Office Depot and OfficeMax: Do Two Losers Make a Winner?

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

Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX), the second and third largest office supply retailers in the United States after Staples (NASDAQ: SPLS), recently joined forces by announcing an all-stock, $1.2 billion merger -- pooling their resources to curb a six-year decline caused by the rise of e-commerce and wholesale retailers. The merger is a sign of the times, as big box retailers, which suffer from the high costs of maintaining large brick and mortar businesses, struggle to stay relevant in today’s market. So the question is simple -- does combining two losers make a winner, or just a bigger, fatter loser?

A tale of two losers

During the fourth quarter, both Office Depot and OfficeMax reported poor top and bottom line results. Office Depot posted a loss of 6 cents per share, or $17.5 million, while OfficeMax lost 39 cents per share, or $33.4 million.

Office Depot’s revenue declined 12% year-on-year to $2.62 million, while OfficeMax’s revenue slid 7% to $1.7 billion.

These bleak earnings are just a continuation of a downward trend that started during the recession. Let’s look at how the three main big box office supply retailers have fared against Amazon (NASDAQ: AMZN), Wal-Mart (NYSE: WMT) and Costco (NASDAQ: COST), which respectively represent the industry’s three largest threats -- e-commerce, discount and wholesale.

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OMX Revenue TTM data by YCharts

Although Staples appears to have escaped the dire fate of OfficeMax and Office Depot, its revenue is still steadily declining -- just not as quickly.

Big, bright showrooms

Increased Internet penetration over the past decade and the rising adoption of smartphones has turned many big box retailers into showrooms. Customers visit their stores to test out products before comparing prices online, often opting to purchase them from a cheaper e-commerce site, such as Amazon or eBay, instead.

Software such as barcode scanners have also simplified this process considerably, offering instant price comparisons. Therefore, big box retailers have completely lost pricing power, and are forced to absorb extra overhead costs such as real estate, inventory and utilities, which can no longer be passed on to the customer.

Cheap, cheaper, the cheapest

While e-commerce sites are squeezing OfficeMax and Office Depot on one side, wholesale retailers such as Costco and Wal-Mart’s Sam’s Club crush them on the other. Costco and Sam’s Club are able to sell office products at steep discounts and in bulk, which is much more appealing for cost-conscious businesses. They are also able to sell at paper-thin margins, undercutting both OfficeMax and Office Depot, because much of their revenue is generated from paid memberships. Even without a Sam’s Club membership, Wal-Mart’s namesake stores are often able to offer lower prices on office supplies, by simply taking losses in certain departments (the loss leader strategy) to drive up sales volume.

Therefore, OfficeMax and Office Depot are being smashed in both the individual consumer and business markets -- which leaves it with very few options. The office supply retailer industry is still worth an estimated $21.2 billion. But the question is how much of that industry -- that OfficeMax and Office Depot helped pioneer -- hasn’t already been gobbled up by e-commerce, discount or wholesale retailers?

The Foolish fundamentals

To understand if OfficeMax and Office Depot have any chance to succeed as a combined company, we should first examine their basic stock fundamentals and compare them to Staples, Amazon, Costco and Wal-Mart.

<table> <tbody> <tr> <td> </td> <td><strong>Forward P/E</strong></td> <td><strong>5-year PEG</strong></td> <td><strong>Price to Sales (ttm)</strong></td> <td><strong>Debt to Equity</strong></td> <td><strong>Return on Equity (ttm)</strong></td> <td><strong>Profit Margin</strong></td> </tr> <tr> <td><strong>OfficeMax</strong></td> <td>14.39</td> <td>1.23</td> <td>0.16</td> <td>89.87</td> <td>51.55%</td> <td>6.43%</td> </tr> <tr> <td><strong>Office Depot</strong></td> <td>46.44</td> <td>25.10</td> <td>0.13</td> <td>63.11</td> <td>-4.57%</td> <td>-0.45%</td> </tr> <tr> <td><strong>Staples</strong></td> <td>9.58</td> <td>2.64</td> <td>0.40</td> <td>26.89</td> <td>0.44%</td> <td>-0.22%</td> </tr> <tr> <td><strong>Amazon</strong></td> <td>74.21</td> <td>4.45</td> <td>2.01</td> <td>53.53</td> <td>-0.49%</td> <td>-0.06%</td> </tr> <tr> <td><strong>Costco</strong></td> <td>20.14</td> <td>1.73</td> <td>0.44</td> <td>10.75</td> <td>14.72%</td> <td>1.78%</td> </tr> <tr> <td><strong>Wal-Mart</strong></td> <td>12.89</td> <td>1.51</td> <td>0.50</td> <td>73.22</td> <td>22.96%</td> <td>3.57%</td> </tr> <tr> <td><em>Advantage</em></td> <td>Staples</td> <td>OfficeMax</td> <td>Office Depot</td> <td>Costco</td> <td>OfficeMax</td> <td>OfficeMax</td> </tr> </tbody> </table>

Source: Yahoo Finance, Feb. 21

Fundamentally, the big box office retailers aren’t faring too badly against these other competitors. However, as I stated earlier, its competitors have different methods of staying ahead of the game, by either shifting around their loss leaders or using membership costs to generate revenue in lieu of actual sales.

On that note, we should look at their EBITDA growth over the past five years for a better perspective.

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OMX EBITDA TTM data by YCharts

Therein lies the source of pain for OfficeMax and Office Depot shareholders -- terrible declines in its bottom line due to increased competition and the total loss of pricing power.

Everyone’s favorite buzzword: "Synergies"

After the merger is approved, OfficeMax shareholders will receive 2.69 shares of Office Depot stock, which values the deal at $13.50, a tame premium to its previous closing price of $13. The deal is expected to close by the end of fiscal 2013.

OfficeMax claims that the merger will result in $400 million to $600 million in cost-saving synergies, which is to be expected since both companies share similar business models with a lot of overlapping segments. A shared inventory and shipping network should also alleviate some overhead pressure.

The new company, which has yet to be named, will pull ahead of Staples as the largest office supply retailer in the United States. Staples currently controls 35% of the market, while Office Depot holds 26.1% and OfficeMax trails at 15.6%.

The antitrust paper shredder

Although most shareholders expect the merger to complete, antitrust hurdles may trip up the company’s ambitions. Back in 1997, Staples attempted to buy Office Depot, but was stopped by the Federal Trade Commission, which claimed that the combined company would have an unfair advantage in the market.

Considering that the combined company will control 51.6% of the office retailer market, the government could still step in and put this deal through the paper shredder.

The Foolish bottom line

Investors shouldn’t get excited about the OfficeMax and Office Depot merger. Actually, I think they should avoid shares of either company -- or the new one -- altogether. A lack of pricing power, high overhead brick and mortar costs, and declining top and bottom line growth are all stacked up against this company. Pressure from both e-commerce and wholesale retailers will eventually crush whatever is left of its market.

While big box retailers were all the rage in the 1990s, they aren't any more. Investing in e-commerce or wholesale retailers would be a much smarter move in today's market.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends and Costco Wholesale. The Motley Fool owns shares of, Costco Wholesale, and Staples. You can follow Leo Sun on Twitter at for more investing ideas. 

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