November 5 marked the one year anniversary of the merger between Office Depot and OfficeMax.  Following this milestone and the company’s quarterly earnings report on November 4, both Office Depot insiders and industry watchers have expressed a surprising amount of optimism despite Office Depot’s challenges.

There are many reasons to view the merger of Office Depot and OfficeMax as a smart defensive maneuver, enabling the combined chain to more effectively compete with brick-and-mortar and online rivals. Office Depot has laid out an aggressive strategy to expand margins and grow its business, and has so far executed on cost cutting plans to the cheers of the market.

While the first 12 months as a merged company has provided an endless number of clear opportunities for progress and to tout early successes, the coming years will prove much more difficult. Facing countless competitive and secular headwinds, the retailer has to improve its core business execution, expand sales beyond its traditional customer base and sales channels, and reengineer its value proposition. One year into its merger, Office Depot’s recent honeymoon phase has nearly ended and pressure will only grow on its core business. As a larger and leaner company Office Depot is managing to survive at the moment, but if it underperforms in any of its strategic goals its already weak position in the market will only get worse.

Huge Successes and Fist Bumps

One-year into its merger, and despite a very long list of looming threats to its business, Office Depot’s CEO recently went out on a limb to describe its union with OfficeMax as a “huge success.” While this statement may be a bit premature, the company has good reason to be optimistic. Synergies in a merger of this size can generate a quick improvement in profitability, which in turn provides more resources to make strategic investments and can produce an appreciation of its market value. Meanwhile the company’s larger combined scale is very much a competitive improvement in a consolidating market.

Since it merged with OfficeMax in November 2013, Office Depot has made cost reductions a cornerstone of its near term strategy. This strategy has taken shape in the form of 400+ store closures through 2016, a plan to reduce store footprints, a focus on eliminating supply chain redundancies, divesting business abroad, trimming expenses such as advertising, and aligning its in-store and online operations, among other initiatives.

So, has this strategy worked? Is the company as successful as it believes? Wall Street is certainly bullish on Office Depot’s new direction. The company’s shares have been on a tear, appreciating more than 300% since an August 2012 low. Expectations for Office Depot were set so low, pricing the chain at one of the lowest multiples among its peers, that any bit of positive news, however expected or forward looking, now seems to garner industry-wide praise (often from value investors) and likely a few fist bumps at Boca Raton HQ.  Just last week, Office Depot announced that its adjusted operating income in Q3 more than doubled to $126 million on planned cost reductions. But sales also dropped once again, this time down 4% as foot traffic continued a steady decline, and (logically!) Office Depot shares have since jumped about 25%.

Back to Reality

Having clocked one year since its merger became official, Office Depot’s grace period with its investors, customers, and employees is nearing an end. Despite a number of wins in recent months –increasingly optimistic cost savings forecasts, healthy margin expansion, restructurings and divestitures in the U.S. and abroad – there is no shortage of challenges facing Office Depot today. Many of its core products are in secular decline, customer purchasing habits are rapidly changing, and the chain’s competitors all have at least a few years head start in reinventing their own businesses.

As Office Depot steps forward into its second year as a combined company, the chain needs to move beyond its focus on business synergies and address the long list of difficult decisions that will shape how the company evolves to meet changes in the market. The summary below outlines some of the most urgent problems facing Office Depot in the months and years ahead:

Future Direction Uncertain – Office Depot continues to shy away from disclosing the details of its long-term growth strategy, a major portion of which is its “Unique Selling Proposition” or USP. Office Depot has provided almost no clarity into what this USP will look like, even though it’s the primary driver of the chain’s future differentiation in the office supply industry and will dictate future target segments. The USP will likely bring massive change to Office Depot, as it will determine who the company will target, through what channels, with what products, and at what price points. USP rollout isn’t planned to begin until late-2015 and into 2016, which is an eternity in the retail channel and likely too long for employees and customers to wait without more transparency into what the USP really is. Office Depot needs to communicate its USP as soon as possible and demonstrate that is can evolve beyond its worn-out office supply business model.

Lack of Innovation Engine – Can two underperforming office supply chains really combine to make one that is more competitive and innovative? The two merged companies’ underlying business models are nearly identical and Office Depot’s top leadership appears to have little experience in ecommerce or business services, which are two major components of Office Depot’s growth strategy. As it looks to dramatically reshape its business model, Office Depot needs to enlist the aid of outside experts that can help it navigate the strategic and tactical development of its ecommerce platform and services delivery.

Lagging Behind Competitors – If Office Depot’s strategy sounds familiar, it’s because a good portion of it is straight out of rival Staples’ playbook: store reductions, smaller stores, a redesigned in-store concept, online assortment growth, improved online storefront, expansion into adjacent product and service segments, omnichannel go-to-market, etc., etc. Facing unprecedented changes in the market, many retailers have been developing these initiatives for at least a few years, and in the case of Staples the chain has already executed many of these ambitious goals. While these are smart strategic goals for Office Depot too, the chain is at least a few years behind its brick and mortar competitors, underscoring the urgency needed to begin executing change. Any further delays will hurt the chain’s ability to maintain share and develop competencies in services and new product categories where it does not currently have a presence.

Slow Store Alignment – Here at gap intelligence, we pride ourselves on our comprehensive knowledge of the market, the players, and the 4Ps of marketing – what we like to call the forest, the trees, and the leaves. Understanding each element is crucial to providing our clients with timely and accurate market intelligence. A closer look at the leaves of this merger reveals that there’s still work to be done.

Office Depot’s latest earnings report states that the chain has already aligned its assortments, its SKU systems, its rewards programs, its in-store execution, and so on. Now, compare the assortment of an Office Depot to an OfficeMax (differences still exist), try to use an OfficeMax gift card at Office Depot (you can’t as of late-Oct.), or ask a store associate about how the merger will affect you as a customer (they typically don’t know). Despite the chain’s assurances, many tactical elements of the merger have not progressed as smoothly as promised and need to be addressed before it affects already dwindling store traffic and the confidence of the brands that sell there. If Office Depot cannot get the blocking and tackling of the office supply business correct then surely more ambitious goals are likely to fail – the chain must execute on store alignment immediately.

Declining Foot Traffic and Product ASPs – Office Depot shares a common problem with many other retailers: less customers are visiting its retail locations each quarter. And while Office Depot reported flat purchases per customer in Q3, its ability to maintain average order values in the future is in question. Like rival Staples, Office Depot is very exposed to product categories that are in secular decline, such as printers, toner/ink, PCs, and other office supplies. Previously important categories such as digital cameras have all but disappeared from shelves and likely have a very diminished impact on the chain’s sales.

The chart above paints a clear picture of a major problem in Office Depot’s current product mix. Average selling prices at Office Depot continue to decline across most hardware categories tracked by gap intelligence. Coupled with declining foot traffic, Office Depot will be hard pressed to generate retail sales growth with its current assortment. Investing in its online presence (in addition to B2B direct) is a natural route to pursue growth, but that too has its own challenges that include lower margins and a hostile competitive environment where customers have a low barrier to switching resellers. Differentiating itself online and generating profitable growth is surely one of the most challenging obstacles facing Office Depot today, an obstacle that is only compounded by the retailer’s late entry.

Time to Execute!

Again, the near term opportunity to execute on merger synergies is good reason for Office Depot to be optimistic. The combined company is stronger together and the market has validated this with a strong increase in share price and patience in the rollout of its long term strategy. But, streamlining operations and improving profitability is just the first piece of a much more uncertain strategy that will play out through 2017 and beyond.

The channel is experiencing change at an unprecedented rate and Office Depot’s competitors are becoming larger, more diversified, and more responsive to customer needs every day. For Office Depot, time is of the essence. The chain will benefit itself, its customers, and its vendors if its moves sooner rather than later to execute on its growth strategy.