Office Depot, Inc. Just Soared 16%, but It Could Go Much Higher

Shares of Office Depot, Inc. (NYSE: ODP  ) jumped 16% amid a broad market sell-off on Tuesday, as investors applauded the company's Q1 earnings results. While Office Depot's pro forma sales declined 3% -- with comparable sales falling in most of its operating segments -- adjusted EPS came in ahead of expectations at $0.07.

Office Depot's margins remain thin. Its full-year projection for adjusted operating income of at least $160 million implies that the company's operating margin could be as low as 1% this year. That would be only a slight improvement from last year's level of 0.6% (on a pro forma basis, that treats Office Depot and merger partner OfficeMax as a single company).

Office Depot reported better-than-expected Q1 earnings on Tuesday.

However, merger synergies will significantly reduce Office Depot's costs in the next few years. Meanwhile, store rationalization at both Office Depot and Staples (NASDAQ: SPLS  ) should drive significant margin expansion by the end of 2016. The likely result will be higher earnings and a higher stock price.

Beginning of a turnaround
Q1 was the first full quarter following the merger of Office Depot and OfficeMax, but the company has already made a lot of progress on cutting costs. CFO Steve Hare called out $14 million in merger-related cost synergies that helped Office Depot increase adjusted operating income from $54 million to $72 million. However, the company also benefited from better cost control overall.

For the full quarter, Office Depot's domestic retail same-store sales declined 3%, but that was better than the 4% decline in Q4. Moreover, severe weather disrupted sales in the earlier part of the quarter, but the trend improved as the quarter progressed.

In light of the stronger-than-expected Q1 earnings results, Office Depot's full-year forecast for adjusted operating income of at least $160 million seems very conservative. Hare did note on the conference call that persistent sales declines for some key products will offset some of the cost synergies. Nevertheless, management seems to be setting the bar pretty low.

Time to close stores
Office Depot has a lot of opportunities to reduce costs "behind the scenes" by cutting duplicative staff, office space, and other overhead. However, store closures will also be a key area for cutting costs. Accordingly, Office Depot's most momentous announcement this week was that it expects to close at least 400 stores by the end of 2016, including approximately 150 stores that will close by the end of 2014.

Since Office Depot and OfficeMax competed in many parts of the country, there are quite a few markets where Office Depot and OfficeMax stores are located near one another. Rationalizing the store footprint will allow the combined company to save money on occupancy costs, labor, and other operating expenses while still offering convenient locations for customers.

Office Depot's store closure plans would bring its North American retail footprint down from 1,900 locations today to 1,500 or less. Meanwhile, top rival Staples will be downsizing, too. Earlier this year, Staples announced plans to close up to 225 stores in North America by the end of next year. That represents more than 10% of its North American store base.

Staples also plans to close hundreds of stores in the next couple of years.

Staples and Office Depot are the only two national office supply-focused retailers left in the U.S. As a result, both companies will see huge gains from closing underperforming stores. While some customers may take their business to online competitors or big discount chains, most will simply patronize the nearest remaining office supply store.

Some people who currently shop at an Office Depot location that will close may become Staples customers. Conversely, some customers of Staples locations slated to close may end up taking their business to Office Depot. Both companies benefit from this dynamic.

The bottom line is that the office supply store base will shrink much faster than the decline in demand for office supplies. This will lead to higher sales per square foot in the remaining stores, boosting profit margins at both Office Depot and Staples.

Foolish final thoughts
Office Depot is beginning its merger from a position where it is barely breaking even. However, CEO Roland Smith is acting decisively to capture merger synergies. The company is already targeting total synergies of at least $675 million, and based on its early successes, it seems very likely that this is a conservative figure.

The office supply business is never going to be a big growth industry again. Still, there's no reason that a right-sized Office Depot (or a right-sized Staples) cannot be solidly profitable for many years to come. Office Depot is on track to deliver strong and stable earnings and cash flow within just a few years, which should keep the stock moving higher.

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