The Staples-Office Depot Merger Terminated In Face of FTC Objection

“Time is the friend of the wonderful business.” The spirit of that famous sentence should be part of the touchstone inquiry before ever contemplating any type of investment. If you are sure that the asset you purchase will be selling more goods or services ten years from now at higher prices, and thereby earning more profits, you’re already well on the path to investment success. The only remaining impediments to watch out for are (1) overpaying and (2) buying something with an over-leveraged balance sheet.

I had this on my mind when I observed much of the attention the investor community is giving to the called-off merger between Office Depot (ODP) and Staples (SPLS). If you are investing with a 5+ year time horizon, you should be living your life as if these companies don’t exist.

These are both companies that, over the long term, will eventually experience some type of wipeout event. Office supply stores are too niche–people are turning to Amazon for their regular orders, and will just opt for Wal-Mart for their spontaneous needs. The only real market need that Office Depot and Staples can fill is the large contract for office supplies in greater quantities than you can get on Amazon, as well as the urgent yet obscure item business purchase. That’s not enough of a market to propel long-term shareholders to riches over the coming decades.

Staples has the superior management and balance sheet compared to Office Depot, and it has relied upon share repurchases to mask its deteriorating business model. It has retired 100 million of its shares in the past twelve years, or about 1/7th of the overall shareholder base. The problem is that the core economic engine is in decline–there were 2200 Staples locations eight years ago, and now that number is coming down to the 1800 range. The pre-recession days of billion-dollar profits have turned into $500 million profits, and my view is that shareholders are lucky to have a residual claim on that.

Office Depot is far more of a train wreck. They’ve closed 25% of their stores in the past three years due to consolidations after the OfficeMax merger. They paid a high price to do this–using stock that had fallen from $31 to $6 to consummate the purchase–and you still have a business that is only generating $250 million compared to the pre-recession numbers in the $500 to $600 million range.

The businesses that last do a combination of three things well: price, convenience, and quality. This speaks to Peter Drucker’s thesis about the future in which businesses that act as middlemen are the most susceptible to wipeout because the only basis for supporting them is that they win on price or convenience. There’s no “quality” component–the products you get at Office Depot or Staples can be bought at the manufacturer website, on Amazon, or at Big Box retailers.

You’re already seeing Amazon win on price, and for long-term planners, convenience. The only remaining foundation for businesses like Staples and Office Depot is convenience and large volume–things you need now that you can’t get at Wal-Mart or Target or that require an order size that exceeds Amazon’s current capacity. This is a very narrow scope of competitive advantage, and even that is under threat by Amazon’s perpetual move toward shorter and shorter delivery times as well as increasing capabilities to handle large volume orders.

Now, as a political/legal matter, I don’t think the FTC should have tried to block this. Their rationale is that Staples and Office Depot control $33 billion of the $58 billion office supply market, and as a combined entity, they would exert too much pricing pressure over companies that make bulk orders through them. The antitrust formulas are complicated, but a good approximation is this: Any proposed merger that crosses the 50% of an industry mark is highly disfavored. While that would normally sound like a lot of consolidated power, it took Office Depot slashing its 400 least profitable stores just to get its net profit margin from 0.7% to over the 1% hump.

This reminds me of the successful FTC efforts to block the $1 billion bid by Blockbuster to acquire Hollywood Video in 2005. Blockbuster was making the very credible argument that Netflix, iTunes, and Amazon Video were more than nipping at their heels and on the verge of destroying their business model, and consolidated market share was a necessary condition to even have a chance at maintaining solvent. But because the deal would give Blockbuster over half of the market at the time, it got nixed.

The current FTC fight against Staples-Office Depot is an example of history rhyming with the Blockbuster-Hollywood Video attempted deal. U.S. District Judge Emmet G. Sullivan accused the FTC of influencing an Amazon official’s testimony to downplay their planned entrance into the office supply market. Three years ago, Amazon was only selling $200 million worth of office supplies. Now, it is over $1 billion. The market is in flux, and I think Staples-Office Depot just lost their best chance at remaining solvent for 20+ years. If they ever do get to combine, it will likely be too late–they won’t get to join forces until they are in an inferior position to Amazon.

Long story short: I don’t think any long-term investor should be thinking about making an allocation to Office Depot or Staples. Time is not your friend. The business performs terribly during recessions, and Amazon is going to take away a lot of Staples and Office Depots’ long-term business supply contracts once it ramps up the volume capability to do so. The 21st century risk posed to passive investing is that businesses whose value derives from convenience will find itself competing in a game that has zero-sum characteristics with other portals that can deliver goods faster. The only way Staples and Office Depot shareholders can do well over the next few years is if: (1) Amazon’s substantial competition in the supplies market takes much longer than anticipated, and (2) the U.S. avoids a deep recession, as supply costs are drastically cut during times of hardship. I very little confidence either of these businesses will exist come 2035, and I don’t understand why someone would put their hard-earned money into either of these businesses when there are other businesses like Diageo or Hershey right now that can give you all of the best-case hypothetical upside of Staples or Office Depot without exposing you to any of the downside risk.

Originally posted 2016-05-15 12:30:37.

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