Staples Inc. ( SPLS - Analyst Report ) remains well positioned compared to its peers, given its margin expansion, effective merchandising, and growth prospects across its retail, delivery and international divisions. However, the sluggish state of the economic recovery remains a concern.

Strengths & Opportunities

Staples is making prudent investments in the highly fragmented North American retail market to improve its business technology, and copy and print services that generate higher profit margins. The company entered into partnership with Martha Stewart Living Omnimedia Inc. ( MSO - Snapshot Report ) and Avery Dennison Corporation’s ( AVY - Analyst Report ) office and consumer products group for retailing a new line of products.

Going forward, Staples intends to focus on improving store productivity by generating incremental sales per store, accelerating growth in adjacent categories, increasing market share in core office supplies, streamlining its cost structure and improving profitability in the International division.

During the first quarter of 2012, the company posted earnings of 30 cents per share, representing an increase of 7.1% from 28 cents in the comparable prior-year period. Moreover, management stood by its earlier forecast and expects sales to increase in the low single-digit range in fiscal 2012, while the bottom line is expected to increase in the high single-digit range. The company expects to generate more than $1 billion of free cash flow in fiscal 2012.

Staples’ decision to slow down the pace of store openings makes sense given the sluggish spending environment. The company opened just 37 new stores in 2011 compared with 53 in 2010, 56 in 2009 and 121 in 2008.

Weaknesses & Threats

The International segment continues to struggle with sales contracting 8% during the first quarter of 2012, following a decline of 4.6% in the previous quarter. The drop in revenue reflected decline in comparable store sales in Europe coupled with sluggish sales in Australia.

We noticed that the margins remained under pressure in the first-quarter 2012. Gross profit for the quarter inched down 1.6% to $1,609.7 million, while gross margin contracted 10 basis points to 26.4%. The decline in gross margin was experienced mainly due to a drop in International revenue driven by lower product margins.

The decline in business and consumer spending in the wake of the global meltdown and the deterioration of credit markets has resulted in sluggish demand for big-ticket items such as business machines, furniture and other durable products. Management expects sluggish growth in the U.S. economy and hinted that demand will remain soft in Europe.

Due to high exposure to international markets, Staples remains prone to currency fluctuations. The weakening of foreign currencies against the U.S. dollar may require the company to either raise prices or see its profit margins contract in locations outside of the U.S. An increase in price may have an adverse impact on the demand for products.

Conclusion

The company is trying every means to keep itself afloat amidst the tough economic conditions. Staples is taking up initiatives in almost all its categories in order to drive customer traffic.

However, the company faces stiff competition from office supply retailers, such as OfficeMax Inc. ( OMX - Analyst Report ) and Office Depot Inc. ( ODP - Analyst Report ) , and warehouse clubs such as Costco Wholesale Corporation ( COST - Analyst Report ) , discount stores, mass merchandisers such as Wal-Mart Stores Inc. ( WMT - Analyst Report ) , and computer and electronics superstores.

Therefore, the stock carries a Zacks #3 Rank, which means a short-term ‘Hold’ rating and correlates with our long term ‘Neutral’ recommendation.