The proposed merger of OfficeMax (OMX) with Office Depot (ODP) has created quite the buzz making me wonder what is so exciting about Office Depot's future prospects (post-merger) in the highly competitive office supplies retailing market. The merger is awaiting the Federal Trade Commission's approval, which I expect should come late this year. Since the merger won't pose any threat to the competitive nature of the office supplies retailing market in the U.S., unlike the 1997 proposed merger of Office Depot with Staples (SPLS), I am optimistic about the approval. In 1997, the Staples and Office Depot proposed merger was rejected as they were the No.1 and No.2 players respectively in the office supplies market in the U.S. Therefore, it was highly probable the merger could have exploited the U.S. office supplies market by adopting abusive pricing. However, the office supplies retailing market has changed and consumers now have multiple options to buy office products, making it a perfect competitive market. Further, the office supplies retailing market is becoming highly competitive and the number of players in the market is increasing, which may be the reason the shareholders of Office Depot approved the merger through a special resolution.
Before getting into the terms and effects of the merger, let's look at the competition that prevails in the market where Office Depot operates. The company competes with stationers, superstores, merchandisers such as Walmart (WMT) and Target (TGT), direct mail distributors, and last but not the least the online retailing giants such as Amazon (AMZN). One other important factor behind the merger has to be the threat the company was facing in customers to online retailers. Though one can argue that even Office Depot sells its products via an online retailing chain, the reality is the online retailing giants in the U.S. have taken over the office supplies market. Under such circumstances, will it be possible for Office Depot to grow its customer base? Currently this question remains unanswered but with the merger going through I believe it can be answered.
Effects of the merger
The deal will be a stock-for-stock transaction and will require an issue of 2.69 shares of Office Depot for every one share of OfficeMax. By the end of 2013, OfficeMax will have 87 million basic shares outstanding, which will lead to an issue of approximately 234 million shares of Office Depot. This will amount to 520 million basic shares outstanding of Office Depot by the end of 2013 (assuming no further share issue or share buyback initiated in the remainder of 2013).
For the past three years, the company's top line hasn't experienced any growth, remaining flat at almost $11 billion annually, which I believe is due to losing market growth opportunities to the online retailing giants. On the other hand, the company's operating expenses are rising consistently, which led it to report an operating loss of $30,841 in 2012. I believe the company's top line will not highlight any immediate effects from the merger, but there will surely be cost synergies flowing from the merger, which can exceed $500 million annually. These cost synergies will mostly be in the form of improving vendor terms (supply chain), reducing advertisement expenditure, and closing out loss making stores.
Savings in different areas
· Post-merger, Office Depot will gain access to OfficeMax's supply chain, which when integrated with its own existing supply chain will bring about a reduction in the cost of goods sold, or COGS. Generally, companies experience an improvement in COGS margins, which ranges between 1 percent and 3 percent. Last year, Office Depot's COGS was almost 70% of its revenue, which post-merger will come down by at least one percent (taking the lower end of the reduction). This reduction in the COGS will bring savings of $186.11 million.
Amounts (in USD million)
Revenue in 2012
COGS (70% of revenue)
Estimated combined revenue
Reduction in COGS (1% of revenue)
· Moving further, last year Office Depot reported an advertising expenditure of $396 million, which was 3.7% of revenue, as compared to the industry average of 2.2% during the same period. Following the merger, the advertising expenditure should decrease due to better availability of infrastructure to reach the consumer. If the company reaches to the industry average of 2.2%, it can bring about a savings of $279 million.
= (18611.11*.037) - (18611.11*.022)
= 279 USD million.
· Additionally, there is a substantial opportunity to maximize Office Depot's retail footprint. Office Depot's announcement to close down stores that are too old or big and are duplicative of each other seems to be on the right track. As many as 500 store leases, representing nearly 45% of the company's North American stores, are coming up for renewal in the next three years. I expect there will be a substantial reduction in the company's square footage and occupancy, which will bring about cost synergies of approximately $50 million.
Moving out of the Mexican joint venture
As a restructuring effort, on July 9, 2013, Office Depot announced the closure of its joint venture in Office Depot de Mexico with Grupo Gigante, in which it held a 50% stake. Office Depot sold its entire stake in the joint venture, which yielded it after tax cash proceeds of $550 million. It will use the cash proceeds to redeem 50% of Office Depot's convertible preferred shares, which will require approximately $218 million, and to redeem 6.25% bonds due in August 2013, which will require $150 million. It will use the remaining amount for restructuring costs and for general business purposes.
How will this sale affect Office Depot's financial statements?
Last year, Office Depot de Mexico reported profit before taxes, or PBT, of $60 million, of which 50%, that is $30 million, was attributable to Office Depot. Taking the sale into consideration, Office Depot's PBT per share will decrease by approximately $0.10 (calculated on 286 million basic shares outstanding). On the other hand, due to the redemption of preference shares and 6.25% bonds, Office Depot will save $29 million. So, on a net basis the reduction in the interest payment and the preference dividend payment will negate the decrease in Office Depot's PBT.
Additionally, Office Depot accounted for this joint venture under the equity method, in which it showed the income from this joint venture under the head "Miscellaneous Income," in the income and expenditure account and the fair value of the investment under the head "Investments" in the balance sheet. So watch out for a reduction in these areas in the company's financial statement in the current year, which should not be a matter of concern for investors.
Stock price movement
ODP data by YCharts
When the announcement regarding the merger of OfficeMax came earlier this year, Office Depot's stock price shot up sharply and reached $5.00 (look at the chart above in between February and March), but since then it has shown some volatility and has traded in a range bound between $3.5-$4.4. Seeing this, I consider Office Depot's stock to be an event driven stock. Moving further in 2013, I don't see any major event, which can drive the stock price higher. However, investors should remain aware that Office Depot's stock can rise up sharply again when it receives FTC approval later this year. This will be a short-term phenomenon as the synergies that Office Depot will derive from the merger have already been discounted in the share price.
I do not see any major improvement in Office Depot's top line immediately post-merger. If you combine the revenue generated by OfficeMax and Office Depot in 2012, it amounts to $17.65 billion. And, I don't anticipate it to rise beyond $18 billion following the merger.
On the other side, I believe there can be cost synergies of more than $500 million on an annual basis, post-merger, but this shouldn't persuade investors to jump on the stocks immediately. The investors should wait for further guidance on synergies.
Additionally, the sale of a 50% stake by Office Depot in Office Depot de Mexico will not have any major effect on the company's financial statements in 2013. The decrease in the interest and the preference dividend payment will offset the decrease in the net income due to the stake sale. Therefore, finalizing the sale didn't have any major effect on the company's stock price
I do not see any major event, which can drive Office Depot's stock price higher from the current levels of $4.31. Though, it may experience some strong volatility with the announcement of second-quarter earnings on July 30. Therefore, I recommend the investors "hold" the stock.