Has Office Depot Defied the Odds?

In what was perhaps the most surprising story of earnings season, big-box office supplier Office Depot (ODP 4.85%) wowed the Street with much better than expected earnings. Disrupted by the titan that is e-commerce and shifting retail trends, Office Depot's business model was held to the fire a few years back, and it's been on a treacherous slope until last week. Management is pulling all the levers and pushing all of the buttons to get this ship back on course, and it may just be working. With its recent acquisition of Office Max, its closure of poor performers, and its focus on merchandising, the company is doing everything that is typically suggested by turnaround-savvy activists. The question is: Will these efforts yield a long-term recovery, or is this the final burst of a dying star?

Smooth moves
If its essential business wasn't in such peril, Office Depot would be a no-brainer turnaround story, with a management team that will not sit still until things are back on track. For one thing, the company employed the strategy often espoused by businessman extraordinaire Richard Branson: When in doubt, grow. In November of last year, the company announced its purchase of Office Max for nearly $1 billion. Both companies were in trouble and served the same market; it was a natural marriage and allowed Office Depot to focus on operational issues rather than market share battles. Even better, the deal was done in an all-stock transaction -- a much more favorable tax scenario than a cash purchase.

Satisfying the optimists, management turned to placating the MBAs -- cutting costs anywhere and everywhere, including closing hundreds of U.S. stores that were underperforming and acting as a ball-and-chain on sales and cash flow. Those savings are expected to show up on the financial statements as early as the current quarter.

Office Depot is perhaps most compelling in its strategy with its ongoing operations. Bigger rival Staples is attempting to transition to its online business as quickly as possible (Stapes is the second-largest Internet retailer, behind Amazon), and is closing down hundreds of its brick-and-mortar stores in the process. Office Depot's management was wise not to try to follow suit. Staples already struggles to compete with the e-commerce giant, and Office Depot would almost certainly be in perpetual catch-up mode -- not a formula for long-term success.

Instead, the company is making use of its physical square footage. Management cited positive trends in the printing and copying business (partially a factor in the quick growth of small businesses), in addition to maintenance services. Office Depot can act as a custodian for small and medium-size companies that do not have their own back office to rely on.

The bottom line
Investors and analysts were impressed with the improved guidance and higher-than-expected cost savings from the Office Max acquisition. While those were nice perks to the recent earnings report, investors will want to keep an eye on the long-term trends in the business. Office Depot still has a tremendous hill to climb in order to secure a stable, long-term future. Keep a close eye on the development of its business services segment, as this is a defensible business compared to the retail segment.

This could be one of the more interesting turnaround stories, but it's way too early to tell.