Office Depot (ODP) merged with OfficeMax last November. Prior to the merger, the two companies sold an undifferentiated product from too many stores with territories that overlapped significantly. The strategy was simple — ODP and OMX would merge to cut costs, consolidate stores, and the resulting “synergies” would allow them to compete with Staples (SPLS), Wal-Mart (WMT), and Amazon (AMZN).
John here, and I happened to visit an ODP location last week to see how the back-to-school shopping season was going. The store reminded me of Family Dollar (FDO) but without the classy atmosphere (snark). The location was a mess, and there were surprisingly few shoppers considering that school in my district was starting the next day. Clearly, this wasn’t a thorough survey of Office Depot stores…but after reviewing the financials, I can’t help but think this is typical.
Historically speaking, merging two unprofitable companies with shrinking margins, losses, and declining sales trends is not a very good model. Sears (SHLD) and Kmart; New York Central and Pennsylvania; CompUSA, Systemax (SYX) and Circuit City are all examples of how this kind of how poorly this strategy usually turns out. The bottom line is that a merger usually can’t change the fundamental issues that created the problem in the first place.
Office Depot vs. Staples
SPLS reported earnings on Aug. 20 and actually beat expectations. Profits are still falling, but they were falling less than expected, and initially the stock opened higher. Unfortunately, SPLS stock then closed the day with a large bearish engulfing pattern. Ironically, while SPLS is actually profitable, it has declined more than 30% this year, while ODP is down just 5% so far for 2014.
The difference in price performance between SPLS and ODP is an important one. An acquisition frenzy has gripped the market since early 2013 such that it is typical for both the target and the acquirer to gain on an acquisition announcement. The best Wade and I can do to attribute ODP’s superior performance to SPLS is the residual effect of the deal with OfficeMax last year.
The bottom line is that we see Office Depot as an overvalued firm supported by quickly deflating expectations from investors. The stock caught a big bounce in May when they reported fewer losses than expected, but the SPLS report is a more accurate reflection of market sentiment and industry trends. ODP looks extremely overvalued, and a break below $5.00 per share is likely to send it back to April’s lows.
From a technical perspective, ODP has nearly completed a head-and-shoulders, bearish, reversal-pattern that began with a bearish divergence in May and June this year. As you can see in the next chart, the stock has already flirted with a break below the neckline at $5.00 following its earnings report earlier this month. Big reversals like this are often a little messy, but we would still put the probability of a confirmed breakout to the downside very high.
Office Depot (ODP): Chart Courtesy of eSignal
Conclusion
The broad market is still quite bullish. Traders are in a buying mood, and even junk is in high demand. Shorting ODP is definitely interesting, however, because the market is so positive that confirmation of a break is required.
Sure enough, on Thursday ODP began to lose value as SPLS warned about the coming quarter, which we think indicates that ODP’s out-performance is eroding. This is a very bad sign for the industry. As we mentioned, back-to-school is a critical season for Office Depot, and it looks like the data aren’t going to be good. Our recommendation is to consider a short position in ODP after a close well below $5.00 per share.
Some traders may also prefer a long put position instead of an outright short to avoid the slim possibility of another round of consolidations within the industry when it does break the neckline. Here’s our option recommendation:
Use a limit order to ‘buy to open’ the ODP October 5 Puts (ODP141018P00005000) for a maximum price of $0.35. The bid/ask price on these options has been a little wide, but manageable when compared to the potential profits if the stock hits our price objective.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
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