Office Max, Office Depot merger no panacea

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

Jeremy Glaser 19 February, 2013 | 2:00PM Liang Feng



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, he's 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 it 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 to 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 supply 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 expense, advertising expense, and sales force expense, could potentially bring about some synergies that could allow them to increase investments in their sales force or other productivity initiatives.

Glaser: So 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 to about 1,900 stores for Staples, which includes the U.S. and Canada, but excludes other international locations. Even though they 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. So 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.

Glaser: So, if we look at that competitive advantage then 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 assigned no moat, negative moat trend for all these industry players, because we believe over the long run, they'll face increased competition from non-traditional office distributors, such as Amazon, Costco, Walmart, and they're also struggling with a secular decline of traditional office products; some of their most profitable categories are papers, pen and ink, which as you can imagine given the increasing digitization of our world has been declining. But these -- both OfficeMax and Office Depot are in very poor competitive position right now, and this might not elevate them to a moat, but it could potentially give them some more leeway, although we still remain negative on the long-term competitive dynamics of the office supply superstores in general, regardless of whether the acquisition or the merger actually would be completed.

Glaser: So it sounds like 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: So, we think that shares across the sector look kind of pricy because they're already incorporating some benefits from the merger. We remain very cautious about -- again we remain very cautious about the long-term dynamics of these office supply superstores. They not only are going to face increased competition from non-traditional 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.

So, it's hard to estimate exactly how much cost synergies OfficeMax and Office Depot can realize. Our initial estimates suggest that it could yield over US$400 million in cost savings. The problem is that it would require strong execution on management's part. It would also require that secular or 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 after the last financial recession we saw office supply 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.


Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating Inc1,865.60 USD-0.66
Costco Wholesale Corp304.11 USD0.36
Office Depot Inc2.58 USD4.45

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Jeremy Glaser

Jeremy Glaser  Jeremy Glaser is the Markets Editor for