Staples To Merge With Office Depot: A Buyout With An Ugly Outlook

Office Depot has had an ugly business model for the past two decades. The company has only had one seven year stretch in its corporate existence (2000-2006) in which profits grew. Other than that, the company see-sawed along a trajectory of “two steps forward, three steps back, two steps forward” for most of its existence. Even Home Depot’s glory days, however, had more to do with financial engineering (borrowing debt to reduce the stock count through buybacks) rather than actually growing a healthy business.

Specifically, throughout the 2000 to 2006 period, profits had only grown from just under $300 million to $396 million, but the office supply company leveraged the balance sheet to reduce the share count from  (a high of) 312 million to 272 million within that time frame. Since then, Office Depot’s numbers have been disappointing in a way that should have made the company off limits to long-term investors: losses in 2008, 2009, 2010, 2011, 2012, and 2013. After merging with Office Max, Office Depot was able to make $0.20 per share, or $105 million.

The big picture problem with the company is that its margins are super thin, not even 1% (depending on the year, the company’s profit margin is somewhere between 0.2% and 0.6%). This creates a significant problem during recessions—Office Depot tends to lose about 2% on all items sold and report losses (see years like 2008 and 2009 when Office Depot lost $216-$240 million per year). Given that the company carried $1.5 billion in debt while owning earning $105 million per year in profit during its only profitable year post-recession, it is fair to assume that protracted economic conditions like 2008-2009 would result in bankruptcy if they continued for 5+ years (in contrast to something like Nestle which maintains its rates of profitability in the bad years).

Today, Staples announced plans to merge with Office Depot by buying out each share of Office Depot stock for $7.25 in cash and 0.2188 shares of Staples. At the time of the announcement, this valued Office Depot at $11 per share (the reason why the price of the stock is $9.48 is because $1.52 is the current price of the uncertainty that regulators in the United States will block the two office chains from merging, and that decision would probably send Office Depot stock back down towards the $6-$7 mark it was trading at before the deal’s announcement).

Personally, I think it would be an exercise in kneejerk ideology to block this deal on anti-competitive grounds, given that neither Staples nor Office Depot has managed to put together an extended streak of profitability. Staples has never had higher than 5.2% profit margins in its corporate history; at their best, Staples is making a little over $0.05 in profit on every dollar spent to buy an eraser, stapler, or glue bottle (whereas Coca-Cola makes over $0.30 on every dollar spent buying a soda). And, as a matter of common sense, many items sold at Office Depot and Staples can also be purchased cheaper at Wal-Mart, Target, eBay, or Amazon, so the Office Depot vs. Staples logic sets up an image of a duopoly when the market place for notebooks, pens, and office supplies is much greater than the two specialty stores.

Without a doubt, Staples is a superior business to Office Depot (that’s why Staples went down 10% on the news; this merger will lower the quality of Staples’ earnings going forward). It is profitable every year. It actually pays a dividend (since 2004) which has never been cut or lowered in its eleven-year history of payouts. It has a much stronger balance sheet than Office Depot—both companies carried a little over $1 billion in debt, but Staples does it with cash flow in the $700-$900 million range while Office Depot does it with cash flow in the $100 million range (in a good year).

But still, Staples is not the kind of stock that I would want to own for a long period of time. As a short-term speculation or value investment, fine. As something you buy today and hold for twenty years, no. It doesn’t have the kind of earnings power I find impressive—I read articles on line where people talk about how cheap the stock is compared to book value, but I remain skeptical of the valuation given that half of Staple’s value comes from $2.3 billion in inventory that has yet to be sold. The company has good management—the high-interest 5% to 6% debt has been cut from the balance sheet, so Staples only carries $1 billion in debt now compared to $2.5 billion in 2009.

But still, this is a company that just can’t hold a profit. It made about $1 billion in profit in 2007, and the figure has grinded downward towards $600 million in 2014. This has also been the company’s story—you have a couple good years, and then some sharp down years that end up leaving you treading water at the end of the decade back where you started. The whole premise of my writing is that you buy high-quality assets that have habits—natural characteristics—towards regularly growing profits so that your personal endurance with the stock will enable compounding. Companies like Staples and Office Depot are the opposite of that—there is always a fire to put out, and years of value eroded. Sure, they may have a good quarter, or the stock may have a good year or two, but you don’t want to hitch your family’s fortunes to these kinds of companies. Why? Because they lack brand equity or low-cost producer status, and this prevents the kind of sustainable profit growth that is essential to long-term compounding.



Originally posted 2015-02-04 18:54:42.

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