This article was originally published at RealMoney on Sept. 14, 2007.

I’ve always had a soft spot for Office Depot (ODP), where I served my MBA internship. So when I noticed that a sales and earnings speed bump has put the stock in the 50% off bin, I thought I should check it out more closely. After all, at 10x earnings it certainly looks cheap enough. Its primary competitor Staples (SPLS) has weathered the storm far better but trades at a significantly higher earnings multiple. OfficeMax (OMX) has been hit nearly as hard as Office Depot, but also sports a higher valuation.

That comparison begs an obvious question: is Office Depot cheaper than those companies because it is doing much worse than they are? To some extent this is certainly true, as Staples’ same-store sales have been trending down 2% while Office Depot’s are down 5%. OfficeMax has actually seen positive comps, but that is at least partially driven by having closed more than 100 underperforming stores. At any rate, it seems safe to say the whole group is doing poorly but Office Depot’s lower valuation is at least partially merited by virtue of it doing even worse.

At the Goldman Sachs conference last week, management discussed the impact of a slowing housing market, which has apparently been affecting the home-based businesses that constitute a portion of office superstore sales. The company explained that the change in store sales is strongly related to local housing inventory and the number of days houses stay on the market. Since Office Depot has a larger concentration of stores in Florida and California - two of the hardest-hit markets - this may explain much of the underperformance, and is supported by the fact that the biggest drops have been in the furniture category. However, it also suggests that things may get even tougher for all of the office suppliers as the housing decline continues to spread. Fortunately the international business continues to grow, and accounted for more than 25% of total revenue in the latest quarter.

So that brings me to the financial nitty gritty. Is the valuation cheap enough to merit a long-term investment, or is it still time to stay away from a falling knife? Although net income is still up year-to-date, cash from operations is down - and that dichotomy is often a warning sign. The difference has been working capital investments. Inventory on hand has crept up to 54 days from 52 last year, but receivables are down a bit. It looks like the timing of tax payments was the main culprit, which makes me a little less concerned about the decline.

Even in the face of the downturn, the company has generated $636 million in cash from operations over the last 12 months. The pressure is expected to continue into the third quarter but should start to ease next year, if only because the comparisons will be easier. It used up nearly $450 million on capital expenditures and is expected to continue spending about $500 million annually - mostly on store openings and remodels. I estimate that of that, about $200 million is going to new stores and the rest is required maintenance. Since the new stores are presumably expected to boost future cash flows, the “no-growth” free cash flow stands at about $325 million per year, a 5.8% free cash flow yield on the current enterprise value. It doesn’t take much growth from there to get to an enticing total return.

What’s more, if this worst-case scenario does unfold the company has shown that it has the discipline to act on it. Office Depot has already reduced planned store openings to 100 this year (from an initial plan of 150) and 125-150 next year (from initial plans of 200).

Office Depot has also been buying back shares (although in retrospect they were paying too much for them.) The share count is down nearly 6% from one year ago, and further buybacks will help soften the EPS blow during the downturn as well as provide leverage to the recovery.

All that said, an investment in Office Depot will require patience and possibly a strong stomach, as things are likely to get worse before they get better. It looks like a stock that will pay off in the end, but there are probably some names that will pay off sooner.

William Trent currently has a short position in put options related to Office Depot (ODP).