Friday, January 15, 2010

Officemax (NYSE:OMX): Upgraded to Overweight at J.P. Morgan; target raised to $20

J.P. Morgan is making a major call on Officemax (NYSE:OMX) and Staples (NASDAQ:SPLS) upgrading both to Overweight from Neutral and raising price targets to $20 (prev. $13) and $30 (prev. $25), respectively.

Firm notes their upgrade reflects 1) the companies’ high correlation to modestly improving labor markets; 2) the significant potential earnings power in a stronger economic environment; and 3) their view that the back-to-business season in 1Q will be an important positive catalyst for the group. For OMX specifically, a recovery from depressed sales and earnings combined with structural margin improvement during the downturn should lead to outsized stock performance. For SPLS, sales growth in 2010 should drive accelerating margin progression from CXP synergies, product mix, and expense leverage, ultimately leading to upward earnings revisions. Finally, while both names have intriguing valuations, OMX is still trading near trough levels.

These rating changes are now in tandem with JPM's Overweight rating on ODP (upgraded in May 2009). Given the significant correlation to payroll expansion, they view this as a sector call once one expects a modest labor market rebound. At this point in the cycle, if one of these stocks works, then the others will likely do so as well (as they believe others over-estimate “structural” deficiencies at ODP). ODP and OMX are the riskier small-cap, depressed earnings recovery investments. SPLS is the larger cap, relatively lower risk, and best-in-segment investment (and one of the deepest management teams in all of retail). The corresponding risk-reward for ODP and OMX reflect this dynamic and offer higher potential upside. In other words, they view the choice as a risk tolerance question.

Substantially higher earnings power. Mid-cycle EPS for ODP and OMX center on $1.00 and $1.70, respectively, suggesting upside to ~$14 and ~$24 (using mid-cycle PE multiples of 14x). This represents potential upside of 109% and 73% for ODP and OMX, respectively. Using similar criteria, mid-cycle potential upside for SPLS is 15%. As one would expect, peak cycle reflects even higher potential appreciation.

OMX: Raising their Dec 10 price target to $20. JPM is raising their December 2010 price target to $20 from $13 previously, representing 45% upside from current levels. This is based on the following: 5.2x EV/EBITDA – this compares to its historical FY2 average of ~8x and a peak valuation of ~12x; 0.21x price-to-sales (per share) – this is below its historical average of 0.25x and compares to its current valuation of 0.15x, which is one of the lowest tracked valuations in their weekly Valuation Master report and the lowest in their coverage universe

Substantially Higher Earnings Power
As JPM highlights in the chart that follows, all three companies (ODP and OMX in particular) have significant earnings power in a normalized sales and margin environment.

Firm's mid- and peak-cycle sales assumptions are as follows: mid-cycle, they assume $13.5B in annual sales for ODP, $8.0B for OMX, and $26.0B for SPLS; during the peak-cycle, they assume $15.0B in sales for ODP, $9.0B for OMX, and $29.0B for SPLS.

Mid-cycle EPS for the beaten down “junior players” center on $1.00 and $1.70 for ODP and OMX respectively, suggesting upside to ~$14 and ~$24, respectively (using mid-cycle PE multiples of 14x). This represents potential upside of 109% and 73% for ODP and OMX, respectively. Using similar criteria, mid-cycle upside for SPLS would be 15%. As one would expect, peak cycle reflects even higher potential appreciation.

OMX Is at a Big Discount
OMX continues to trade at a discount compared to JPM coverage universe and historical multiples, while SPLS remains a compelling large cap, best-in-segment retailer.

For OMX, on a P/E basis, the company appears to be trading at a premium, but one must consider the significant earnings power highlighted above. Furthermore, using our EV/EBITDA and P/LTM Sales, OMX is arguably the cheapest stock in our coverage at 5.2x EV/EBITDA using our 2011 forecasts. As a reference, the company’s historical EV/EBITDA and P/LTM Sales averages are ~8x and 0.25x, respectively

Notablecalls: Make no mistake, this call is all about Officemax (OMX) and a lot less about Staples (SPLS). Take a look at what Office Depot (ODP) did when when JPM upgraded it on May 29 2009 (see archives) - it gapped up over 10% and resumed higher by 25% over the next 2 days.

Needless to say JPM's $20 target is the new Street high.

I would not be surprised to see OMX trade up 7-10%, putting the $15 possibly in play. Note that JPM is saying there may be even more upside than implied by their $20 target. This should create strong buy interest. Note there's a 14% short interest in the name.

We have Intel (INTC) and J.P. Morgan (JPM) trading weakish in the early going in reacting to earnings, which is keeping the general market in check & should give you possibly good fills already in the pre-market.


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