Officemax (NYSE:OMX): Buyout Math Supports a Much Higher Value for OMX - JPM

J.P. Morgan is out with some interesting comments on Officemax (NYSE:OMX) saying the company is a takeover/LBO candidate with potential upside to $28 per share (implying ~100% upside).

- It’s cheap on trough earnings…OMX is trading at 4.3x on an EV/EBITDA basis for 2010 – the lowest in JPM coverage universe and compared to their group average of 7.2x. If one includes OMX’s ~200MM of underfunded pension liability, the multiple would still only be 4.9x. Sales and EBIT rates remain depressed, with their 2010 forecasts 21% and 60% below 2007 levels, respectively. Predicated on mid-single-digit revenue growth in its five-year plan, OMX expects to reach its historical peak EBIT of 3.8% (and OMX has since taken out ~$400MM/550 bps of costs). At this level, EBITDA has the potential to leap from $180MM in 2009 to ~$450MM.

- Ability to restructure. JPM believes that there remains an opportunity to continue to restructure the business – a key selling point to private investors. CEO Sam Duncan’s successful turnaround strategy emerged in 2005 and the current five-year plan builds upon this foundation. Certainly there are questions as to the differences in the underlying assets, but there is a significant gap between OMX and SPLS/ODP in store productivity (OMX 30% and 13% lower, respectively) and to SPLS in margin (1.9%E EBIT in 2010 vs. SPLS 7.1%E).

- Real estate provides real options. With 60% of leases expiring through 2014, OMX has an ample opportunity to 1) right-size the average store size, 2) relocate into higher traffic locations, and/or 3) close a swath of stores (JPM believes that ~10-15% may not be four-wall profitable).

- Multiple exit strategies. JPM sees three potential exit strategies on the back end with a potential public offering or a full/partial sale to SPLS and/or ODP. There has always been a strong appetite for consolidation in the space going back to the FTC’s successful block of SPLS’ attempted acquisition of ODP in the late 1990s. Moreover, with OMX well below its potential earnings, a recovery in sales and margins takes the pressure off the exit multiple. The current sub-5x 2010 valuation compares to historical mid-cycle levels closer to 7x.

- The silly math. If JPM were to assume, let’s say, a 20-25% premium to the current market value, the potential IRRs would be in the 70% to 90% range. While they believe this would likely be moot considering the Board would be unwilling to consider an offer that does not bake in the potential for an economic recovery, it certainly provides a compelling argument for PE investors to look at OMX.

- 20-25% IRR equates to a $28 takeout. If they use the “rule of thumb” private equity return threshold of 20-25%, under the assumption of a sales acceleration from flat in 2010 to a 3% average growth from 2011-2015 with a 20% average incremental margin, OMX could be bought for $28 (roughly double current levels).

- SPLS and ODP could take a fresh look. If OMX were to begin to garner private interest, SPLS and ODP could be compelled to take a fresh look as well. The synergies are potentially dramatic as OMX’s domestic supply chain costs could essentially be eliminated (perhaps 5-7% of sales), plus there could be overhead reductions of 1-2% and buying synergies of up to 1%.

- Would OMX sell? Among the big issues, this is one of the key questions. Industry players such as ODP CEO Steve Odland have acknowledged the need for long-term consolidation given the potential synergies and fragmented nature of the industry. Indeed, JPM views this as an economies-of-scale business that grew through acquisition and now has a need to right-fit the industry store base. The blocked 1997 SPLS-ODP deal is still brought up in investment circles. It is difficult to know if any minds within OMX have changed (the company has not publicly commented on exploring a possible sale) but the challenges of the recession, uncertainty on the employment outlook, the retirement of Sam Duncan in February 2011, and the right price could be a powerful combination for either a financial or strategic transaction.

Notablecalls: With the recent GYMB deal and Ackman & Vornado going after JCP, JPM's call is going to put OMX in the spotlight today.

I would not rule out a 5-7% move here, barring a market crash.