“Being the largest means you have economies of scale that lower costs, and Staples is the low-cost provider in the [office supply] space. No. 2 Office Depot and No. 3 OfficeMax just can’t compete.” 

—Investing Daily’s Jim Fink

The string of recent M&A deals continued yesterday, when Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX) announced that they will merge, creating a company with $18 billion of combined revenue. That would put it in second place behind Staples Inc. (NasdaqGS: SPLS), which reported $25.0 billion of sales in its 2012 fiscal year.

Under the deal, OfficeMax investors will receive 2.69 Office Depot shares for each share they own. That assigns each OfficeMax share a value of $13.50, or around $1.2 billion in total. The offer price is a 25.6% premium on the stock’s closing price on February 15, before rumors of the merger talks got out.

The companies say the “merger of equals” will let them better leverage their assets, including their websites. They also expect to save $400 million to $600 million annually by the third year after the deal closes. The combined company will hold about $1 billion in cash but also roughly $1.8 billion in combined long-term debt. That’s comparable to Staples, which also has about $1.0 billion in cash on its balance sheet, along with $1.5 billion of long-term debt.

Technology Has Sideswiped Office Supply Stores

The merger comes at a tough time in the office supply market. The weak recovery has slowed business expansion, hurting demand for paper, office furniture and computers. At the same time, ballooning budget deficits have limited the amount of money government agencies have to replace outdated office fixtures.

Chains are also facing rising competition on a number of fronts, including from general merchandisers like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), which are selling more office supplies. But perhaps the biggest threat comes from online giant Amazon.com (NasdaqGS: AMZN), which claims to offer over a million office products. That, combined with Amazon’s discount shipping rates and plan to cut delivery times by building warehouses closer to major cities, has lured customers away from brick-and-mortar stores.

The shift toward mobile devices and away from PCs also appears to be taking a toll. “The No. 1 reason for softness in this business is the iPad,” Credit Suisse retail analyst Gary Balter told the Wall Street Journal in September. “Look at how much less we print today.”

In response, OfficeMax, Office Depot and Staples have been closing stores and shifting from big-box outlets to smaller spaces more appropriate for consumers on the go: as part of its ongoing restructuring, Staples plans to reduce its square footage in the U.S. by 15% by 2015, while increasing its focus on its website.

Hedge Fund Will Likely Keep Up the Pressure

A glance at the two companies’ latest results (which they also released yesterday) gives a good illustration of the reasons behind the merger: in the fourth quarter, Office Depot’s sales declined 12% from a year ago, to $2.6 billion. The company reported a net loss of $17.5 million, or $0.06 a share, compared to a year-earlier profit of $12.3 million, or $0.04. Without one-time items, Office Depot would have earned $1 million, or nil per share.

OfficeMax, meanwhile, saw its sales fall 7.4%, to $1.70 billion, in the fourth quarter. Net income was negative $33.9 million, or $0.39 a share, down from a profit of $2.9 million, or $0.03 a share, a year ago. On an adjusted basis, Office Max earned $28.1 million, or $0.16 a share, down from $30.4 million, or $0.17.

It’s likely that pressure from activist investment firm Starboard Value LP also played a role in the move. In September, Starboard announced that it had taken a 13.3% stake in Office Depot, and CEO Jeffrey Smith dashed off a letter to the company’s board calling for accelerated spending cuts and a focus on more higher-margin services, like copying and printing. In the letter, Smith said that while the company’s current cost reductions “represent a step in the right direction, they clearly have not been enough, as is evidenced by the dramatic decline in profitability and underperformance compared to peers.”

In particular, Smith pointed to general and administrative costs, which had been on the rise despite Office Depot’s falling sales: “We seriously question why the company’s G&A expenses increased by $43 million, while the store count declined by 108 stores and revenue declined by $4.0 billion [between 2007 and 2011]. By simply reducing G&A expense ratios back to 2007 levels, we believe Office Depot could improve profitability by approximately $94 million to $211 million,” wrote Smith.

Starboard’s involvement could be good news for investors if Smith continues to press the combined company to unlock value by accelerating its cost-cutting drive or selling off real estate and other non-core assets.

Staples Still Has an Edge

By combining, the chains will be able to close unnecessary stores faster, which would improve the office supply store market as a whole. According to a February 20 Bloomberg article, 52% of the combined company’s stores are within five miles of each other. Credit Suisse’s Balter also told Bloomberg that up to 600 current OfficeMax and Office Depot stores could disappear.

But even with the deal, Staples will continue to have advantages that will let it remain competitive on price: for one, there is still the aforementioned $7 billion gap in sales between Staples and the combined company. Moreover, Staples will likely emerge from the current retrenchment in the industry with more stores: right now, it has 2,295, compared to 941 for OfficeMax and 1,629 for Office Depot.

Staples is also seeing strength in its delivery business, which mainly serves business customers. That’s helping offset softness at its retail stores. In the latest quarter, Staples’ North American Delivery segment posted a sales gain of 1%, compared to a sales decline of 5.3% and 8% at comparable businesses at OfficeMax and Office Depot.

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