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Shares of Office Depot (ODP) and OfficeMax (OMX) have witnessed a fair bit of volatility over the past trading week. On Tuesday, reports hit the news wires that a merger agreement between both firms had already been agreed upon. Later Office Depot announced the release was made pre-mature and by accident. The final confirmation of the deal took place on Wednesday.

Initially shares of both firms rallied up sharply on the news, but they have given up ground on Wednesday and Thursday. Shares of Office Depot trade with losses of 11% for the week, while shares of OfficeMax are still up some 9%.

The overall process has been very messy. The merger of equals appears to be an acquisition by Office Depot. Furthermore, there was a premature press release, uncertainty about the combination's name and location of its headquarters. At last, no CEO has been appointed yet for the combination.

The Deal

Both office suppliers announced that they have reached a merger agreement of "equals" to create an $18 billion global office solutions company.

According to the press release, the deal will create a stronger and more efficient office supplier needed to meet the growing challenges of a changing industry. Both firms have suffered from low-cost competitors and the emergence of the internet. The deal will lead to significant value creation as the combination anticipates annual synergies of $400-$600 million within three years of completion of the deal.

Under terms of the deal, shareholders of OfficeMax will receive 2.69 shares of Office Depot for each share they currently own. Based on Office Depot's closing price of $5.02 on Monday, the deal values Office Max at $13.50 per share, a $0.50 premium compared to Monday's closing price. As a result of the slide in Office Depot's share price to $3.98 by Thursday, the implicit offer value has fallen to $10.70 per share for OfficeMax. Shares of OfficeMax closed at $11.64 on Thursday.

Under terms of the deal, shareholders of Office Depot would hold a 51% stake in the combined company. Shareholders of OfficeMax will hold a 44% stake, while BC Partners would hold a 5% stake.

CEO and Chairman of Office Depot Neil Austrian commented on the deal, "In the past decade, with the growth of the internet, our industry has changed dramatically. Combining our two companies will enhance our ability to serve customers around the world, offer new opportunities for our employees, make us a more attractive partner to our vendors, and increase stockholder value. Office Depot and OfficeMax share a similar vision and culture, and will greatly benefit from drawing on the industry's most talented people, combining our best practices and realizing significant savings."

It is understandable why a merger of equals is less beneficiary for shareholders of Office Depot. Investors in Office Depot react disappointed to the deal:

First of all, Office Depot generated annual revenues of $10.7 billion for 2012, roughly 55% more than OfficeMax's $6.9 billion in revenues. Second, Office Depot holds $671 million in cash, for a net debt position of just $11 million at its fourth quarter report. OfficeMax ended its fourth quarter with $495 million in cash and equivalents, for a net debt position of roughly $475 million. Third, there is the possibility for OfficeMax to pay a one-time dividend of $1.50 per share to its shareholders, not affecting the merger-ratio.

Both CEOs will remain in their current role until a new replacement has been found. The board of directors of the combination will be comprised out of members of the current boards of both companies.

The deal is expected to close by the end of 2013 and is subject to shareholder approval of both firms, regulatory approval and normal closing conditions.

Value Creation

The deal has the potential to create more value to shareholders. The combined market valuation of both firms is approximately $2.2 billion at the moment of writing.

On a pro-forma basis the combination generated revenues of $17.6 billion for the full year of 2012. Office Depot lost $110 million during the year, while earnings for OfficeMax excluding one-time items came in approximately around zero.

As a result of the merger, both firms expect to incur between $350 and $450 million in one-time costs, excluding a $200 million extra capital investment. Annual synergies of $400-$600 million could boost earnings in 2014 and beyond.

It is fair to say that the present value of estimated synergies might equal or exceed the current market capitalization of the combination. The financial position is sound with a net debt position of roughly $0.5 billion and plenty of liquidity.

While all the mathematics seems sound, shareholders are not convinced yet. If the combination manages to generate $500 million in annual synergies for 2014, the bottom line might see a boost of approximately $350 million. As such the combination could report profits of $200-$300 million per year, less than 10 times the current valuation.

The problem is not the credibility of the estimated synergies, rather the continued strategic problems. Office Depot continues to lose business to internet gains such as Amazon.com (AMZN) and brick-and-mortar retailers including Wal-Mart (WMT), Costco (COST) and Target (TGT). On top of that is obviously the fierce direct competition with its larger competitor Staples (SPLS) in a declining office supplies market.

Investment Thesis

Both firms have seen a great share price run up over the past year. Shares of OfficeMax rose from lows of $4 during summer to levels around $12 at the moment. Share of Office Depot rose from $1.5 in August to $4 at the moment. As such, the combined market valuation has already increased from $700 million to $2.2 billion at the moment. The combination's valuation even temporarily peaked around $3 billion on Wednesday after the announcement of the deal.

With annual synergies estimated at $500 million per annum, the present value of synergies could be estimated around $5 billion. Given that the market "only" values the combination at $2.2 billion at the moment, it sends a clear signal about the credibility of the future business.

While the deal might look good on paper, it appears to have occurred in a great hurry given the large confusion that took place. Furthermore the integration of the deal will massively distort management from their real challenge, getting a grip on the internet and formulate a credible online strategy.

As such the deal might even turn out negative. Most likely the revenue base and value of the combination will continue to deteriorate. Given the low absolute value, shares are not an obvious short, but for those thinking shares are a no-brainer based on synergy estimates, think again!

Source: Office Depot Deal With OfficeMax Is Not A No-Brainer