s consistent performance in this

ratio we believe that the enhancement of their financial statements is not likely.

Pensions could not be found anywhere in Staples reported financial statements.

Conclusion To Expense Manipulation Diagnostics

After conducting an expense manipulation diagnostics test for Office Depot and

Staples we did not find significant evidence that would lead us to believe that either of

these two firms have manipulated their financial reports. Office Max, however, did

display behavior in its ratios that might be a direct effect of manipulation. In general,

the retail office supplies industry performed relatively well in expense diagnostics.

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The following table contains the exact ratios that were calculated and used to compose

the graphs that are located above.

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Overall Conclusion to Revenue & Expense Diagnostics

After conducting a sales manipulation diagnostics test on the three major firms in

the retail office supplies industry, we only found one ratio that could lead us to believe

that Office Depot overstated sales over the past five years. However, due to the fact

that the spike in the ratio is so small, we do not believe that Office Depot has

manipulated their reported sales. We also believe that Staples has been a consistent

performer over the past five years and we come to the same conclusions with them as

we did with Office Depot. Office Max, on the other hand, has displayed behavior in their

sales manipulation diagnostic ratios that would lead us to believe that Office Max could

have manipulated it sales over the past five years and a further investigation in this

matter would have to be taken in order to develop a conclusion to the matter. In terms

of expense manipulation diagnostics, Office Depot and Staples did not have any

significant type of behavior that would lead us to believe that they have recently

manipulated their financial reports. Once again, Office Max’s performance was

questionable and the company and its financial statements would require a much,

more, in-depth look to figure out why their performance is so erratic. Overall, the retail

office supplies industry, with the exception of Office Max, had a respectable diagnostic

outcome.

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Potential “Red Flags”

When analyzing the financial statements of firms in a particular industry some

accounting “red flags” usually are discovered. If “red flags” are discovered in the firm’s

financial statements then the numbers that created the “red flags” should be

reevaluated to determine whether management accounting flexibility was used. If the

“red flags” were a direct result of accounting flexibility then the firm’s financial

statement will have to be restated using numbers that are conservative and that display

zero accounting flexibility.

When evaluating ratios for Office Depot, all activities seemed to be fairly normal

and no red flags were raised in regards to the possibility of them enhancing their

financial reports and the same is true for Staples. Office Max, on the other hand, did

have a few ratios that led to red flags. Office Depot does however have operating

leases that distort their liabilities and assets. In conclusion, with the results of the ratio

analysis of Office Depot we believe that the financial statements for Office Depot are

accurate and depict an accurate financial picture of the firm with the exception of their

accounting practices for operating leases.

Undo Accounting Distortions

If “red flags” were discovered inside the financial statements of a particular firm,

the analysis will have to recast the financial statements and undo the accounting

distortions that created the “red flags.” After analyzing the financial statements of Office

Depot we determined that the assets and liabilities are understated because of Office

Depots accounting practices of operational and capital leases. Due to the fact that the

majority of Office Depots leases are operational, we calculated the present value of all

future obligated lease payments to determine the amount that their financial

statements are understated.

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2007 Current Lease Obligations

After the above calculations using the industry average 7.5% discount rate, it is

determined that Office Depot is liable for $2.773 billion dollars due to contractaul,

operational leases. To undo this distortion we will recast Office Depots financial

statements and increase their assets and liabilities according as well as account for any

change in net income due to this accounting practice.

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Financial Analysis & Forecasting A financial analysis is a important task that must be performed becuase the

results will give someone a much better overall picture of a particular firm after the

analysis has been performed. In order to perform the analysis many ratios have to be

calculated that deal with the liquidity, profitability, efficiency, and capital structures of a

firm. In order to better gauge the performance of a firm it is always good to calculate

and evaluate the same ratios for the firms competitors. This will allow for an industry

average to be calculated and then the average can be the benchmark for all firms in the

industry.

Once all ratios have been calculated, a graph can provide many answers as well

as raise many questions. These answers and questions are a direct result of a detailed

analysis of all ratios and will lead to a much better understanding of all firms in a

particluar industry as well as the industry itself. The following section of the report will

calculate and analyze every legitimate ratio that will help in the understanding of what

is going on at a particular firm and whether that firm is liquid or not as well as

profitable or not. We will also be able to determine how each individual firm finances its

operations, either by debt or equity. Once these very important ratios have been

calcuated and evaluated a detailed forecast into the future (10 years) will be conducted

to determine whether or not Office Depot will have a promising future or not.

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Liquidity Analysis

A liquidity analysis will be conducted in order to evaluate the ability of Office Depot

as well as other firms in the retail office supply industry to pay its debts on time and

whether or not inventory, working capital, and accounts receivables are being properly

managed. In order to conduct a liquidity analysis, the seven major ratios that are

located below will be calculated using the numbers from the reported financial

statements of the three major firms in the retail office supply industry and then

analyzed and interpreted.

• Current Ratio = Current Assets/Current Liabilities

• Quick Asset Ratio = Quick Assets/Current Liabilities

• Accounts Receivable Turnover = Sales/Accounts Receivable

• Days Sales Outstanding = 365/Account Receivables Ratio

• Inventory Turnover = COGS/Inventory

• Days Supply of Inventory = 365/Inventory Turnover Ratio

• Working Capital Turnover = Sales/Working Capital

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Current Ratio

The current ratio of a company determines the ratio of current assets to current

liabilities for a firm. This is a great ratio to include in a financial analysis because it

indicated whether a firm would be able to cover its immediate liabilities with only its

current assets. If a firm is not able to cover its immediate liabilities with only its current

assets, if needed, the firm would then have to begin liquidating its long term assets in

order to cover these liabilities or take on debt, which the majority of the time is not

considered a good thing for a firm given the situation. The following graph and table of

data indicates the current ratio for the three major firms in the retail office supplies

industry for the past five years (2002-2006).

When analyzing the current ratio of Office Depot and its competitors, as well as

benchmarking them to the industry average, all three firms are performing relatively

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well. A number greater than one is considered to be a good ratio for firms because that

proves that the firm’s current assets can indeed cover all of their current liabilities if

that particular need arises and a liquidation of long term assets would not be needed to

cover those current liabilities.

Since 2002, Office Depot’s current ratio has steadily declined, dropping from 1.6

to roughly 1.15. Normally, a constant decline in this ratio would lead an investor to

speculate whether the ratio will continue to decline and eventually drop below one,

which would not be a preferable event. In this case, though, concern should not be

very high when considering Office Depot’s current ratio decline over the past five years

because after a review of their reported financial statements, accounts receivables for

Office Depot has constantly risen over the years. This is because back in 2002, Office

Depot’s full operations focus was on primarily retail sales, in which accounts receivables

are not needed. Over the past five years, though, Office Depot has began trying to sell

directly to businesses and allowing these businesses terms such as Net 30, hoping that

this shift in operations would increase its revenue, which is has to some extent.

Therefore, a decrease in Office Depot’s current ratio is actually a good thing, because a

ratio of 1.6 is very high and suggests that they could stimulate more sales if they

increased their accounts receivable, which increases sales, profits, and revenues. When

forecasting Office Depot in the forecast section of this report, it will be assumed that

Office Depots current ratio will now remain considerably constant, declining at a small

rate over the next ten years and eventually leveling off. This represents the fact that

Office Depot is now engaging in more B2B activities and A/R will be expected to

increase over time due to these activities. To conclude, the decrease in Office Depot’s

current ratio has actually made the firm more profitable by increasing its accounts

receivables, which in turn has increased the firm’s revenues and profits.

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Quick Asset Ratio

The next financial ratio that must be calculated and analyzed is the quick asset

ratio. This ratio determines a firm’s ability to pay its current liabilities with assets that

are either cash or an asset that can be quickly converted into cash. Assets that can be

quickly converted into cash include short term investments and securities as well as

accounts receivable, because A/R can be sold for a discount to certain investors looking

for that particular type of investment. Unlike the current ratio, inventory is not

calculated in the quick asset ratio because inventory can take some time to sell, and

hence is not considered a quick asset. The following graph and table of data indicates

the quick asset ratio for the three major firms in the retail office supplies industry for

the past five years (2002-2006).

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After analyzing the quick asset ratios for all firms in the retail office supplies

industry, we agree that Office Depot and Staples have a sufficient amount of quick

assets that could be used to satisfy any immediate current liabilities that come due.

Office Max, on the other hand, has had an erratic quick asset ratio over the past five

years, noted by its performance in 2004, which was Office Max’s best business year of

its existence. If Office Max did not have such a good year, in 2004, its quick asset ratio

would have been constant over the years and it would be considerably lower than the

industry average. This suggests that if Office Max’s current liabilities came due

immediately it would currently only be able to pay roughly 50% of the liabilities with its

quick assets.

Now Office Depot has had steady performance over the past five years, with the

exception of 2006, in which its quick asset ratio declines considerably, dropping nearly

40% from .78 to .56. After reviewing Office Depot’s financial statement, we discovered

that in 2005, the firm recorded 703 million in cash and cash equivalents and in 2006, it

only reported 174 million. This raises concerns for Office Depot and further

investigations must be conducted to determine the reasons Office Depots cash and cash

equivalents declined so dramatically in only one year and these findings will be included

in the calculations for the forecast of Office Depot in the following section of this report.

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Accounts Receivables Turnover

Accounts receivables turnover is also a very important ratio that must be

calculated and analyzed. This ratio tells investors and the likes how well a firm manages

its collections of accounts receivables as well as whether or not a majority a firms sales

are paid for by either cash or credit. To calculate this ratio, one must divide a firm’s

sales by the amount of accounts receivable reported at the end of the fiscal year. If the

ratio is a high number this will indicate that either the majority of a firm’s sales are paid

for by cash or that the firm is managing its collections of accounts receivables

efficiently. The following graph and table of data indicates the accounts receivable ratio

for the three major firms in the retail office supplies industry for the past five years.

The results indicate that Staples is the industry leader when it comes to accounts

receivables turnover. After further research, we confirm that the reason Staples leads

the industry in accounts receivables turnover is because it has engaged in a large B2B

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operation in the past five to seven years and they extend credit terms to its customers

at a much greater pace than Office Depot and Office Max. Office Max is close to the

industry average suggesting that their collections of receivables and B2B operations are

managed fairly efficiently. Although Office Depot has increased their accounts

receivable account on the balance sheet quite dramatically over the past five years, it is

due to a large growth in total sales its accounts receivable turnover ratio is quite low

and has continued to decrease. This suggest that although Office Depot has increased

its B2B operation to an extent, which in turn has increased its accounts receivables

account, they most likely could do better and stimulate more sales if they ramped up

their B2B marketing and attract more customers with favorable credit terms.

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Day’s Supply of Receivables

Day’s supply of receivables tells us the average number of days it takes to turn a

credit sale on account receivables into cash. To calculate days supply of receivables,

one must divide 365 (number of days in the year) by the accounts receivable turnover

ratio. This ratio is very important to analyze because it will indicate whether a firm is

efficient in collecting on its accounts receivable. If this holds true, then the smaller the

number the better, because that would indicate that a firm collects on its accounts

receivables quickly. The following graph and table of data indicates the day’s supply of

receivables for the three major firms in the retail office supplies industry for the past

five years (2002-2006).

Once again, Staples is the industry leader in day’s supply of receivables ratio.

Office Max again is close to the industry average, but Office Depot has now raised some

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questions after analyzing its day’s supply of inventory and inventory turnover ratio. As

discussed above, Office Depot is the industry laggard in terms of accounts receivables

turnover. Now it has established itself also as the industry laggard in terms of day’s

supply of receivables. This can mean three things: First, it could suggest that due to the

fact that Office Depot does not concentrate primarily on B2B sales. It would be obvious

that they would have the lowest percentage of sales from accounts receivable and due

to this fact, they do not try as hard collecting on the small accounts of credit sales it

does have. Secondly, this could suggest that in an attempt to stimulate credit sales and

increase its B2B business operations it is offering very gracious credit terms hoping that

businesses will make the switch from one of Office Depots competitors to them. On the

other hand, it suggests that Office Depot is not utilizing a sector of its industry to its

fullest because it is very obvious they do not try very hard increasing its credit sales

which would lead to an increase its accounts receivable. It also suggests that when they

do get credit sales they are not very efficient at collecting on them. We believe that the

latter suggestion applies better to Office Depot than the first or second. Office Depot

should seriously consider stimulating its credit sales and find a better, more efficient

way to collect on those receivables when they come due which we believe would

increase their revenues and profitability.

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Inventory Turnover

Inventory turnover is a good ratio to see how efficient a firm is in terms of

moving its products as well as determining the volume and demand for a firm’s

products. It is calculated by dividing the cost of goods sold by inventory. In general, a

high ratio is better than a low ratio. A lower inventory turnover ratio would suggest

difficulty in moving products. This could be a direct result from either a decrease in

product demand or over-stocking inventory. This would suggest that they are not

efficient in terms of inventory management and a JIT inventory system may possibly be

implemented in order to reduce the firms’ inventory costs. The following graph and

table of data indicates the inventory turnover ratio for the three major firms in the retail

office supplies industry for the past five years (2002-2006).

The first thing that we noticed when analyzing the inventory turnover ratio for

Staples, Office Depot, and Office Max was the spike Office Max experienced in 2004.

Our research revealed 2004 was Office Max’s best operational year in its history. This

graph supports that fact because Office Max’s inventory turnover ratio was incredibly

high compared to the industry average, indicating that Office Max experienced a high

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demand for its products. Office Depot and Staples are both very close to the industry

average suggesting that all of these firms have been highly efficient in this respect over

the last five years.

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Days Supply of Inventory

Days supply of inventory indicates the number of days it takes for a firm to

exstinguish its entire inventory supply. A lower number is considered preferable to a

high number. A lower number of days required to for a firm to cycle its inventory the

more profitable that firm will be because the firm will be moving a higher volume of

products in a shorter period of time. If the days supply of inventory is low this also

suggests that demand for a firms products are high and/or a firm is very efficient at

managing its inventory levels. Either scenario contributes to increased firm profitability.

The days supply of inventory is calculated by dividing 365 (the number of days in a

year) by the inventory turnover ratio. The following graph and table of data indicates

the day’s supply of inventory for the three major firms in the retail office supplies

industry for the past five years (2002-2006).

Judging from the graph we have determined that both Office Depot and Staples

are very close to the industry average in terms of days supply of inventory. This

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suggests that demands and/or the managment of these firm’s inventory levels are very

good and have been very good for the past five years. Office Max has also been close

to the industry average but only for the past two years. This suggests that Office Max,

compared to the other major firms in the industry, might have a tougher time

producing consistent results in the future.

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Working Capital Turnover

It is also very important to calculate and evaluate the working capital ratio for a

firm and compare it to other firms in the industry. In order to calculate working capital

turnover, working capital itself must be calculated. To calculate working capital, you

must subtract current liabilities from current assets. Once this has been calculated you

need to divide total sales by working capital giving you a working capital turnover

ratio. A high working capital turnover ratio is preferable to a low working capital ratio

because a high working capital turnover ratio indicates an ability to generate a high

level of sales from working capital. The following graph and table of data indicates the

working capital turnover ratio for the three major firms in the retail office supplies

industry for the past five years (2002-2006).

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Due to increased competition, a firm’s working capital turnover ratio can decline

as a result of either new firms entering the industry as well as existing rival firms

pursuing competitive strategies thus diverting future sales of the firm in question. An

analysis of the working capital turnover ratio for these three firms reveals superior 2002

working capital turnover ratios for both Staples and Office Max. During 2003 through

the middle of 2004 it is evident that working capital turnover ratios decline for Staples

and OfficeMax but not Office Depot. This could be a direct result of increased

competiton. From the middle of 2004 throught the end of 2005, working capital for

Office Max and Office Depot has increased considerably compared to the industry

leader in sales, Staples. Office Depot experienced its largest growth in working capital

turnover recently in 2006. Staples working capital turnover ratio is considerably lower

than the industry average and trails Office Max by roughly five points. This then proves

that while Office Depot and Office Max are generating a large amount of sales from

their working capital, Staples is not as efficient and is not generating near the amount

of sales from working capital as the other two major firms in the industry.

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The following is a supplementary account of all liquidity ratios for the major firms in this

industry as well as industry data.

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The following are opinions formulated with respect to Office Depot’s liquidity ratios.

To conclude, Office Depot is considered to be a fairly liquid company after the

liquidity analysis of all the firms in the industry. We came to this conclusion because

although Office Depot’s current ratio and quick asset ratio has declined over the past

year, they are still considered to be relatively acceptable for a firm such as Office

Depot, especially its current ratio, which is still above one after the drop from the

previous year. Inventory turnover, day’s supply of inventory, and working capital

turnover were all either equal to or better than the industry average, which is

considered to be a good thing. The only negatives that we found from the liquidity

analysis is that it is very obvious that Office Depot needs to put some serious work into

increasing its B2B credit sales and decrease the amount of time it generally takes them

to turn their credit sales into cash. Due to to the fact that Office Depot’s main focus is

retail sales and not B2B wholesaling or distributing, not a serious amount of weight was

given to the negative numbers that were calculated for Office Depots Receivables

Turnover and Days Supply of Receivables which is why we all agree that Office Depot

is, once again, a fairly liquid company when benchmarked against other firms in its

industry.

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Profitability & Efficiency Analysis

Profitability and efficiency ratios are used to determine what percentage of total

sales and net income are consumed by various components of the financial statements,

respectively. One may also determine the profitability of a firms assets and total equity.

Profitability ratios must be calculated in order to evaluate the profitability of a firm.

Profitibility analyses of the three major firms of the retail office supplies industry will be

conducted and discussed after each of the following ratios have been calculated:

• Gross Profit Margin = Gross Profit/Sales

• Operating Profit Margin = Operating Income/Sales

• Net Profit Margin = Net Income/Sales

• Asset Turnover = Net Income/Total Assets

• Return on Assets (ROA) = Net Income/Total Assets

• Return on Equity (ROE) = Net Income/Equity

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Gross Profit Margin

The gross profit margin is one of the major ratios that are calculated and

evaluated for any firm. The gross profit margin indicates how much gross profit is

earned for each dollar of sales. For example, if a firm has a gross profit margin of 25%,

then it can be interpreted that that particualr firm makes a gross profit of $.25 for every

dollar of sales. To calculate gross profit, one must divide the dollar amount of gross

profit by total sales of the firm. The following graph and table of data indicates the

gross profit margin for the three major firms in the retail office supplies industry for the

past five years (2002-2006).

According to the above graph and calculations it is obvious that Office Depot

leads the industry in gross profits from sales. Staples trails behind Office Depot at about

4.5% and is relatively consistent with the industry average. Office Max, on the other

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hand, is the industry laggard in terms of gross profits generated from total sales. It is

always better to have a higher gross profit margin because higher the gross profit is

usually corelated to higher net income, all else held equal. When net income is higher it

leads to a higher earnings per share which in turn leads to a higer equity stock price.

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Operating Profit Margin

Operating profit margins are also a very large component of a profitabilty

analysis of a firm. It is always preferred to have a operating profit margin as high as

possible because the higher a firms operating profit margins are, the higher the firms

net income will be, all else held equal. In order to calculate operating profit margin for a

firm, one must divide the operating income by sales. The following graph and table of

data indicates the operating profit margin for the three major firms in the retail office

supplies industry for the past five years (2002-2006).

After observing the operating profit margins for all three firms in the retail office

supplies industry, we can conclude that Staples is the industry leader and is very

profitable in terms of generated operating profits. Office Depot is relatively consistent

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with the industry average. Office Max, on the other hand, has a very low operating

profit margin compared to other firms in the industry. Operating profits margins are so

low that Office Max faces that probability each year that they might lose money if they

are not as efficient as possible in term of their operations. It will be interesting to see

what Office Max’s net profit margin will be in the following analysis given the fact that

its operating profit margins are almost zero. It is also interesting to note that Staples

operating efficiency is second to none because Staples gross profit margin was close to

five percent lower than Office Depots, yet its operating profit margins is 3% higher

than Office Depot. This implies that Staples operating costs are considerable less than

Office Depots, not to mention Staples operations are slightly larger than Office Depot.

This then tells us that in the future, Office Depot should strive to become a more

efficient firm by reducing some of its operating costs so that it will become more

profitable.

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Net Profit Margin

Net profit margin is one of the most applied ratios when determining the overall

profitability of a firm. Net profit margin tells us how much is earned out of each dollar

after all expenses for a firms have been paid. To calculate net profit margin one must

divide the net profit of a firm by the total amount of sales. That is the percentage of

each sale for a firm that is considered to be after tax profits that would be potentially

transferred to the stockholders equity section of the firms balance sheet. The following

graph and table of data indicates the net profit margin for the three major firms in the

retail office supplies industry for the past five years (2002-2006).

Not surprisingly, the leader of operating profits for the industry (Staples) is also

the leader of net income for the industry. Office Max, the laggard in operating profits, is

also the laggard in net profit margin. Office Depot is positioned nicely in between

Staples and Office Max, earning a net profit from sales that is almost equal to the

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industry average. This is a good position for Staples and Office Depot but a bad position

for Office Max. Once again, if Office Depot can work towards reducing its operating

costs it would eventually have a net profit margin more competitive with Staples, all

else held constant.

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Asset Turnover

Now that we have calculated all profitability ratios that tell us what percentage of

total sales are actual gross, operating, and net profits, we can now look at how

profitable the firm is in terms of generating sales from its assets and equity. To begin,

we will calculate and evaluate the asset turnover ratio. This ratio is calculated by

dividing total sales by total assets. The number that will be computed will indicated how

profitable the firm is in terms of its assets and will tell us how much revenue is

generated from the firm’s assets. The following graph and table of data indicates the

asset turnover ratio for the three major firms in the retail office supplies industry for the

past five years (2002-2006).

When evaluating asset turnover for the three major firms in the retail office

supplies industry we discovered that Office Depot has led the industry for the past five

years, sharing the industry lead with Staples from 2003-2004. Once again, Office Max is

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struggling to keep up with its competitors, posting an average of just around 1.5

compared to the industry average of 2.0. Due to the fact that there is no erratic

volatility in the asset turnover ratio for all three firms over the past five years it is

determined that all three firms are utilizing its assets reasonably well to generate sales.

Although Office Max trails the industry leaders, we still believe that they still are utilizing

its assets quite decently to generate sales for itself.

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Return on Assets

As mentioned above, asset turnover ratio determines that amount of sales that

are generated from assets. Return on assets, in turn, determines what percentage of

net income (net profit) is generated from assets. To calculate return on Assets, one

must divide net income of the current year and then divide by total assets from the

previous year. The number that is then calculated will indicate whether or not a firm’s

assets bring in a significant amount of profits for a firm or not. The following graph and

table of data indicates the return on assets for the three major firms in the retail office

supplies industry for the past five years (2002-2006).

Staples is the industry leader when considering returns on assets. Office Depot is

slightly higher that the industry average and Office Max is once again trying to keep up

with its competitors. Now a number that is high is considered to be better than a

number that is low when evaluating the returns on assets ratio. No firm in the industry

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has experienced a considerably large increase in returns on assets, yet all three firms

have experience increasing returns on assets in the past year. Office Depot had a slight

decline in return on assets from 2003-2005, but the decline in those years is not

considered to be significant because during those years Office Depot was quite

profitable which led to an increase it its total assets base. This is why Office Depot

experienced a slight decline over those years.

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Return on Equity

Return on equity indicates how profitable a firm is in respect to the equity that is

funding the company. To calculate return on equity one must divide net income from

total equity in the firm. This number will then indicate whether or not the particular

firms are creating an actual profit in respect to the amount of equity in the firm. As with

return on assets, a high number is preferred over a small number for returns on equity,

because a high number indicates that the firm is generating a high percentage of actual

profits from the equity that is financing the firm. The following graph and table of data

indicates the return on equity for the three major firms in the retail office supplies

industry for the past five years (2002-2006).

Again, Staples is the industry leader in terms of generating net profits from its

equity. Office Depot has always trailed Staples for the past five years, but in the past

year Office Depot has narrowed the gap from 10% to only 3%. This indicates that

Office Depot has been able to generate a considerable amount of profits from the

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equity in the firm and if the activity stays constant Office Depot will eventually pass

Staples as the industry leader in return on equity. Office Max is once again the industry

laggard but has experienced an increase in return on equity over the past year.

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Operating Expense Ratio

The last ratio that will be evaluated in the profitability analysis section of the

repot is the operating expense ratio. This ratio indicates what percentage of sales is

consumed by operating expenses of the firm. To calculate, one must divide total

operating expenses by total sales. If a number such as 85% is calculated, that would

then indicate that on average $.85 of every dollar of total sales is spent on the firms

operating activities and expenses. The following graph and table of data indicates the

operating expense ratio for the three major firms in the retail office supplies industry for

the past five years (2002-2006).

As mentioned above, we concluded that Staples has been a very efficient firm

and has also achieved the lowest operating expense ratio in the industry. This is why

although Staples gross profit margin was not as high as Office Depots, its operating

profit margin was much lower which awarded Staples with a higher operating profit

margin as well as net profit margin. Office Depot had a slight increase over the years in

operating expenses but over the past year they were able to decrease its operating

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expenses by three percent to 95%, on par with the industry average. Office Max once

again is having trouble keeping up with its competitors, posting the highest operating

expense ratio in the indsutry for nearly the past five years. It should be noted that in

2005, Office Max’s operating expense ratio was equal to one, indicating that its

operating cost were equal to its total sales, which led to Office Max recording a loss in

2005. Office Max has been able to decrease its operating expenses over the past year,

but it is still to high to be considered acceptable.

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The following are opinions the industries profitability and efficiency ratios

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The following are opinions formulated with respect to Office Depot’s profitability and

efficiency ratios.

Now after conducting the profitability and efficiency analysis many things came

to mind. First, Office Depot was almost always very close to the industry average for all

of its ratios. One issue arises from the data comparison of the three major firms, with

respect to industry averages, due to the effect of Office Max’s downward effect on the

industry average. Over the past five years has generally reported dismal performance,

Office Depot would not be in a very great place, because they lagged behind Staples in

almost every category for the past five years. So the industry average, we believe, is

not a great indicator of the performance of Office Depot because of the downward

effect Office Max had on the average. This then implies that Staples is the industry

leader for the office supplies industry and if Office Depot wants to be able to perform at

the same level as Staples they will have to work on their efficiency and reduced its

operating costs dramatically.

We also noticed that Office Max performed decently in the liquidity analysis yet

performed horribly in the profitability and efficiency analysis. We began to think how

this could effect the industry and the major forms of the industry and this is what we

speculate: since Office Max is relatively liquid company yet cannot seem to profit from

its operations, Office Max could be a potential future acquisition target by Office Depot

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or Staples. In Staples and Office Depots current situation, we believe that the only firm

that would be able to aquire a firm such as Office Max would be Staples. If this

happens, Office Depots revenue, profits, and market share would decline considerably

while the new Staples/Office Max combination would increase in size and market share

and the price of Office Depots common stock would take a dramatic hit if an event such

as this happened. We do not want to speculate too much, but if this scenario actually

happened, it could possibly put Office Depot out of business over a ten to fifteen year

period, or at least decrease Office Depots market share so dramatically that they just

go private.

More to the point, Office Depot performed much better on the profitability and

efficiency ratio analysis which indicated that Office Depot, is a very liquid and profitible

firm. One key thing they should work on is increasing its B2B operations through

increased credit sales and work on decreasing their total yearly operating costs. These

effective prosecution of these actions may make Office Depot a more liquid and

profitable firm.

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Capital Structure Ratios

“The capital structure of a company refers to the sources of financing used to acquire

assets and is shown by the liabilities and owners’ equity section of the balance sheet”

(FSA: Ratio Analysis Handout). Now what the capital structure is concerned with is the

amount of debt to equity and the ability to pay its principal and interest payments. The

three ratios we will be using are the Debt to Equity ratio, Times Interest Earned, and

the Debt Service Margin. The Debt to Equity ratio shows the proportion of all debt

relative to the proportion of all equity. The Times Interest Earned ratio is a way to see

how well a company can pay its interest expense. Finally, the Debt Service Margin

measures how well the company can pay off its current long term debt.

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Debt to Equity Ratio

This ratio shows the proportion of debt to equity. This ratio is a way for lenders to see if

a company is more or less of a risk. A ratio of 1 would suggest that the company is

equally levered and that’s good. A desirable number would be lower than one, meaning

that the company does not have debt greater than its equity, but for companies that

have more works in progress and inventory, this number is going to be greater than

one.

Office Depot has a fair debt to equity ratio; it was 1.07 in 2002 and has gone up to 1.51

for 2006. Office Depot is very steady from year to year as well. The industry leader

Staples keeps just about the same Debt to Equity ratio as Office Depot which is a good

thing.

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Times Earned Interest

The times earned interest ratio examines how well a company can pay off its interest

expense. This is calculated by dividing operating income by the total interest expense.

It shows how many times over a company can pay its interest expense. In this case the

bigger the number the better because a larger number means that it is easier for the

firm to pay its interest payments that are due for its debt.

After looking at Office Depot’s times interest earned and comparing it to the industry

leader and the industry average, they once again fall right in the middle of the pack and

currently have no problems paying the interest payment on it debt. Office Depot and

Staples are fairly comparable in 2005 and 2006.

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Debt Service Margin

This ratio measure how well a company can pay off its long term debt obligations for

that current year. The Debt Service Margin (DSM) needs to be greater than one. If it is

not greater than one then that means that the company has negative cash flows and is

in serious trouble. The debt service margin is calculated by dividing operating income

by short term debt (current maturities of long term debt).

After analyzing this data, Office Depot has a very steady DSM, which says that they

currently and in the past have had no problem paying off their short term debt. Again

Staples also has no problem paying off their short term debt, but the main reason is

because they have such a small amount of short term debt.

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The following are opinions the industries profitability and efficiency ratios

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Cash to Cash Cycle

The cash to cash cycle shows how long it takes to acquire resources (products), make

and sell the product, and then sell to collect the cash. This is also referred to as the

Money Merry Go-round and it is the number of the Days Supply Inventory plus the

number of Days Sales Outstanding. It equals the total number of days for inventory to

turn itself back into cash in hand. The smaller the number the better because it

measures how fast the inventory is converted back into cash. Office Depot’s cash to

cash cycle is fairly high at 91.04 but the main reason for this is the large amount of

products they are expected to carry.

Cash to Cash Cycle

Internal Growth Rate (IGR)

The internal growth rate is a way for a company to measure the highest level of growth

achievable without outside financing. This is calculated by taking the Return on Assets

(ROA) multiplied by the retention rate or the dividend payout ratio. Since Office Depot

does not pay dividends, this will not paint an accurate picture. The dividend payout

ratio to be zero; and one minus zero is one. One times the ROA is just the ROA.

IGR

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Sustainable Growth Rate (SGR)

The Sustainable Growth Rate is similar to the IGR but it main focus is to see how the

company can grow by just using profits or internal income without the use of leveraging

the company. It is calculated by multiplying the ROE by one minus the dividend payout

ratio. The higher the number the better, and it tells how well the company can do on its

own without the help of outside financing. Since the IGR is not a very accurate number

the SGR will also not be a very good number to take any value from.

SGR

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Financial Statement Analysis

This section of the report will forecast Office Depot’s income statement, balance

sheet, and cash flows statement for the following ten years (2007-2016). We will also

recast Office Depots financial statements and make corrections for capital leases and

then proceed to forecast them as well. In order to produce an accurate, logical, and

realistic forecast of Office Depot, common-sized financial statements must be calculated

for Office Depot and its competitors. The information that produced these common-

sized financial statements were taken directly from the companies reported 10-k’s that

were filed with the SEC. Once this was completed, we then proceeded to forecast out

Office Depot’s financial statements using the most logical average or ratio that

produced an end result that was realistic. The main concept though for financial

statement forecasting is to link certain financial statements to each other so that they

can “talk,” for example, linking income from the income statement to cash flows from

operation. By doing this these two financial steatement will then have relationships that

are realistic. The following are the forecasted financial statements that we produced as

well as a description of the procedure that was taken in order to produce these

forecasts.

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Income Statement Analysis

There are several possible ways to produce a “forecast” of the next ten years for

Office Depot’s income statement. Not only was it decided that the average increase or

decrease of the major line items of Office Depot’s income statement for the past five

years should be calculated (most importantly sales), we also decided that in order to

produce an accurate and intelligent forecast, we must continue and compute the

averages of the same major line items for the two other major firms of the retail office

supplies industry. By calculating the averages of the major line items for Staples and

Office Max, we were able to compute the industry average for these major line items

for the past five years and then benchmark them to our assumed forecasting growth

rates for accuracy.

When analyzing the income statements of all three major firms of the retail office

supplies industry we came to a few major conclusions:

1. The five year industry average’s that were computed were skewed due to the

erratic performance of Office Max during these years. In an effort to correct this

problem, we decided to compute the industry average of only Office Depot and

Staples for the past five years (reference IAWO) because they are the only firms

in this industry that have performed consistantly. The result led to a higher sales

growth rate than with Office Max included and this growth rate over-forecasted

the income statement of Office Depot for the following ten years. This is due to

the fact that Staples was experienced exceptional sales growth over this period

while Office Depot has tailed off.

2. We then decided to calculate the averages of the major line items of Office

Depot’s income statement for the only past three years. We decided to do this

because over the past three years, Office Depot has been a relatively consistant

performer. We also had to consider other factors such as slowed growth for

Office Depots industry as well as the expected state of the economy. We

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concluded that a growth rate of 6.29% was a better, more realistic forecast of

Office Depots expected increase in sales for the next ten years.

The following are the previous five years of reported income statements for Office

Depot, the assumed growth rates that were calculated and used, and the forecasted

results for the next ten years of Office Depot’s operations.

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Actual Un-Revised Income Statement & Common Sized IS with Forecast

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Balance Sheet

The next financial statement of Office Depot that needs to be forecasted is the

balance sheet. The first step that was taken was the forecasting of Office Depot’s total

assets. In order to forecast total assets, we used the asset turnover ratio that was

computed earlier in this report and forecasted out years 2007-2016. To do this we

divided total forecasted sales by the average asset turnover ratio of 2.15 for the years

2007-2016. In 2016 it is determined that Office Depot’s forecasted total assets will be

$13.56 billion dollars. Once total assets were calculated for the forecasted years we

divided the total current assets by total assets and we determined that in the past five

years, 54% of Office Depots total assets were current. We then proceeded to forecast

the next ten years using this growth rate for current assets. To determine the

percentage of non current assets, we subtracted the percentage of current assets by

one and we reached a legitimate growth rate of 46% to forecast non current assets.

Within assets, we forecasted net receiveables using the receiveable turnover ratio and

we also forecasted inventory using the inventory turnover ratio that was computed

earlier in this report.

Now that total assets have been calculated we now know what the total liabiliies

and shareholders equity amount should total. First we carried net income from the

income sheet over to retained earnings and the we proceeded to forecast total equity

and then took the difference of the total equity and total assets and found total

liabilities.

The ultimate check that we used to determine if our forecasting methods for

Office Depot’s balance sheet were realistic was to determine if all forecasted years total

assets equal all respected years forecasted total liabilities and shareholders equity. After

conducting the check it is determined that the forecasted balance sheet balances, with

both total assets and total liability and shareholder equity equaling $13.56 billion on

2016, leading us to believe that the numbers that were forecasted are realistic.

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The following tables include all reported information that was on Office Depot’s

balance sheet for the past five years as well as all the forecasted years of data and

common sizedbalance sheet.

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Actual Un-Revised Balance Sheet with Forecast

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Actual Un-Revised Common-Sized Balance Sheet

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Statement of Cash Flows

The statement of cash flows is the most difficult financial statement to forecast. The

first step that was taken was to input the forecasted net income at the top so that we

may begin forecasting all other numbers that are needed. Secondly, we decided that

the first forecast that should be conducted is the forecast for the cash flows from

operations. To do this, we wanted to link income from the income statement to cash

flows using the CFFO/IO ratio that was computed earlier in this report and

benchmarked it to the industry average. Determining that it was a realistic number to

use, we proceeded to forecast 2007-2016 cash flows from operations and the end result

was realistic both for Office Depot and its industry. The next forecast that was

conducted was the forecast of capital expenditures. In order to forecast capital

expenditures for the next ten years, we determined that we should calculate the

average capital expenditure from cash flows from operations for the previous five years

of reported financials of Office Depot. We then took this percentage, which turned out

to be 41%, and forecasted capital expenditures for the next ten years. Lastly, in order

to forecast cash flows from investing activities, we decided that we should divide the

reported cash flows from investing activities for the past five years by the reported cash

flows from operations for the past five years. The number that resulted was 1.58, and

we then used this number to forecast the following ten years for Office Depot’s cash

flows from investing activities, by dividing capital expenditures by 1.58.

Below are the cash flows statement that was reported by Office Depot for the past five

years as well as the forecasted results and the common sized cash flows statement that

was constructed.

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Actual Un-Revised Statement of Cash Flows with Forecast

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Actual Un-Revised Common-Sized Statement of Cash Flows

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Forecast with Capital Lease Correction

It was determined in the accounting analysis section of this report that Office

Depot currently has a large amount of lease obligations that it must fulfill. By reporting

these leases as operating leases, Office Depot was able to understate its net income for

the past five years by expensing more than what should have been. We recast Office

Depots income statement with capital lease corrections and then forecasted out years

2007-2016 to find their revised net income. Once the revised net income was calculated

for the forecasted years it was added to retained earnings on the revised balance sheet

for its respected years. We also added the lease obligation that was due for the

forecasted years in the liabilities section and added the same amount to assets as

capital lease rights. By doing this we have proved the fact that Office Depot actually has

2.773 billion dollars of liabilities that it is obligated to and should be on its books.

The revised statement of cash flows with capital lease corrections was forecasted

by using the forecasted year’s new, revised, net income that was calculated on the

revised income statement. Calculation methods remain the same as the unrevised

statement of cash flows. The revised financial statements and forecasts can be viewed

in the appendix of this report.

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Analysis and Forecasting Conclusion:

We believe that Office Depot will continue taking market share away from the

industry laggard Office Max, which could possibly lead to a higher growth rate for Office

Depot over time. We also believe that in the future, if Office Depot ramps up its B2B

operations their sales would increase sales significantly. The industry has experienced

slower growth over the past few years, though, compared to the growth it experienced

in 2003. After forecasting all of Office Depot’s financial statements with this in mind and

benchmarking to the industry averages, we conclude that Office Depot will continue to

grow its total sales over the next ten years at a rate of 6.29% per year.

Valuation Analysis

Firm valuation boils down to two distinct schools of thought: Method of Comparables

and Intrinsic Valuation. The method of comparables looks at earnings ratios from the firm in

question as well as the industry average. In a variety of metrics, you are able to compare

equivalent data across firms. This method requires little to no insight into the companies or

their industries and does not incorporate a fundamental approach to determining, for instance,

the viability of reported numbers.

The intrinsic valuation method uses models to represent forecasted financial data as a

function of WACC, cost of equity, perpetuity growth rates, and/or return on equity. It allows the

user to create sensitivity analyses which serve to create hypothetical scenarios with cost and

growth rates to see the possible effects on share price. The user can assess the feasibility of

the different possible inputs to see the possible direction the firm can take in the future.

Comprehensive valuation analyses will incorporate both of these schools of thought into their

report, highlighting the strengths and weaknesses of each method and model and determining

the appropriateness for their own firm.

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Cost of Equity

The calculation of a firm’s cost of equity (KE) is a measure to determine the rate

or expected return on stock or equity securities in a given year. In order to derive this

number for Office Depot we will use the CAPM model. The cost of equity that the CAPM

model produces is dependent on variables from both the market and the firm. The

current risk free rate (Rf), firm beta (B), and expected return on the market (RM) all

factor into the cost of equity calculation. Our risk free rate and market return rate were

calculated using statistics from the St. Louis Federal Reserve Site. A risk free rate of

4.00% was taken from the most recent treasury bill rate to be used in the CAPM model.

The market risk premium (MRP) was calculated using intuition from our regression

results. In order to calculate a market risk premium, the 3-month market risk premium

data from our regression results over a 72 month period were averaged. This average

yielded a market risk premium for the CAPM model of 4.32%. The last variable

necessary to complete the CAPM equation is a firm beta. In order to make an

estimation of this number, we performed a regression analysis.

From 2000 to 2007, observed monthly prices of Office Depot’s stock price, the

S&P 500 and 3-month Treasury Bills were used as inputs to run our regression analysis.

We can regressions for 3-month, 6-month, 2-year, 5-year, and 10-year rates at times

periods of 24, 36, 48, 60, and 72 months. From this point we could use the different

regression statistics produced to determine the most accurate and meaningful firm

beta.

3 Month Rate

72 months

60 months

48 months

36 months

24 months

Risk Free 4.00% 4.00% 4.00% 4.00% 4.00%

R2 0.3011 0.2572 0.1254 0.1183 0.1569

β 1.6289 1.9039 1.4613 1.4884 1.6363

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KE 11.04% 12.22% 10.31% 10.43% 11.07%

We concluded that the 72 month outputs from the 3-month rate gave us the

best results because it had the highest R2. This coefficient of determination explains the

movement against a benchmark index. From this regression we took 1.63 to be most

accurate beta estimate for Office Depot. Now we can calculate the cost of equity for

Office Depot:

KE = Rf + B(MRP)

KE = 4.00% + 1.63(4.32%)

KE = 11.04%

The computed cost of equity for Office Depot is 11.04%. This calculation not

only tells us Office Depot’s cost of equity financing, but is also used in our weight

average cost of capital computation.

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Cost of Debt

The other form of capital financing is debt. Here we also need to calculate a cost

of debt for Office Depot. Here we will use a weighted average calculation of the current

and long term liabilities. We assigned a 4.91% rate to trade accounts payable, accrued

expenses, and the other current liabilities based on the 3-month commercial paper rate.

A rate of 3.97% was assigned to the long term liabilities based on the 2-year treasury

constant maturity rate. This rate was taken from the St. Louis Federal Reserve website.

After taking a weighted average of the two liability categories, and 4.48% weighted

average cost of debt was determined.

Weighted Average Cost of Capital

With both the cost of equity and cost of debt calculated, a weighted average cost

of capital before and after tax can be derived. A corporate tax rate of 35% was

provided by Office Depot’s 10-K. The before tax WACC formula takes a weighted

average of the cost of debt and cost of equity. The after tax WACC formula is the same

except it takes into account a tax effect on the weighted average cost of equity. The

formulas and results are as follows:

WACCBT = (Ve/Vf)(Ke) + (Vd/Vf)(Kd)

WACCBT = 5.10%

WACCAT = (Ve/Vf)(Ke)(1-t) + (Vd/Vf)(Kd)

WACCAT = 4.42%

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Method of Comparables

This section of the report will value Office Depot using a certain set of ratios

including but not limited to trailing price to earnings and price to book. We first

gathered all information from Staples and Office Max that was needed to compute the

industry average of each model. We then used this industry average to compute the

value of Office Depot and the following are the results.

Trailing Price to Earnings

In order to calculate trailing price to earnings, we took the current price per

share and divided by the earnings per share for the past year.

After computing the industry average of 13.545, we then multiplied this number

by the earnings per share for the past year, which is 1.79. According to the model

Office Depot is undervalued by about $6.50.

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Forward Price to Earnings

In order to compute forward price to earnings we took the price per share and

then divided it by the forecasted earnings per share.

We once again computed the industry average and then took the forecasted

earnings per share, 1.51, and multiplied it by the industry average. According to the

model, Office Depot is a fairly valued company when calculating its price per share

using forecasted earnings per share.

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Price to Book Value

In order to compute the price to book value of a firm, we took the current stock

price of Office Depot as of November 1st, 2007, and then divided that number by the

previous quarters book value per share.

According to the model Office Depot is undervalued by roughly $4.00. We

calculated Office Depots Book Value from numbers that were reported on their most

recent 10-k.

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Dividend Yield

Due to the fact that Office Depot does not pay dividend the dividend yield was

not calculated. We did however provide a table with Staples and Office Max’s

information.

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P.E.G.

The price earnings growth valuation is calculated using a company’s P/E ratio

and dividing that number by the estimated growth rate of earnings.

To derive a share price for Office Depot, we first took an average of the PEG ratios for

Office Depot, Staples, and OfficeMax. We then took this average and divided it by an estimated

earnings growth rate of Office Depot of 4%. From this point, you then multiply that number by

the EPS. For Office Depot, we calculated a share price from the P.E.G. model of $31.68. This

model concludes that Office Depot is undervalued.

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P/EBITDA

In order to calculate the value of a firms price per share using the P/EBIDTA

model we divided the price by earning before interest, taxes, depreciation, and

amortization for all firms and then calculated an industry average. We then took this

number and multiplied it by Office Depot’s EBITDA to find Office Depots valued price

per share. Numbers below are percentages and 8.38 should be interpreted as .0838.

According to the above table for the P/EBITDA model Office Depot is fairly

undervalued by roughly $5.50.

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P/(FCF Per Share) Valuation

This valuation model incorporates the price of a company and divides it by the free cash

flows (CFFO-CFFI) on a per share basis. Inputs necessary for this model were the current price

as of valuation date, shares outstanding, and free cash flows. From this point, we calculated the

P/FCF on a per share basis for Office Depot, Staples and Office Max. From here, we took an

average of these ratios to calculate a valuation for Office Depot. In order to do this, we took the

industry average P/FCF Per Share and multiplied it by Office Depot’s free cash flows. The

computations and display are given below:

P/FCF Per Share Industry Average * ODP FCF

.08 * 341 = 25.86

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Enterprise Value/EBITDA

This model uses a company’s enterprise value divided by its EBITDA (Earnings

before interest, taxes, depreciation, and amortization).

We computed this number for Office Depot to be 8.95. From here, we needed to

calculate an industry average. We took the numbers for Office Depot’s competitors from

Yahoo! finance. From here, you next need to multiply Office Depot’s EBITDA by the

industry average of 8.19. Next, you divide the product of that number by the total

number of shares outstanding of Office Depot. This model yielded an estimated share

price of $21.22. This model concludes that Office Depot is again under valued.

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Conclusion to Method of Comparables Valuation

After running all method of comparable models for Office Depot all but one

model indicated the Office Depot is undervalued. Trailing price to earnings, price to

book value, P.E.G., Price/EBITDA, and Enterprise Value/EBITDA models all indicated

that Office Depot is undervalued. The undervalued range is from $.40 up to $11.00 per

share. Forward Price to Earnings is the only model that indicated that Office Depot is

fairly valued. Not one model indicated that Office Depot was overvalued. With this in

mind, we conclude that Office Depot is undervalued according to the method of

comparable valuation models.

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Intrinsic Valuation Methods

Intrinsic valuations are another way to get a value for the firm by looking at four

different methods to get an idea of the true value. Rather than looking strictly at

industry comparables, these methods take an in-depth approach to the fundamental

analysis component of valuation. The methods are Free Cash Flow, Residual Income,

Residual Income Perpetuity, and Abnormal Earnings Growth. Also the Dividend Discount

Model is used but in Office Depot’s case, it is not applicable because they are not a

dividend paying company.

Discount Dividend Model

This model determines the value of a firms stock share price using dividend and

future dividends. Due to the fact that Office Depot does not pay dividends, this model

does not need to be performed.

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Free Cash Flows Model

The free cash flow model takes the cost of capital and compares it to the

perpetuity growth rate to find a price-per-share value based off of free cash flows. It is

calculated by discounting back all future cash flows minus all future liabilities. To use

this model you need the forecasted cash flows from operations (CFFO), forecasted cash

flows from investments (CFFI), a calculated WACC, and an observed share price*. The

free cash flows are found by taking the CFFO and adding/subtracting the CFFI. Then

take all the future years FCF and discount them back to present value terms and the

sum of that and the perpetuity of that string of cash flows gives the value of the firm.

Take that value and subtract the book value of liabilities then yields the market value of

equity. Dividing that by the number of shares outstanding gives the estimated price per

share. Because of the nearly equal weights of future cash flows and the terminal value

of perpetuity, the model is highly sensitive to growth rate changes and is one of the

least accurate intrinsic valuation models. The findings of our model are below:

G 0 0.01 0.02 0.03 0.04

χ > $21.70 UNDER 0.13 $10.84 $11.66 $12.62 $13.78 $15.20$16.04< χ < 21.70 FAIR 0.11 $16.26 $17.62 $19.29 $21.38 $24.05

χ < $16.04 OVER 0.095 $21.81 $23.92 $26.59 $30.07 $34.83 0.07 $36.37 $46.77 $55.62 $69.55 $94.61

WACC

0.051 $57.02 $68.86 $88.34 $126.37 $233.53

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Long-Run Return on Equity Residual Income Model

The long run return on equity residual income model is a highly accurate

perpetuity model linking the cost of equity, long run ROE, and long run growth

percentages to calculate the value of a company by using a perpetuity equation linked

from the residual income model. The findings of our model are below:

G 0 -0.02 -0.04 -0.06 -0.08 -0.1

χ > $21.70 UNDER 0.13 $9.45 $9.61 $9.72 $9.81 $9.89 $9.95

$16.04< χ<$21.70 FAIR 0.11 $11.01 $10.92 $10.86 $10.81 $10.77 $10.74

χ < $16.04 OVER 0.09 $9.00 $12.71 $12.34 $12.36 $11.85 $11.69 0.07 $16.77 $15.30 $14.36 $13.71 $13.23 $12.86

KE

0.05 $23.12 $19.36 $17.27 $15.95 $15.03 $14.35

We used a cost of equity of 11% which we found using the CAPM model. We

assumed a perpetuity growth rate of 0%. We needed to have the forecasted numbers

for the Book Value of Equity and Net Income for this model. We took Book Value of

Equity (t-1) and added Earnings (t) to give us the ending balance of Book Value of

Equity. (If ODP paid a dividend, that amount would be subtracted from earnings.) We

then took the beginning balance of Book Value of Equity (t) and multiplied it by our Ke

to find normal earnings. This figure represents earnings equal to the required rate of

return of investors and is value neutral. It is also referred to as benchmark earnings.

From here, we can compare our ending balance of Book Value of Equity to this

benchmark figure. A positive difference denotes value being added while a negative

balance represents the destruction of firm value. This figure is known as residual

income. From here we calculated the year by year difference for comparison to the AEG

model. We took the present value of the sum of each year’s residual income as well as

the terminal value of the perpetuity. From here we can calculate the implied price per

share given various growth and Ke inputs and conduct our sensitivity analysis.

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Residual Income Model

The long run return on equity residual income model is a highly accurate

perpetuity model linking the cost of equity, long run ROE, and long run growth

percentages to calculate the value of a company by using a perpetuity equation linked

from the residual income model. It is computed by adding book value of equity and the

present value of future value. The equity from future financials, a cost of equity, and an

observed share price are needed for this model. We took our forecasted financials and

came up with a book value of equity, then using the cost of capital we discount back all

the future cash flows. Now we compared these values to our benchmark of the product

of our Ke and beginning balance of Book Value of Equity to see if we are adding value

or destroying it. The findings of our model are below:

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Abnormal Earnings Growth

The AEG is model also calculates an intrinsic market price for a share of a company’s

stock. This model shows the relationship between the cumulative dividend earnings and

our earnings multiplied by Ke. A key component to this model is dividend payment and

the rate at which they are reinvested. Office Depot does not pay dividends so it was

simply a calculation of earnings. Then to find the annual AEG we take the cumulative

dividend income minus our normal earnings to find abnormal earnings. This is the figure

which should match the change in residual income on the residual income model. The

findings of our model are below:

G 0 -0.02 -0.04 -0.06 -0.08 -0.1

0.11 $3.88 $4.92 $5.67 $6.25 $6.71 $7.080.09 $8.75 $9.83 $10.57 $11.11 $11.53 $11.860.07 $18.94 $19.51 $19.88 $20.14 $20.33 $20.470.06 $28.46 $28.09 $27.87 $27.72 $27.62 $27.54

KE

0.05 $44.36 $41.65 $40.14 $39.19 $38.52 $38.03

χ > $21.70 UNDER $16.04<χ< $21.70 FAIR

χ < $16.04 OVER

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Altman’s Z-Score

The Altman’s Z-score is a credit analysis instrument to determine the bankruptcy

risk of a firm. After computation, if a firm has a bankruptcy score less than 1.81 then

the firm is at severe risk of bankruptcy. If a firm scores between 1.81 and 2.67 then

they will be considered a moderate bankruptcy risk. Any firm scoring 2.67 or higher is

considered to be financially healthy with very little or no risk of bankruptcy. This model

is used regularly by financial analysts and has a strong reputation of accurately

prediction bankruptcies. The mathematical model for the Altman’s Z-score 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) + .6(Market

Value of Equity/Book Value of Debt) + 1.0(Sales/Total Assets)

The model takes a weighted average of financial ratios imperative to a firm’s operations

and going concern. The Altman’s Z-score for Office Depot was calculated over the past

five years (2002-2006) and one year into the future (2007) using forecasted financial

statements. In addition, we felt it necessary to calculate the Z-score for the forecasted

year 2007 with consideration to capital lease obligations.

ODP 2002 2003 2004 2005 2006 2007 2007 (CL)

Z-Score 4.2 3.63 3.53 3.89 3.84 3.64 2.79

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The Z-score for Office Depot only fell below 3.53 during the forecasted year of 2007

with capital lease consideration and therefore has very little risk of bankruptcy. The

reason for the falling Z-score in the capital lease consideration year of 2007 is due to

the last input to the Altman Z-score computation. The capital lease modifications for our

forecasted financials did not affect sales. With our sales number remaining constant and

our total assets number increasing, the final input ratio to the Z-score decreased

significantly. Overall, these numbers are healthy at the very least and would be

encouraging for both shareholders and stakeholders of Office Depot. The low mark of

3.53 during 2004 could possibly contributed to a new CEO being hired or the high

amount of acquisitions being under taken during that particular year.

Conclusion To Intrinsic Valuation Models

According to our models and the valuation methods used, we find that Office

Depot is moderately overvalued. The intrinsic valuation models with the highest

degree of explanatory power and relevance to the firm and industry provide supporting

data results. The method of comparables sections highlights ODP and its two

competitors, SPLS and OMX. In this method we found ODP to be undervalued.

However, the more comprehensive intrinsic models remove industry and market

“intangible” factors on share value that drive prices far beyond financially represented

value. Indeed this fundamental analysis provides a more realistic picture of the financial

situation of a firm.

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Intrinsic Valuation Models with Capital Lease Corrections

Revised Free Cash Flows Model

We found this model to be highly distorted by the accounting of capital and

operating leases. When we adjusted for this difference, the calculated share price was

effected noticeably. As before, the free cash flow model takes the cost of capital and

compares it to the perpetuity growth rate to find a price-per-share value based off of

free cash flows. It is calculated by discounting back all future cash flows minus all

future liabilities. To use this model you need the forecasted cash flows from operations

(CFFO), forecasted cash flows from investments (CFFI), a calculated WACC, and an

observed share price*. The free cash flows are found taking the CFFO and

adding/subtracting the CFFI. Then take all the future years FCF and discount them back

to present value terms and the sum of that and the perpetuity of that string of cash

flows gives the value of the firm. Take that value and subtract the book value of

liabilities then yields the market value of equity. Dividing that by the number of shares

outstanding gives the estimated price per share. Because of the nearly equal weights of

future cash flows and the terminal value of perpetuity, the model is highly sensitive to

growth rate changes and is one of the least accurate intrinsic valuation models. The

findings of our model are below:

G 0 0.005 0.01 0.015 0.02

0.13 $17.34 $17.76 $18.22 $18.72 $19.26 0.11 $23.33 $24.03 $24.80 $25.65 $26.60

0.095 $29.44 $30.51 $31.71 $33.50 $34.58 0.07 $43.35 $47.84 $50.74 $54.16 $58.27

WACC

0.051 $67.79 $73.47 $80.54 $89.56 $101.51 χ > $21.70 UNDER $16.04<χ <$21.70 FAIR χ < $16.04 OVER

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Revised Residual Income Model

In this model we found only small distortions in share prices between the original

and revised versions. This is due in part to the smaller degree of sensitivity changes in

growth and Ke. As before, this model links the cost of equity, ROE, and long run growth

percentages to calculate the value of a company by using a perpetuity equation linked

from the residual income model. It is computed by adding book value of equity and the

present value of future value. The equity from future financials, a cost of equity, and an

observed share price are needed for this model. We took our forecasted financials and

came up with a book value of equity, then using the cost of capital we discount back all

the future cash flows. Now we compared these values to our benchmark of the product

of our Ke and beginning balance of Book Value of Equity to see if we are adding value

or destroying it. The findings of our model are below:

G 0 -0.02 -0.04 -0.06 -0.08 -0.1

χ > $21.70 UNDER 0.15 $5.85 $6.24 $6.54 $6.79 $7.00 $7.17$16.04< χ<

$21.70 FAIR 0.13 $7.79 $8.18 $8.49 $8.72 $8.92 $9.07χ < $16.04 OVER 0.11 $10.65 $10.96 $11.19 $11.36 $11.50 $11.61

0.09 $15.10 $15.08 $15.06 $15.04 $15.03 $15.02

KE

0.07 $22.59 $21.51 $20.82 $20.34 $19.99 $19.72

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Revised Long-Run Residual Income Model

The long run return on equity residual income model is a highly accurate

perpetuity model linking the cost of equity, long run ROE, and long run growth

percentages to calculate the value of a company by using a perpetuity equation linked

from the residual income model. The findings of our model are below:

We used a cost of equity of 11% which we found using the CAPM model. We

assumed a perpetuity growth rate of 0%. We needed to have the forecasted numbers

for the Book Value of Equity and Net Income for this model. We took Book Value of

Equity (t-1) and added Earnings (t) to give us the ending balance of Book Value of

Equity. (If ODP paid a dividend, that amount would be subtracted from earnings.) We

then took the beginning balance of Book Value of Equity (t) and multiplied it by our Ke

to find normal earnings. This figure represents earnings equal to the required rate of

return of investors and is value neutral. It is also referred to as benchmark earnings.

From here, we can compare our ending balance of Book Value of Equity to this

benchmark figure. A positive difference denotes value being added while a negative

balance represents the destruction of firm value. This figure is known as residual

income. From here we calculated the year by year difference for comparison to the AEG

model. We took the present value of the sum of each year’s residual income as well as

G 0 -0.02 -0.04 -0.06 -0.08 -0.1

χ > $21.70 UNDER 0.13 $10.02 $10.10 $10.16 $10.20 $10.24 $10.27$16.04< χ<

$21.70 FAIR 0.11 $11.67 $11.48 $11.34 $11.24 $11.15 $11.09χ < $16.04 OVER 0.09 $14.05 $13.36 $12.89 $12.54 $12.28 $12.07

0.07 $17.79 $16.08 $15.00 $14.25 $13.70 $13.28

KE

0.05 $24.51 $20.36 $18.05 $16.58 $15.56 $14.82

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the terminal value of the perpetuity. From here we can calculate the implied price per

share given various growth and Ke inputs and conduct our sensitivity analysis.

Revised Abnormal Earnings Growth Model

The AEG model also calculates an intrinsic market price for a share of a

company’s stock. This model shows the relationship between the cumulative dividend

earnings and our earnings multiplied by Ke. A key component to this model is dividend

payment and the rate at which they are reinvested. Office Depot does not pay

dividends so it was simply a calculation of earnings. Then to find the annual AEG we

take the cumulative dividend income minus our normal earnings to find abnormal

earnings. This is the figure which should match the change in residual income on the

residual income model. The findings of our model are below:

G 0 -0.02 -0.04 -0.06 -0.08 -0.1

0.11 -$1.23 $0.75 $2.20 $3.31 $4.18 $4.890.09 $1.39 $4.03 $5.85 $7.19 $8.21 $9.020.07 $7.30 $10.82 $13.06 $14.62 $15.75 $16.620.06 $13.02 $16.99 $19.37 $20.95 $22.09 $22.94

KE

0.05 $22.74 $26.87 $29.16 $30.62 $31.63 $32.37 χ > $21.70 UNDER $16.04<χ< $21.70 FAIR χ < $16.04 OVER

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Conclusion to Revised Intrinsic Valuation Models

According to our models and the valuation methods used, we find that Office

Depot is moderately overvalued just as the unrevised models showed. The intrinsic

valuation models with the highest degree of explanatory power and relevance to the

firm and industry provide supporting data results. The method of comparables sections

highlights ODP and its two competitors, SPLS and OMX. In this method we found ODP

to be undervalued. However, the more comprehensive intrinsic models remove industry

and market “intangible” factors on share value that drive prices far beyond financially

represented value. Indeed this fundamental analysis provides a more realistic picture of

the financial situation of a firm.

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Sales Manipulation Diagnostic Ratios

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Expense Manipulation Diagnostic Ratios

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Liquidity Ratios

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Operating & Efficiency Ratios

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Actual Un-Revised Balance Sheet with Forecast

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Actual Un-Revised Common-Sized Balance Sheet

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Balance Sheet Revised with Capital Lease Corrections

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Revised Common-Sized Balance Sheet with Capital Lease Corrections

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Actual Un-Revised Income Statement with Forecast

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Income Statement Revised with Capital Lease Corrections

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Actual Un-Revised Statement of Cash Flows with Forecast

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Actual Un-Revised Common-Sized Statement of Cash Flows

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Statement of Cash Flows Revised with Capital Lease Corrections

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Revised Common-Sized Statement of Cash Flows with Capital Lease Corrections

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Regression Results

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2002 Current Lease Obligations

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2003 Current Lease Obligations

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2004 Current Lease Obligations

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2005 Current Lease Obligations

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2006 Current Lease Obligations

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2007 Current Lease Obligations

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References

1. Office Depot Website: www.officedepot.com 2002, 2003, 2004, 2005, 2006 Annual Reports 2002, 2003, 2004, 2005, 2006 10k Investor Relations. 15 Sep. 2007. Office Depot. 12 Sep. 2007. <http://investor.officedepot.com/phoenix.zhtml?c=94746&p=irol-IRHome>.

2. Staples Website: www.staples.com 2002, 2003, 2004, 2005, 2006 Annual Reports 2002, 2003, 2004, 2005, 2006 10k Investor Relations. 16 Sep. 2007. Staples. 13 Sep. 2007. <http://investor.staples.com/phoenix.zhtml?c=96244&p=irol-IRHome>.

3. Office Max Website: www.officemax.com 2002, 2003, 2004, 2005, 2006 Annual Reports 2002, 2003, 2004, 2005, 2006 10k

Investor Relations. 11 Sep. 2007. Office Max. 15 Sep. 2007. <http://investor.officemax.com/>.

4. Price History. 13 Sep. 2007. MSN. 12 Sep. 2007. <http://www.moneycental.msn.com>.

5. Cygnus Business Media 2006. 13 Sep. 2007. About. 12 Sep. 2007. <http://retailindustry.about.com/od/abouttheretailindustry/p/retail_industry.htm>.

6. 12 Sep. 2007. First Search. 17 Sep. 2007. <http://www.firstresearch.com/industry-research/Office-Supply-and-Paper-Distribution.html>.

7. Industry. 14 Sep. 2007. Hoovers. 16 Sep. 2007. <http://www.hoovers.com/office-depot/--ID__14308--/free-co-factsheet.xhtml>.

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8. 16 Sep. 2007. Cisco. 17 Sep. 2007. <http://www.cisco.com/warp/public1779/ibs/solutions/learning/office_depot_profile.pdf >.

9. Finance.Yahoo.com

10. CNNMONEY.com

11. MarketWatch.com