Following the merger of Office Depot (NASDAQ:ODP) and Office Max in 2013, only two major office-supply retailers were left standing in the United States: the new Office Depot and Staples (NASDAQ:SPLS). Both companies announced major store-closing initiatives in 2014, as demand for traditional office supplies waned and competition from online retailers took its toll.
Staples now plans to acquire Office Depot, a move that was announced earlier this year. This would leave just one major office-supply chain in the United States, and even more store closings would probably result, as many cities have both Staples and Office Depot stores. Staples' and Office Depot's retail stores face plenty of competition, ranging from big-box stores to online retailers, and combining the businesses could lead to greater efficiencies and higher levels of profitability.
The fate of the merger, however, is up in the air. Both the Federal Trade Commission in the United States and European Union antitrust regulators are investigating the tie-up, with the latter having until Feb. 10 to approve or reject the deal. The odds that the merger will be approved quickly appear slim, and there's a chance that the deal will end up falling apart over regulatory concerns.
Retail has nothing to do with it
Both Staples' and Office Depot's stores face plenty of competition, and combining the companies won't create any kind of competitive advantage. Office-supply stores are meant to serve consumers and small businesses, both of which can buy the same products elsewhere. If Staples and Office Depot were only retailers, I suspect there would be no hesitation in allowing the companies to merge.
But both Staples and Office Depot operate commercial businesses, where they sell products directly to large companies and organizations, and in this area there is far less competition. For both companies, the commercial business has become the most profitable segment, and regulators are right to be concerned that a merger could lead to higher prices for large organizations.
Staples and Office Depot attempted to merge in 1997, but the FTC blocked that attempt. The retail side of the office-supply industry has changed since then, particularly because of the growth of online retail and the decline in demand for traditional office supplies. But the commercial side is far more concentrated than the retail side, and a merger could give the resulting company an unfair advantage.
It's hard to say whether the merger will be approved. It seems the same concerns that existed last time a merger was floated still exist today, and if the process gets dragged out for too long, Staples may simply abandon the effort.
Staples is the stronger company
In the event that the merger fails, Staples is in a far better position to succeed in the long run. While the retail sides of both Staples and Office Depot have been performing poorly, Staples' commercial business is both larger and more profitable than Office Depot's.
In the latest reported quarter, Staples' North American commercial business generated $2.05 billion of revenue and an operating margin of 6.7%, while Office Depot's commercial business generated revenue of $1.43 billion and an operating margin of just 4.4%. Staples' commercial business is also growing, posting 2.6% year-over-year growth during the latest quarter, while Office Depot's is shrinking, with sales falling by 3% during the same period.
Staples has managed to grow its commercial business despite weak demand for traditional office supplies by expanding into new categories. Along with selling paper and ink, Staples has expanded its offerings to include everything from cleaning supplies to specialized products for the healthcare industry. The idea is to become the supplier for everything an organization may need, not just office supplies, and Staples had added hundreds of category specialists to its commercial business over the past few years to help grow sales in these new categories.
Office Depot has added new product categories as well, but the company's commercial business isn't growing, and costs associated with the merger with Office Max and the closing of stores have caused Office Depot to post persistent losses. While Office Depot has produced just $55 million of free cash flow over the past year, Staples has generated $650 million.
The best-case scenario for Staples is that the merger is approved, giving the company a dominant share of the commercial office-supply market. But if the merger fails, I think Staples will be fine. The company's commercial business is doing well, and as the company continues to close stores, the profitability of the retail business should eventually improve.
Office Depot would have a tougher time in second place. The company has never been as successful or profitable as Staples, and although it now has greater scale, combining two not particularly good companies, Office Depot and Office Max, certainly doesn't guarantee that a great company emerges in the end.
It may be a while before we know whether the merger will be approved. Either way, I think Staples' position in the commercial office-supply market will remain intact.
Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.