Wall Street's Crazy Idea for Staples and Office Depot

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Last month Credit Suisse analyst Gary Balter suggested office supplies retailer Staples should merge with Office Depot (NYSE: ODP) because of increased online competition, sending shares of both companies soaring. He asks, "Why are they waiting?"

Office Depot isn't done digesting its own acquisition and now it may be gobbled up itself. Photo: Flickr user Mike Mozart.

It could just be the old saw, the burned hand learns best. Eighteen years ago Staples tried to do just that and was stopped cold by the Justice Department because of antitrust concerns. It's a testament to the futile nature of such second-guessing regulation because lawyers can't tell what the future holds.

By denying Staples the opportunity to buy up its rival back then, it ensured the industry would suffer mightily in the future because there was actually too much competition, more than the market could sustain. Substituting a regulator's judgment on what's best instead of allowing the market to decide is foolhardy.

It's not your daddy's office supply market anymore
But Balter notes that today there's a lot more online competition with rivals like Amazon.com stealing market share from the bricks and mortar stores, and he believes the FTC's approval of Office Depot's acquisition of OfficeMax -- the necessary outcome of having prevented Staples from winnowing the field before -- suggests it would also sign off on the two remaining office supplies giants joining together.

I'm not convinced regulators have caught up with modern times. They still tend to severely lag real-world events and it's hard to see how leaving just one major office supplies company would sit well with them.

The Justice Department sought to block AT&T from acquiring T-Mobile, even though the latter is ailing and needs the support of a major carrier, and there would still be sufficient competition to negate fears of price increases. It sought to stop American Airlines Group from merging with US Airways because it thought it would "eliminate competition." The antitrust division also blocked H&R Block from acquiring TaxACT, prevented the Nasdaq exchange from buying the NYSE, and inserted itself into Anheuser-Busch InBev's acquisition of Grupo Modelo.

The cigarette industry is facing similar cannibalization of its business like office supplies, and the merger of Lorillard and Reynolds-American is expected to face particularly harsh scrutiny by antitrust regulators, even though Altria remains a potent rival and the deal actually creates a fourth major cigarette player, Imperial Tobacco, through the shedding of assets.

Completely eliminating all major competition in the office supply market just won't pass regulatory muster.

It's not really a crazy notion
Yet Balter's got a point.

Revenues at Staples fell 2% last quarter to $5.2 billion while adjust per-share profits fell 25% year over year. Pro forma sales at Office Depot were also down by a like amount to $3.9 billion, but its adjusted net losses narrowed in the quarter to $0.02 per share from $0.03 in the year ago period.

Balter contends Staples buying Office Depot could save them $1.44 billion and more than double their combined operating profit by 2017, resulting in Staples stock more than doubling to $30 a share.

When the idea was first broached, shares of both companies jumped, with Staples rising 8% and Office Depot climbing 6%, but since then cooler heads have prevailed, no doubt understanding the difficulty of such a combination and their respective stocks have all but given up the gains previously made.

Photo: Flickr user Carl Malamud.

The online avenue, though, is where much of the future lies. Staples, which has the second largest web presence behind Amazon in terms of SKUs and now sells some 500,000 items online compared to the 100,000 a year ago, saw sales growth of 8% last quarter as it launched its Buy Online, Pick Up in Store initiative. It's also branched out beyond just your typical pens, paper clips, and reams of paper. Now it's selling stuff more akin to an MRO operation like W.W. Grainger or Fastenal.

Office Depot also saw increases in online sales domestically, though in international markets it has been down.

Go directly to the heart of the matter
The growth of the direct channel is leading to a decline in the physical one. Staples will be shutting as many as 225 stores in North America by the end of the year, or 12% of its total footprint, to save $500 million dollars. It closed just 42 stores in all of 2013. Office Depot anticipates closing at least 400 stores through 2016 as it integrates the two operations, or one-fifth of the 1,876 stores it had open at the end of June.

It's clear a merger ought to happen, as it would strengthen both businesses. It's not a situation like the union of Sears and Kmart, two failing businesses that came together to make one giant sickly company. When management failed to invest in the company, consumers had plenty of options to turn to.

A Staples/Office Depot merger would succeed because the market just can't support two office supplies stores. Bringing them together would stabilize them. It's hard to believe though that regulators would see that as a viable option.

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The article Wall Street's Crazy Idea for Staples and Office Depot originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and Staples. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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