Office Sector Outlook: With cues from the past, ’08 may finally see merger

NEW YORK —The prospect of a mega-merger between Staples and Office Depot looms large over the office products industry, as two of its largest players begin the New Year pointed in opposite directions.

Staples continues to demonstrate consistent growth, stellar execution, margin expansion and an ability to exceed profit targets in a difficult economic environment. Meanwhile, Office Depot stumbled badly during the second half of 2007 as it was plagued by weak same-store sales growth, operational challenges and unsettling accounting mistakes, which contributed to a plummeting stock price and a decision to slash store expansion.

In addition to the divergent paths these companies have taken, merger speculation is fueled by other recent developments. Staples is amassing a stockpile of cash that is expected to approached $1.2 billion by the time its fiscal year ends later this month. Conversely, Office Depot disclosed at the end of its third quarter that it had discussions with investment banks concerning “alternative capital strategies” and also hired the investment banking advisory firm Peter J. Solomon Co. to further review capital structure options and advise the company on the proper course of action to ensure appropriate steps are being taken to add shareholder value and optimize the cost of capital. Peter J. Solomon Co. specializes in merger and acquisition activity and Solomon himself was an Office Depot board member from 1990 to 2004, which gives him familiarity with the intimate details of the retailer’s attempt to merge with Staples that began in the fall of 1996.

It is the combination of all these events, along with some wishful thinking on the part of investors, that are fueling speculation that 2008 could be the year the office products industry sees a return of the mega-deal. “The office products sector has long been ripe for consolidation and the current landscape seems to increase the possibility of some event in the near to medium term,” said Bernstein Research analyst Colin McGranahan. “We think the ultimate deal would be an acquisition or merger of Office Depot and Staples.”

Investors love consolidation in the retail industry because larger companies are generally better able to leverage expenses, produce higher rates of return on invested capital and improve margins through increased pricing power. Of course, the latter point tends to be the same reason why the Federal Trade Commission takes a dim view of mergers and often seeks to block deals on the grounds they are anti-competitive and will lead to higher prices for consumers.

That was the case in 1997 when the FTC presented evidence to a federal judge that clearly showed competition between Staples and Office Depot resulted in lower prices. The judge granted the FTC’s request for an injunction on June 30, 1997, and effectively killed the deal that had been announced on Sept. 4 of the previous year.

McGranahan acknowledges a Staples and Office Depot combination would face significant regulatory hurdles. The FTC would be as wary today as it was 11 years ago about the impact on prices associated with allowing a merger between the two largest operators of office superstores. Staples is expected to end its current fiscal year with 1,735 stores in North America, compared to an estimated 1,228 Office Depot stores, according to Deutsche Bank analyst Mike Baker. OfficeMax is its closest direct rival in the retail space with a projected year-end total of 952 stores.

Combining the two largest retail entities, who also serve the market through multibillion delivery and international operations, would result in massive merger synergies of as much as $775 million. “The math around such a deal is quite compelling, so the motivation certainly exists for the companies to explore and work through the regulatory questions,” noted McGranahan.

The interest level around such a deal in the financial world is high enough that McGranahan hosted a conference call on the subject last month where he enlisted Orley Ashenfelter, the lead econometric expert for the FTC in the 1997 court case, to explore how the market has changed and why things might be different this time around. It was Ashenfelter’s examination of the pricing effects that were taking place 10 years ago that helped sink the deal.

Back then, the office super-store concept was only 10 years old, and Staples and Office Depot combined operated only 1,038 stores. The industry was more highly fragmented than it is today, but the big difference related to the pace at which new stores were being opened in competitor’s markets. As a result, Ashenfelter was able to obtain documents that showed a Staples entry into markets occupied by Office Depot, and vice versa, produced a benefit to consumers because prices were lowered prior to the arrival of competition.

According to Ashenfelter, were a similar combination proposed today, one of the first things regulators would do is look for pricing data. However, there would likely be less evidence available because the industry has matured, the pace of new market entries has slowed and, in some cases, there have been market exits, which makes it more difficult to apply the methodology used in 1997.

Further complicating pricing comparisons is the changing nature of the companies’ product assortments. Sales of private brands at both companies are approaching 30% and headed higher. There is also an increased emphasis on services such as copy and print. The result is a reduction in the subset of identical branded items offered at both companies’ stores that could be used for a pricing comparison. It is also worth noting that 10 years ago, Staples and Office Depot were both primarily operators of domestic retail stores, but in the years since, both have moved aggressively to grow their delivered products businesses and expand internationally.

Another significant difference relates to the competitive environment and the presence of the Internet. A key reason the merger was defeated in 1997 involved the narrow manner in which the FTC defined competition as limited to Staples, Office Depot and OfficeMax, rather than looking more broadly at the universe of retail outlets where office products were available. Lawyers for Staples and Office Depot argued unsuccessfully at the time, that they also competed with Wal-Mart, Best Buy and warehouse clubs.

Although the federal judge sided with the FTC, non-office superstore formats are even more formidable competitors now than they were in 1997. This is especially true in the case of warehouse club operators Costco and Sam’s Club, both of whom emphasize the office products category, publish catalogs and offer delivery of products via third parties.

The Internet is another factor that has changed the marketplace. In 1997, retailers were just beginning to venture online. Today, the Internet has brought pricing transparency to the market and dramatically changed how consumers buy office products.

There is much that is different today about the office products industry and the nature of competition compared to 1997, but whether those changes are significant enough to justify the risk associated with Staples and Office Depot taking another run at a merger remains to be seen.