Office Depot Shares Are Cheap With Or Without The Merger

| About: Office Depot (ODP)
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Summary

On February 4, 2015, Staples entered into a merger agreement with Office Depot which both companies' Board of Directors approved.

On December 7, 2015, the US Federal Trade Commission informed both companies that it intended to block the merger. The companies decided to contest FTC's decision.

US District Judge Emmet Sullivan must now decide whether to issue a preliminary injunction to block the merger. The deal will likely be terminated if the FTC wins the order.

In his delightful book "Zero to One," Peter Thiel argues that monopolists lie to protect their monopolies. They do not want to bring attention to their power in the marketplace. Non-monopolists, he argues, tell the opposite lie. They define their market narrowly. In this article, I first argue that the FTC need not fear monopolistic power of the combined Office Depot (NYSE:ODP) and Staples (NASDAQ:SPLS). Second, I argue that with or without the merger, Office Depot is a good investment at the current trading prices.

Background

In 1997, Office Depot and Staples attempted to merge. Back then the office supplies business was dominated by the two companies plus a third company, Office Max. The Federal Trade Commission successfully argued that the merger violated antitrust laws and it was able to block the merger.

In 2013, Office Depot and Office Max merged in an all-stock deal. The FTC unanimously voted to clear the transaction at that time. The FTC stated the "explosive growth of online commerce" has had a major impact on the office products market. The FTC stated: "Altogether, the overwhelming evidence supports the conclusion that OSS today face significant competition and demonstrates that the proposed merger is unlikely to substantially lessen competition in the retail sale of consumable office supplies." FTC then concluded:

"Analyzing the likely competitive effects of a proposed transaction is always a factspecific exercise that must take into account the evolving nature of markets. Our decision highlights that yesterday's market dynamics may be very different from the market dynamics of today. In this case, significant developments in the market for consumable office supplies have led us to approve a merger when we had blocked a similar merger sixteen years ago. In so finding, we emphasize that our decision, including our view of the competitive interaction between brick-and-mortar retailers and Internet sellers, is limited to the facts before us in this particular matter."

On February 4, 2015, Staples entered into a merger agreement with Office Depot which both companies' Board of Directors approved. According to the merger terms, ODP shareholders were to receive $7.25 in cash and 0.2188 of a share in Staples. On December 7, 2015, the FTC sued to block the deal and on the same day, the two companies decided to contest the FTC's decision. The FTC argued in February of 2016 that large B-to-B customers only have two choices for office supplies. Office Depot and Staples each considers the other their main competitor hence the proposed merger would eliminate competition. The FTC argued for a preliminary injunction to stop the merger. Staples has said that it will walk away from the deal if the judge grants the FTC's request for a preliminary injunction. US District Judge Emmet Sullivan is expected to give a final ruling by May 10th. Seeking Alpha writer Tim Worstall wrote an excellent article as to why the FTC should reverse itself. The FTC and the two companies have been unable to reach a compromise, so now the deal is in the hands of the judge.

I do not think that the merger of the companies will pose major anti-competitive risks. The merged companies will have a combined market capitalization of less than $12 billion and revenues of less than $40 billion. Amazon, by contrast, has a market capitalization of about $300 billion and revenues of about $100 billion. The two companies may wish they had monopolistic powers. If they had so much power over their customers then why are they struggling? Monopolies have pricing power and hence are very profitable. ODP and SPLS each has a return of equity of less than 1%. Other monopolies (although as Peter Thiel would say these companies would never admit that they have monopolistic powers) like IBM (NYSE:IBM), Apple (NASDAQ:AAPL) and Google (GOOG, GOOGL) have ROE of 101%, 25% and 42%, respectively.

Of course the companies' customers prefer that the merger does not proceed. Companies prefer weak vendors which allow them to negotiate for lower prices. An official for McDonald's (NYSE:MCD) testified for the FTC in the ODP/SPLS case. It is unfair to place too much weight on the companies' customers' testimony. The only instance when a customer may testify for their vendor is when the vendor is so weak that they may be eliminated from the marketplace altogether. Requesting testimony from a competitor is even more unfair. Amazon, the likely up and coming competitor to the companies, also testified in the trial. Ironically if the FTC prevails, they will hand a victory to Amazon (NASDAQ:AMZN), one of the most formidable monopolies in the market. The government will end up aiding a monopolist, if the judge grants an injunction against these two companies.

Office Depot Shareholders will win either way

I do not know how the judge will rule. There are plenty of signs that he will vote against the FTC's request and plenty that point the other way. However, Office Depot shareholders will be rewarded no matter what the ruling. If the companies prevail in court and the merger proceeds, then according to current stock price of Staples, ODP shares will be worth almost $10. It is currently trading for around $6.30. That is over a 50% return in a matter of a few months.

What if the FTC wins? Office Depot shareholders will still do well for the following four reasons:

First, Office Depot will receive $250 million as a breakup fee from Staples. That is approximately 50 cents a share. It amounts to roughly 8% of the company's current market capitalization.

Second, the uncertainty of the merger deal will be removed. The market punishes uncertainty. For example, Sysco's (NYSE:SYY) stock price was stagnant during its struggles to acquire US Foods. It finally capitulated and terminated its merger agreement with US Foods on June 29, 2015. Its stock price has since reached a ten-year high.

Third, Office Depot's integration with office Max is proceeding well and the company's results are improving. The company was barely profitable in 2015. They earned one penny per share, but these results should improve once the merger distraction goes away.

Fourth, the risk of arbitrage in mergers and acquisitions is that the stock price will revert to what it was prior to the merger agreement. What was ODP's price prior to the announcement on February 4, 2015? On February 2, 2015, the stock closed at$7.63. That means the market valued it about $1.30 more than it does currently. Since then their results have improved. The main reason the stock price has declined in a flat overall market has been the uncertainty around the merger agreement.

Risks

The merger is necessary to have a viable competitor to Amazon. With or without the merger, these two companies face a very difficult economic environment. Amazon is a formidable competitor that will likely cause them lots of pain. The long-term future is not bright. Their contracts with large businesses are profitable, but they hardly have a moat and pricing power in this segment. Their brick and mortar stores are shrinking and face tremendous headwinds. Although I am bullish in the short term, I would not sign on to investing in these companies for a long period of time. They do not have the powers of a monopolist, which is precisely why the FTC should not have challenged their merger.

Disclosure: I am/we are long ODP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.