Michael Khouw of Action Alerts OPTIONS: A Bull Case for Office Depot

(Michael Khouw offers options analysis and insight at Action Alerts OPTIONS. You can sign up for a trial subscription here.)

NEW YORK (Real Money) -- Options are powerful tools for investors to enhance returns, reduce risk and produce income. But as powerful a tool as options are, sometimes when you're carrying a hammer, everything begins to look like a nail.

I'm going to beg your indulgence because we have an actionable trade and a lesson on when NOT to use options. If you're only interested in the trade idea, I'll tell you upfront. Buy Office Depot (ODP) . This is a longer-term trade and I have a $9.50 price target.

If you want to know why I'm bullish on ODP, and why options are not the way to play it this time, read on.

Office product warehouse stores such as Office Depot and Staples (SPLS) might not seem like a particularly exciting segment in retail. A narrow-margin business to begin with, these companies have to contend with competition from broader big-box retail stores such as Walmart  (WMT) and Target (TGT) and, increasingly, from online retailers and direct sales.

If your printer cartridge is due for replacement, you have likely seen the pop-up message asking if you wanted to order more online. Automatic notification that you are running low on supplies with click-to-order features are a convenient, expanding trend. Clearly, Amazon (AMZN) is also a material threat.

Still, even in an industry with relatively low margins (about 4%) and no or low growth, the right plan and execution can really pay off. The acquisition of OfficeMax by Office Depot is proving to be that type of game-changer. After nine quarters of no/low EBITDA (earnings before interest, taxes, depreciation and amortization), the earnings indicate they have turned the corner.

ODP actually beat estimates when it reported 3Q 2014 earnings Nov. 4. While management remained pretty conservative, it's clear that some of the synergies that justified the merger of Office Depot and OfficeMax are starting to materialize as they doubled adjusted operating income in the third quarter, improved gross margins and raised guidance by about 4% to $265 million for the full year.

On the downside, it did see a 4% sales decline. But half of that was explained by planned store closings. One year after the merger, it may only be scratching the surface of what's possible.

The Street's average estimate of $728 million in EBITDA for 2015 is a number that is playing catch-up as analysts adjust that number upward. A better estimate is about $775 million and the enterprise value is 4.7 times that, or about $3.65 billion.

The synergies that the merger created, such as closing redundant stores and distributions centers, reducing the workforce and moving to a single point-of-sale system among them, have only just begun. It has closed only one of the five distribution centers, only one OfficeMax has migrated to the Office Depot point of sale system, and although it has reduced the workforce by 300, another 1,100 are to follow. We see that the cost cutting is working, and 80% of it has yet to be realized.

Even more interesting, compare Office Depot's valuation to that of Staples. Staples current enterprise value is about $9.4 billion, or about 6.6 times fiscal 2015 EBITDA estimates of about $1.42 billion. So we have two companies in the same business, selling largely the same products to the same demographic, and yet one that is seeing significant improvement in operating results is trading at a 4.7x multiple to EBITDA, while the other, that is not seeing the same improvements, is trading at a 6.6x multiple, or about 40% more. Despite the sharp rally we've seen in ODP shares lately, it still appears to be quite inexpensive compared with its closest peer.

As good as all that is, there is one potential speculative catalyst that could really propel the stock: an acquisition by Staples. If there were synergies merging with the much smaller OfficeMax, presumably they would be much greater for the larger Staples to acquire Office Depot.

Naysayers have suggested that this would leave only one major office supply store and that might raise antitrust concerns. But with online retail and other big-box retailers, we see that even the combined entity would not control the market for most of the products they sell.

The biggest suppliers for these stores include Hewlett-Packard (HPQ) (which is looking increasingly to direct sales), Microsoft (MSFT) , Acer, International Paper  (IP) , 3M  (MMM) and Newell Rubbermaid (NWL) . In no case would the combined entity have more than 10% of the sales of a major supplier. The economic benefits to the combined companies would be tremendous. Some estimates put the number as high as $1.4 billion per year.

Assuming such a merger took place, and Office Depot got credit for half of the incremental cost savings, the company could potentially double pre-tax earnings. We could be looking at $1.5 billion in EBITDA in that case, hypothetically.

So, let's sum up the bull case for Office Depot.

  • Operating results are improving materially as the company begins to realize the synergies of the OfficeMax acquisition.
  • The company is inexpensive relative to the market and to its closest peer, Staples.
  • The company is an appealing takeover target for Staples, providing a speculative upside catalyst.
  • If the company simply traded up to Staples multiple, it has about 40% upside (price target $9.50).
  • Astonishingly, even well above $14 a share, the deal would ultimately be significantly accretive for Staples if the cost savings estimates are to be believed.

So, should we purchase the stock? Or should we look for an options structure? For this we should ask ourselves a few questions.

  • Options are excellent tools for hedging downside risks. Do we see a lot of downside risk in ODP shares? Probably not in the near future. The company beat earnings and raised guidance and isn't expensive despite the recent rally, so we probably don't need options as a hedge.
  • Options are excellent tools for making income on range-bound stocks, but in this case, we don't really believe ODP is range-bound. We have price targets that are 40% higher than the current level and if Staples were to make a bid for the company, much higher still.
  • Options can be excellent tools for leveraging bets into catalysts. Do we see a near-term catalyst and are options inexpensive enough to take advantage of it? We've identified a potential catalyst (a bid by Staples), but we don't know if or when that might occur. The other factors that are contributing to ODP's improving operating results are occurring somewhat steadily. This could take a little time. Also, looking to ODP options prices, we see that they are not particularly cheap. For example, look at the January 2016 $7 strike calls. Those are currently offered at $1.25, but for us to make money, the stock would need to rise above the $7 strike price by at least the amount of premium we would pay to buy them, or in this case above $8.25 ($7 strike plus $1.25 in premium) by January of 2016. That's more than 20% above the current stock price. So if ODP rises 20% in one year, I would merely break even buying the options. If it didn't move at all, I would lose all the $1.25 in premium that I paid, or nearly 18% of the current value of the stock. That's a pretty expensive way to get upside leverage.

I love options and what they can do to enhance returns, but in this case simply buying the stock is the way to play.

Editor's Note: This article was originally published at 3:30 p.m. EST on Real Money on Nov. 17.

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