The office supply market is extremely competitive and currently struggling as businesses and consumers cut back on office procurement during the current global recession. Staples (Nasdaq:SPLS) reported second-quarter results on Tuesday that reflected these themes, but indications are that it will come out of the current environment in a much stronger competitive position, thanks in part to continued struggles among archrivals and the completion of a major acquisition.

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Staples' Falling Sales
Reported sales advanced 9% to $5.5 billion as last year's acquisition of Dutch office supply rival Corporate Express boosted the top line. But on a pro forma basis, or counting Corporate Express in last year's second quarter sales figures, the top line fell 13.8% on a 13% fall in North American delivery and a horrific 25.7% drop in international operations. The fall wasn't as dramatic when looking at sales from a local currency perspective and fell 12% and 14%, respectively, but still reflects the fact that customers continue to switch to lower-priced items and have cut back on spending. This has been occurring for a number of quarters now, as business customers remain especially frugal in the current economic downturn.

Relatively Successful
Staples' North American retail business, which competes with the likes of Office Depot (NYSE:ODP) and OfficeMax (NYSE:OMX), reported a 5% decline in sales as same-store sales also fell 5% and the opening of eight net stores (it opened 10 and closed two) had a minimal impact on results. This is clearly nothing to write home about, but Office Depot posted a 21% decline in its North American retail sales, comparable store fall of 18%, and operating loss of $13 million. It also continues to close stores. OfficeMax reported similar results as retail sales fell 11.1%, comps decreased 11.6%, and the retail segment overall posted an operating loss of $2 million. (For more insight, read Analyzing Retail Stocks.)

Meeting Expectations
Staples is also struggling on the sales front as the current recession has caused consumers and businesses to cut back to basic necessities and competitors such as VistaPrint (Nasdaq:VPRT) and eBay (Nasdaq:EBAY) continue to gain share in a crowded office supply market. Staples did however manage to remain firmly profitable during the quarter and reported earnings of 13 cents per diluted share. Backing out Corporate Express restructuring and integration charges and earnings were 16 cents per diluted share. This met quarterly analyst projections. Staples refrained from providing sales or earnings guidance but analysts currently project full-year sales of $23.9 billion and earnings of $1.13 per share.

Bottom Line
Based on the low forward earnings expectations, Staples is trading at a lofty P/E multiple of almost 20. A better indicator of its financial capabilities is operating cash flow, which came in at nearly three times reported net income for the first two quarters of its current fiscal year. Capital expenditure has also fallen as, reported on the Q2 earnings call, management "continued to invest prudently in growth ideas." It expects to generate $1 billion in free cash flow, which works out to approximately $1.40 per diluted share, based on quarter end share count. (These types of companies can give clues to the health of the economy, read Economic Indicators: Retail Sales Report.)

As such, the forward price to free cash flow multiple is more reasonable at just under 16 times. A more reasonable margin of safety to invest in Staples would be a stock price below $20 per share, but there could still be upside from current levels once the sales environment improves, rivals continue to close stores, and the company fully realizes the cost-cutting and other synergies that will come from fully integrating Corporate Express.

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