ODP >> Takeover Target - December 11, 2014 - Updated 12/17/2014 by C. Hagan Business Summary: Office Depot, Inc. (ODP, $7.54/shr - NOW...

ODP >> Takeover Target - December 11, 2014

ODP >> Takeover Target - December 11, 2014 - Updated 12/17/2014 by C. Hagan

Business Summary: Office Depot, Inc. (ODP, $7.54/shr - NOW AT $7.99) supplies office products and services to consumers and businesses through approximately 2,000 stores and its primary websitewww.officedepot.com in North America (approximately 80% of sales) and select international countries (20% of sales). ODP is entering the second year of a three-year integration plan following its merger with Office Max in late 2013 and the combined company generates annual revenue of approximately $16 billion.

Activist Investor: Activist investor Starboard Value LP on December 10, 2014 filed a 13 D/A reporting an increased 9.9% stake in ODP after filing an initial 13D back in September 2012. Starboard has been an active ODP shareholder over the last two years and won three board seats in an August 2013 settlement with the company. Also on December 10, 2014 Starboard filed a 13D reporting a new 5.1% stake in larger competitor Staples, Inc. (SPLS, $16.10/shr). Both ODP and SPLS stocks popped after yesterday's joint filings as Starboard is reportedly pushing for a merger of the two competitors.

SPLS / ODP Merger Mania: SPLS and ODP actually agreed to merge in 1996, but the transaction was subsequently blocked by the FTC. Credit Suisse analyst Gary Balter recently proposed that the two companies should now give it another go (see 9/2/14 research report) and Starboard seems to agree. The competitive landscape has changed dramatically and based on language in the FTC's unconditional approval of the ODP/OMX 2013 merger (seehttp://www.ftc.gov/sites/default/files/documents/closing_letters/office-depot-inc./officemax-inc./131101officedepotofficemaxstatement.pdf), Balter thinks a SPLS/ODP combination would likely be approved. For its merger with OMX, ODP is targeting $750 million of synergies after three years and recently posted better than expected 3Q14 results and provided better than expected 2015 guidance, indicating that the synergies are real and dropping to the bottom line. Balter estimates that a grander SPLS/ODP merger could yield $1.4 billion of annual synergies and double the current combined operating profit of the two companies, suggesting huge value creation for both ODP as target and SPLS as acquirer.

Thesis Summary: ODP at 5.5x 2015 EV/EBITDA and 0.28x EV/Sales trades at a big discount to SPLS at 7.5x EV/EBITDA and 0.48x EV/Sales despite ODP being the rumored takeover target and despite ODP having a better earnings trajectory than SPLS as significant ODP/OMX merger synergies are expected to benefit the bottom line for the next few years. For example, ODP EBITDA is expected to grow from approximately $565 million in 2014 to $775 million in 2015 with further growth in 2016 as synergies ramp and annualize; while consensus estimates for SPLS suggest flattish EBITDA of approximately $1.4 billion from 2014 to 2016. While ODP has upside to $10.20/shr (plus 35%) simply based on a 7.5x SPLS EV/EBITDA multiple, the real upside will come if SPLS buys or merges with ODP in a transaction that seems to make perfect sense if it were to pass antitrust review. As detailed below, ODP may have huge upside to $20/shr (plus 165%) in a merger scenario and arguably modest near-term downside due to its big discount to SPLS, improving operating results, synergy tailwind, net cash balance sheet, activist involvement and general SPLS/ODP merger buzz. [Note: ODP's indicated EV multiples include $500mm of estimated liabilities for remaining integration costs, legal accruals, and timber sale deferred taxes.]

Upside Takeover Scenario: Balter suggests that SPLS move sooner rather than later and hypothesizes that SPLS pay an 80% premium in an all-cash, debt-financed purchase of ODP (note: ODP was trading at $5.12/shr when the research was published). I would advise, however, that ODP demand credit for at least 50% of the estimated synergies from a transaction, which would still be hugely accretive to SPLS. I frame an upside scenario for ODP as follows: 1) ODP has guided to approximately $475 million of operating profit in 2015, or roughly $775 million EBITDA; 2) Add $700 million for 50% of estimated SPLS/ODP merger synergies, gets you to $1.475 billion EBITDA; 3) Apply SPLS current EV/EBITDA multiple of 7.5x (so not even figuring a premium multiple) derives $11 billion of enterprise value attributable to ODP; 4) Subtract $200 million of ODP net debt/obligations estimated at year-end 2014 (roughly $1.0b cash, $700mm debt, and $500mm estimated other liabilities) derives $10.8 billion of equity value, or $20/shr (plus 165%) for ODP based on 545 million diluted shares. Even with the huge premium, SPLS would be purchasing ODP at only 5.1x EBITDA pro forma for 100% of Balter's estimated synergies and a still reasonable 7.5x EBITDA pro forma for 50% of estimated synergies. The ODP takeover would be hugely accretive to SPLS based on the modest purchase multiple and cheap debt financing, even if SPLS uses some equity consideration.

Confucius Says: When the rumored target of an activist-inspired-logical-value-creating-merger in a cheap-money-fueled-hot-M&A-market is trading at a big discount to the rumored acquirer despite having superior earnings trajectory, the target is a buy... even if it sells office supplies.Thank you Andrew Shirley, 9665 Wilshire Boulevard, Beverly Hills, CA, 90212

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