Office Supply Shake-Out: How to Play Staples, Office Depot, and OfficeMax

John is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With nine months remaining in the calendar year, 2013 has plenty of room left to earn accolades for the record books. For stock market investors, the year has already been earmarked as 1) "the year of the deal," with plenty of M&A activity, and 2) a definite time of transition for the office supply sector.

Pencils, paper, and ink cartriges are a serious business. We entered the new year at a time when many traditional brick-and-mortar retailers were absorbed in a power struggle, struggling to adapt to larger mass merchandisers and online competitors. The only guarantee for the marketplace and U.S. consumer was that the office supply industry was evolving rapidly.

Internet behemonth Amazon quietly launched a new subsidiary, Amazon Supply, which is designed to compete directly with Staples' (NASDAQ: SPLS) online North American Delivery business. Launched officially on April 24, 2012, Amazon’s service is still in its infancy, but is quickly gaining traction as it approaches its first birthday. In addition to office supplies, Amazon Supply provides a variety of other products for business, scientific, and industrial uses.

I wrote positively on Staples during early January when shares were trading in the $11 range. Since this time, Staples reported a disappointing quarter on March 6, but the stock is trading well above $13 per share, a tidy gain of more than 15% in less than 2 months.

Beyond Staples, smaller competitors Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX) have been struggling to compete in the modern retail environment. Leading into Staples' fourth quarter results, the companies' announced on Feb. 20 a merger to combine efforts in a “rapidly changing” industry. For companies involved with pencils, paper, and printer ink, there’s been a great deal of activity in less than two months time!

Readers Should Ask

How should readers react to the news of the Office Depot and OfficeMax merger announcement? Is there still an investment opportunity in Staples, and is the teaming up of competitors a positive or negative development for Staples? And what about Amazon, which may have been the quiet force underpinning the merger?

Let’s consider the good and the bad for Staples before providing commentary on the developing industry trends.

Staples: The Good

  • Analysts are commenting that Office Depot / OfficeMax store closings are a net positive for Staples. Citigroup upgraded Staples to Neutral from a previous Sell rating specifically for this reason, with a new $16 price target.
  • Management expects earnings-per-share from continuing operations to reach $1.30 - $1.35 for 2013, giving the stock a 10x forward yield. Staples should also generate more than $900 million in free cash flow and $23.9 billion in revenue.
  • During the Q4 earnings call, management stated that expects to see high-single digit revenue growth during the 2013 fiscal year. The company also plans to triple the number of items available for sale online.
  • Staples’ board of directors approved a 9% quarterly dividend increase to 12 cents from a previous 11 cents. Dividends are an important component of a total market return, and the stock has a 3.5% yield based on recent market prices. The company will also repurchase stock on the open market during 2013.

Staples: The Bad

  • Fourth quarter net income fell 72% on one-time charges related to store closings. The company only earned $90 million during Q4 2012, compared to $284 million during the fourth quarter of 2011. Comparable-store sales also fell 4% in North America and 9% in Europe.
  • A large component of Staples’ turnaround plan is closing non-performing stores in North America. This strategy could ultimately backfire as Staples becomes more dependent on online customers, a category where businesses and consumers have virtually no switching costs to shop elsewhere. Furthermore, Office Depot / Office Max collectively plan to close stores, which doesn’t bode well for the industry as a whole.
  • isn’t going away, and Staples’ plans to close stores will force consumers to make purchases either online or at discount retailers. Mass merchandisers such as Target, Wal-Mart, and Dollar General also sell a wide assortment of office supplies and back-to-school items at competitive prices.
  • Loyal investors such as Karen Finerman of Metropolitan Capital Management are losing faith in the turnaround story. Finerman stated on tv that she sold her position in Staples on Feb. 7 following the poor earnings release.
  • Staples’ plans to reduce square footage is reminiscent of Circuit City’s early stages of demise. However, neither Circuit City nor Best Buy enjoyed the tremendous online business of Staples, which may have a more durable advantage.

Office Depot and OfficeMax: A “Merger of Equals”

On Feb. 20, Office Depot reported disappointing results that made Staples’ quarter look like a home run in comparison. The company recorded neither a profit nor a loss in the fourth quarter, earning 0 cents per share compared with analyst expectations of 4 cents. Revenue came in $170 million lighter than expected, reaching $2.6 billion vs. the $2.76 billion consensus.

Same-store sales in North America fell 6% at Office Depot, a definite sign that the company needed to enact change in order to carry on.

A discussion of the planned Office Depot and OfficeMax merger would be incomplete without making known the deal is subject to regulatory approval. Both companies will remain publicly-traded for at least 7 to 9 months until the government makes a decision. I recommend that readers invest elsewhere in the market in the meantime.

If the deal is approved, OfficeMax shareholders will receive 2.69 shares of Office Depot per share of OfficeMax. The companies told news reporters that they have a high level of confidence the deal will pass regulatory hurdles.

What about

With respect to Amazon, I am bullish on the stock and reflect my views in a separate, more detailed article. While it’s difficult to set apart office supplies from the rest of Amazon’s business, the company is undoubtedly a beneficiary of net retail store closings at Staples and Office Depot / OfficeMax.

The Financial Times also penned an excellent piece titled Retailers turn to M&A to survive, making multiple direct references to Shares have risen a modest 3% since I wrote my own article on Feb. 6.

Foolish Bottom Line

The recent merger announcement between Office Depot and OfficeMax removes all doubt that the retail environment is more competitive than ever. Investors will have greater clarity in the fall following a regulatory verdict.

In regards to Staples, I am neutral to bullish on the stock. Downside is limited in my opinion, and the rebound in the stock following the earnings release is a sign of mild investor confidence.

Thanks for reading, and consider subscribing to my posts for more Fool ideas on outperforming the market.

johnmacris has no position in any stocks mentioned. The Motley Fool recommends The Motley Fool owns shares of and Staples. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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