When two companies merge to take on a market leader, the big kid on the block often suffers.
Yet Staples Inc. may get stronger -- at least for a while - - if Office Depot Inc. (ODP:US) and OfficeMax Inc. (OMX:US) get married as planned. The companies, respectively the second- and third-largest U.S. office-supply chains after Staples, agreed to combine in a stock swap today that values OfficeMax at $1.17 billion. David Balto, an antitrust attorney in Washington, has said the deal may be challenged by the Federal Trade Commission.
While the combination has the potential to extract cost savings and make the chains stronger, Staples, already widely considered a better-managed operator, is poised to grab market share in parts of the U.S. where it has lagged behind.
“Normally, you would expect the No. 1 player to take a hit, but I don’t think that happens,” Brian Yarbrough, an analyst for Edward Jones & Co. in St. Louis, said in an interview. “Staples will definitely be a winner here.”
Staples, which Mitt Romney’s Bain Capital LLC helped take public more than two decades ago, surged (SPLS:US) 13 percent to $14.65 yesterday in New York. It was the largest increase since October 2008. Still, those gains may be ephemeral because Staples faces increasing competition from the likes of Amazon.com Inc. as Americans increasingly shun big-box stores for the convenience of the Web.
Office Depot will issue 2.69 new shares for each outstanding OfficeMax common share, according to a statement today. That’s equal to $13.50 a share, based on yesterday’s closing price, a premium of about 26 percent to Feb. 15 before reports the companies were in talks to continue.
Office Depot and OfficeMax surged yesterday after Bloomberg News reported that a deal could be completed this week. Revenue has been declining at both chains, and they’ve both been cutting costs to goose profits.
The question for all of the office-supply chains -- including Staples -- is whether they can surmount the long-term challenges. Gary Balter, an analyst for Credit Suisse AG in New York, rates Staples outperform, the equivalent of a buy. Still, he acknowledges that “the argument against this sector is that people are using less paper, everything is going online, and you just don’t need these guys as much.”
Since the financial crisis, the U.S. retail industry has struggled under the weight of too many stores left over from the boom years, when chains expanded pell-mell. Some categories consolidated and the likes of Borders Group Inc., Linens ’n Things Inc. and Circuit City Stores Inc. folded. Yet the office-supplies category continued to support three chains long after the economic rationale evaporated. Office Depot and Staples proposed a merger almost 16 years ago, until it was stopped by regulators.
An Office Depot and OfficeMax merger would push consolidation into overdrive, leading to as many as 600 store closings, Balter said. That’s the size of some national retail chains and bigger than Borders, the bookseller, when it liquidated in 2011. Daniel Binder, an analyst for Jefferies & Co., said in a research note that 52 percent of Office Depot’s and OfficeMax’s stores in the U.S. are within five miles of each other, offering plenty of opportunities to cut locations.
The closings would create a vacuum that Staples could fill with little effort, according to Balter. The company is well situated to increase sales in such markets as Miami, Houston and Denver, where it has fewer stores than its rivals, he said.
Staples sells more paper, envelopes and printer cartridges to businesses and government than it does in its stores. In the 12 months through October, the so-called contract segment (SPLS:US) generated $10.1 billion, compared with $9.6 billion at retail. Here, too, an Office Depot-OfficeMax combination might help Staples as it wins contracts from customers worried about the newly merged company’s future. Staples also could hire experienced sales representatives let go in the merger.
“It’s the contract side where the upside is,” said Balter. “That’s where the real profits are in this business. That business is more protected, while retail is under pressure from Amazon, discounters and over-storing.”
Even with an OfficeMax and Office Depot merger, Staples’s more than $24 billion in sales would eclipse their combined $18 billion. Staples also would retain a strong hold on the lucrative market in the U.S. Northeast dating back to its founding in Massachusetts, Balter said.
“It’s a much better-managed company,” Yarbrough said. “There is such a gap here. That gap doesn’t close by merging No. 2 and No. 3 that are much weaker than Staples.”
Private-equity firms may see opportunity. Even after yesterday’s rally, Staples still has an enterprise value of 5.3 times earnings before interest, taxes, depreciation and amortization. That’s about a 40 percent discount to the median for similar-sized U.S. specialty retailers, according to data compiled by Bloomberg. At 10.5 percent, Staples’s free cash flow yield is higher than 65 of 68 peers, the data show.
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