Shaking Up the Office Supply Space

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

Through a merger announcement that surprised virtually nobody, Office Depot (NYSE: ODP) agreed to buy OfficeMax (NYSE: OMX) for roughly $1.2 billion on Feb. 20.  The two companies, along with industry leader Staples (NASDAQ: SPLS), control the office supply store sector.  However, the mass merchandisers and online merchants, like Costco and Amazon (NASDAQ: AMZN), have been using their purchasing power and free shipping offers to eliminate the superstores’ profit margins.  While the Feds broke up a potential industry merger years ago, this one looks pretty solid.  So, which companies are winners in this shake-up?

Office Depot

The #2 chain finally made its big move, after receiving unrelenting pressure from its institutional shareholder base over the past year.  The company has over 1,100 domestic stores, as well as a smaller international segment that sells products in 59 countries.  Office Depot also offers printing, mailing, and tech support services in select stores through its Copy and Print Depot unit.

The past five years have been tough for the company, with declining revenues, store closings, and marginal profitability.  In FY2012, Office Depot’s results remained true to form, with declines in revenues and adjusted operating income of 6.9% and 11.4%, respectively, versus the prior year.  The company’s results were hurt by a 5% decline in domestic comparable store sales, as well as relative weakness in its international division.

On the upside, Office Depot’s gross margin has benefited from less promotional activity and lower occupancy expenses in its smaller store formats.  The merger with OfficeMax should also improve Office Depot’s financial profile, given OfficeMax’s strong net cash and investment holdings.  Management expects $400 million to $600 million in operating synergies from the merger, with the combined company’s $18 billion in sales vaulting it into the industry leadership position.

Staples

The #1 chain is roughly the size of its two nearest competitors combined and it should benefit from the removal of a major industry player.  Staples has similarly suffered from a lack of sales growth, with notable weakness in its European and Australian markets.  In response, the company has closed select stores and initiated the sales process for its European printer systems division.

In FY2012, Staples reported generally weak results that led to a poor performance for its stock price.  For the year, the company reported decreases in revenues and adjusted operating income of 2.6% and 9.6%, respectively, compared to the prior year.  Its international operations were especially weak, with a 12% decline in sales, due to Staples’ significant presence in Europe gained through its 2008 purchase of Corporate Express.  However, the company has the highest operating margin in the industry, which should be further enhanced by its restructuring activities and its focus on contract business.

Amazon

The electronic commerce giant changes the dynamic in every sector that it enters, including online marketplaces, publishing, video streaming, and web hosting services.  Founded in 1995, Amazon’s mission is to provide the world’s greatest selection of merchandise at the lowest prices through easy to use websites.  Unfortunately for the office supply superstores, Amazon’s product mix increasingly includes office supplies.

In FY2012, the company continued to grow at a solid pace, with a 27.1% increase in total revenues.  Despite economic headwinds in various international markets, Amazon’s international segment grew 23% and came close to accounting for half of the company’s total sales.  However, Amazon’s operating income declined again due to the high technology and personnel costs of building leading positions in so many segments.

Amazon’s goal is fund investments that will create long-term, sustainable growth in its free cash flow.  For years, the company has foregone near-term operating profits in the hopes of creating an online business with massive scale and massive profitability.  While management’s investment activities have pushed Amazon’s operating profits into future years, investors believe the story and have bid the shares up over 200% in the past five years.

The bottom line

The OfficeMax/Office Depot tie-up should improve the surviving competitors’ profitability, but it is unlikely to change the underlying sales trends.  While the office supply superstores previously offered unbeatable selections, online merchants now offer virtually unlimited merchandise.  The superstores likely need to continue downsizing their retail store bases and focus on their higher margin business and government distribution channels.  As for investors that want to play in the retail office supply space, they need to stick with the e-commerce king, Amazon.


rghanley owns shares of Officemax and Amazon. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com 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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