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OfficeMax-Office Depot Merger No Panacea

Wed, 20 Feb 2013

Although the two office-supplies companies could realize meaningful cost synergies, the combined firm would still face enormous competitive pressures, says Morningstar's Liang Feng.

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Video Transcript

Editor's note: Since the taping of this video, OfficeMax and Office Depot officially announced a definitive merger agreement.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. News reports were out this week that OfficeMax and Office Depot were considering a merger. I'm here with Liang Feng, an analyst at Morningstar, to see if this merger would make sense and what it could mean for the industry.

Liang, thanks for joining me today.

Liang Feng: Thanks for having me today.

Glaser: So, let's start just a little bit about why a merger like this would make sense. Is building a lot of scale in this space something that could be beneficial for these two firms?

Feng: So both OfficeMax and Office Depot have notably underperformed their larger industry peer Staples over the past few years. Staples has been earning operating margins around 6%-7% compared with OfficeMax and Office Depot, which are reporting operating margins of less than 2%. What we've seen happen is that these two companies have relatively high cost structures and were less prepared to deal with the drop in office-supplies spending after the recession, and they're just struggling to earn any economic profits at the time.

So a potential merger, where they could leverage some of their corporate expenses, advertising expenses, and salesforce expenses, could potentially bring about some synergies that could allow them to increase investments in their salesforces and other productivity initiatives.

Glaser: What would the combined company look like? Would it rival Staples for profitability?

Feng: This is one of the interesting points. OfficeMax and Office Depot would have about 2,000 stores, and this compares with about 1,900 stores for Staples, which includes the U.S. and Canada, but excludes other international locations. Even though [the combined company] would directly have a larger store base, they are also generating about 70% as much revenue as Staples, and that just speaks to how much more productive Staples is in both the contract and the retail division. Retail, we estimate that Staples' sales per square foot is about 25%-30% higher than both OfficeMax and Office Depot. And even if these companies can realize substantial cost synergies, these companies might not be able to generate the same returns as Staples is currently doing.

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Glaser: If we look at that competitive advantage, over time, what would your outlook be for a combined company? It sounds like it's not going to turn into a behemoth or a wide-moat company overnight.

Feng: We've actually have assigned no moat rating and a negative moat trend for all these industry players because we believe over the long run, they'll face increased competition from nontraditional office distributors, such as the Amazon, Costco, Wal-Mart, and they're also struggling with a secular decline of traditional office products. Some of their most profitable categories are papers, pens, and ink, which as you can imagine given the increasing digitization of our world, have been declining. But both OfficeMax and Office Depot are in very poor competitive positions right now, and this might not elevate them to a moat, but it could potentially give them some more leeway, though we still remain negative on the long-term competitive dynamics of the office-supplies superstores in general, regardless of whether the merger would actually be completed.

Glaser: It sounds like that even if this merger does go through, it's not a slam-dunk even if it might help a little bit. What should current shareholders do? How should they think about their holdings in these firms right now?

Feng: We think that shares across the sector look kind of pricey because they're already incorporating some benefits from the merger. Again, we remain very cautious about the long-term dynamics of these office-supplies superstores. They are not only going to face increased competition from nontraditional office distributors that operate on lower cost structures, they are seeing demand decline in some of their most profitable categories. Even if the merger goes through, we don't think they'll be able to earn excess economic returns.

It's hard to estimate exactly how much in cost synergies OfficeMax and Office Depot can realize. Our initial estimates suggest that it could yield more than $400 million in cost savings. The problem is that it would require strong execution on management's part. It would also require that structural headwinds don't accelerate from the current levels, and that's a perfectly possible scenario. It also implies that if another major economic recession or downturn occurs, one thing that could happen is that after the last financial recession we saw office-supplies spending just drop dramatically, and another drop could be very damaging to what's already a relatively shaky competitive position for both OfficeMax and Office Depot.

Glaser: Liang thanks so much for your thoughts on this today.

Feng: No problem. Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.

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