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Market Update

Office Depot Has Potential, but Faces Stiff Headwinds

Office Depot's poor fourth-quarter results show that the company continues to struggle against the immense structural headwinds facing the office superstores.

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 Office Depot's (ODP) poor fourth-quarter results show that the company continues to struggle against the immense structural headwinds facing the office superstores. The OfficeMax merger did drive a 33% increase in the quarter’s top line (to $3.5 billion), but sales at Office Depot continued to weaken (down 2.9%), due to soft North American Retail (down 4.0%), Business Solutions (down 1.7%), and international (down 4.6%) divisions. Sales at Max were not fully captured since the merger was not completed until Nov. 5, but we believe Max was also hard hit by the same headwinds. The cost deleverage offset the ongoing cost-savings programs, as the adjusted operating margin fell 80 basis points to 0.2%. Looking forward, management expects that sales will once again decline in 2014, but still guided toward at least $140 million in adjusted operating income, due to approximately $170 million in anticipated merger synergies.

We will update our model to reflect the first consolidated financial statements of the Office Depot-Max combination, and anticipate a moderate decrease to our $5 fair value estimate, as both the quarter’s sales and profits came in well below our estimates. From our perspective, there is upside potential to the company’s profits as management continues to guide toward more than $600 million of potential synergy gains within three years of the merger (not including potential savings from the rationalization of the store-base), which we view as reasonable. However, there remains a great deal of uncertainty in any profit projections and we still do not view shares as attractively priced, since no office supply superstore (including both  Staples (SPLS) and Office Depot) benefits from an economic moat, in our view, as both companies remain vulnerable to significant structural headwinds from the secular decline of traditional office supplies, increased competition from non-traditional office players, and general cyclicality that could accelerate these structural threats.

Liang Feng does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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