OfficeMax, Office Depot Unite? Not Impressed

by James Brumley | February 20, 2013 9:03 am

So, OfficeMax (NYSE:OMX[1]) and Office Depot (NYSE:ODP[2]) have agreed to merge.

The market’s initial reaction to the news was more than a little positive. Both stocks finished up double digits on Tuesday after the possibility was put on the table.

Just for the record though, the buying wasn’t born out of a “from good to great” point of view. This union is a last-ditch effort to salvage what’s left of both struggling companies. As such, the pops from both stocks may also a prime exit opportunity … before the market gets a chance to rethink things and deflate each again.

Reality Check

The motivations for a merger are the usual suspects, all ending with one overarching goal: synergy. If the two companies can share some expenses and work together rather than against one another, they may find some much-needed operational viability.

The goal of synergy, however, implies there’s at least something positive to use as a foundation. Neither OfficeMax nor Office Depot have enough going for them to use as that stepping stone.

For starters, both office supply retailers have been bleeding revenue since 2007. Office Depot’s top line has shriveled every year from 2007’s peak of $15.53 billion to what will be roughly $10.88 billion once 2012’s final numbers are posted.

OfficeMax hasn’t fared quite as badly, though it hasn’t exactly painted a compelling picture either. The company saw its sales peak at $9.08 billion in 2007, while revenue decline has turned into revenue stagnation at just a tad over $7.1 billion for each of the past three years. 2012’s top line will be slightly lower.

And earnings? Fuhgettaboutit. Even in “good” years like the early 2000’s, OfficeMax never booked net profit margins of more than 2.3% in any year. Office Depot’s best net profit rate for its past ten years was 2006’s tepid net margins of 3.4%.

To be fair, it’s not like nearest rival Staples (NASDAQ:SPLS[3]) is lighting it up on the net-margins front. At best, Staples has only cleared 5.4% of its sales as a net profit, and 4% is closer to its norm. Those thin margins underscore the bigger problems for Office Depot and OfficeMax, however, which is simply that there’s no room for error. If these retailers don’t execute properly in every way — which they haven’t in years — then producing consistent profits is a near-impossibility.

And just for the record, it’s not like these two companies haven’t been trying to cut costs before now. They have been. When revenue is slumping in step with cost cuts though, it’s tough to make forward progress.

Winners and Losers

While the merger may be too little, too late, it hasn’t prevented some onlookers from guessing what kind of savings a combined company could realize.

On the low end of the scale is annual savings of $300 million. At the high end, the pros say almost $600 million could be saved each year. That’s not bad, given how Office Depot only earned $95 million in 2011, and has cleared $375 million in EBITDA for the past four quarters. OfficeMax hasn’t cleared more than $70 million in net operating profits in any normal year since 2007. An extra $400 to $500 million per year is mathematically a game-changer.

But those post-merger savings are far from a done deal, and I find it unlikely that these struggling outfits would do any better as one unit. Indeed, there are some like Morningstar’s Joscelyn Mackay who think the associated costs of closing redundant stores (in the same geographical space) would eat away at any cost savings for years to come, defeating the purpose of the union.

And, once again, a merger still doesn’t solve the larger problem at hand: those falling sales. So the real question remains: If Office Depot and Office Max aren’t going to cash in on the merger, who will?

Well, the presumed winner from a merging of OfficeMax and Office Depot is the dominant player in the office supply space, Staples. It’s not an off-base theory either. Aside from added market share stemming from Office Depot and OfficeMax store closures, the sheer act of combining two separate companies can be disruptive, giving Staples a chance to win new customers by better-serving them.

It may be overly optimistic to assume Staples is going to pick up all of the potential $4 billion in annual OfficeMax/Office Depot could be shedding if and when it starts to close overlapping stores, though.

See, while Staples is fierce competition in this particular space, it was actually discounters like Target (NYSE:TGT[4]) and Walmart (NYSE:WMT[5]) that have caused as much trouble for Office Depot and OfficeMax since 2007. Those two general merchandise retailers stand to gain as much as Staples does, except for printing-service business.

Bottom Line

This isn’t necessarily a zero-sum game, where there’s one finite winner for every loser. In fact, there may not be a big winner at all in this case.

Merged or not, OfficeMax and Office Depot probably should have started cutting loose more stores a long time ago simply because the business wasn’t there. The only thing left to do now is just bite the bullet and bear the expense. Why traders think there’s a big net upside to any of this is anyone’s guess.

As of this writing, James Brumley did not own a position in any of the aforementioned securities.

  1. OMX:
  2. ODP:
  3. SPLS:
  4. TGT:
  5. WMT:

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