Can OfficeMax/Depot Succeed?

 | Feb 19, 2013 | 3:01 PM EST  | Comments
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Office Depot (ODP) and OfficeMax (OMX) are in merger talks. Finally! On Feb. 8, I tweeted (@shortideas) that nothing would make me happier than consolidation in the office-supply space to better compete with the leader, Staples (SPLS). Looks like I will get my wish.

The office-superstore format has been under pressure since 2002. Back in the golden age of office superstores, the industry generated sales per square foot close to $300. But with endless competition and store saturation, sales have crashed below $200. At that level, they might as well close down and turn the place into a dog park. Office Depot, for example, generates a depressing $183 per square foot. As sales per square foot headed south, margins disappeared. In this business, an operating margin greater than 10% is considered an achievement. And if that wasn't enough, business spending on office supplies has declined at a 2% annualized rate since 2000. Forty percent of office supply orders are less than $75, which means it's an ugly way to make a profit.

Because the industry has been under so much pressure, the major chains are closing locations and shrinking existing stores. In 2004, the average superstore was about 23,000 square feet. Nowadays, after closures and relocations, the average store is 21,000 and the industry is trying to get down to stores that average 19,000 square feet.

What makes the deal attractive is the fact that 75% of OfficeMax's leases expire through 2016. That's approximately 675 of the 900 stores the combined company can relocate or shrink. Of Office Depot's 1,675 stores, the chain is committed to downsizing or relocating 500 stores over the next four years.

The combined company could save about $700 million a year in expenses. But let's face it, the office superstore is a lousy business with little growth. While I can't get excited about the industry over the long-term, OfficeMax shares will move higher in the short run as investors dream of higher profits and mass layoffs. But don't get too carried away, the office supply business never delivers.

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