Competition
Office supply retailing has been a tough business lately. Demand for paper, writing materials, envelopes, and many other products is falling as people do more and more work on line. On-line stores are making big inroads, just as they have done in books, music, and consumer electronics in the U.S. and the U.K. mass merchants are also selling more and more office products.
It’s a fiercely competitive industry, with intense rivalry, demanding buyers, growing substitutes, and aggressive new entrants. Even the biggest competitor, Staples, can only manage a paltry 0.44% return on equity. It seems foolish to commit any more capital to an industry with so little potential for profit.
Competitive position
But the deal makes sense just because things are so grim in office supplies. It’s bad enough to be buffeted by the forces of a hyper-competitive industry, but it’s much worse to be facing such challenges from a weak competitive position.
Office Depot and OfficeMax are among the industry’s top three competitors. Office Depot has about 19% of the office supply market and OfficeMax has 16%, while Staples has 30%. Amazon, W.B. Mason, WalMart, Costco, and the other competitors have the rest.
Size matters. Companies with large market shares are generally more profitable than companies with smaller shares. They benefit from bigger economies of scale in production, marketing, distribution, and financing. They enjoy greater experience curve efficiencies, more bargaining power with customers and suppliers, and an advantage in attracting and retaining good managers.
But it’s not absolute size or ranking among the leaders that matters, it’s relative size – how much bigger or smaller a company is compared to its competitors. Staples is much bigger than either Office Depot or OfficeMax, and its size advantage is apparent in table below.
|
|
Sales1 |
Sales growth2 |
Operating margin |
Debt to capital |
| Staples |
$25,022 |
2.8% |
6.5% |
22.5% |
| Office Depot |
$11,490 |
(6.9%) |
0.8% |
29.2% |
| OfficeMax |
$7,121 |
(4.6%) |
1.7% |
74.0% |
| 1 for 2011 in millions of U.S. dollars 2 Average over last 3 years | ||||
Staples is more than twice the size of Office Depot and three times the size of OfficeMax. Of the major independent office-supply retailers, only Staples is growing and profitable. The other two are making money, but they’re losing share and are much less profitable.
And the reason they’re losing share and struggling to make money is because Staples is so much bigger. It’s able to exploit economies of scale and the other advantages of size to undercut Office Depot and OfficeMax on pricing, or outspend them on marketing, or both.
Credit risk
For Office Depot and OfficeMax, the best chance they have to survive in office supplies is to close the gap in relative share with Staples. The easiest way to do that is to merge. They can trim costs by closing overlapping stores and cutting corporate overhead, and they can start exploiting their new economies of scale in purchasing, distribution, and marketing.
There’s no guaranty of success, but the merger greatly reduces the risk of failure. When conditions are tough, it’s best to deal with them from as strong a position as possible. For Office Depot and especially for OfficeMax with its high debt-to-capital ratio, the deal is a chance to reduce credit risk and raise shareholder value. Without it, both firms face an even more dangerous future.
Is this industry going the way of consumer electronics or book selling, where even some of the largest have gone under? Or shifting to a different model like music and movies? I don’t think it is simply WBMason and Aamzon that are the problem.
Is 2+2 = 5 in this case or is it more like 3?…Even with synergies, can the combined entities match Staples operating margin of 6.5%? And how about relative financial flexibility? Staples may still have the upper hand on both counts to continue to put downward pressure on operating margins….
My question: Is this just a short run answer to what could be a fundamentally long-term structural change within the industry and if so, what lessons can be gleaned from other dying/struggling industries like newspapers and bookstores that could be applied to the DepotMax story?