Staples: Bull Case Gets Stronger with Starboard Stake


  • The Staples bull case is not well understood by casual investors
  • The Office Depot - OfficeMax merger paves the way for a potential Office Depot - Staples merger down the road
  • Starboard's presence indicates that they may push for this to occur, just as they did with Office Depot and OfficeMax
  • A merger between Staples and Office Depot could significantly increase operating margins
  • While we're one-step closer to the dream-big scenario for bulls, we're still a ways away. Furthermore, the core office supply business continues to decline.

The bull case for Staples is not well understood by casual investors. However, as I wrote on 11-20, there is a bull case here, and its ultimate home-run scenario is based on a merger between Staples and Office Depot. Today, the bull case took another step towards the home-run scenario as Starboard disclosed a stake in Staples and increased their existing stake in ODP. The stocks for both ODP and SPLS were up significantly on the news. I'll explain why this is an important development for the stocks.

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Casual Investors Fail to Account for Potential SPLS-ODP Merger

The prevailing sentiment among casual investors seemed to misrepresent the bull case on Staples. A review of the articles on Staples revealed that most people believed the bull case involved store closures, expense cuts, high free cash flow, and inexpensive valuation. However, none accounted for the implications from the Office Depot - OfficeMax merger.

The ODP-OMX Merger Paves the Way for Other Mergers

There's several important takeaways from the ODP-OMX merger, but the biggest implication is that brick and mortar stores can now merge together with a reasonably high chance that the merger will receive FTC approval. 

To explain this further, we have to go back to 1997 when Staples tried to merge with Office Depot. The merger was shot down by the FTC in a 4-1 vote on the grounds that the merger would hurt consumers in the form of higher prices.

The case for and against a merger at the time hinged on the definition of the industry that they operate in. Staples and Office Depot argued that the industry they operated in was all retailers that sold office supplies, which would include a broad range of retailers. With this definition, Staples and Office Depot did not own a significant market share of the industry, and their merger would not have harmed prices because they still would have represented a small portion of the overall industry (and thus would not have significant pricing power). The FTC disagreed, and argued that the relevant industry is the office supply superstores -- namely Staples, Office Depot, and OfficeMax. With this narrow industry view, a Staples-Office Depot company would have significant pricing power, which would harm consumers. The merger was not allowed to go through, and the consequences were a chilling effect on brick and mortar retailer mergers for years to come. 

Fast forward to 2010-2013, when you had many people in the industry calling for a merger between Office Depot and OfficeMax. While many investors believed they needed to merge due to declining results and increasing competition from the online channel, the companies were reluctant to attempt to merge. A merger attempt would be costly for several reasons. One, you would get higher legal expenses. Two, you could potentially lose a lot of customers (as Office Depot did in 1997) as the customers find out about the merger and start using other companies to fulfill their orders. With the 1997 merger as the precedent, there was a good chance that the FTC would again take a narrow view of the industry and vote down the merger, even though the online channel has grown to become a legitimate competitor since 1997.

Office Depot and OfficeMax finally took the plunge and attempted to merge again in 2013. This time, the FTC approved the merger, citing a more broad industry definition that included the online channel as well as other retailers (such as mass merchants). With this case as the new precedent, it opens the way for new mergers to occur where online competitors own a significant portion of market share. It also opens up the possibility that Office Depot and Staples could potentially merge.

Starboard's Importance in the Merger

Starboard was the activist that initially pressured Office Depot to merge with OfficeMax. It was their pressure, along with a difficult office supply industry, that made Office Depot and OfficeMax announce a merger early last year.

Almost two years later, it's now clear to us that this was the right move for the retailers and for Starboard. Now, with a new stake in Staples and an increased stake in Office Depot, it seems possible that they may try to repeat the playbook on Office Depot and Staples. 

The Implications of a Merger

If SPLS and ODP were to merge, there would be drastically higher operating margins at the combined company. Office Depot is now attempting to capture over $750 million in synergies from the merger with OfficeMax, and a larger merger with Staples could potentially capture even more in synergies -- some equity research analysts are projecting as much as $1.5 billion. While the merger wouldn't necessarily improve the difficult sales outlook for the combined companies, it would more than double their profit margin, which would drive significant shareholder value.

A simple intuitive way to think about where these synergies might come from is their advertising budget. Office Depot and Staples each are paying for advertising where they tout their own stores. As a combined company, it would not be necessary to keep all of these ads running. Instead, they could cut half of the ads, thereby saving themselves a significant amount in advertising as combined company. 

The Bear Case Remains

The office supply industry's woes are well understood by investors, but it's worth repeating here. Paper usage is declining driven by the growth of online communication and digitization. As paper usage declines, office supply demand declines as well, given their reliance on paper. Think of paper clips, staples, drawers, envelopes, scanners. This is not a surprise to investors as this trend has been ongoing for some time. However, it's a steady bleed that continues to hurt office supply retailers. Staples is attempting to cut its cost base in response, but can it keep with the decline?

Additionally, while a Staples-Office Depot merger is now possible, we are still several steps removed from it occurring. Recall that Office Depot and OfficeMax merged just last year, and they are now undergoing a long and complicated process of combining stores and employees. They don't have the resources to digest another merger, let alone one of this size. Furthermore, while a broader industry definition certainly helps, there is no guarantee that the FTC will approve a merger between the two largest office supply superstores, even with online competitors.