By Ryan Derousseau
FORTUNE -- Dennis Delafield and Vincent Sellecchia have run the Delafield Fund (DEFIX), which oversees $1.4 billion, since its launch in 1993. They seek turnarounds: undervalued companies with copious cash flow that are grappling with change (an acquisition, a troubled industry, or management) and that they think can rebound in a few years. Their efforts have fueled 10.4% annualized returns over 15 years, vs. 4.8% for the S&P (SPX). One holding they think is primed to rise: Staples (SPLS).
1. It's all about the cash
Sure, sales have been uninspiring, slipping 2.6% through the third quarter of 2012, compared with the previous year's period. But the Delafield duo raves about Staples' $1 billion-plus in annual free cash flow. The $25 billion (revenue) company is using that stash for dividends and stock buybacks (nearly $1 billion planned), and to pay down debt on its $2.65 billion purchase of Corporate Express, which sells office supplies to large companies. The cash also makes Staples an attractive buyout target for private equity firms.
2. Amazon won't crush staples
Analysts fear that Amazon (AMZN), which launched an office-supply operation aimed at businesses last year, will encroach on Staples' turf. Sellecchia admits the competition will depress online prices. But he thinks Staples can defend itself. Some 80% of its sales come from businesses, which he says are less fickle than individuals. Plus Staples is already strong online. With 100,000 products available in its warehouses or from suppliers that ship directly to customers (a typical store offers 7,000 to 8,000), Staples can expand its e-commerce offerings.
3. It's pairing costs wisely
Staples has begun taking steps to dump underperforming businesses and locations. In the wake of overseas losses, Staples announced in September that it plans to save $250 million a year by closing 60 stores, 45 of them in Europe and the rest in the U.S. Staples is still bigger than Office Depot (ODP) and OfficeMax (OMX) combined, but with Amazon on the march, physical size is not so crucial. "Clearly the macro environment is different than it was 10 years ago," says Sellecchia. "Staples is reacting to it in an intelligent way."
4. The price is appealing
Staples shares have sagged 45% over the past three years. That's bad news for existing shareholders, obviously, but good news for new ones. The stock trades at 4.3 times earnings before interest, taxes, depreciation, and amortization (Ebitda) and a forward price/earnings ratio of 9.1, vs. 13.3 for the S&P 500. The Delafield team thinks the shares should be priced at about five times Ebitda -- an upside of 16% in the short run. Sellecchia says of the stock, now just under $14, "In a year or two, it should be trading in the high teens."
This story is from the February 25, 2013 issue of Fortune.
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