OfficeMax, OfficeDepot Merger: Synergies, Staples Big Winner

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OfficeMax, OfficeDepot Merger: Synergies, Staples Big Winner

Something may now be really happening in Office Supply as the Wall Street Journal reported yesterday that OfficeMax Incorporated (NYSE:OMX) and Office Depot Inc (NYSE:ODP) are in advanced merger discussions with a possible deal this week. The financial press has widely reported an increasing likelihood of consolidation in the Office sector. If the merger occurred – it could be very positive for an overcrowded sector. If a combination were to develop, Office Depot Inc (NYSE:ODP) and OfficeMax Incorporated (NYSE:OMX) could ultimately close as much as 25% of their combined store base, perhaps using a merger as a catalyst to incur extraordinary charges.

“Surprisingly” l the analysts out with reports today, believe that potential synergies could be dramatic. Nomura estimates buying synergies alone could represent 1.0% of the combined entity’s COGS. The two could also share advertising. Office Depot Inc (NYSE:ODP) spends $450m on advertising. OfficeMax spends $225m. Only one budget is ultimately necessary.

Corporate costs could also be eliminated over time. Corporate G&A (not allocated to segments) is ~3% of sales at Office Depot. If it is a similar amount at OfficeMax, a combined company may ultimately be able to cut up to $215m in annual costs. The ability to cut at the segment level is also possible.

Longer-term, distribution centers could be rationalized, since each company boasts a relatively national footprint. The key here would be maximizing sales per DC system-wide. At is stands today, both are flirting with break-even levels due to low productivity metrics.

Financially, the significant amount of synergies could lead to upside for both Office Depot and OfficeMax shareholders. Of course, that would depend on how (and if) a deal was ultimately structured. The key question also is how well the two companies can execute in order to realize synergy.

Staples would also be a winner in either scenario. It would stand to pick up lost sales from store closings. It would also stand to benefit from Contract sales that shake out from the merger. And, if Office Depot Inc (NYSE:ODP) or OfficeMax failed to execute well,  Staples, Inc. (NASDAQ:SPLS) could benefit more significantly.

While the terms of a potential deal are not yet knowable, the potential benefit to  Staples, Inc. (NASDAQ:SPLS) would be similar regardless of the structure and price paid. Nomura thinks that  Staples, Inc. (NASDAQ:SPLS)’ top line stands to benefit by 2% in NA Retail and Delivery for a minimum potential EPS lift of $0.10.

Analysts from Jeffries add, “a merger between ODP and OfficeMax would yield large synergies in several areas through store closings, increased purchasing power, a reduction in corporate overhead, lower advertising and other SG&A expenses as well as distribution rationalization over time. Before any of Office Depot’s current initiatives are considered, we think synergies from a deal could be about $480-580 million, but this does not take into account possible sales deleverage as the industry shrinks, so not all of this will necessarily go to the bottom line over an estimated 3-year integration period. Office Depot is also working on a 3-year plan to extract another $300 million of EBIT, but again, the effects of sales deleverage may not allow all of this to fall to the bottom line. If we give them credit for $100-150 million then you are looking at $600-700 million + in synergies.”

Antitrust concerns should be less of an issue this time around. The competitive landscape within the office products retail channel has dramatically changed since the FTC nixed the proposed 1997 merger between SPLS and Office Depot Inc (NYSE:ODP). The rise of large players in the internet retail channel and the entrance of club and mass channel to the office product market resulted in a significant increase in price transparency and competition. Recent price studies show that the office superstores have a double digit price premium to Walmart on the web and a mid-single digit premium to Amazon, before shipping costs are considered. After shipping the gap with Wal-Mart Stores, Inc. (NYSE:WMT) narrows considerably, but widens with, Inc. (NASDAQ:AMZN). Structural changes to the office products market caused by the digitization of the office have resulted in a market that cannot support three office superstore retailers. This is most evident in the lacklustre sales and margin erosion over the last several years even as labor conditions have shown some improvement.

Industry consolidation could also help Staples. Staples, Inc. (NASDAQ:SPLS) stands to benefit from a combination of Office Depot and OfficeMax Incorporated (NYSE:OMX), but the range is wide and will largely be determined by how many stores are closed in Staples markets and how many, if any, stores are sold to Staples in a transaction. With Office Depot and OfficeMax having closed numerous stores in recent years, plus a potential $1-2 million cash cost to close additional stores,

Credit Suisse analysts estimate that the value of the new OfficeMax Incorporated (NYSE:OMX) would be at least $16, reflecting 5x pro forma EBITDA of $955 million and the combined balance sheets of the two businesses.

Credit Suisse projects $441 million in net synergies, which would bring the combined EBITDA including Mexico to $989 million. Given the size of the synergy, which is roughly in line with the combined earnings of the two companies. That synergy number is highly dependent on the merged entity finding someone to take its excess locations as the cost of closing a store could be as high as $1 million and they estimate up to 600 stores will be closed or sold to SPLS. About 52% of Office Depot’s store base overlaps with an OfficeMax store (within 5 miles), so there are plenty of store closing opportunities over time.

The analysts also assume SPLS and regional contract players will take some share during the consolidation and possibly some departing salespeople from the combined entity. That said, SPLS lost nearly no volume when it merged with Corporate Express.

Why merge now?  A merger makes sense now given activist involvement at ODP, the lack of an operating head at ODP, OfficeMax’s increasing currency given its stock appreciation and OfficeMax’s Boise Cascade monetization. A fifth reason is ODP’s potential monetization of its Mexico joint venture.

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