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By Joscelyn MacKay

We had thought the five-year strategic plan that OfficeMax (NYSE:OMX) issued in March 2010 was reasonable, but the firm has since failed to achieve revenue growth and meaningful margin expansion. Now management has presented an updated strategy to address the company's challenges. While OfficeMax has outlined a plan to reach multiyear sales growth and margin goals, we remain skeptical that it can overcome industry headwinds and compete effectively with leader Staples (NASDAQ:SPLS) and nontraditional competitors like Wal-Mart (NYSE:WMT) and Amazon (NASDAQ:AMZN). OfficeMax's new strategy does not strike us as being meaningfully different than the prior plan, and we view the shares of this no-moat firm as overvalued.

OfficeMax has taken steps to address lagging sales and profits the past several years. First the firm reorganized and streamlined management, which should improve the decision-making process. Next it enhanced its contract website by refining pricing, automating its salesforce, and upgrading its call centers in order to differentiate from Staples (which is the number-two online shopping site behind Amazon). However, OfficeMax hasn't reported an increase in net sales since 2007, and its adjusted operating margin remains well below that of Staples.

In our opinion, margins and customer stickiness are two critical factors. While gross margins are decent, operating margins are still weak. The overall operating cost structure remains bloated and needs to be addressed, in our view. While management's plan of continued store closures will help, we believe more action needs to be taken on a company-wide level. We appreciate the need for further investments in business process improvements, but first the firm needs to reverse its market share losses and drive sales.

Customer stickiness is also a challenge. OfficeMax has found that its share of the customer wallet is well below the industry average--only one third of customers who shop the store actually make most of their purchases there. While office product distributors sell largely commodified products and customers are primarily driven by price, we contend that Staples also operates better stores, with convenient locations, customer service, and updated layouts that drive store traffic.

'New' Strategic Plan Offers Few Revelations
Management has laid out a strategy to drive top-line growth and manage costs that is not much different from the previous long-range plan, in our view. While a rough economic patch has plagued the firm (and rivals) over the past few years, we believe OfficeMax's competitive position has deteriorated and it will take more than a dressed-up plan from 2009 to stem top-line declines and margin erosion.

OfficeMax's goal is to stop the revenue declines in 2012 (it projects flat year-over-year sales or a slight increase) and increase sales at a 2%-4% compound annual rate for the following three years. Longer term, management targets annual revenue growth of 4%-5%. It expects 2012 operating margins to be flat with 2011 and cumulative expansion of 100-200 basis points for the three years after. Importantly, the company's updated plan doesn't hinge on an economic recovery; its base case assumes only modest GDP growth in 2012-15 and continued high unemployment (but no double-dip recession). As the macro environment normalizes, management believes that annual operating margin improvement of 25-50 basis points--implying operating margins of 2.5%-3.5%--and double-digit returns on invested capital are achievable.

OfficeMax intends to reach its financial goals through four pillars: (1) optimize retail space through closures and by using a smaller store format; (2) leverage existing global contracts instead of expanding internationally; (3) target new segments such as janitorial and breakroom supplies and increase customer penetration in small and midsize businesses; and (4) build the digital business via continuous investment, focusing on improving the search function and content and assortment available online.

However, we harbor reservations. We believe OfficeMax faces several obstacles, and we are skeptical of its ability to comprehensively address them. Key structural headwinds include retail saturation, the difficulty of brand differentiation in a highly commodified market, and competition from nontraditional office product distributors.

While OfficeMax has been closing stores at a decent clip, we believe the implied 1% annual rate simply isn't aggressive enough. We also argue that closing stores doesn't address the underlying problem of weak customer traffic. Instead, brand strength and product and service differentiation should be at the core of OfficeMax's initiatives.

Staples outshines its competitors with consistently higher same-store sales. In this highly commodified industry, we doubt that OfficeMax will be able to differentiate itself. Branching out into new product lines is not revolutionary. Additionally, we expect OfficeMax's efforts to successfully penetrate the more profitable middle market will be stymied. Last year, Staples outlined a strategy that also included an increased focus on the middle market; over the past year, its contract segment has realized steady low-single-digit gains each quarter, while OfficeMax only recently returned to quarterly positive year-over-year growth in its contract division. We view this discrepancy in relative performance as more indicative of OfficeMax's share loss, rather than simply underlying economic weakness.

Nontraditional competitors are gaining as well. OfficeMax is up against not only Staples and its other direct competitor, Office Depot (NASDAQ:ODP), but also warehouse clubs, discounters, grocery stores, and online retailers. The commodity-like nature of office supplies has made it easy for low-cost retailers such as Wal-Mart, Costco (NASDAQ:COST), and Amazon to capture market share. Without any discernible competitive advantages, OfficeMax may be forced to match prices just to remain in the game, which could weigh on its already thin margins.

Consolidation Isn't the Answer
With roughly 4,000 outlets, the North American office product retail industry is saturated, but we don't believe consolidation makes sense. Staples is still digesting its 2008 acquisition of Corporate Express and is focused on improving margins internationally. Acquiring one of its weaker competitors outright would divert management's attention, and we believe integration would be difficult and costly. We also don't believe a combination of the two weaker players--OfficeMax and Office Depot--makes sense given the difficulty in integrating such distinct corporate cultures. A larger entity would still be a distant second to Staples.

Any direct combination among the top players would need to involve massive store closures, in our view. The only viable solution we see would be for one of the major office product distributors to acquire the contract business of another. This could work at the right price, given the limited customer overlap among the firms. However, since Staples is still posting year-over-year gains in its contract segment (as opposed to the declines at its peers), this could be a more relevant opportunity for OfficeMax and Office Depot.

Still Overvalued
Our $4 fair value estimate is unchanged. We still believe that over the next few years, OfficeMax may hold some ground and achieve modest revenue and margin gains. Over the longer term, however, we expect the firm will cede share to Staples and other office product distributors like Amazon and Wal-Mart. Toward the end of our explicit 10-year forecast, we project low-single-digit revenue declines, driven by weak sales in the retail segment (which should force OfficeMax to close stores) and further customer losses in the contract segment. We expect the firm will gradually give back recent margin gains as sales stagnate and it implements price cuts in order to remain competitive. During the next 10 years, we expect returns on invested capital to average 5.1%, compared with management's double-digit target.

Source: OfficeMax's New Strategy Isn't Exactly New