Market Fails to Grasp Officemax Deal; Special Opportunity Open

The pending merger – and the potential for value creation – between OfficeMax (OMX) and Office Depot (ODP) is fundamentally misunderstood by the market, particularly as the investor base rotated from fundamental holders to merger arbitrageurs, likely due to the following factors:

(1) Corporate Governance – Pundits and investors expressed concern/confusion as the companies did not offer a definitive plan for management succession. Further, in unorthodox fashion, the combined board will have equal representation from each company, potentially setting the stage for a “culture clash”. OMX’s CFO recently resigned to take another post, sparking concerns about the integration process and progress/discussions with the FTC.

(2) Business Outlook – Skeptics believe that the office supplies brick-and-mortar business is in secular decline and may suffer the same fate as traditional book, music and consumer-electronics retailers.

(3) Deal Dissolution/Regulatory Obstacle(s) - Concern regarding antitrust issues/deal rejection by the FTC, possibly stemming from residual pain (for the “arb” crowd) when the Staples/Office Depot deal broke in 1997.

(4) Valuation – Back-of-the-envelope calculations suggests that the combined business, pro forma, trades at an enterprise value of ~7X TTM EBITDA; a seemingly fair/appropriate multiple given the cost synergy opportunities ($400mm to $600mm), against the backdrop of low-to-negative top-line growth prospects and a levered balance sheet (~$1bn in net debt; >2X EBTIDA).

Though some of these risks and concerns are partially valid, it is our belief that they are being placed in an improper/incomplete context. The reality is, when adjusting for “hidden”/recently-monetized assets (ODP’s Grupo Gigante stake; OMX’s BCC stake) and “phantom” liabilities (OMX’s non-recourse debt), the combined businesses trade at a TEV of less than 5X TTM EBITDA, before synergies and with de minimis net debt.

Post synergies (assuming the mid-point of guidance), shares trade at a TEV of just ~3X EBITDA (adding implementation costs and CapEx to net debt). Further, management’s guidance for cost/G&A synergies is completely incremental to the opportunities from:

(a) geographic synergies (store consolidation in overlapping markets);
(b) each company’s respective plan to “right-size” the store base (move to smaller locations as leases roll off);
(c) working capital release/synergies; and
(d) ODP’s plan to reduce the G&A cost structure of its European business. Lastly, combined, OMX and ODP will possess nearly half a billion dollars in NOLs, which should minimize cash taxes for the foreseeable future. At this valuation, and given the potential upside, we believe investors are being amply compensated for the attendant risks.

In the past, we have studied both OMX and ODP, on a stand-alone basis. In our view, each story presents a high level of analytical complexity, particularly in terms of valuation. The merger of OMX and ODP compounds the issue of complexity, creating a special situation. We think it would require advanced prior knowledge of each company to contextualize all the moving pieces in order to handicap the fair value of the combined businesses.

Though the full run-rate of synergies likely won’t be reached until 2016, we believe there are a number of potential catalysts over the next 6-to-12 months that will cause shares to re-rate:

(1) 3Q/4Q releases will reflect monetization of Mexico JV and BCC assets, making respective balance sheets cleaner and valuation more straightforward;
(2) OMX/ODP fully comply with the second information request by the FTC and, ultimately, receive regulatory approval;
(3) OMX/ODP provide a clear plan for management succession;
(4) the merger is completed by year-end;
(5) the new management team places firm numbers around occupancy, labor and working capital synergies and, thus, raises the target synergy range; and
(6) as the holder base rotates back to fundamental investors that possess a longer-term orientation and can spend the time to more carefully scrutinize the underlying value drivers.

Structuring the Trade
In our opinion, the best way to own the future cash flows of the combined business is to purchase OMX rather than ODP. The exchange ratio for the merger is 2.69 ODP shares: 1 OMX share. With ODP’s share price at $4.35, OMX’s deal-adjusted price is $11.70, representing a 1.8% risk-arbitrage spread (4.2% annualized; 12/31/13 closing date). By going long OMX, investors can pocket the deal spread. Put another way, if the deal were to go through, for about every 21-22 shares of OMX, you would receive an extra share of the pro forma entity, essentially for free. If the deal breaks, all else equal, we would prefer to own OMX over ODP. Though OMX trades between half a turn to a turn above OMX, we believe this is a fair premium to pay given OMX’s superior margin structure, larger B2B business and minimal exposure to distressed European markets.

Risks:
• The merger is not consummated, for regulatory reasons or otherwise
• ODP fails to monetize its JV stake
• OMX opts to forego paying a special dividend
• OMX fails to sell its Croxley business
• Fundamentals of the retail, wholesale/B2B, and/or European office supplies business performs/deteriorates worse than expected
• Management's cost synergy estimates prove to be too sanguine
• Strategies for real estate/geographic prove ineffective
• Corporate governance concerns are not addressed in a timely and/or satisfactory manner