How the Office Depot & OfficeMax Merger Will Create Great Value

The pending merger between the second and third biggest U.S. office supply retailers -- OfficeMax (NYSE: OMX  ) and its rival Office Depot (NYSE: ODP  ) -- may be a clear win-win situation that will bring long term value to both companies' shareholders because the new entity will enjoy better profitability.

OfficeMax and Office Depot have both experienced contracting revenue because of the increasing relevance of e-commerce sites such as Amazon (NASDAQ: AMZN  ) . How will this deal help correct this negative trend?

OMX Revenue Quarterly Chart

Source: YCharts

Understanding The Deal
For the past 10 years, OfficeMax and Office Depot had to deal with two negative market trends:

  • The increasing relevance of non-traditional distributors, such as e-commerce sites and warehouse retailers.
  • A contraction in the demand for printing supplies, paper, and ink. 

The latest recession made it even more difficult for office supply superstores to compete against non traditional distributors like Amazon. By relying on a more efficient cost structure, these distributors are able to offer lower prices to increasingly price-sensitive consumers. Amazon controls the online retail space, generating more than $51 billion in sales last year, almost three times the combined annual revenue of OfficeMax and Office Depot.

To remain in business, both chains had to rely on various cost-reduction measures.These initiatives helped Office Depot reduce its losses -- adjusted operating margin improved 40 basis points in the last quarter --, but the firm was not able to return to profitability. OfficeMax was slightly better off, as the company experienced a smaller contraction in total revenues and was able to keep its operating margin positive at 0.7%.

In a strategic move aimed at increasing profitability, both companies decided to merge and create the nation's largest office-supplies chain. The market reacted positively to the deal announcement in February and it was approved by shareholders in early July.

Can the Deal Be Blocked?
Approval from the U.S. Federal Trade Commission, or FTC, is pending. Investors fear the FTC might block the merger because the new entity would concentrate too much market share, just as alleged when the FTC blocked Office Depot's proposed merger with Staples in 1997. 

However, the industry has changed considerably since then, and now even competitor Staples sees the merger as a positive event. According to the latest update, the companies hope to close the deal by the end of this calendar year, and will continue working with consulting firm Boston Consulting Group on an integration plan. The name of the new entity and its future CEO remain unknown. Given the fact most stakeholders and even competitors agree with the merger, the FTC may not block the deal.

A Giant in the Making
Final FTC approval should also be welcomed positively by the markets. This is because the new entity could achieve up to $600 million of synergies within 3 years of the merger, according to management. This may be just the beginning. According to Michael Sea from Midsummer Capital, it is feasible to see the new management team raising the target synergy range even higher, after placing firm numbers around labor and working capital synergies, and consolidating its plan for management succession.

Moreover, if the new entity decides to consolidate its stores to avoid overlapping markets, further geographic synergies could emerge. For example, almost 500 Office Depot store leases -- 45% of North American stores -- will start their renewal time frame within the next three years. This could be a great opportunity for the entity to reduce unnecessary square footage by closing Office Depot stores that are near OfficeMax locations and vice versa.

In terms of revenue growth, considering that the combined revenue generated by both companies amounted to $17.65 billion in 2012 and the increasingly fierce competition from online retailers like Amazon, or discount warehouses like Walmart, there probably won't be any immediate top-line improvements after the merger. However, in the long run the new entity could use some of the new cash it has available to increase its marketing spending and strengthen its e-commerce business. This could help stop the decreasing revenue trend.

What a Fool Believes
A more compact office-supplies chain with fewer stores and better profitability is in the making. It will have more cash available for investing in marketing spending, discounts, or online expansion. It will be better prepared to compete against Amazon, which has successfully captured market share in most categories, such as backpacks. According to marketing company Compete, 1 in 5 Amazon office supply shoppers conducted a backpack related search.

Notice that one of Amazon's strongest competitive advantages is its highly cost-efficient structure. The firm is able to avoid hiring a huge sales force by keeping no physical stores. It also avoids leasing and maintenance costs, and therefore it can provide better pricing.

The merger between Office Depot and OfficeMax is a strategic move aimed at creating an entity with a more efficient cost structure. The new chain will be more compact in terms of space and stronger in terms of margins. In other words, the new entity will have more resources to compete against online retailers, while keeping the advantages of owning physical stores. After all, there will always be customers looking for opportunities to inspect the merchandise they buy for quality, especially if they are buying a large amount of such items.

The Future of Retail
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


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