Office Depot (ODP 0.36%) just unveiled a bold new direction for its business. But after combining that direction with freshly reduced financial guidance, it's clear that investors aren't so sure about the move.
More specifically on Wednesday, Office Depot announced it has agreed to acquire IT services specialist CompuCom Systems from private equity firm Thomas H. Lee Partners (THL) for roughly $1 billion -- a massive deal considering Office Depot's entire market capitalization sits just below $2 billion as of this writing. According to Office Depot's press release, this marks the first step in strategically "pivoting the company from from a traditional office products retailer to a broader business services and technology products platform."
A new outlook
Before we delve deeper into the acquisition, let's address Office Depot's new outlook. At the bottom of its press release, Office Depot reminded investors that it's set to release fiscal third-quarter results in November. But with that quarter technically complete, Office Depot now expects sales to fall between 7% and 8% year over year, driven by store closures, a roughly 5% to 6% decline in comparable retail store sales, and a 5% to 6% decline from its Business Solutions Division (BSD). Trending toward the bottom line, third-quarter adjusted operating income should be between $125 million and $135 million.
Thus, Office Depot now expects adjusted operating income for the full fiscal year of 2017 to be between $400 million and $425 million, excluding the impact of its CompuCom acquisition. This marks a significant reduction from its previous guidance for fiscal 2017 adjusted operating income of $500 million -- a figure that, by the way, management reaffirmed in August along with its second-quarter report despite continued "challenging market conditions."
Office Depot blamed the reduction on a combination of the hurricanes in Texas, Florida, and Puerto Rico, where a "significant concentration" of its BSD customers are located, as well as lower sales and traffic during the crucial back-to-school season.
On the acquisition's pros
But you'd think a promising acquisition and new strategic direction might assuage investors' concerns over guidance. After all, the deal should add roughly $1.1 billion to Office Depot's top line and yield around $40 million in annualized cost synergies within two years.
In addition, CompuCom's established Tech-Zone concept -- which caters primarily to small and medium-sized businesses (SMBs) -- will be placed within all of Office Depot's roughly 1,400 retail locations nationwide, giving it more direct access to nearly 6 million SMBs within three miles of those stores. In the process, Office Depot believes it can take market share in what it describes as a "highly fragmented" $25 billion market for enterprise-level tech services and products, particularly for SMBs.
However, there are a number of reasons the stock fell despite the deal's upside.
For one, Office Depot is funding the $1 billion purchase -- which still requires regulatory approval but is not subject to a shareholder vote -- with a combination of new debt and the issuance of 45 million shares of its common stock to THL. That means THL will own an 8% stake in Office Depot, diluting existing shareholders' stakes in the process. In addition, Office Depot expects to refinance CompuCom's existing debt with a new term loan of roughly $750 million.
That said, Office Depot insists that it should maintain "substantial financial flexibility with low balance sheet leverage, strong liquidity, and positive free cash flow available for debt repayment, capital returns to shareholders, and growth initiatives."
That's also not to say Office Depot is diving into the SMB IT services market via CompuCom unchallenged. Best Buy's (BBY 2.42%) Geek Squad, for example, already offers a small-business-focused service with multiple pricing tiers, though it's unclear how much traction that service has garnered to date.
There's also the problem that necessitated this strategic pivot for Office Depot in the first place: the relative underperformance of its core retail business. To a certain extent, the incremental traffic resulting from the Tech-Zone additions to all stores could help bolster that performance. But again given its reduced guidance, and with the sting of last year's failed merger with Staples still fresh, it's hard to blame Office Depot investors for being skeptical about the chances of a retail turnaround coming to fruition.
That's not to say Office Depot can't pull this off. Perhaps CompuCom is exactly what it needs to expand its scope and drive incremental sales and earnings over the long term. But the market is almost certainly viewing this move as being done from a position of weakness, not strength. So assuming the deal passes regulatory muster and closes as planned, I suspect Office Depot shares will remain under pressure until we see some tangible proof that the combination is yielding its desired results.