Rogue Missives Tuesday, April 15, 1997

The Federal Trade Commission (FTC) demonstrated Friday a newfound resolve to work against the grain of the merger mania that has gripped corporate America in the last two years. The commission blocked a proposed merger between STAPLES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SPLS)") else Response.Write("(Nasdaq: SPLS)") end if %> and OFFICE DEPOT <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ODP)") else Response.Write("(NYSE: ODP)") end if %>, the two biggest companies in the office-supply business. The implications of the case could reach far beyond the price of paper for your laser printer.

The FTC had been scrutinizing the case for weeks before it handed down its 4-1 decision. That in itself was somewhat unusual. Although the commission blocked a proposed merger between RITE-AID <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RAD)") else Response.Write("(NYSE: RAD)") end if %> and REVCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RXR)") else Response.Write("(NYSE: RXR)") end if %> a year ago on the grounds that it would raise prices for health-care organizations, the most ballyhooed unions of the past two years -- TIME WARNER <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TWX)") else Response.Write("(NYSE: TWX)") end if %> and TURNER BROADCASTING, BOEING <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BA)") else Response.Write("(NYSE: BA)") end if %> and MCDONNELL DOUGLAS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MD)") else Response.Write("(NYSE: MD)") end if %> -- seem never to have been in real peril of being halted. The commission's willingness to interrogate the specifics of this deal thus might have been taken as a sign that something was different.

Nonetheless, until the decision was actually handed down, the management of both companies continued to insist that all the signals they were getting from the FTC were green. Indeed, Staples had agreed to a requirement by the staff of the FTC that it sell 63 stores to OFFICE MAX <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OMX)") else Response.Write("(NYSE: OMX)") end if %>, the third-largest player in the market, before the deal could be approved. And Staples CEO Thomas Sternberg told the press just two days before the deal was blocked that he expected no problems from the commission. Investors, meanwhile, were similarly optimistic. The momentum players that normally feast on merger talk piled in, particularly into Office Depot stock, sending the company's shares up to $20.

In retrospect, it seems clear that Sternberg and others were attempting to pressure the commission into accepting the deal by presenting it as a fait accompli. Talking about the deal as if it were beyond scrutiny, and as if -- as Sternberg suggested -- the FTC's staff had given him assurances that it would be approved might have made it harder for the members of the commission to block it. But it also appears that the FTC's decision reflected two things: an insistence on differentiating between the mergers of large domestic competitors and those of international players, and a growing unwillingness to accept quick-fix solutions to mergers whose initial conditions are deeply flawed.

The fact that antitrust law even exists may seem somewhat curious in an age when the decisions of the free market are taken as necessarily socially beneficial. Antitrust legislation highlights a paradox at the center of free-market capitalism as practiced in the United States, which is that it is a system built on the premise that competition brings about efficiency which nonetheless ends up encouraging the development of monopolistic and oligopolistic situations. One of the arguments that Staples and Office Depot used in defense of the merger was that as one company, they would be able "to take advantage of enormous cost reductions and efficiencies in buying, distribution, operations, and marketing," which in turn would mean significant savings for customers. But in a situation in which efficiencies of scale were surely already in operation, it was decidedly unclear whether the cost benefits of the merger would offset the lack of price pressure that would result from an elimination of one of the industry's three major players.

In a sense, the FTC's decision is straight in line with the classic rationale for antitrust law, which is the protection of consumers. At a time when MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> controls 90% of the market for computer operating systems and yet sells those systems for less than $100, it may seem as if monopolistic pricing is a thing of the past. But it would be a mistake to somehow separate the tremendous price reductions in, for example, the office supply market from the reality of price competition between Staples, Office Depot, and Office Max. If one really believes that competition makes corporations leaner, more efficient, and more anxious to please consumers, it seems difficult to understand how a merger would help consumers.

Some economists have suggested that enhanced antitrust scrutiny by the FTC is a bad thing in general, and that a more activist FTC would be a bad thing for American business. Fortune, for instance, came out strongly in favor of the merger with an article titled, improbably enough, "Why the FTC Needs to Chill." It quoted conservative economist Don Boudreaux of the Competitive Enterprise Institute saying that "any decision that prevents American companies from becoming more efficient will be more quickly revealed because of increased foreign competition."

But Boudreaux's statement is curious in two ways. In the first place, if there was going to be increased foreign competition, one would imagine that corporations would make the changes that needed to be made even if they didn't merge. More importantly, though, there is not going to be any increased foreign competition in the office-supply market. The new Staples/Office Depot company was not going to be going up against the superstore version of Airbus or Bertelsmann. The case dealt not with multinational corporations looking to expand into global markets, but with domestic consumer companies looking to have one giant store in the local strip mall instead of two.

Staples and Office Depot insisted that the merger would not mean higher prices for consumers. But there were two interesting bits of anecdotal information offered up during the case that suggested the opposite. The first was a study done by Ralph Nader's Consumer Project on Technology of the price of fax paper at 88 superstores across the country. In those cities where there was both a Staples and an Office Depot, the price of the paper was significantly lower. In the second case, William Baer, chief of price competition at the FTC, displayed two Office Depot color ads from Florida newspapers. The first ad was from the Orlando Sentinel, the second from the Leesburg Daily Commercial. Leesburg is just forty miles away from Orlando, but five of the six items featured in both ads were dramatically more expensive in Leesburg. There were, unsurprisingly, three superstores in Orlando and just one in Leesburg.

Of course, one might say that all this means is that Office Max should be building a store in Leesburg. Or one might say that it means that the people of Leesburg should be buying their office supplies at K-Mart instead of Office Depot. While the superstores are by far the most visible players in the office-supply market, after all, they do not dominate it. Together, Staples and Office Depot control somewhere between 6% and 18% of the market, depending entirely on how you define what the market is. That seems to leave a lot of room for price competition. Yet, a number of studies have suggested that, in fact, superstores play a disproportionately important role in setting prices for a region. Consumers are not, after all, the perfectly informed, perfectly rational beings of neoclassical economic theory. And the empirical reality seems to be that cheaper prices at K-Mart and Wal-Mart, the only kinds of stores that can reasonably compete with a Staples in terms of price, cannot drive down prices at the local Staples. Lower prices at Office Depot, on the other hand, can.

Indeed, one of the striking things about the FTC's decision was how firmly rooted it seemed in concrete results rather than any broader theoretical attitude toward the virtues or vices of mergers. And the best example of this was not Baer's exhibition of the different display ads so much as it was the FTC's decision, at the urging of economist James Love of Nader's Consumer Project, to open up its Web site to comments from the public on the deal. Although the Web link was not highly publicized, the FTC received 300 emails in the first couple of days, and more than 2000 emails in less than two weeks, the majority of which voiced serious reservations about the proposed merger and a number of which included information about pricing differences between one-, two, and three-superstore cities. In that sense, one of the most important results of the Staples/Office Depot case could be a further recognition of the democratizing possibilities of the Internet. While we don't know how important the public's comments on the deal were to the commissioners' eventual decision, Love's initiative was undoubtedly one that will be replicated in the future. Certainly the Securities and Exchange Commission (SEC), for one, should think seriously about soliciting public opinion through the Net.

Staples has vowed to fight the FTC's ruling in court, with CEO Sternberg saying there was a "better than 50% chance" that the company would sue to have the merger go through. In the past, corporations have tended to back down from the costs of litigation, which in turn has encouraged the FTC to pursue its antitrust mission more vigorously, since it has had an excellent chance of succeeding when it has decided to block mergers. Nonetheless, FTC chairman Robert Pitofsky has been frank about the fact that it is often difficult for the government to win complex antitrust cases if they are taken to court. So the possibility does exist that the FTC's ruling could eventually be overturned. What seems unlikely is that the commission will settle outside of court, even if Staples and Office Depot agree to further concessions like the selling of more stores. The FTC's new attitude seems to be: if the deal is seriously flawed, it's better to kill it than to fix it.

All of which has left Office Depot shareholders, in particular, somewhat in the lurch. The stock dropped more than 25% the day the FTC announced its ruling, and while it rebounded slightly after the companies announced that they planned to litigate the decision, all those who bought the stock in anticipation of a merger-made premium are now sitting on losses. The curious thing about the deal, in the end, was that it was Staples which was acquiring Office Depot, even though it was Office Depot that was the largest company in the industry. In fundamental terms, the deal reflected Staples' more aggressive marketing and expansion strategy and its better long-term prospects, evidence of which could also be found in the fact that the company's stock was hurt hardly at all by the FTC's decision. At this point, Office Depot seems more like an option play than anything else. The long-range prospects for the deal are uncertain enough that wagering on successful litigation seems like a big gamble.

Antitrust law has come to represent a real anomaly in the American economy, since it survives as a vestige of a time when the decisions of the market were not seen as above scrutiny. But one might also see the FTC's willingness to examine the real-life consequences of any given merger as part and parcel of a pragmatism that is often defined as peculiarly American. And the broader vision toward which the commission seems to be gesturing, whereby domestic consumer companies insulated from foreign competition bear a heavier burden of proof than large multinational corporations, seems appropriate to an age in which size, in and of itself, no longer seems inherently disastrous. It's a long way from Teddy Roosevelt, but then, so too are we.

-- Jim Surowiecki (Surowiecki)

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