Office Depot-OfficeMax Deal Seen Rescuing Value

7 Nov

Merging Office Depot Inc. (ODP) with OfficeMax Inc. (OMX) would help reverse the U.S. retail industry’s worst valuations.

After Office Depot tumbled 94 percent since peaking in 2006, Starboard Value LP became its biggest owner in September. The activist investor is demanding action as Office Depot, which last week erected a takeover defense, and OfficeMax trade for the lowest multiples versus sales among U.S. retailers valued at $500 million or more, according to data compiled by Bloomberg.

Sanford C. Bernstein & Co. sees Starboard seeking board seats and possibly agitating for a merger with OfficeMax as businesses spend less on paper and ink and the unemployment rate sits 2.1 percentage points above the average since 1948. Combining Office Depot and OfficeMax is the most logical way to spur profit growth and cut costs via store closures, according to Caris & Co. Even Staples (SPLS) Inc., which was blocked in 1997 from purchasing Office Depot, said last year that a merger of its two smaller rivals would be “natural.”

“It’s a tough industry and consolidation definitely needs to occur,” and Starboard’s presence is highlighting that, Mike Balkin, a Chicago-based fund manager at William Blair & Co., which oversees about $50 billion, said in a telephone interview. “There’s obviously been different combinations thrown out there, but the most obvious one is probably OfficeMax and Office Depot. It’s clear that there would be cost savings and synergies.”

Starboard Filing
Brian Levine, a spokesman for Boca Raton, Florida-based Office Depot, and Naperville, Illinois-based OfficeMax’s Julie Treon declined to comment on whether their companies would consider a merger.

Starboard, the New York-based investment firm that recently lost its fight to install three new directors at AOL Inc., said in a regulatory filing Sept. 17 that it took a 13 percent stake in Office Depot, making it the largest shareholder. The stake has since increased to 14.8 percent.

The original filing showed that Jeffrey Smith, chief executive officer of Starboard, wrote a letter to Office Depot’s board that said the retailer’s “poor operating performance” has hurt its stock price.

The shares were almost unchanged during the 12 months leading up to Starboard’s filing. After peaking at $44.46 in May 2006, the stock had tumbled 94 percent for the worst performance in the Standard & Poor’s MidCap 400 Index, data compiled by Bloomberg show. It closed at $2.51 yesterday.

Shrinking Stores
Starboard’s letter called for Office Depot to shrink the size of its stores (ODP), reduce the number of items it sells and cut general expenses and advertising costs. Smith declined to elaborate yesterday.

Office Depot responded last week by creating a takeover defense that gives shareholders additional stock when someone acquires a 15 percent stake without the board’s approval. The so-called poison pill is designed to protect against buyers seeking to “take advantage” of Office Depot owners (ODP) “through coercive and unfair tactics,” according to an Oct. 30 statement.

“Starboard is trying to agitate for significant changes at Office Depot, and Office Depot is moving into the defensive crouch to try to ward off Starboard,” Colin McGranahan, a New York-based analyst for Bernstein, said in a phone interview. “The most likely path, given Starboard’s past actions, would be a proxy contest to try to get board representation.”

Board Elections
The investor could then push for a merger or sale if it gains control, McGranahan said. All 10 of Office Depot’s board (ODP) members are up for re-election at its annual meeting next year, according to a company filing. This year, the company held the gathering in April.

Starboard is “making waves,” Andrew Berkin, co-chief investment officer at Los Angeles-based Vericimetry Advisors LLC, which owns Office Depot shares, said in a phone interview. “One way that one can eventually profit on a stock is if there is consolidation.”

The most logical transaction would be a merger between Office Depot and OfficeMax, according to Caris’s Scott Tilghman. The companies would be able to reduce overhead by shutting down stores in overlapping areas, leveraging their distribution networks and combining their Mexican operations, the New York- based analyst said.

Office Depot has a joint venture selling office products and services in Mexico and Central and South America, according to its annual report. OfficeMax also owns a 51 percent stake in a joint venture in Mexico, its year-end filing showed.

‘Very Nicely’
“Office Depot and OfficeMax’s two strengths are their domestic business and Mexican business,” Tilghman said in a phone interview. “They would fit very nicely together. You’d have a good, sizable competitor with Staples, which would help avoid any regulatory hang-ups.”

Staples, based in Framingham, Massachusetts, generated $25 billion in revenue last year, two times more than Office Depot and triple OfficeMax’s sales.

After merging with OfficeMax, Office Depot could sell its European business to Staples, which also has a division in that region, Caris’s Tilghman said. Staples said Sept. 25 that it plans to close 45 stores and several delivery operations in Europe by the end of the year to boost profitability. Tilghman said combining the European units of Staples and Office Depot would drive efficiency and create a more formidable competitor.

Owen Davis, a spokesman for Staples, declined to comment on whether it’s interested in buying the unit.

Dwindling Demand
Office-supplies retailers are grappling with declining demand for their products and a weak labor market, said Bernstein’s McGranahan. The jobless rate rose last month to 7.9 percent, versus the average of 5.8 percent since January 1948, according to data compiled by the U.S. Labor Department.

Those challenges have left Office Depot’s stock trading at a 94 percent discount to its sales in the year through June 30, the lowest valuation among U.S. retailers larger than $500 million, data compiled by Bloomberg show. OfficeMax traded yesterday at a 91 percent discount to sales, the second-cheapest valuation.

As of yesterday, analysts projected that both Office Depot and OfficeMax’s revenue will decline (OMX) for a fifth consecutive year in 2012, data compiled by Bloomberg show. Even based on estimates for this year and next, the two still have the lowest price-sales multiples, the data show.

“They’re extraordinarily cheap” based on revenue, McGranahan said. “The problem is, there’s not a lot of earnings right now. There’s been no recovery in the labor market and they’re in an industry that’s in secular decline.”

No Fix
Both companies reported third-quarter results today. Office Depot reported adjusted earnings (ODP) of 6 cents a share after a preferred dividend. Analysts projected profit of 1 cent a share, according to the average of estimates (ODP) compiled by Bloomberg. The stock rose 19 percent to $2.99, giving the company a market value of $852.8 million.

OfficeMax posted a profit (OMX) of 27 cents that topped the average analyst estimate of 25 cents. The shares gained 12 percent to $8.33, boosting the market value to $722.6 million.

While the union of Office Depot and OfficeMax might boost shares of the combined company and reduce the plethora (ODP) of places to buy office supplies, it isn’t going to fix the longer-term problems, said Malcolm Polley, who manages $1.1 billion as chief investment officer at Stewart Capital Advisors LLC in Indiana, Pennsylvania.

The business would still face competition from retailers such as Wal-Mart Stores Inc. and Target Corp. as well as online sellers as demand for office supplies shrinks, he said.

Cost Improvements
“The improvement is all on the cost side,” Polley said in a phone interview. “If you can take capacity out of the system by merging Office Depot and OfficeMax, it should make the environment better for the remaining players.” However, “if you put two underperforming firms together, typically you get one big underperforming firm,” he said.

Still, a merger may be the best way for Office Depot and OfficeMax to weather the challenges and stay competitive with Staples and other retailers, according to Walter Todd, who oversees about $940 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina.

“They’re kind of getting hit from all sides,” Todd said in a phone interview. “They need to combine.”

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