Staples To Buy Office Depot?

[Anonymous]

Staples To Buy Office Depot?
Why Staples Should Buy Office Depot
The only sound way to address a sluggish retail environment is through merging.
In our view, the primary reason for Staples and Office Depot to combine is that the value in both companies is that they have a distribution channel into multinational corporations, a channel that has tremendous value should it trade alone.

Staples, the stronger of the two, has already shown that it can effectively and profitably sell other non-office supplies through that channel, with facilities and breakroom now representing over $1 billion in sales for their contract segment and this product category is still growing at a double-digit rate for them this year.

At first glance, many will say, "But wait, the Office Depot and OfficeMax merger integration is just starting." To us, that is all the more reason to do it now, particularly on the retail front. Since there will be ongoing store rationalization between now and the end of 2016 (at least another 485 stores will close by 2016), we stress the importance of keeping open only the stores among the three chains that make the most economic sense to do so, rather than doing this as a less efficient two-step process where each management team might keep open unprofitable stores simply because they hope to grab share from a competing player closing their stores. That thought process has led to Staples keeping open some unprofitable stores for too long. The $313 million of synergies we predict from a joint retail-store optimization alone makes the merger math work.

That said, despite the Office Depot and OfficeMax merger, we would note that both chains continue to underperform expectations, not just at retail, but also in contract due to core office-supply product weakness. Although there is no magic bullet, we would assume that slashing, not trimming, stores and transferring volumes to remaining stores makes eminent financial sense. More importantly, by combining the delivery and contract businesses, we believe efficiencies around distribution and the rationalization of both companies' salesforces will be even greater than the retail savings.

Unfortunately, retail remains the anchor around both stocks' neck and is reflected in the companies' low valuations. Results in this segment remain abysmal for both companies, as the country is way overstored, particularly given an environment where 55% of core office-supply products are estimated to be bought online today and retail traffic in general is down more than 5% year-to-date. The most economically sound way to address this problem is through combination and as we have written before and touched on again inside, we see little chance of the Federal Trade Commission blocking a Staples and Office Depot merger due to the vastly changed environment.

The bottom line is that we believe a combination can yield $1.44 billion in synergies, adding approximately 69% to the pro forma earnings before interest, taxes, depreciation and amortization (Ebitda) of the two companies by 2017, and with less-conservative assumptions, more than that. This represents a tremendous option for investors in both Staples and Office Depot, and does not seem to be represented in these businesses' valuations, as they trade only 6.5 times and 4.1 times, respectively, our 2015 Ebitda estimates.

Assuming Staples is the acquirer given its larger balance sheet and healthier free cash flow, we propose they acquire Office Depot in an all debt deal. We calculate Staples could pay an 80% premium for Office Depot's shares today, which gives Office Depot credit for future synergies. If we apply Staples' current valuation multiples to the combined entity (including synergies), we believe the stock price of Staples would be closer to $30 by 2017 from its current price of under $12.

Given the cash flow of the acquirer (Staples trades at a nearly 10% free-cash-flow yield on consensus 2015 estimates), we view this deal as particularly attractive for private-equity funds looking for a leveraged buyout candidate or other activist investors that can shake up the status quo and capitalize on the potential inherent in a merger with Office Depot.

– Gary Balter
– Andrew Kinder

Staples To Buy Office Depot?
Why Staples Should Buy Office Depot
The only sound way to address a sluggish retail environment is through merging.
In our view, the primary reason for Staples and Office Depot to combine is that the value in both companies is that they have a distribution channel into multinational corporations, a channel that has tremendous value should it trade alone.

Staples, the stronger of the two, has already shown that it can effectively and profitably sell other non-office supplies through that channel, with facilities and breakroom now representing over $1 billion in sales for their contract segment and this product category is still growing at a double-digit rate for them this year.

At first glance, many will say, "But wait, the Office Depot and OfficeMax merger integration is just starting." To us, that is all the more reason to do it now, particularly on the retail front. Since there will be ongoing store rationalization between now and the end of 2016 (at least another 485 stores will close by 2016), we stress the importance of keeping open only the stores among the three chains that make the most economic sense to do so, rather than doing this as a less efficient two-step process where each management team might keep open unprofitable stores simply because they hope to grab share from a competing player closing their stores. That thought process has led to Staples keeping open some unprofitable stores for too long. The $313 million of synergies we predict from a joint retail-store optimization alone makes the merger math work.

That said, despite the Office Depot and OfficeMax merger, we would note that both chains continue to underperform expectations, not just at retail, but also in contract due to core office-supply product weakness. Although there is no magic bullet, we would assume that slashing, not trimming, stores and transferring volumes to remaining stores makes eminent financial sense. More importantly, by combining the delivery and contract businesses, we believe efficiencies around distribution and the rationalization of both companies' salesforces will be even greater than the retail savings.

Unfortunately, retail remains the anchor around both stocks' neck and is reflected in the companies' low valuations. Results in this segment remain abysmal for both companies, as the country is way overstored, particularly given an environment where 55% of core office-supply products are estimated to be bought online today and retail traffic in general is down more than 5% year-to-date. The most economically sound way to address this problem is through combination and as we have written before and touched on again inside, we see little chance of the Federal Trade Commission blocking a Staples and Office Depot merger due to the vastly changed environment.

The bottom line is that we believe a combination can yield $1.44 billion in synergies, adding approximately 69% to the pro forma earnings before interest, taxes, depreciation and amortization (Ebitda) of the two companies by 2017, and with less-conservative assumptions, more than that. This represents a tremendous option for investors in both Staples and Office Depot, and does not seem to be represented in these businesses' valuations, as they trade only 6.5 times and 4.1 times, respectively, our 2015 Ebitda estimates.

Assuming Staples is the acquirer given its larger balance sheet and healthier free cash flow, we propose they acquire Office Depot in an all debt deal. We calculate Staples could pay an 80% premium for Office Depot's shares today, which gives Office Depot credit for future synergies. If we apply Staples' current valuation multiples to the combined entity (including synergies), we believe the stock price of Staples would be closer to $30 by 2017 from its current price of under $12.

Given the cash flow of the acquirer (Staples trades at a nearly 10% free-cash-flow yield on consensus 2015 estimates), we view this deal as particularly attractive for private-equity funds looking for a leveraged buyout candidate or other activist investors that can shake up the status quo and capitalize on the potential inherent in a merger with Office Depot.

– Gary Balter
– Andrew Kinder

[Author]

September 4, 2014 at 12:24 PM