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Lower sales on account of store closures and lower product margins took a toll on the third-quarter fiscal 2013 earnings of Staples Inc. (SPLS - Analyst Report). The company’s third-quarter earnings of 42 cents came in line with the Zacks Consensus Estimate but decreased 8.7% year over year.

Including one-time items and discontinued operations, Staples reported quarterly earnings of 21 cents per share, down 76.4% from 89 cents earned in the comparable prior-year quarter.

Total sales decreased 3.8% year over year to $6,111.7 million and missed the Zacks Consensus Estimate of $6,203 million. The shuttering of 107 stores in North America and Europe in the past 12 months adversely affected sales in the quarter along with unfavorable foreign currency fluctuations.

Gross profit decreased 5.5% year over year to $1,654.7 million, while gross margin contracted approximately 50 basis points (bps) to 27.1%. Adjusted operating profit fell 13.8% to $431.0 million, whereas adjusted operating margin contracted 82 bps to 7.0% in the quarter.

The decline in margin was primarily due to reduced product margins, unfavorable impact of fixed expenses on reduced sales and investments related to the company’s strategic initiatives. These negatives were partly offset by savings pertaining to headcount reductions, and fall in marketing expense and equity compensation.

In the quarter, Staples unveiled the biggest refurbishment of Staples.com and Staples.ca since 2005. Moreover, the company enhanced its assortment on Staples.com by nearly 50%. The company achieved its target of $150 million of cost reduction in 2013 much ahead of its schedule. With regard to its European operations, the company is constantly rationalizing business and reducing expenditure.

The office supply retailers are going through tough times, given the decline in business and consumer spending in the wake of the global meltdown. The financial crisis has resulted in sluggish demand for big-ticket items such as business machines, furniture and other durable products.

Moreover, intense competition from online rivals like Amazon.com Inc. (AMZN - Analyst Report) is denting the company’s profitability. Amid such a scenario, two of Staples’ competitors, Office Depot Inc. (ODP - Analyst Report) and OfficeMax Inc. have merged their businesses to capture a wider market and generate incremental revenues.

Given the near-term challenges, the company lowered its sales guidance while reiterating the earnings guidance for fiscal 2013. Staples expects earnings per share to be in the range of $1.21–$1.25. Moreover, total revenue is expected to decline in low single digits to $23.9 billion. Moreover, the company expects to generate more than $900 million of free cash flow in 2013.

Segment Details

Sales at North American Stores and Online, which include its retail stores and Staples.com business in the U.S. and Canada, marked a decline of 5.3% to $3,013 million. The fall resulted from decrease in sales of office supplies, business machine, computers and technology accessories.

Moreover, 59 store closures in the past 12 months negatively impacted sales. Despite challenges, the segment witnessed increased sales of tablets, facilities and breakroom supplies as well as copy and print services.

During the quarter, comparable-store sales declined 3% owing to a 3% fall in traffic and unchanged average order size from the prior-year quarter. Sales through Staples.com, rose 3% year over year. Operating income decreased 13.3% year over year to $285 million, whereas operating margin contracted 88 bps to 9.5%. The decline reflected the company’s increased investment in its .com business and lower product margins, partly offset by lower retail store labor and marketing costs.

North American Commercial, which includes its Contract operations in the U.S. and Canada, witnessed a 0.7% rise in sales to $2,089 million due to growth in the facilities and breakroom supplies, tablets and furniture, partially offset by lower demand in office supplies and paper as well as ink and toner.  Operating income decreased 13.6% to $159 million, while operating margin contracted 126 bps to 7.6%, reflecting increased marketing expenses.   

Revenues at International Operations waned 8.0% to $1,010 million, reflecting lower sales in Europe and Australia. Comparable store sales in Europe marked a decline of 2% on account of lower traffic and average order size. The segment reported an adjusted operating income of $2 million as against loss of $2 million incurred in the year-ago quarter.

Other Financial Details

Staples ended the quarter with cash and cash equivalents of $1,391.2 million, long-term debt (net of current maturities) of $1,000.5 million and shareholders’ equity of $6,063.4 million.

Year-to-date, Staples generated operating cash flow of about $875 million and incurred capital expenditures of $204 million, resulting in a free cash flow of $671 million. In the quarter, Staples repurchased 6.8 million shares for $104 million, bringing the count to 18.2 million at a cost of $269 million year to date.

Currently, Staples holds a Zacks Rank #4 (Sell). Another stock worth considering in the retail sector is Five Below, Inc. (FIVE - Snapshot Report), which carries a Zacks Rank #2 (Buy).

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