Can Investors Find Value in the Office Supply Sector?

Three major office supply chains control nearly 75% of their sector, according to data provider IBIS World, but this hasn't led to strong profitability for any of them.  Despite their collective market share, these stores have been buffeted by encroachment from mass merchandisers and online retailers, as well as moves by shipping giants FedEx and UPS into the space through FedEx Office and UPS Store outlets.  However, the pending merger between Office Depot (NYSE: ODP  ) and Officemax (NYSE: OMX  ) should reduce the combined company's retail network and operating costs, likely moving its profitability more in line with industry leader Staples (NASDAQ: SPLS  ) .  Should investors buy into this story?

What's the value?

Office Depot has the most expansive operating network in the industry, with operations in 59 countries around the globe, primarily through joint ventures or licensing relationships.  However, the cost of maintaining a global base of administrative and distribution facilities has led to sub-optimal profitability. Office Depot had a 0.4% adjusted operating margin in its latest fiscal year.  Activist investment fund Starboard has been trying to get the company to rationalize its footprint through the proxy ballot box, recently winning three board seats and providing the impetus for the July 2013 sale of the company's interest in its Office Depot de Mexico subsidiary.

In contrast, Officemax is primarily U.S.-centric, with a major international presence only in Mexico through its 51% ownership of Grupo Officemax.  Unfortunately, the company's more limited geographic diversification hasn't led to much better profitability, with a strikingly similar 0.5% adjusted operating margin in its latest fiscal year.  On the upside, Officemax enjoys a solid financial profile. Its long-term investment in Boise Cascade's parent holding company has generated financial benefits through dividends and returns of capital.

In FY2013, top-line growth for both Office Depot and Officemax has been hurt by selective pruning of the companies' respective retail networks, as well as declines in comparable store sales.  More importantly, both companies' operating margins remain near the break-even level, due to sales declines in higher-margin categories like PCs and furniture.  Assuming regulatory approval of their combination, though, future profits are looking better, as the managements of both companies expect $400 to $600 million in annual cost savings and operating synergies.  A larger scale will also allow the combined company to pursue growth in services, including printing and computer services for small businesses.

A likely beneficiary

A combined Office Depot/Officemax entity will still be smaller than Staples, which leads the industry with a sales tally that topped $24 billion in its latest fiscal year.  While Staples also has a global operating footprint, 24 countries at last count, it focuses its international efforts on a select group of countries, including Canada and the U.K.  The strategy leads to better critical mass in its operating areas and higher profitability, with a 6.3% adjusted operating margin in its latest fiscal year.

In FY2013, Staples has reported top-line results similar to its smaller competitors, with a 2.9% decline in sales due to falling comparable store sales and a small reduction in its global retail network.  The initiation of a company-wide restructuring plan in 2012 has led Staples to close under-performing stores, 103 over the prior twelve month period, and put its European printing equipment division on the auction block.  The elimination of Officemax as a major competitor, though, should enhance Staples' profitability, because it likely lowers Staples' required marketing expenditures in the retail segment and allows it to reinvest in its growing digital and services initiatives.

The bottom line

Consolidation in the office supply sector has been long overdue as the number of retail and online sellers of office supplies has increased.  Office Depot and Officemax have already been positioning themselves as small business service providers, both in the distribution of a growing diversity of supplies and as physical outlets for services that include printing, copying, and technology support.  While the individual companies previously didn't want to reduce their operating footprint to avoid losing marginal sales, the combined company will be able to sharply curtail its retail network, which should create significant margin expansion and lead to greater value for investors. This combination is a winner.

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