Activist Hedge Fund Takes a 10% Stake in Office Depot

Starboard Value LP, managed by Jeffrey Smith, is estimated to have assets under management in excess of $1 billion, and our records show that the fund has a 13F portfolio worth over $630 million. According to a Form 3 filing with the SEC last Friday, the fund now has a stake in Office Depot Inc. (NYSE:ODP) comprising more than 10% of the company’s outstanding shares of common stock. The filing, which was reported jointly by a variety of funds within the Starboard umbrella of operations, states that its ownership sits at 31.1 million shares worth a total of $76.8 million.

Jeff Smith

As of the end of last quarter, the hedge fund industry as a whole had limited exposure to Office Depot, with 17 funds holding a mere $29.7 million in the company’s stock. Some of the most prominent bulls at the time of their 13F filings were D.E. Shaw, Ken Griffin, Joel Greenblatt, and Jim Simons. Due to the fact that Starboard Value’s latest transaction increases total hedge fund interest in the office supply company by a factor of nearly four, it’s worth exploring the motives behind this purchase.

Since the start of 2012, shares of Office Depot have gained 14.9%, which is actually below the specialty retail industry’s average (32.6%), and middle-of-the-road compared to “brick and mortar” peers like Staples, Inc. (NASDAQ:SPLS) at -12.1%, OfficeMax Incorporated (NYSE:OMX) at 79.5%. The company’s web-based competitors, most notably Amazon.com, Inc. (NASDAQ:AMZN) and eBay Inc. (NASDAQ:EBAY), have also outperformed Office Depot over this timeframe.

Interestingly, the office supply retailer disappointed in its most recent earnings report, missing the Street’s second quarter revenue and earnings estimates quite badly. When the dust settled, Office Depot’s revenues came in at $2.51 billion, below the $2.60 billion analysts were expecting. Even worse, this total was 7.4% below Q2 2011 revenues. From an earnings standpoint, the company reported a loss of 14 cents a share, 5 cents worse than average estimates. By the end of next year, Office Depot is expected to improve its bottom line into profitable territory ($0.09), but the company’s recent whiff definitely gives investors reason to pause.

Assuming that it is able to flirt with earnings of a dime a share by next Christmas, Office Depot’s stock could see moderate price appreciation over the interim, as it currently sports deeply discounted Price-to-Earnings (10.9X) and Price-to-Book (1.0) multiples. Now, the bears can cry that any company with an earnings portrait as cloudy as this one deserves to trade at a cheaper valuation than its peers, but it’s notable that with a PEG ratio of 0.94, Office Depot is looking under-appreciated by the markets at the moment. While any stock with a PEG below 1.0 can be considered a good value-play, it is especially notable that Office Depot’ earnings growth also trades below the likes of OfficeMax (5.06), Amazon.com (10.07), and eBay (1.33).

One intriguing factor that most analyses of Office Depot don’t take into account is short sellers’ sentiment toward the stock. As of August 31st, Office Depot had a short percentage of float in excess of 14.0%, more than any of its aforementioned competitors, except for OfficeMax (20.5%). While it’s typically not considered to be a warning sign unless a stock has a short interest above 30%, this situation is monitoring when FINRA filings are reported at the end of this month.

To recap: Starboard Value’s recent move into Office Depot increased the hedge fund industry’s total interest in the stock from $29.7 million to $106.5 million. Shares of the office supply retailer have been a decent investment in 2012, though the company’s Q2 earnings miss represents a black eye on the company’s record, at least in the short term. By the end of 2013, analysts are expecting profitability out of Office Depot, and valuation metrics indicate that there is still a buying window here, assuming that short selling activity doesn’t get out of hand.

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