Why I'm Betting on Office Depot Inc

Office supply stores have been hit with persistent same-store sales declines in recent years as key categories like printing, PCs, and even basic paper products have been disrupted by the mobile revolution. Meanwhile, more diversified competitors like Amazon.com and Wal-Mart have made inroads in the traditional office supply business.

Top-line pressure is here to stay. As a result, why would you want to invest in Staples or Office Depot Inc ? That's the question my Foolish colleague Jeremy Bowman asked just last week.

Despite the undeniable issues confronting office supply retailers, Office Depot and Staples both look like intriguing turnaround plays. I don't expect either one to turn into a growth business in the next few months -- or years! However, cost-cutting should make them vastly more profitable and put each one on sustainable footing.

The merger is the key
While I think Staples is a solid stock for value investors because of its plan to close 225 locations and shrink most of its remaining stores, I'm putting my own money on Office Depot for one simple reason. Last year, Office Depot merged with OfficeMax. This combination will turn two inferior chains into a more viable competitor to Staples, boosting profit margins.

Last month, Staples announced plans to dramatically shrink its real estate footprint.

Office Depot and OfficeMax have both struggled on the edge of profitability in recent years. On a pro forma basis, the combined company turned in a breakeven performance last year, thanks to a small profit from OfficeMax and a small loss at Office Depot. However, merging the two creates enormous synergy possibilities.

Looking for merger synergies
In February, Office Depot announced it expects to achieve annual synergies of at least $600 million by the end of 2016, excluding the effect of store rationalization. The company plans to realize $170 million in synergy gains this year, and exit the year at a $340 million/year run rate. Office Depot projects that merger synergies will fully offset an expected sales decline in 2014, boosting adjusted operating income to $140 million -- up about 30% year over year.

Even if Office Depot achieves this goal, its earnings will remain at a very low level. However, the bigger opportunity for earnings gains comes in the next few years after 2014, as Office Depot ramps up its merger synergies from $170 million to $600 million and closes money-losing stores.

Store closings could dramatically boost Office Depot's earnings.

New Office Depot CEO (and turnaround expert) Roland Smith stated on Office Depot's Q4 conference call that the company is working with consultants from Bain & Company to develop a store consolidation plan. Office Depot and OfficeMax have traditionally competed against each other in many markets. This creates an opportunity to close stores and dramatically reduce expenses while holding on to a good chunk of the associated revenue.

Office Depot aims to have a store closure plan in place by mid-year, and to begin executing that plan in the second half of 2014. There are more than 2,200 Office Depot and OfficeMax stores worldwide, and it would not be surprising to see the company close one quarter of its stores in the next few years.

Smith has stated that about 75% of Office Depot's domestic store leases expire within five years, creating plenty of flexibility to reduce the store count rapidly. Office Depot's lease commitments for 2014 total more than $700 million, while SG&A expenses totaled $3.8 billion last year. Store closures could significantly reduce this cost base, boosting the bottom line by hundreds of millions of dollars annually.

Sales declines might not matter
Office Depot will dramatically cut its costs in the next three years by reducing overhead and culling the combined Office Depot/OfficeMax store base. Meanwhile, Staples is also closing a lot of stores. Demand for office supplies will probably continue to decline for the next few years, but not at nearly the same rate as the two office giants downsize their retail footprints.

The most likely result is that profit margins will rise significantly in the next few years at both Staples and Office Depot, even as revenue declines. While both companies should benefit from this consolidation and downsizing trend, Office Depot has lower margins and trades at a much lower multiple of sales than Staples.

This makes Office Depot a much riskier bet than Staples. If merger synergies don't pan out, or the office supply sector declines faster than expected, Office Depot is more likely to go under than Staples. On the flip side, if everything goes as expected, I wouldn't be surprised to see Office Depot shares double or even triple in the next few years.

Three stocks to own for the rest of your life
As every savvy investor knows, Warren Buffett didn't make billions by betting on half-baked stocks. He isolated his best few ideas, bet big, and rode them to riches, hardly ever selling. You deserve the same. That's why our CEO, legendary investor Tom Gardner, has allowed us to reveal The Motley Fool's 3 Stocks to Own Forever. These picks are free today! Just click here now to uncover the three companies we love.

The article Why I'm Betting on Office Depot Inc originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Office Depot. Adam Levine-Weinberg is short shares of Amazon.com. 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.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.