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).

Key indicators for business spending include corporate profits and the cost of borrowing. Both have been favorable for years, yet businesses have focused more on cutting costs than on developing their infrastructure. With borrowing costs rising (at least in terms of the spread between Baa bonds and treasuries) I thought it another good opportunity to read the tea leaves from some recent conference calls.

Tech Data (TECD) starts things off on a positive note.

Looking at the Americas, our net sales exceeded our internal growth expectation which called for growth in the mid single digit range through strong execution and focused sales and product management efforts we want incremental business in the second quarter that boosted our growth rate to over 16% in the region, while still delivering our targeted operating margin. This double digit net sales growth was broad based with growth across virtually all of our product and customer segments….

Our Q3 business outlook calls for low double digit year-over-year growth in the Americas and flat to low single digit growth in Europe on the local currency basis.

(Excerpt from full TECD conference call transcript)

Staples (SPLS) is running into some tough spots.

Our North American retail business again experienced softer than expected sales during the quarter with same-store sales down 2% and total sales up 5%, which led to only a modest increase in the bottom line. Our North American delivery business continued to gain market share with top line growth of 16% and operating income of 18%. Finally, we’re happy with the strong improvement we’re seeing in our international business, where total sales were up 18% in U.S. dollars. That’s 11% in local currency. Same-store sales grew 7% and operating margin jumped 225 basis points to 1%.

So while we were very pleased with our results in North American delivery and international, it’s clear we’re operating in a tough retail environment in North America….

We had strong growth in copy center, laptop computers, ink and software, but these gains did not make up for negative comps in furniture, supplies, and tech durables.

(Excerpt from full SPLS conference call transcript)

And since both Staples and Tech Data source a good percentage of their tech products from Hewlett Packard (HPQ - Annual Report) it is important to get their take on the situation as well.

Moving to PSG, we shared an outstanding quarter with excellent revenue growth, market share gains in every region and strong margin performance. Revenue increased 29% year-over-year to $8.9 billion with unit shipments up 33% and double digit revenue in unit growth in every region. These results bring PSG’s year-to-date revenue growth to nearly $5 billion. We have a strong momentum driven by our notebook business which grew revenues 54%, and units 71% versus the prior year period. According to our estimates for the second calendar quarter, we increased HP’s notebook market share lead by over 5 points versus the prior year….

We now expect Q4 revenue to be approximately $27 billion to $27.2 billion, growing roughly 10% to 11% year-over-year. While the sequential increase of 6% to 7% implied by our guidance is less than the historical 10% to 12%, we do not believe it is prudent to set investor expectations that our Personal Systems business can continue to grow at almost three times the market rate, nor do we think it appropriate to build a cost structure on that basis.

(Excerpt from full HPQ conference call transcript)

There don’t seem to be too many signs of weakness, although the GDP numbers suggest there is. I’d argue for cautious optimism regarding tech spending over the next few quarters despite the rise in corporate interest spreads.