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Office Depot Inc (ODP), Staples, Inc. (SPLS): A Specialty Retailer the Internet Cannot Kill

Specialized retailers and category killers make for excellent businesses, but there’s a very big difference between good and bad.

Some are runaway successes; others are businesses in perpetual decline. Whether or not a business will fail or succeed comes down to one variable: the effect of tech.

Retail vs. the internet.

Built on the idea that they could deliver office supplies to corporate customers, and offer a range of product choices that exceed any other store, Office Depot Inc (NYSE:ODP) and Staples, Inc. (NASDAQ:SPLS) were outrageously profitable…until the internet came. Now it appears that Staples and Office Depot are in long-term declines as their core customers go to other retailers.

Unfortunately for these two specialty retail giants, their customer isn’t loyal, nor is the customer concerned with time sensitivity. Corporate customers of Staples, Inc. (NASDAQ:SPLS) and Office Depot Inc (NYSE:ODP) can find the same products at a lower price from a low-overhead online retailer like Amazon, and have their purchases delivered to their address with a marginal delivery fee and without a minimum order size.

Office Depot Inc (NYSE:ODP)Furthermore, corporate purchases are scrutinized by the purchaser and a manager. There’s no room for high pricing when customers have incentive to shop around. While a merger of Office Depot Inc (NYSE:ODP) and OfficeMax Inc (NYSE:OMX) may relieve the industry of some competitive pricing pressure, it will only extend the longevity of a business that has an expiration date.

Office Max most recently missed on earnings, posting first quarter 2013 earnings that were half as large as the consensus estimate – $0.11 vs. expected earnings of $0.22 per share. In typical fashion for a dying retailer, OfficeMax Inc (NYSE:OMX) highlighted new initiatives in a small store format to cater to small businesses. The company also entered into the low-margin business of web hosting, partnering with GoDaddy to provide small business hosting solutions.

Staples, Inc. (NASDAQ:SPLS) CEO Ronald Sargent said he was confident the company would reach its full year estimates of $1.30 per share in earnings, but the first quarter for Staples looked no better than results from Office Depot Inc (NYSE:ODP). European sales fell by 3%, which one would expect given Europe’s economic reports point toward a constant battle with recession. In North America, the results weren’t much better, with sales declining by 2% as the company deals with a decline in the PC, weak software sales (a hot product online), and tepid business spending. Gross margin also fell, in part because the slowdown in capital-intensive, brick and mortar channels.

A retailer the internet cannot kill

Even investors who avoid technology stocks because of rapid changes to the industry are still exposed to big trends in tech. Investors should seek to find businesses that become stronger with new technology, not those that become weaker.

I believe this category killing company is just that – a company that will be strengthened by tech rather than weakened.

Autozone, Inc. (NYSE:AZO)

Autozone leads the pack as a company that will become empowered by the internet. Automotive parts are products that are generally time sensitive purchases (you wouldn’t wait a week to replace a dead battery) and purchases that have a steep learning curve. As such, customers prefer a company that can provide answers to their toughest questions, and help with simple product installations and services.

Many auto parts are too heavy relative to product cost to ship direct to the customer, which rules out the possibility the internet will eat away at brick and mortar sales of car parts.

AutoZone, Inc. (NYSE:AZO) is by far the best company in the auto parts space. Besides leading in the sale of auto parts, it’s also using its brand to leverage new private-label products under the name of Duralast and Valucraft. Autozone’s own brands make up more than half of its sales.

In the most recent quarter, Autozone posted returns on invested capital that would imply a ridiculously strong position in the auto parts market. AutoZone, Inc. (NYSE:AZO) reported ROIC of 32.4%, crushing the performance of smaller competitors.

As large as Autozone is, it still has room for decades of growth. The company opened 9 new stores in Mexico where it has 334 stores and recently placed its first store in Brazil. Should these two markets continue to develop and automotive ownership in Latin America grow, Autozone could tap into two new billion-dollar markets. Autozone is still largely an American story, with 4,735 of its 5,070 stores in the United States.

At 13 times forward earnings expectations, AutoZone, Inc. (NYSE:AZO), a company with a moat worthy of envy, a buyback program that fuels a rising valuation, and opportunity for years of organic growth, is undeniably cheap. The internet cannot kill the car parts store; this is a business that could pay investors rewards for as long as cars are a household commodity.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of Staples.

The article A Specialty Retailer the Internet Cannot Kill originally appeared on Fool.com.

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